Types of Employee Compensation

Compensation to employees plays a critical role in attracting, retaining, and motivating talent. For numerous firms, compensation constitutes the most substantial part of their operating expenses, thus making human capital management pivotal.

Types of Compensation

1. Short-term Benefits: These are benefits expected to be paid within a year of being earned. Examples include salaries, annual bonuses, non-monetary perks like medical care, contributions to social security, and paid leave.
2. Long-term Benefits: These are benefits expected to be paid after a year. They include long-term paid leave such as sabbaticals and long-term disability benefits.
3. Termination Benefits: This compensation is given when an employee is terminated. Examples are severance pay, continued access to non-monetary benefits like healthcare, and services like career counseling.
4. Share-based Compensation: This involves compensation using the employer’s stock. Examples are restricted stocks and stock options.
5. Post-employment Benefits: This is the compensation provided after an employee retires. Examples include pensions, lump sum payments, and retiree insurance or healthcare.

Accounting Standards for Compensation

IAS 19 Employee Benefits sets guidelines on how compensation should be accounted for in financial statements. The essential principle here is that compensation costs should be recognized at fair value during the period when the employee provides services. This often aligns with the vesting period when an employee becomes unconditionally entitled to said compensation. After vesting comes the settlement, when the compensation is finally paid.

Accounting for Short-term Benefits

For most companies, short-term benefits form the bulk of compensation costs. Their accounting is relatively direct. When compensation vests (usually when the service is rendered), a compensation expense and a related current liability are recognized. Upon settlement, cash is paid, and the liability is removed. In the statement of cash flows, cash compensation appears as an outflow under operating activities.

Some compensation, like that for manufacturing employees, might be capitalized to inventories. It is then expensed as the cost of sales when the goods are sold.

On income statements, most companies aggregate compensation expense based on the employee’s function. For instance, R&D related compensation is under “R&D Expenses”. However, termination benefits might be listed separately, such as under “Restructuring Charges”.

Share-Based Compensation

Share-based compensation, usually awarded as a bonus to highly compensated employees, aligns employee interests with shareholders and is a key retention tool. It requires no immediate cash outlay, making it particularly beneficial for younger companies seeking talent. However, it can lead to issues like limited influence over share price by employees, potential suboptimal risk-taking by managers, and loss of wealth due to share price declines. The accounting for share-based compensation includes measuring the fair value at the grant date and recognizing it as an expense over the vesting period. Any changes in the fair value after the grant date do not affect the accounting for the grant.

Though it requires no initial cash outlay, there is an implicit cash cost to share-based compensation. The shares might have been sold to investors for cash. Also, to counter dilution effects from giving shares to employees, some companies buy back their shares from the open market.

Question

Which of the following best describes the nature of short-term employee benefits.

1. Compensation primarily in the form of equity-based awards.
2. Benefits that are expected to be paid after more than 12 months.
3. Compensation is expected to be paid within 12 months including salaries and wages.

Solution

The correct answer is C:

Short-term employee benefits are those that are expected to be paid within 12 months from the time of accrual. This includes typical forms of compensation such as salaries, wages, annual bonuses, and non-monetary benefits like medical care.

A is incorrect: Equity-based awards are categorized under share-based compensation, not short-term benefits.

B is incorrect: Benefits that are expected to be paid after more than 12 months are classified as long-term benefits, not short-term benefits.

Reading 12: Employment Compensation: Post-Employment and Share-Based

LOS 12 (a) Contrast types of employee compensation