Employee Compensation: Post-Employment and Share-Based
Refresher reading access
Introduction
Employee compensation often accounts for the majority of costs at most companies and is thus a key input for earnings forecasts and valuation. Share-based compensation and post-employment benefits are two types of compensation that present analytical and modeling difficulties, owing to their measurement complexities. Unlike salaries paid shortly after an employee performs services, share-based compensation and post-employment benefits can be paid many years in the future at a cost that is uncertain, requiring assumptions and estimates by management.
This module provides an overview of the financial reporting for share-based compensation and post-employment benefits and methods of analyzing related disclosures, as well as financial statement modeling and valuation considerations. Although we focus on International Financial Reporting Standards (IFRS) as the basis for discussion, instances where US GAAP significantly differs are also discussed.
Learning Outcomes
The candidate should be able to:
- contrast types of employee compensation;
- explain how share-based compensation affects the financial statements;
- explain how to forecast share-based compensation expense and shares outstanding in a financial statement model and their; use in valuation;
- explain how post-employment benefits affect the financial statements;
- explain financial modeling and valuation considerations for post-employment benefits.
Summary
This reading discussed two different forms of employee compensation: post-employment benefits and share-based compensation. Although different, the two are similar in that they are forms of compensation outside of the standard salary arrangements. They also involve complex valuation, accounting, and reporting issues. Although IFRS and US GAAP are converging on accounting and reporting, it is important to note that differences in a country’s social system, laws, and regulations can result in differences in a company’s pension and share-based compensation plans that may be reflected in the company’s earnings and financial reports.
Key points include the following:
- Defined contribution pension plans specify (define) only the amount of contribution to the plan; the eventual amount of the pension benefit to the employee will depend on the value of an employee’s plan assets at the time of retirement.
- Balance sheet reporting is less analytically relevant for defined contribution plans because companies make contributions to defined contribution plans as the expense arises and thus no liabilities accrue for that type of plan.
- Defined benefit pension plans specify (define) the amount of the pension benefit, often determined by a plan formula, under which the eventual amount of the benefit to the employee is a function of length of service and final salary.
- Defined benefit pension plan obligations are funded by the sponsoring company contributing assets to a pension trust, a separate legal entity. Differences exist in countries’ regulatory requirements for companies to fund defined benefit pension plan obligations.
- Both IFRS and US GAAP require companies to report on their balance sheet a pension liability or asset equal to the projected benefit obligation minus the fair value of plan assets. The amount of a pension asset that can be reported is subject to a ceiling.
- Under IFRS, the components of periodic pension cost are recognised as follows: Service cost is recognised in P&L, net interest income/expense is recognised in P&L, and remeasurements are recognised in OCI and are not amortised to future P&L.
- Under US GAAP, the components of periodic pension cost recognised in P&L include current service costs, interest expense on the pension obligation, and expected returns on plan assets (which reduces the cost). Other components of periodic pension cost—including past service costs, actuarial gains and losses, and differences between expected and actual returns on plan assets—are recognised in OCI and amortised to future P&L.
- Estimates of the future obligation under defined benefit pension plans and other post-employment benefits are sensitive to numerous assumptions, including discount rates, assumed annual compensation increases, expected return on plan assets, and assumed health care cost inflation.
- Employee compensation packages are structured to fulfill varied objectives, including satisfying employees’ needs for liquidity, retaining employees, and providing incentives to employees.
- Common components of employee compensation packages are salary, bonuses, and share-based compensation.
- Share-based compensation serves to align employees’ interests with those of the shareholders. It includes stocks and stock options.
- Share-based compensation has the advantage of requiring no current-period cash outlays.
- Share-based compensation expense is reported at fair value under IFRS and US GAAP.
- The valuation technique, or option pricing model, that a company uses is an important choice in determining fair value and is disclosed.
- Key assumptions and input into option pricing models include such items as exercise price, stock price volatility, estimated life of each award, estimated number of options that will be forfeited, dividend yield, and the risk-free rate of interest. Certain assumptions are highly subjective, such as stock price volatility or the expected life of stock options, and can greatly change the estimated fair value and thus compensation expense.
1.75 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.