TAX NEWS - DECEMber 2009
G-20 and the principles for sound compensation – accounting implications for cash bonus arrangements
financial stability, and endorsed the standards of the Financial Stability Board (FSB).
This is the second of a two-part series that examines the principles set out in the G-20 Leaders' Statement and the Financial Stability Board's Principles for Sound Compensation Practices (refer to Box 1) and the effects of implementing those principles in cash compensation arrangements, that are in the scope of IAS 19 Employee Benefits. Part one of this series was published in our November 2009 issue of IFRS outlook, and examined the effects of the G-20 compensation principles for share-based payments that are within the scope of IFRS 2 Sharebased Payment.
Management should consider the implications for profit or loss, debt covenants, taxes and legal requirements, as well as the views of shareholders and regulators, before acting in response to the G-20 principles.
Box 1: G-20 principles for sound compensation practices
G-20 principles
- Avoid multi-year guaranteed bonuses
- Require a significant portion of variable compensation to be deferred,
tied to performance and subject to appropriate clawback
- Ensure that compensation for employees having a material impact on
the entity's risk exposure aligns with performance and risk
- Make entity's compensation structures transparent through disclosure
requirements
- Limit variable compensation as a percentage of total net revenues when
it is inconsistent with maintaining a sound capital base
- Ensure that compensation committees are able to act independently
- Review entity's compensation policies with institutional and systemic
risk in mind and, if necessary, apply corrective measures
- Modify compensation structures for entities that fail or require
extraordinary public intervention
Accounting implications
Cash bonuses
- Service vesting conditions
- Non-service conditions
- Long-term employee benefits
- Service vesting conditions
- Non-service conditions
- Service vesting conditions
- Non-service conditions
- Disclosure requirements
- Non-service conditions
- Modifications
- Modifications
Accounting implications for cash bonus arrangements
In implementing the G-20 principles, management may decide that payment of annual cash bonuses should be deferred, based upon performance conditions, and subject to clawback provisions. Such changes raise a number of potential accounting implications, some of which we explore in more detail here.
Long-term employee benefits
If management decides to defer payment of cash bonuses over extended periods, arrangements previously accounted for as short-term employee benefits may become long-term employee benefits under IAS 19. An entity is then required to use the projected unit credit method (PUCM) to measure the obligation. This requires an estimate of the total expected future obligation based upon a set of assumptions, discounting of that projected obligation, and accrual of the expense over the service period.
Service vesting conditions
When management decides to make payment of a deferred cash bonus contingent upon an employee's continued service, the service period over which a bonus is recognised will increase to include the period over which the cash payment is deferred. The principles of IAS 19 require employee benefits to be recognised as service is rendered by employees. The attribution of the expense accrual to service periods under IAS 19 follows the benefit formula, unless an employee's service in later years will lead to a materially higher level of benefit than in earlier years, in which case the bonus should be accrued on a straight-line basis over the service period giving rise to the benefit. This concept is illustrated in examples 1 and 2 below.
Example 1: Cliff-vesting service condition
If a cash bonus is granted for meeting certain performance targets in the year ended 2009, but is only paid to employees remaining at the end of 2012, the service period over which the bonus is earned and recognised extends to the end of 2012. This cliff-vesting formula, with the full award vesting entirely on the final day of 2012, would result in a materially back-ended benefit. Therefore, IAS 19 requires recognition on a discounted straight-line basis over this service period.
Example 2: Graded-vesting service condition
As in Example 1, a cash bonus is granted for meeting certain performance targets in the year ended 31 December 2009. However, the bonus vests based on continued increments of service as follows: an employee will receive 50% of the bonus if he remains employed at 1 January 2011, an incremental 25% if he remains employed at 1 January 2012, and the remining 25% of the bonus if he remains employed at 1 January 2013. In this case, each tranche of the award vests based upon a different service period. In this example, the expense accrual would follow the benefit formula for vesting, which results in a front-loaded expense.
Non-service conditions and clawback provisions
Non-service conditions, such as performance targets, impact the measurement of cash bonuses, as estimates must be made about whether the target will be achieved and what level of bonus will be earned. Recognition may also be impacted by non-service conditions since an employee will usually need to render service during a performance measurement period in order to achieve a performance target. If so, that performance measurement period must inherently be included in the service period over which the benefit expense is recognised. All service periods that result in benefit should be included in the service vesting period, as discussed above.
The incorporation of clawback provisions into the conditions of a cash bonus payment may further complicate the assumptions necessary to measure the amount of the benefit obligation. To account for a long-term employee benefit, an entity measures the projected obligation, incorporating all related assumptions affecting the benefit to be paid. This includes, among others, assumptions about the probability of meeting initial performance targets, attrition rates over the deferral period, and the likelihood of a clawback occurring. Changes to these assumptions, as well as actual experience differences, are actuarial gains or losses. While IAS 19 currently allows policy choices for accounting for actuarial variances of post-employment benefit plans, only one method exists for other long-term employee benefits; they are recognised
immediately in profit or loss.
Modifications
To comply with the G-20 principles, management may make modifications to current cash bonus schemes. Like actuarial gains or losses, which are discussed above, the effects of curtailments, settlements and changes to the arrangement terms are recognised immediately in profit or loss when they occur for other long-term employee benefits. At the time when a change is made to a long-term bonus scheme, the obligation will be remeasured and any resulting adjustment, whether a gain or loss, will be recognised immediately, as shown in example 3.
Example 3: Modifications
A cash bonus will be paid during 2010 if stated performance targets are met at the 2009 year-end. At the beginning of thefourth quarter in 2009, management changes the terms of the bonus scheme to defer payment and require continued service by employees from 1 January 2010 for three years in order to receive payment.
The original bonus estimate was to have been accrued during 2009. When the change is made, the modified bonus scheme is measured using the PUCM and the accrual period extends to four years, (being the 2009 performance measurement year and the three-year required service period). A gain is recognised during the fourth quarter of 2009 to adjust the accrual period of the award. Additionally, any gain or loss resulting from the change in estimate of ultimate award payout (perhaps due to attrition assumptions) or resulting from the application of the PUCM is recognised at the same time.
Conclusion
Following the G-20 summit in Pittsburgh, management may want to re-evaluate whether existing compensation schemes are in line with long-term value creation, as opposed to excessive risk-taking. If compensation schemes are not aligned with the G-20 principles, it may be in the entity's best interest to make changes before regulators perceive a lack of response from entities and take action. Implementing these changes is likely to impact financial results, even if cash outflows are not affected. It is not possible to summarise all of the accounting impacts here for the many types of compensation arrangements that exist in practice. The facts and circumstances of each scenario will need careful consideration.
Additionally, the changes may have tax, debt covenant compliance and legal consequences, and may have a significant impact on the view of shareholders. All of these potential impacts should be carefully considered, together with accounting consequences, in determining any actions to be taken.
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