Employee Compensation: Post-Employment and Share-Based

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2024 Curriculum CFA Program Level II Financial Reporting and Analysis

Two ways to enjoy this Refresher Reading

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Introduction

This reading covers two complex aspects of employee compensation: post-employment (retirement) benefits and share-based compensation. Retirement benefits include pensions and other post-employment benefits, such as health insurance. Examples of share-based compensation are stock options and stock grants.

A common issue underlying both of these aspects of employee compensation is the difficulty in measuring the value of the compensation. One factor contributing to the difficulty is that employees earn the benefits in the periods that they provide service but typically receive the benefits in future periods, so measurement requires a significant number of assumptions.

This reading provides an overview of the methods companies use to estimate and measure the benefits they provide to their employees and how this information is reported in financial statements. There has been some convergence between International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP) in the measurement and accounting treatment for pensions, other post-employment benefits, and share-based compensation, but some differences remain. Although this reading focuses on IFRS as the basis for discussion, instances where US GAAP significantly differ are discussed.

The reading is organized as follows: Section 2 addresses pensions and other post-employment benefits, and Section 3 covers share-based compensation with a primary focus on the accounting for and analysis of stock options. A summary and practice problems conclude the reading.

Learning Outcomes

The member should be able to:

1. describe the types of post-employment benefit plans and implications for financial reports;
2. explain and calculate measures of a defined benefit pension obligation (i.e., present value of the defined benefit obligation and projected benefit obligation) and net pension liability (or asset);
3. describe the components of a company’s defined benefit pension costs;
4. explain and calculate the effect of a defined benefit plan’s assumptions on the defined benefit obligation and periodic pension cost;
5. explain and calculate how adjusting for items of pension and other post-employment benefits that are reported in the notes to the financial statements affects financial statements and ratios;
6. interpret pension plan note disclosures including cash flow related information;
7. explain issues associated with accounting for share-based compensation;
8. explain how accounting for stock grants and stock options affects financial statements, and the importance of companies’ assumptions in valuing these grants and options.

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.