2238 Financial Reporting | 2021/2022 T1

Employee Benefits

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Importance of accounting for

employee long-term benefits
• The percentages of pensioners and public pension expenditure are increasing
– In the U.S., the percentage of population over 60 is projected to be 29 in 2040, which compares
to 17% in 2000

• Pensions are becoming a large portion of companies’ liabilities due to

– aging population,
– increased probability that state pensions will not be paid,
– firms use pension plans and share base compensation as remuneration

• More and more companies use share-based compensation, which accounting can be complex

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EMPLOYEE BENEFITS

Pension schemes

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Types of Pension Schemes

• Employer makes certain contributions each year, usually as a percentage of salary
Defined • Employee usually supplements the employer´s contributions
contribution • Money is then invested and, on retirement, employee gains the pension benefits
schemes
• Such schemes have uncertain future benefits to the employee but fixed and predetermined
costs to employer

• Employees, on retirement, will receive a pension based on the length of their service and salary
• Employers must contribute to the scheme to ensure it is adequately funded to cover promised
Defined benefit
pension obligations
schemes
• Cost to employer is uncertain and risky, while benefits to employee are more certain compared
to defined contribution schemes

Note: Employer can also grant pension benefits on an ad-hoc, case-by-case basis (ex gratia arrangements)

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Accounting for defined contribution

schemes
THE RULE

• Cost of providing the pension recorded as remuneration expense in the period in which it is due/service occurs
• Assets or liabilities can be created if the company has not paid the amount due for the period

ILLUSTRATION JOURNAL ENTRIES DURING YEAR

• Andrew plc has payroll cost of 2.7 million pounds for Dr Pension expense 120,000 (12 months*10,000)
the year ended June 30 Cr Cash 120,000
• The company pays contributions to defined contribution
JOURNAL ENTRIES AT YEAR END
pension scheme equal to 5% of salary each year, but
for convenience actually pays 10,000 pounds per Annual pension expense = 135.000 (5%*2,700,000)
month in cash, and makes up for the shortfall in the Dr Pension expense 15,000
July contribution
Cr Accrued pension liability 15,000 (135,000 – 120,000)

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Accounting for defined benefit schemes

DEFINITIONS

• Defined benefit asset or liability is equal to the present value of defined benefit obligation less the fair value of plan
assets out of which the obligation will be settled. If negative = asset, if positive = liability

• Defined benefit obligation calculated using the “projected unit credit method”
• Obligation is built up each year for an extra year of service and a reversal for discounting.
• Discounting of obligation is done using investment-grade corporate bonds with similar currency and duration.

• Fair value of plan assets is the market value of the assets of the plan

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Accounting for defined benefit schemes

CHALLENGES IN DEFINED BENEFIT SCHEMES

• How can the future obligation be estimated?

• Can we assess how many years will employees work?

• What will be employees wage pattern?

• When should the obligation be recognized?

• How can we transform the future obligation into present value terms?

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Accounting for defined benefit schemes

ESTIMATION OF DEFINED BENEFIT OBLIGATION

• Steps 1: Estimate salaries over which lump sum benefit will be estimated

• Step 2: Estimate benefit accrued for each additional year of service

• Step 3: Estimate present value of benefit accrued for each additional year of service (i.e., Current Service Cost)

• Step 4: Estimate compounding for accrued benefit (i.e., Interest)

• Step 5: Estimate Closing Benefit Obligation = Opening Benefit Obligation + Current Service Cost + Interest

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Accounting for defined benefit schemes

ESTIMATION OF DEFINED BENEFIT OBLIGATION //
ILLUSTRATION
• Lump sum benefit is payable on termination of
service and equal to 1% of final salary for
each year of service
• Salary in year 1 is $10,000
• Salary increases 7% (compounded) each year
• Discount rate used is 10%
• Employee is expected to leave at year 5

Final lump sum benefit = 5*[1%*10,000*(1.07)4] = 655

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Recognition Rule
Statement
Financial • Defined benefit asset or liability (present value of defined benefit obligation less the fair value of plan
Position assets)

• Current service cost: cost of providing pension benefits to employees for the current period
Income • Interest cost/revenue: unwinding of the effect of discounting on the pension liability/asset
Statement • Past service cost: costs that arise as a result of improving the scheme or when a business unit
introduces a plan, i.e., extra liability in respect to previous year’s service by employees

Actuarial gains and losses:

Other • Gains and losses that arise either from changes in the present value of defined benefit obligation or
Comprehensive changes in the market value of the plan assets
Income • Experience adjustments, which are differences between actuarial assumptions and actual experience
• E.g.: unexpectedly high or low rates of employee turnover, changes in life expectancy etc.

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Illustration for defined benefit schemes

• On 1 January 20X1
Additional Data:
– PV of defined benefit obligation is 1,000
– MV of defined benefit plan assets is 1,000

• Assume that in 20X2 the plan was amended to provide

additional benefits starting from 1 January 20X2
– PV of additional benefits in 20X2 (year end) was 50

• Show the impact of the pension scheme on the

statement of financial position and statement of
comprehensive income for 20X1, 20X2, and 20X3.

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Illustration for defined benefit schemes

Present Value of Obligation

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Illustration for defined benefit schemes

Fair Value of Plan Assets

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EMPLOYEE BENEFITS

Share-based schemes

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Share-based schemes
• Equity compensation plans
– Shares or share options issued as part of employee compensation

• Types of share-based schemes

– Equity-settled share-based transactions: firm issues shares in exchange for goods or services
– Cash-settled share-based transactions: firm pays in cash for goods or services it received but the cash
payment is dependent on the price of the entity’s shares
– Discretionary scheme: either the entity or the supplier of goods or services can choose between equity or
cash settlement

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Share-based schemes
Advantages Disadvantages

• Alignment of interests between employer • Excessive risk taking (stock options)

and employee • Lack of transparency regarding
• Employer preserves cash (equity-settled payments
only) • Potentially excessive payments
• Potentially favorable tax treatment for
employee

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Accounting for share-based schemes

(IFRS2)
 Entities should recognize the goods or services acquired in a share-based payment transaction over the period the
goods or services are received/rendered.

 The entity should recognize an increase in equity if the share-based payment is equity-settled and a liability if the
payment is a cash-settled payment transaction.

 The share-based payment should be measured at fair value, on grant date.

 Market based performance conditions are included in the grant-date fair value measurement. Adjustments will not be
made through the life of the options.

 Non-market based performance features will be included in the measurement of the share-based payment transaction,
and are adjusted each period until such time as the equity instrument vests.

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Case of stock options

• Establish the fair value of the option at the grant date.

• Charge to comprehensive income over the vesting period.

• Recognize increase in equity over the vesting period.

• The vesting period is the period in which the employees are required to satisfy conditions that allow
them to exercise their options.

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The case of employee options

ILLUSTRATION 1 What is the fair value of the option at grant date?

Employees were granted options to acquire 100,000 shares at • $150,000 (= 100,000 options x $1.5 per option)
$20 per share.
What is the vesting period? What is the charge to income
The market value of an option was $1.50 per share. statement at year end?

Prepare journal entries at grant date. • Vested immediately

What are the journal entries?

• Dr Staff costs $150,000

• Cr Additional paid in capital, stock options (Equity) $150,000

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The case of employee options

ILLUSTRATION 2 What is the fair value of the option at grant date?

A Ltd issued share options to staff on 1 January 20X0 • 1,000 employees × 500 options × £3 × (0.95 × 0.95 × 0.95) =
£1,286
Number of employees 1,000
Number of options to each staff member 500
What is the vesting period? What is the charge to income
Options’ vesting period 3 years
statement at year end?
FV of each option at grant date £3
Expected employee turnover (per annum) 5% • £1,286 / 3 = £429

Prepare journal entries for the period ended 31 December 20X0

What are the journal entries for Dec 20X0?

• Dr Staff costs £429

• Cr Additional paid in capital, stock options (Equity) £429

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The case of employee options

ILLUSTRATION 2 B) The amended total value of the option award at fair value at
the grant date is:

• 1,000 employees × 500 options × £3 × (0.92 × 0.92 × 0.92) =

In Dec 20X1 the company revised turnover for the 3-year period to
£1,168
8% per annum.
• The correct staff cost per year is then £1,168 / 3 = £389
• On 31/Dec/20X1 acc. amount has to be £1,168 x 2/3 = £779
How should this information be incorporated? What adjustments are
needed?
In Dec 20X1 also adjust for wrongfully recognition in
previous periods.

• Dr Staff cost £350 (= 779 – 429)

• Cr Additional paid in capital, stock options (Equity) £350

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The case of employee options

ILLUSTRATION 2 C)
At the end of 20X2 they realize that the actual employee turnover had
averaged 6% per annum for the three-year vesting period.
How should this information be incorporated? What adjustments are
needed?
The amended total value of the option award at fair value
at the grant date is:
• 1,000 employees × 500 options × £3 × (0.94 × 0.94 × 0.94)
= £1,246
• The correct staff cost per year is then £415
In Dec 20X2 also adjust for wrongfully recognition in
previous periods.

• Dr Staff costs £467 (= 1,246 – 779)

• Cr Additional paid in capital, stock options (Equity) £467

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The case of employee options

Dec 2005
Dr Employee benefits expense £1,667 (=100*10*5/3)
Cr Additional paid in capital, stock options £1,667
ILLUSTRATION 3
Dec 2006
In Jan 2005, company grants 100 options to each of its 10 key Dr Employee benefits expense £1,000 (=100*8*5*2/3-1,667)
executives. The options have (i) 3 years vesting period, (ii) 10
Cr Additional paid in capital, stock options £1,000
years contractual life, (iii) the option exercise price is 3 euros,
and (iv) the fair value of each option is 5 euros.
Dec 2007
At grant date, the company believes that none of its executives Dr Employee benefits expense £1,333 (=100*8*5/3)
will leave the company during the vesting period. Nevertheless, Cr Additional paid in capital, stock options £1,333
in 2006, two employees left the company unexpectedly.
Dec 2008
In 2008, 8 employees exercised their options, and the company Dr Cash £2,400 (=100*8*3)
issued shares with 1 euro par value to its employees.** Dr Additional paid-in capital, stock options £4,000* (=1,667+1,000+1,333)
Cr Equity share capital £800 (=100*8*1)
** Par value is the per share amount written on stock certificates. Cr Equity share premium £5,600 (2,400+4,000-800)
It is presented on the balance sheet as share capital.

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