Employee Compensation and Post-Employment Benefits (CFA Level 2): Covers Overview of Employee Compensation and Share-Based Compensation with key formulas and practical examples. Includes exam-style practice questions with explanations.
Employee compensation comes in many forms. Some of us have a straightforward base salary. Others might enjoy hefty bonuses, stock options, commissions, or maybe even a fancy onsite gym membership. In Canada, for instance, health insurance might be part of a government-backed arrangement supplemented by the employer. In the U.S., healthcare compensation is typically more employer-driven. You might see variations in how social security or pension deductions are handled, but the overarching principle is that total compensation encompasses both direct (e.g., salary, bonuses) and indirect benefits (e.g., pensions, health insurance, share-based plans).
Common types of compensation include:
While the basic categorization is consistent across regions, the funding mechanisms, disclosure requirements, and tax treatments can differ (especially when crossing the U.S.-Canada border).
Share-based compensation is popular among companies that want to align employee incentives with shareholder interests. After all, employees granted stock options or restricted shares might be more motivated to drive the share price up. However, from an accounting perspective, the devil is in the details—particularly concerning how to measure and recognize these expenses under IFRS (IFRS 2) and US GAAP (ASC 718).
Before we dive into the specifics, let’s visualize a simplified flow of how share-based compensation eventually hits the financial statements:
flowchart LR
A["Share-Based <br/>Compensation Expense"] --> B["Income Statement <br/>(Net Income Impact)"]
B --> C["EPS Calculation <br/>(Basic & Diluted)"]
When the company grants share-based awards, the fair value is calculated at the grant date and recognized as compensation expense over the vesting period. This reduces net income and can also affect basic and diluted EPS due to the potential increase in the number of outstanding shares.
Stock options give employees the right—but not the obligation—to buy shares at a predetermined price (the exercise price) after a certain vesting period. Under both IFRS 2 and US GAAP (ASC 718), the fair value of the option is typically computed using options pricing models like the Black-Scholes or a binomial/lattice model. Key inputs include:
The recognized expense is spread over the vesting period. Once the option vests, and if the employee decides to exercise, the employer might issue new shares (diluting existing shareholders) or deliver shares previously repurchased.
To put this into a simple numeric example:
Annual compensation expense = (10,000 × $5) / 2 = $25,000 per year.
This $25,000 expense is recognized in the income statement, reducing net income by that amount annually, and it will also affect diluted EPS, since the options may eventually boost the total share count.
Restricted shares (and performance shares) often come with conditions (e.g., remaining employed for a certain length of time, meeting financial targets). Under IFRS 2 and ASC 718:
If performance conditions exist, the accounting can get trickier: you might need to revisit your assumptions each period, adjusting for the probability of those performance conditions being met. Once again, these awards can cause dilution if new shares are issued after vesting.
As a financial analyst, it’s not just about historical numbers. You also need to forecast these expenses. The future compensation expense corresponds to grants you expect the company to issue in upcoming periods (perhaps the company has a policy of granting stock options each year). You might average out historical equity grants, factor in new plans, or consider changes in share price volatility.
When it comes to forecasting diluted earnings per share (EPS), you must incorporate the likely exercise or vesting of shares. This forecast can be more art than science because it involves assumptions about how employees behave (do they tend to exercise early?), along with volatility and share price growth.
From a Canadian perspective, IFRS 2 is the standard. The fundamental measurement approach mirrors that of US GAAP, though some disclosure specifics differ.
Pensions and retiree health benefits often represent major long-term obligations. If you’ve ever tried to read the pension section of a large corporation’s financial statements, you might have scratched your head over the wide range of assumptions that feed into the final liability number. Under IFRS, the relevant standard is IAS 19 (Employee Benefits). Under US GAAP, it’s ASC 715 (Compensation—Retirement Benefits).
Let’s illustrate the basic flow of pension payments in a defined benefit plan:
flowchart LR
A["Employer <br/>Contributions"] --> B["Plan Assets"]
B --> C["Defined Benefit <br/>Payments to Retirees"]
C --> D["Retirees' <br/>Retirement Income"]
The difference between the plan assets (B) and the plan obligations (the present value of those future benefits) can create a surplus or a deficit on the sponsor’s (employer’s) balance sheet.
A DB plan promises a specific retirement income (e.g., 2% of final salary for each year of service). The employer bears the investment and actuarial risk. The cost recognized in the employer’s accounts includes:
Remeasurements arise from changes in actuarial assumptions—like discount rates, salary growth, mortality rates—and from differences between actual and expected returns on plan assets. Under IAS 19, these remeasurements go to OCI and remain there (not recycled to profit or loss). Under US GAAP, it’s similar in many respects nowadays, although you might still see references to the older corridor approach in some companies’ statements or certain transitional provisions.
In a DC plan, the employer contributes a set amount. Employees typically invest these funds in various asset classes. The big difference? There’s no big liability on the employer’s books beyond making the contributions. So, from an analysis perspective, if you see a company with predominantly DC plans, you don’t usually worry too much about huge pension liabilities creating potential solvency or liquidity concerns.
Actuarial assumptions can significantly change the size of pension obligations. For instance, a 1% change in the discount rate might produce tens of millions of dollars in difference for a large plan. Because these assumptions are forward-looking estimates, IFRS and US GAAP require extensive disclosures so that analysts can gauge the sensitivity of the plan obligation to changes in assumptions.
If you’re analyzing a Canadian public sector employer, you’ll likely notice DB plans are still fairly common. Disclosures might reveal large deficits, requiring higher future contributions. That means potentially lower free cash flow for the entity. Under IFRS, you’ll see these obligations recognized on the balance sheet, net of plan assets. Also watch out for changes in discount rates prescribed by regional regulatory guidelines.
Big pension deficits may inflate a company’s leverage ratio if the net pension liability is included as part of total debt or total liabilities. Additionally, certain equity analysts will adjust their valuation metrics by considering net pension liabilities as “debt-like.” This can shift everything from enterprise value (EV) calculations to coverage ratios.
At this point, you might be thinking: “So how do I handle a question that shows me all these different assumptions and partial data sets?” This is exactly the kind of scenario you’ll face in a real CFA exam vignette.
Calculating Share-Based Compensation Expense:
Suppose you have a stock option grant of 5,000 options with a grant-date fair value of $4 each, vesting over 4 years. The annual expense is ($4 × 5,000) ÷ 4 = $5,000. If the question changes the vesting schedule, you have to recalculate carefully.
Changing Actuarial Assumptions for a DB Plan:
If discount rates decline, the projected benefit obligation (PBO) increases, which may also increase annual service cost. The difference is recognized in the remeasurement portion, going to OCI under IFRS and typically to either OCI or the standard corridor approach (if still applied) under US GAAP.
Presentation Differences for Pension Remeasurements:
A cross-border firm might record remeasurements in OCI under IFRS, while in the U.S. segment’s statements, you see them recognized in a different line item or systematically amortized. Knowing how to interpret these differences is key to performing like-for-like comparisons.
I remember the first big pension footnote I wrestled with. It was jam-packed with references to everything from “service cost” to “unrecognized actuarial gains.” Frankly, I was lost. Eventually, I realized you just have to go line by line, carefully matching each concept to how it gets recognized (or not) in net income vs. other comprehensive income. Over time, that big footnote lost its intimidation factor, and I even started to enjoy the detective work.
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