Week 8 - Employee benefits Flashcards
Pension fund (plan)
The SEPARATE legal/accounting ENTITY (ie. independent of employer) that…
1. receives the contributions from the employer
2. makes the benefit payments to the retired employees
Why do employers recognise an obligation/liability at PV for pension plans?
Due to the TIMING GAP between contribution and payment
Defined Contribution plan
- Employer makes a FIXED/defined amount of CONTRIBUTION to the pension fund, eg. 10% of salary
- Employer guarantees only CONTRIBUTIONS, not benefits
- the EMPLOYEE is the beneficiary of the fund’s performance & employee assumes all RISK, bears losses from the fund’s performance - Easy accounting treatment
Defined Benefit plan
- Employer defines/fixes the amount of EMPLOYEES’ FUTURE BENEFITS (as a function of years of service)
- the contribution defined today is based on the amount of estimated future benefits and current status of the pension asset (uncertain, difficult to determine & done by actuaries) - EMPLOYER is the BENEFICIARY of the fund’s performance, assumes all RISK and bears losses
- COMPLEX accounting treatment
- If pension assets increase, contribution is lower (vice versa)
- By adjusting the amount, employer ensures there is enough cash
Vested employees for calculating Obligation for employees {their future benefits}
Employees entitled to receive benefits even if they quit the job today
eg. working >=10 or >=20 years
DB plan - Accounting treatment - 3 components of Pension Liability (BS effect)
1. Obligation for employees. What are the 3 main uncertainties and decisions involved?
- Who are the target employees?
- include/exclude non-vested employees? - What is the salary?
- current/future salary?
- what is the future salary of all employees? - How to measure the pension obligation?
- vested benefit obligation?
- accumulated benefit obligation?
- [best] total DBO (determined by actuaries) = benefits for vested + non-vested employees at future salaries
DB plan - Accounting treatment - 3 components of Pension Liability (BS effect)
2. Plan assets
3. Funded status
- Investments in securities (reported at fair value b/c we care about it a lot)
» Plan assets next year =
Past plan assets
+ Contributions this year (seed money for investments)
+ Actual returns (on investments)
- Benefits paid to retired employees - If DBO - Plan assets > 0, status of defined pension plan is DEFICIT. Report as Pension Liability in BS
- If DBO - Plan assets < 0, status is SURPLUS. Report as Pension Asset in BS
DB plan - Accounting treatment - 3 components of Pension Costs (IS effect)
1. Service costs (Net income)
= CURRENT service costs + PAST service costs
> > current: recognise increase in DBO for EMPLOYEE SERVICE in the current period, to ensure pension stays funded after an increase in DBO instead of underfunded
eg. more employees, inflation & higher salaries
past: change in PV of DBO for employee service for prior periods, usually from plan amendment
eg. 2% to 3% change in plan (so paid too little in the past)
DB plan - Accounting treatment - 3 components of Pension Costs (IS effect)
2. Net interest (Net income)
- INTEREST EXPENSE
= DBO * discount rate
- payment of pension benefits is deferred, so companies record the pension liability on a DISCOUNTED BASIS
- interest expense must be recognised every year to account for the time value of money - INTEREST REVENUE
= Plan assets * discount rate
- the interest/investment return on plan assets that is expected to be generated (can be different from the Actual return on plan assets)
- again have to recognise that money will increase with time value of money (economic reality)
> > Net interest expense (revenue)
= interest expense - interest revenue
*discount rate affects Net income
*if funded status is 0, no net interest expense/revenue
DB plan - Accounting treatment - 3 components of Pension Costs
3. Remeasurements (OCI, accumulated in AOCI as part of equity)
^OCI effect means that this feature of DB pension plans just benefits shareholders with higher equity; the employees are not the beneficiary
- unexpected & uncontrollable changes in fair value of plan assets/DBO
- ASSET GAINS/LOSSES
- If actual return > interest revenue, gain
- If <, loss - LIABILITY GAINS/LOSSES
- any change in actuarial assumptions that affect the DBO amount (determined by actuaries)
3 Benefits & 3 Drawbacks of Share-based compensation
SBC - supplementing salary with equity ownership; making employees SHAREHOLDERS of the firm
Benefits
1. Reduces principal-agent problems
» can avoid productivity problems now that employees’ economic incentives are aligned
» compensation is no longer capped to salary + bonus, but rather firm performance
» employees will be incentivised to generate highest profits for the firm
2. No big CASH payments needed
» no I/S expense by paying SBC
3. Increases COMPETITIVENESS in labour market
Drawbacks
1. DILUTION for current shareholders
2. Dependent on share price
3. Impact on financial statements
Link between Share-based compensation and fraud
- employees could commit fraud by gaming the numbers, selling their shares and leaving the firm
- having a VESTING PERIOD, eg. having to work 5-7 years before allowed to sell shares, reduces chances of fraud
Snapchat’s first earnings announcement after IPO (share price sank) & their Non-GAAP income
- Why is stock compensation so large? (77% of net loss and 3x revenue)
- Why take SBC expense out of the IS?
» Snapchat argued that this is more informative for shareholders
- To attract talent b/c increasingly difficult to pay market salary, as this would cause a huge cash outflow + high expense
2.
- Not a cash payment, so not related to performance now (?)
» no cash flow now means not part of operating activities, not representing economic reality
- we can argue that Transactions with shareholders, eg. dividends and Seasoned Equity Offerings are NOT PART OF INCOME {but representing economic reality}
- but we can also argue that it is VERY COMMON in the industry for firms to have SBC
» so although employees are no longer employees but made shareholders and can take SBC out of income, it is INFORMATIVE for shareholders to keep EXPENSES in the IS
IFRS 2 Share-based payment - since 2005, SBC is now an EXPENSE
Accounting issues with SBC
*Intrinsic value = difference between current price & strike price
vs Fair value = intrinsic value + time value
Issue
- transactions with SHAREHOLDERS are NOT part of income: proceeds from issuance are not revenues & dividends are not expenses
- but, SBC rewards employees for their services (expense?), which makes employees shareholders (so not an expense?)
> > the economic reality is that SBC is part of compensation. employees became shareholders b/c they exerted effort {expense}, not b/c they bought shares
Before IFRS 2, SBC was not an expense -> not useful to investors b/c SBC is a REAL COST…
1. transfer of value
» firm is giving economic value in exchange for employees’ labour
2. opportunity costs of cash
» SBC is just substituting for cash
- if all employee CALL OPTION packages are issued at the money (zero intrinsic value), no expenses recognised
- in extreme cases where all compensation is SBC, then no employee costs
^^ not useful for shareholders
