Employee Compensation
Employee compensation packages are structured to achieve various objectives, including satisfying employees’ needs for liquidity, retaining employees, and motivating employees. Common components of employee compensation are salary, bonuses, health and life insurance premiums, defined contribution and benefit pension plans, and share-based compensation. The amount of compensation and its composition are determined in labour markets, which vary significantly by the types of skills needed, geography, the stage of the business cycle, and labour laws and customs.
Salary, bonuses, and non-monetary benefits tend to vest (i.e., employee earns the right to the consideration) immediately or shortly after their grant date.
Deferred Compensation
Deferred compensation vests over time and can provide valuable retirement savings and financial upside to employees and often serve as an effective retention and stakeholder alignment tool for employers. The financial reporting for deferred compensation plans is generally more complex than that for compensation that vests immediately because of the difficulty in measurement and potential lags between employee service and cash outflows. Employees may earn compensation in the current period but receive consideration in future periods, and the amount of consideration can be based on factors such as their future salary or the employer’s stock price. Management judgment and assumptions are required.
Pensions and other postemployment benefit plans are a common type of deferred compensation. Two common types of pension plans are defined contribution pension plans and defined benefit pension plans. Under a defined-contribution plan, a company contributes an agreed-upon amount into the plan, which may be structured as a match to employees’ contributions into the plan (e.g., 50 percent of 5 percent of employees’ contribution up to a certain limit). The company contribution is the pension expense and is reported as an operating cash outflow. The only impact on assets and liabilities is a decrease in cash, although if some portion of the agreed-upon amount has not been paid by fiscal year-end, an accrued compensation liability would be recognised on the balance sheet.
Defined-Benefit Pension Plans
Under a defined-benefit pension plan, a company makes promises of future benefits to be paid to the employee during retirement.
Accounting for Defined-Benefit Plans under IFRS
Under IFRS, the change in the net pension asset or liability each period is viewed as having three general components. Two of the components of this change are recognised as pension expense on the income statement:
- (1) employees’ service costs, and
- (2) the net interest expense or income accrued on the beginning net pension asset or liability.
Accounting for Defined-Benefit Plan under US GAAP
Under US GAAP, the change in net pension asset or liability each period is viewed as having five components, some of which are recognised in profit and loss in the period incurred and some of which are recognised in other comprehensive income and amortised into profit and loss over time.
The three components recognised on the income statement in the period incurred are as follows:
- employees’ service costs for the period;
- interest expense accrued on the beginning pension obligation; and
- expected return on plan assets, which is a reduction in the amount of expense recognised.
Pension-Related Disclosures
Share-Based Compensation
Share-based compensation is intended to align employees’ interests with those of the shareholders and is another common type of deferred compensation. Unlike pension plans, share-based compensation tends to be highly concentrated among more senior-level employees such as executives as well as directors. Both IFRS and US GAAP require a company to disclose in their annual report key elements of management compensation. Regulators may require additional disclosure. The disclosures enable analysts to understand the nature and extent of compensation, including the share-based payment arrangements that existed during the reporting period.
Share-based compensation, in addition to theoretically aligning the interests of employees with shareholders, has the advantage of potentially requiring no cash outlay. However, share-based compensation is treated as an expense and thus as a reduction of earnings even when no cash changes hands. In addition to decreasing earnings through compensation expense, share-based compensation has the potential to dilute earnings per share. Share-based compensation arrangements can also be cash-settled, which can result in the accrual of a liability.
Stock Grants
A company can grant stock to employees outright, with restrictions, or contingent on performance. For an outright stock grant, compensation expense is reported on the basis of the fair value of the stock on the grant date—generally the market value at grant date. Compensation expense is allocated over the period benefited by the employee’s service, referred to as the service period. The employee service period is presumed to be the current period unless there are some specific requirements, such as three years of future service, before the employee is vested (has the right to receive the compensation).
Another type of stock award is a restricted stock grant, which requires the employee to return ownership of those shares to the company if certain conditions are not met. Common restrictions include the requirements that employees remain with the company for a specified period or that certain performance goals are met. Compensation expense for restricted stock grants is measured as the fair value (usually market value) of the shares issued at the grant date. This compensation expense is allocated over the employee’s service period.
Stock Options
The fair value of stock grants is usually the market value at the date of the grant (adjusted for dividends prior to vesting), the fair value of option grants must be estimated. Companies cannot rely on market prices of options to measure the fair value of employee stock options because features of employee stock options typically differ from traded options. The choice of valuation or option pricing model is one of the critical elements in estimating fair value. Several models are commonly used, such as the Black–Scholes option pricing model or a binomial model. Accounting standards do not prescribe a particular model. Generally, though, the valuation method should
- (1) be consistent with fair value measurement,
- (2) be based on established principles of financial economic theory, and
- (3) reflect all substantive characteristics of the award.
Accounting for Stock Options
Several important dates affect the accounting, including the grant date, the vesting date, the exercise date, and the expiration date. The grant date is the day that options are granted to employees. The service period is usually the period between the grant date and the vesting date.
The vesting date is the date that employees can first exercise the stock options. The vesting can be immediate or over a future period. If the share-based payments vest immediately (i.e., no further period of service is required), then expense is recognised on the grant date. If the share-based awards do not vest until a specified service period is completed, compensation expense is recognised and allocated over the service period. If the share-based awards are conditional upon the achievement of a performance condition or a market condition (i.e., a target share price), then compensation expense is recognised over the estimated service period. The exercise date is the date when employees exercise the options and convert them to stock. If the options go unexercised, they may expire at some predetermined future date, commonly 5 or 10 years from the grant date.
The grant date is also the date that compensation expense is measured if both the number of shares and the option price are known. If facts affecting the value of options granted depend on events after the grant date, then compensation expense is measured when those facts are known.
In sum, the key accounting requirements are as follows:
- Recognise compensation expense based on the fair value of the award. Since no cash is exchanged upon the grant, the offsetting account for the compensation expense is additional paid in capital.
- The grant date fair value is recognised as compensation expense over the vesting period.
- Upon exercise, the company increases equity by the fair value of the options on the grant date plus the cash provided by the employee upon exercise.
Other Types of Share-Based Compensation
Both stock grants and stock options allow the employee to obtain ownership in the company. Other types of share-based compensation, such as stock appreciation rights (SARs) or phantom stock, compensate an employee on the basis of changes in the value of shares without requiring the employee to hold the shares. These are referred to as cash-settled share-based compensation. With SARs, an employee’s compensation is based on increases in a company’s share price. Like other forms of share-based compensation, SARs serve to motivate employees and align their interests with shareholders.
The following are two additional advantages of SARs:
- The potential for risk aversion is limited because employees have limited downside risk and unlimited upside potential similar to employee stock options.
- Shareholder ownership is not diluted.
