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Eduzan / 04 Financial Statement Analysis

FSA 2 – Employee Compensation_ Post-Employment and Share-Based

Published: 10 August 2026
Updated: 3 November 2026

Worked examples are fully visible. Check-yourself items are study aids you can reveal one at a time.

For a great many companies, paying people is the single largest operating cost. Compensation is also a strategic instrument: the package a company offers determines whom it can attract, whom it keeps, and what behaviour it rewards. Because recruiting and training replacements is expensive, retention has a direct effect on reported margins. An analyst who does not understand how a company pays its workforce does not understand its cost structure.

Compensation reaches employees in many forms, from cash wages and commissions through to medical cover, life assurance and shares. The mix is set in the market for human capital and varies with the role, with local labour law and with industry custom. Throughout this lesson the word employee is used broadly, covering contract workers and members of the board as well as salaried staff, because the accounting treats all sources of human capital in the same way.

The five categories

Accounting standards sort compensation into five categories. The two dimensions that separate them are the length of time between the employee performing the service and the employer paying for it, and the form in which payment is eventually made.

The five categories of pay

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 1
Category	What it covers	Typical items
Short-term benefits	Amounts due to be settled inside 12 months.	Wages and salaries; yearly bonuses; benefits in kind such as medical cover; social security scheme contributions; paid holiday
Long-term benefits	Amounts due to be settled more than 12 months out.	Extended paid leave, a sabbatical for instance; disability cover of long duration
Termination benefits	Amounts payable when employment ends.	Severance; ongoing medical and other benefits in kind; career counselling and outplacement help
Share-based compensation	Pay delivered in employer shares, or measured against them.	Restricted stock; stock options
Post-employment benefits	Amounts payable once the employee has retired.	Pensions and lump sums for retirees; life cover and medical care in retirement

Short-term benefits dominate the total for almost every company. The other four categories matter out of proportion to their size because they are where the measurement problems live.

One principle, three dates

IAS 19 Employee Benefits imposes a single organising principle across all of these categories: recognise the fair value of compensation as an expense in the period in which the employee provides the service. Under US GAAP the same idea is spread across several sections of the Accounting Standards Codification rather than gathered into one standard, but the principle is the same.

Three dates give the accounting its shape.

Grant. The employer sets out the terms of the award and the employee accepts them. Nothing is recognised on the financial statements at this point, but for some forms of compensation this is the date on which the amount is measured.
Vesting. The employee becomes unconditionally entitled to the compensation, which creates an obligation for the employer. Vesting normally runs alongside the delivery of service, so this is when expense is recognised.
Settlement. The employer actually pays, in cash or in another form such as shares.

Figure 1: What each statement records at each date

Expense follows service, not payment. The balance sheet carries the gap between the two, and cash moves only at settlement.

Short-term benefits, and the capitalisation exception

Short-term benefits are the simple case. Expense and a matching current liability are recognised as the compensation vests, which is normally the same moment the employee works. When the employer pays, cash leaves and the liability is removed. The cash outflow sits in operating activities.

There is one important variation. Some compensation costs are not expensed as incurred but capitalised into an asset, so that the charge to profit is deferred until the service is consumed. Manufacturing labour is the standard case: wages attach to inventories and only reach the income statement as cost of sales when the goods are sold.

Example 1 · Worked

A company hires an employee into the legal department on 1 January on an annual salary of SGD 82,200, paid every two weeks. The first payment date is 14 January. Separately, on the same date it hires an employee into the manufacturing division on an annual salary of SGD 102,200, also paid every two weeks with a first payment date of 14 January. The goods that the second employee helped to make are sold to customers on 3 April.

1. Set out the effect of the legal department salary on the three statements.

Solution. There are 26 two-week pay periods in a 52-week year, so each payment is SGD 82,200 ÷ (52 ÷ 2) = SGD 82,200 ÷ 26 = SGD 3,162.

At grant on 1 January nothing is recorded. Over the vesting window of 1 to 14 January the company records general and administrative expense of +3,162 and accrued compensation of +3,162 on the balance sheet. At settlement on 14 January the income statement is untouched, accrued compensation is reduced by 3,162, and cash flow from operations shows an outflow of 3,162.

2. Set out the effect of the manufacturing salary on the three statements.

Solution. Each payment is SGD 102,200 ÷ 26 = SGD 3,931.

Grant on 1 January: nothing recorded. Vesting from 1 to 14 January: no income statement effect, because the cost is capitalised. The balance sheet shows inventories +3,931 and accrued compensation +3,931. Settlement on 14 January: accrued compensation is reduced by 3,931 and cash flow from operations shows an outflow of 3,931, with no income statement effect. Sale on 3 April: cost of sales +3,931 and inventories reduced by 3,931, with no cash flow effect.

The cash left the business on 14 January but the expense appears on 3 April. That gap is the whole point of the capitalisation model.

Why the other categories are harder

The same underlying model applies to share-based compensation and to post-employment benefits, but three features change the arithmetic.

Short-term benefits against share-based compensation and post-employment benefits

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 2
Feature	Short-term benefits	Share-based compensation	Post-employment benefits
Typical vesting period	Days or weeks	Years	Years, decades
Form of payment	Cash	Shares	Cash
Amount recognised over the vesting period	Undiscounted salary, wage and similar	Fair value, measured on the grant date	Present value of estimated future benefits

Some companies pay share-based compensation that is settled in cash. Cash-settled awards are accounted for in the manner of short-term benefits, not in the manner described later in this lesson.

Where the expense is reported is a separate question from how it is measured. Most companies push compensation expense out to the functional line that matches the employee role, so that everything relating to research staff lands in research and development expense and everything relating to the sales force lands in selling, general and administrative expense. Termination benefits are the usual exception: because they normally arise inside a restructuring programme, they are often shown on a discrete line such as restructuring charges.

Why companies grant shares

Share-based compensation is typically a bonus layer for highly paid employees, managers and technical specialists. For senior executives at many listed companies it makes up the majority of total pay. Awards are made under formal plans that specify eligibility, the instrument used, the maximum number of shares issuable and the vesting conditions. Plans are approved by the board and, at exchanges such as the NYSE and NASDAQ, by a shareholder vote. Sea Limited, the NYSE-listed internet company based in Singapore, grants awards to employees and directors under its 2009 Share Incentive Plan, which shareholders have amended and re-approved several times. Companies frequently run more than one plan at once.

The advantages are real. Paying in shares aligns employee wealth with shareholder wealth and softens principal-agent conflicts. It lets employees share in value they help create, and it is often paired with minimum shareholding requirements for managers to reinforce that alignment. Multi-year vesting improves retention because leaving early forfeits unvested awards. Finally, no cash goes out at grant, which preserves liquidity. That matters most for young companies that could not otherwise outbid established employers for talent.

The disadvantages are equally real. An individual employee usually has little influence over the share price, so the reward may bear no relation to personal performance. Concentrated ownership can distort risk appetite in either direction. A manager who already has salary and reputation tied to one employer, and now holds shares as well, may avoid profitable but risky projects for fear of a price collapse. Option grants push the other way: because an option pays only on the upside, a manager holding options may take more risk than is appropriate, chasing short-term gains at the expense of long-term viability. And employees lose wealth when the share price falls or simply lags alternatives, which damages the retention benefit the plan was meant to deliver.

One caution about the no-cash-outlay argument. Issuing shares to employees has an implicit cash cost, because those same shares could have been sold to investors for cash. Many companies make the cost explicit by repurchasing shares in the open market to offset the dilution caused by employee issuance.

IFRS 2 Share-based Payment governs the accounting. The model has three steps that map onto the three dates from the previous section.

At the grant date, measure the fair value of the award, adjusted for the number of awards estimated not to vest.
Over the vesting period, recognise that fair value as share-based compensation expense, with the offsetting entry to equity. Adjust or reverse entries if estimates change.
At settlement, issue shares to the employee and move the accumulated balance from one equity account to another.

Straight-line recognition of a single grant with a service condition.

Example 2 · Worked

On 1 January 20X1 a company awards 25,000 shares to a member of its research and development staff. Vesting falls on the third anniversary of that date. Measured at grant, the award carries a fair value of BRL 273,000.

Set out the effect on the financial statements for each of the three years ended 31 December 20X1, 20X2 and 20X3.

Solution. The annual charge is BRL 273,000 ÷ 3 = BRL 91,000.

In each of 20X1, 20X2 and 20X3 the income statement carries research and development expense of 91,000, and the balance sheet shows the share-based compensation reserve within equity rising by 91,000. There is no cash flow effect in any year. In 20X3, on settlement, the cumulative 273,000 is transferred out of the share-based compensation reserve into common stock and paid-in capital.

If the statement of cash flows is prepared using the indirect method, the 91,000 is added back each year in reconciling net income to cash flow from operating activities, because it is a non-cash charge.

Compare this with the salary in Example 1 and three differences stand out. The offsetting entry goes to equity rather than to a liability, because settlement is in shares and not in cash. A single grant touches three reporting years rather than a fortnight. And the measurement basis is fair value rather than the undiscounted amount that will eventually be paid.

The most important consequence follows from that third point. Fair value is measured once, at the grant date, and never revisited. The share price will move, sometimes violently, over a three-year vesting period, and none of that movement touches the expense for a grant already made. Because companies grant continuously, price changes do feed into the expense for future grants, so the reported total does drift with the share price. But it drifts with a lag of years, and it never restates the past.

Vesting conditions

What an employee must do for an award to vest is a defining feature of the instrument. A service condition simply requires the employee to remain employed to a future date, and periods of three to five years are standard. A performance condition adds a further hurdle, such as reaching a target for earnings per share, return on invested capital or segment profit. A performance condition that depends on the share price itself, such as total shareholder return exceeding a threshold or beating an index of peers, is called a market condition. Market conditions are common in awards made to senior executives. Awards that have not vested when an employee leaves are forfeited.

The instruments

The four instruments a plan can award

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 3
Instrument	Other names used	What it is
Restricted stock	Restricted stock awards; RSUs; performance shares or performance share units	Shares, or units that behave like shares, carrying transfer restrictions that fall away once the award vests.
Stock options	Share options	Call options over employer shares that cannot be traded and are usually struck at the money.
Stock appreciation-based	Stock appreciation rights; phantom shares	Cash or shares delivered according to how the share price performs across a set window.
Stock purchase-based	Employee stock purchase plan; employee stock ownership plan	A right to subscribe for a capped quantity of newly issued shares below the market price.

The first two instruments dominate practice and are the focus of this lesson. Throughout, awards are assumed to be settled by issuing shares rather than in cash.

Restricted stock is common shares handed to the employee but subject to selling and other restrictions. Where vesting depends on performance as well as service, the same instrument is often called performance shares. Restricted stock normally carries voting rights and participates in dividends, but it cannot be traded until the restrictions lift on settlement.

Restricted stock units are close cousins. Rather than actual shares, an RSU is a contractual right to receive shares on settlement. RSUs are the most widely used form of share-based compensation at many companies. They carry no voting rights, do not participate in dividends and are not tradeable.

Measurement is the easy part for both. The grant-date fair value of restricted stock and of an RSU is simply the market price of the underlying share. For RSUs the share price is typically adjusted downwards for dividends expected during the vesting period, since the holder of a non-participating unit does not receive them.

Example 3 · Worked

Workflow Corporation is a Japan-based company that designs, builds and sells project management software for businesses. Bonuses for staff in management and technical roles are paid in shares, which both holds on to those people and keeps cash inside the business.

Its shareholder-approved Equity Compensation Plan issues RSUs, one unit for each share of common stock, which carries no par value. Vesting takes three years and turns on continued service. Forfeitures are recognised as and when they happen, and the company pays no dividend and expects to pay none. Three-quarters of the units went to the research and development division and the remainder to executive management.

Workflow RSU grants and grant-date share prices

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 4
Grant date	RSUs awarded	Price of a share that day, JPY
1 January 20X1	4,542,000	4,360
1 January 20X2	3,521,000	3,270
1 January 20X3	5,198,000	3,333

1. Set out what each statement shows for the years ended 31 December 20X1, 20X2 and 20X3.

Solution. Take the product of the units granted and the grant-date share price to obtain the aggregate fair value of each grant, then spread it over the three-year vesting period.

Annual expense arising from each grant, millions of JPY

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 5
Grant date	A: RSUs granted	B: Share price (JPY)	A × B: Aggregate fair value	C: Vesting per year	(A × B) × C: Annual expense
1 January 20X1	4,542,000	4,360	19,803	1/3	6,601
1 January 20X2	3,521,000	3,270	11,514	1/3	3,838
1 January 20X3	5,198,000	3,333	17,325	1/3	5,775

The grants layer on top of one another. Total expense is 6,601 in 20X1, then 6,601 + 3,838 = 10,439 in 20X2, then 6,601 + 3,838 + 5,775 = 16,214 in 20X3, all in millions of JPY.

Splitting three-quarters to research and development and one-quarter to general and administrative expense:
20X1: R&D 4,951 and G&A 1,650.
20X2: R&D 7,829 and G&A 2,610.
20X3: R&D 12,161 and G&A 4,054.

The balance sheet shows the share-based compensation reserve within equity rising by 6,601 in 20X1, 10,439 in 20X2 and 16,214 in 20X3. In 20X3 the 20X1 grant settles, so 19,803 is transferred from the share-based compensation reserve to paid-in capital. There is no cash flow effect; under the indirect method the expense is added back in the operating section each year.

2. Assume the share prices on 1 January 20X2 and 1 January 20X3 had instead been 25 percent higher. Calculate and explain the effect on the income statement.

Solution. The revised grant-date prices are 3,270 × 1.25 = 4,088 and 3,333 × 1.25 = 4,166 JPY. Recomputing the two later grants:
20X2 grant: 3,521,000 × 4,088 = 14,394 million aggregate fair value, giving 4,798 per year.
20X3 grant: 5,198,000 × 4,166 = 21,655 million aggregate fair value, giving 7,218 per year.

Share-based compensation expense under each set of prices, millions of JPY

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 6
Based on	20X1	20X2	20X3
Prior share price	6,601	10,439	16,214
New share price	6,601	11,399	18,617
Percentage difference	0%	9%	15%

A 25 percent higher share price produces a 9 percent higher expense in 20X2 and a 15 percent higher expense in 20X3, and no change at all in 20X1. Two mechanisms damp the effect. Grant-date measurement means the 20X1 grant is untouchable whatever happens later. And three-year vesting means that only one-third of any new grant enters the current year, so a price move phases into the income statement slowly.

That damping is worth holding on to. Share-based compensation expense is a lagged, smoothed function of the share price, which is one reason it is a poor real-time signal of the economic cost being transferred to employees, and one reason analysts pay as much attention to share counts as to the expense line.

An employee stock option is a non-tradeable call option on the shares of the employer, normally struck at the money, meaning the exercise price equals the share price on the grant date. If the share price rises above the strike after the award vests and before it expires, the employee can exercise and capture the spread.

Measuring fair value

For restricted stock and RSUs, grant-date fair value is observable: it is the share price. For options it must be estimated. An option is worth its intrinsic value plus its time value. An option struck at or above the current price has zero intrinsic value, yet its time value can be large, so the notion that an at-the-money grant is free is simply wrong.

Companies use option pricing models, typically the Black–Scholes model or a binomial model, both covered elsewhere in the curriculum. Neither IFRS nor US GAAP mandates a particular model. The method chosen must be consistent with fair value measurement requirements, be grounded in established principles of financial economic theory, and reflect all substantive characteristics of the award.

Because the estimate depends on assumptions, companies must disclose the material inputs in the notes. The directional effects are worth memorising.

Effect of a higher assumption on estimated option fair value

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 7
Assumption	Effect of an increase on estimated fair value
Expected volatility	Increases
Estimated life of the option	Increases
Risk-free interest rate	Increases
Dividend yield	Decreases

Volatility is the most subjective of the four and therefore the one an analyst should watch. Companies usually anchor it to something market-derived: the implied volatility on exchange-traded options over their own shares, or the historical volatility of their own share price. A volatility assumption that drifts downwards year after year while the shares themselves become more turbulent is a signal to look harder.

Settlement is where options differ

Beyond measurement, the second difference between RSUs and options is settlement. When an RSU vests, settlement happens automatically as the unit converts into common stock, and the only entry is a transfer within equity from the share-based compensation reserve to common stock and paid-in capital. When an option vests, nothing settles until the employee chooses to exercise, and that choice depends on the share price. On exercise the company receives the strike price for every option exercised, which is recorded as a cash inflow in financing activities.

Example 4 · Worked

Working from the same Equity Compensation Plan, Workflow Corporation awards its executives 25 million stock options on 1 January 20X1, which vest on 31 December 20X3. The strike is set at the money. On the day of the award the shares change hands at JPY 4,360 and each option is valued at JPY 1,288. Expiry falls seven years after the award.

1. Set out what each statement shows in the years ended 31 December 20X1, 20X2 and 20X3.

Solution. Aggregate fair value = options granted × fair value per option = 25 million × JPY 1,288 = JPY 32,200 million.

One-third vests each year, so the annual charge is 32,200 ÷ 3 = JPY 10,733 million. In each of the three years the income statement carries general and administrative expense of 10,733 million, and equity rises by 10,733 million through the share-based compensation reserve. Cash flows are untouched, although under the indirect method the 10,733 million is added back in reconciling net income to cash flow from operating activities.

2. What is recorded in the year ended 31 December 20X4 if the shares stay below JPY 4,360 throughout?

Solution. The options are out of the money, so no rational holder exercises them. There is no financial statement impact at all in 20X4. The expense has already been fully recognised over the vesting period, and no settlement occurs.

3. During 20X5 the shares climb to JPY 5,400 and 6 million options are exercised. What is recorded that year?

Solution. There is no income statement effect. On the balance sheet, the share-based compensation reserve falls by 6 million × JPY 1,288 = 7,728 million, and paid-in capital rises by the reserve released plus the cash received: 7,728 + 26,160 = 33,888 million. On the statement of cash flows there is an inflow from financing activities of 6 million × JPY 4,360 = JPY 26,160 million.

Note what is absent. The share price of 5,400 at exercise appears nowhere in the entries. It determines whether employees exercise, and how much they personally gain, but the cash inflow is fixed by the strike price and the equity entries are fixed by the grant-date fair value.

Why the accounting was fought over, and what changed when it was settled

Before IFRS 2 and SFAS 123R were issued in 2004 and 2005 respectively, both frameworks allowed share-based compensation to be measured at intrinsic value on the grant date. Since most options are granted at the money, their intrinsic value is zero, so the reported expense for an option grant was zero. The move to fair value was fiercely contested. In the 1990s the FASB attempted the same change and the US Congress threatened to revoke the independence of the board. The arguments made against expensing were that fair value is uncertain so the number would be imprecise; that a transaction which debits expense and credits equity is not economically meaningful; that expensing double counts the effect on EPS by reducing net income and increasing the share count at the same time; that share issuance is a financing transaction and is not expensed elsewhere; and that the change would fall hardest on young, innovative companies. Once expensing at fair value became mandatory, reporting of non-GAAP profit measures grew sharply, with share-based compensation as the leading add-back. After public warnings from the US SEC in 2016, several large US technology companies including Apple, Amazon.com, Alphabet, Microsoft and Meta Platforms stopped reporting non-GAAP earnings, with Alphabet stating that although the charge is not cash it is a real cost of running the business because share-based pay is central to attracting and retaining talent.

The shift from options to restricted stock

The other response to fair value expensing was a change of instrument. Companies moved away from options and towards restricted stock, particularly RSUs. In 2021 options featured in fewer than 50 percent of compensation packages for chief executives of S&P 500 companies, with boards preferring RSUs.

Accounting was only part of the reason. Employees often prefer RSUs, because provided the vesting conditions are met and the share price does not go to zero, an RSU retains some value even in a downturn, whereas an option can expire worthless. Underwater options were a widespread problem after the technology bubble burst in the early 2000s and again after the Global Financial Crisis. RSUs also align interests better, since the holder is exposed to downside as well as upside, while the asymmetric payoff of an option can encourage risk-taking that damages long-term performance. And RSUs are simpler: easier for employees to understand, more straightforward for personal tax, and they do not require the employee to find cash for an exercise price.

Share-based compensation is deductible against taxable income in most jurisdictions, but the deduction rarely matches the accounting expense in either timing or amount.

Financial reporting against tax treatment of share-based compensation

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 8
Dimension	Accounting charge in the financial statements	Deduction claimed on the tax return
Timing	Spread across the vesting period	All of it at settlement
Amount	Fair value fixed at grant	For RSUs, the price of a share on the day of settlement; for options, intrinsic value when exercised

The detail of accounting for these income taxes is beyond the scope of this lesson. What matters is the consequence when the share price at settlement differs from the share price at grant, which is almost always.

If the share price at settlement is above the grant-date price, the tax deduction exceeds the cumulative accounting expense. Taxable income and tax payable fall. This is an excess tax benefit, also called a tax windfall. If the share price at settlement is below the grant-date price, the deduction falls short of the cumulative expense and taxable income rises. This is a tax shortfall.

Treatment of tax windfalls and shortfalls

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 9
Situation	IFRS	US GAAP
Share price at settlement above share price at grant (excess tax benefit or windfall)	Gain recognised directly in stockholders equity	Decrease in income tax expense on the income statement
Share price at settlement below share price at grant (tax shortfall)	Loss recognised directly in stockholders equity	Increase in income tax expense on the income statement

The reasoning behind the IFRS treatment is that windfalls and shortfalls are caused by share price movements, which are transactions between shareholders rather than transactions of the company, so they do not belong in earnings. US GAAP took the same view until 2017, when the treatment was changed as part of a simplification project.

The practical result is that share-based compensation injects volatility into the effective tax rate of a US GAAP reporter and can drive a large wedge between the effective rate and the statutory rate.

Example 5 · Worked

Meta Platforms, the NASDAQ-listed parent of Facebook, Instagram and WhatsApp, reports under US GAAP. Its share price rose by 30 percent in 2020 and by 23 percent in 2021. Its statutory tax rate is 21 percent. The reconciliation below is from the notes to its 2021 annual report.

Meta Platforms statutory to effective tax rate reconciliation

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 10
Reconciling item, year ended 31 December	2021	2020
Statutory tax rate	21%	21%
US state income taxes	1.0%	0.8%
Excess tax benefits arising on share-based awards	(2.2%)	(1.6%)
Credits for research and development	(1.3%)	(1.3%)
Deduction for foreign-derived intangible income	(3.5%)	(1.9%)
Operations outside the United States	0.9%	(2.4%)
Capitalised research and development		(3.0%)
Other	0.8%	0.6%
Effective tax rate	16.7%	12.2%

1. Confirm the 2021 reconciliation and identify the contribution of share-based compensation.

Solution. Adding the 2021 column: 21.0 + 1.0 − 2.2 − 1.3 − 3.5 + 0.9 + 0.8 = 16.7 percent, which matches the disclosed effective rate. Excess tax benefits from share-based compensation removed 2.2 percentage points, the second largest single item after the foreign-derived intangible income deduction. The 2020 column reconciles the same way: 21.0 + 0.8 − 1.6 − 1.3 − 1.9 − 2.4 − 3.0 + 0.6 = 12.2 percent.

2. Meta itself warned that if the share price stayed flat it expected the 2022 effective rate to resemble 2021. Its share price then fell by 72 percent from January to October 2022. What happened to the effective tax rate?

Solution. The excess tax benefits evaporated, and with them the largest share-based item in the reconciliation. The effective tax rate rose sharply towards the 21 percent statutory rate. In the third quarter of 2022 the effective rate was 8 percentage points higher than in the third quarter of 2021.

The analytical lesson is that a historical effective tax rate should never be rolled forward mechanically for a US GAAP reporter that has recognised a windfall or a shortfall. Read the reconciliation, strip out the share-based line, and ask what the share price would have to do for that line to repeat. IFRS reporters put these amounts straight into equity, so their effective tax rates are comparatively stable and sit closer to statutory rates.

Share-based compensation and the share count

Basic shares outstanding, reported as a weighted average on the income statement and as a period-end figure on the balance sheet and the statement of stockholders equity, rises when share-based awards settle. For many companies this is the single largest driver of the share count over time. Meta Platforms saw shares outstanding rise by roughly 1 percent a year over the decade after its 2012 initial public offering, mostly from RSU settlements, and began offsetting that dilution with repurchases in 2017.

Awards that have not yet settled are excluded from basic shares. They enter diluted shares, and not by simple addition. The treasury stock method adds a net figure: the shares that would be issued, less the shares the company is assumed to buy back with the proceeds.

The treasury stock method. The average share price is the average for the reporting period.

Figure 2: The treasury stock method as a bridge

Only the net addition reaches the diluted count. If the assumed buyback exceeds the gross award shares, the award is anti-dilutive and contributes nothing.

Two refinements matter. First, only awards that management judges likely to vest are included. In practice, awards with service conditions are included, while awards with unmet performance conditions are excluded. If a company has RSUs that vest only if earnings per share grows 30 percent over three years and growth in the first year was 5 percent, management will probably leave them out of the first-year calculation.

Second, the assumed proceeds have two parts. Cash proceeds from exercise is the strike price times the number of options, and it is zero for RSUs, which cost the holder nothing. The second part is less intuitive. The treasury stock method pretends the awards vest and settle today, which means the company would avoid the future expense attached to them. That avoided expense is treated as proceeds. Unrecognised share-based compensation expense at a period end is the unvested awards multiplied by their grant-date fair values, and the figure used is the average of the last two period-end values.

Example 6 · Worked

Continuing with Workflow Corporation. Basic shares outstanding in 20X1 were 176,401,000 and the company reported positive net income. It had no potentially dilutive securities other than the RSUs and employee stock options described earlier. The average share price during 20X1 was JPY 4,200. As of 31 December 20X1 unrecognised share-based compensation expense was JPY 21,467 million for options and JPY 13,202 million for RSUs. Unvested RSUs at that date numbered 3,028,000 and options outstanding numbered 25,000,000.

Calculate diluted shares outstanding and identify any anti-dilutive securities.

Solution. Handle the two instruments separately.

Options. Cash proceeds on exercise = 25 million × JPY 4,360 = JPY 109,000 million. Average unrecognised expense = (0 + 21,467) ÷ 2 = JPY 10,734 million. Assumed proceeds are therefore JPY 119,734 million, and at an average price of 4,200 the company is assumed to repurchase 119,734 million ÷ 4,200 = 28,508,095 shares. That exceeds the 25,000,000 shares the options would create, so the net effect is negative. The options are anti-dilutive and contribute zero, which is what you expect for options that are out of the money.

RSUs. Cash proceeds on settlement are zero. Average unrecognised expense = (0 + 13,202) ÷ 2 = JPY 6,601 million. Assumed repurchases = 6,601 million ÷ 4,200 = 1,571,667 shares. Dilutive shares = 3,028,000 − 1,571,667 = 1,456,333.

Diluted shares = 176,401,000 + 1,456,333 = 177,857,333. The 25 million option shares are excluded as anti-dilutive.

Four general results fall out of the method.

Options in the money, where the average share price exceeds the strike, are dilutive and are included.
Options at or out of the money are anti-dilutive and are excluded.
RSUs are dilutive except when the average share price is materially below the share price at the RSU grant date. Because the unrecognised expense is measured at grant-date prices, a collapse in the share price can make even RSUs anti-dilutive.
A rising share price produces more dilution, not less, because fewer shares can be bought back with the fixed assumed proceeds.

Figure 3: Why a higher share price produces more dilution

Assumed proceeds are fixed by strike prices and grant-date fair values, so the number of shares they buy back falls as the average price rises. Gross award shares do not move, so the gap between the two, which is the net addition to the diluted count, widens as the price climbs. To the left of the crossover the assumed repurchases exceed the award shares and the award is anti-dilutive.

When anti-dilutive securities matter most

Diluted EPS can never exceed basic EPS. A company reporting a net loss therefore reports identical basic and diluted share counts no matter how many potentially dilutive instruments it has outstanding.

Example 7 · Worked

ServiceNow, the NASDAQ-listed software company, reported net losses from inception through 2018. Its 2018 annual report disclosed the following, with amounts in thousands for the loss figures.

ServiceNow loss per share

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 11
Year ended 31 December	2018	2017	2016
Net loss	(26,704)	(116,846)	(414,249)
Basic and diluted shares outstanding	177,846,023	171,175,577	164,533,823
Net loss per share, basic and diluted	(0.15)	(0.68)	(2.52)

Potentially dilutive securities excluded because they are anti-dilutive

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 12
Year ended 31 December	2018	2017	2016
Options	1,810,580	3,369,732	5,818,435
RSUs	10,201,660	11,403,341	12,222,282
Employee stock purchase plan	317,940	361,688	366,529
Convertible debt	5,806,933	13,589,879	7,783,023
Warrants	13,589,879	13,589,879	7,783,023
Total	31,727,069	42,314,596	33,973,292

Category detail and totals are reproduced as disclosed. The individual categories shown do not foot exactly to the reported totals.

1. How large is the excluded amount relative to the reported share count in 2018, and what would the fully loaded count be?

Solution. Excluded securities of 31,727,069 against basic and diluted shares of 177,846,023 is an uplift of 18 percent. Adding them gives roughly 210 million shares. The reported loss per share of (0.15) is 26,704 thousand divided by 177,846,023 shares.

2. Was that uplift a fair reflection of what actually happened?

Solution. Broadly yes. An 18 percent uplift sounds drastic, but in the three years after 2018, once the company reached profitability, the diluted share count rose by 25 million shares to 203 million. The excluded securities were real claims on the equity, and most of them arrived.

Analysts should therefore add anti-dilutive securities, as disclosed in the notes, to the diluted share count for valuation purposes. Two cases deserve particular attention. The first is loss-making companies, like ServiceNow above, where basic and diluted counts are identical by construction. Be most alert to this in sectors such as technology, where unprofitable companies use large amounts of share-based compensation. The second is companies whose share price has fallen sharply or is simply volatile.

Example 8 · Worked

Return to Meta Platforms and the 72 percent share price decline from January to October 2022. Its quarterly report for the quarter ended 30 September 2022 disclosed the following, in millions of shares.

Meta Platforms share count, three months ended 30 September

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 13
Item	2022	2021
Basic shares outstanding	2,682	2,814
Dilutive RSUs	5	45
Diluted shares outstanding	2,687	2,859
Memorandum: anti-dilutive RSUs	119	0

Explain the movement, and say what it implies for a quarter-on-quarter EPS comparison.

Solution. Dilutive RSUs collapsed from 45 million to 5 million, while anti-dilutive RSUs went from zero to 119 million. This is exactly the mechanism set out above. The assumed proceeds are fixed at grant-date fair values, so as the average share price falls the assumed repurchase count rises, cancelling more of the gross award shares until the awards tip into being anti-dilutive.

For EPS the two 2022 effects run in opposite directions. A smaller diluted share count, 2,687 million against 2,859 million, raises EPS. The higher effective tax rate discussed in Example 5 lowers it. In both cases the driver is the same share price collapse, and in both cases an analyst should refuse to assume that the latest quarter is a fair guide to the next one.

What the disclosures give you

IFRS 2 requires disclosure sufficient for a reader to understand the nature and extent of share-based payment arrangements in the period, how the fair value of instruments granted in the period was determined, and the effect of share-based payment transactions on net income and financial position. These sit in a note usually headed Share-Based Payments or similar. Governance documents such as the proxy statement add detail on executive and director pay, which is typically heavily share-based.

The single most useful table is the unvested award rollforward, which shows opening balance, grants, vestings, forfeitures and closing balance, each with a weighted-average grant-date fair value. Meta Platforms disclosed the following for the year ended 31 December 2021.

Meta Platforms unvested RSU activity, year ended 31 December 2021

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 14
Movement	Units, thousands	Weighted-average fair value at grant, per unit
Unvested, 31 December 2020	96,733	$181.88
Granted	59,127	$305.40
Vested	(44,574)	$198.95
Forfeited	(12,438)	$211.58
Unvested, 31 December 2021	98,848	$244.58

Share counts roll forward exactly: 96,733 + 59,127 − 44,574 − 12,438 = 98,848. Weighted-average prices are disclosed values and are not designed to foot arithmetically from the rows above them.

The same note reported that the weighted-average grant-date fair value of RSUs granted in 2020 and 2019 was $188.73 and $173.66, that the fair value at the respective vesting dates of RSUs vesting in 2021, 2020 and 2019 was $14.42 billion, $9.38 billion and $6.01 billion, and that the related income tax benefit recognised on awards vested or exercised in those years was $3.08 billion, $1.81 billion and $0.98 billion. At 31 December 2021 unrecognised share-based compensation expense on RSU awards stood at $22.77 billion, expected to be recognised over a weighted-average period of about three years. Meta measures RSUs at grant-date fair value, vests them over a service period of generally four years, recognises expense on a straight-line basis over the requisite service period and accounts for forfeitures as they occur. That last item, $22.77 billion of unrecognised expense, is precisely the input the treasury stock method needs, which is why the rollforward and the unrecognised expense disclosure are worth reading together.

Share-based compensation is rarely a discrete line on the income statement. It is buried inside operating expense lines according to the role of the recipient. One consequence is that an analyst who models research and development expense as a percentage of sales has already, implicitly, forecast the share-based component of that line.

That implicit approach is adequate so long as the share-based part of an operating expense shares drivers with, and behaves like, the cash part. That holds for most mature companies. It does not hold for companies early in their life cycle, where share-based compensation tends to fall as a percentage of revenue as the company matures. For earlier-stage companies, model it discretely.

There are three further reasons to break it out even when the implicit approach would do for the income statement. It has to be added back on the statement of cash flows under the indirect method. Free cash flow forecasts are wrong without it. And cash on the balance sheet will be understated if the model assumes that all compensation is paid in cash. Analysts also separate it out to compute non-GAAP measures such as adjusted EBITDA for use in comparisons.

The percentage-of-revenues approach

The standard method forecasts share-based compensation expense as a percentage of revenues. With that as the forecast object, the percentage itself can be set from a historical average, from management guidance, or by assuming reversion to an industry or sector average over time. The forecast must then be threaded back through the statements correctly, or the balance sheet will not balance: the offsetting entry goes to equity, and the expense is added back in the operating section of an indirect-method cash flow statement.

The mechanics run in four steps.

Strip share-based compensation out of each cost and expense line on the historical income statement.
Express both the adjusted lines and total share-based compensation as percentages of revenues.
Forecast those percentages.
Apply the forecast percentages to a revenue forecast to rebuild the adjusted and the reported figures.

Example 9 · Worked

Workflow Corporation reported the following income statement for the three years ended 31 December 20X3, in millions of JPY.

Workflow Corporation reported income statement, millions of JPY

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 15
Item	20X3	20X2	20X1
Revenues	41,628	24,970	15,687
Cost of revenues	4,279	3,162	2,187
Gross profit	37,349	21,809	13,500
Research and development	11,172	6,663	4,932
Sales and marketing	15,559	9,706	5,821
General and administrative	6,529	4,192	2,576
Total operating expenses	33,260	20,561	13,330
Operating income	4,090	1,248	170

The notes disclose the share-based compensation included in each line.

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 16
Share-based compensation included in	20X3	20X2
Cost of revenues	44	17
Research and development	3,161	1,023
Sales and marketing	1,630	516
General and administrative	915	326
Total share-based compensation expense	5,751	1,882

1. Strip share-based compensation out of the 20X3 and 20X2 cost and expense lines and express each as a percentage of revenues.

Solution. Subtract the disclosed amounts line by line, then divide by revenues.
20X3: cost of revenues 4,279 − 44 = 4,234, or 10 percent of 41,628. Research and development 11,172 − 3,161 = 8,010, or 19 percent. Sales and marketing 15,559 − 1,630 = 13,930, or 33 percent. General and administrative 6,529 − 915 = 5,613, or 13 percent. Total share-based compensation of 5,751 is 14 percent of revenues.
20X2: cost of revenues 3,162 − 17 = 3,145, or 13 percent of 24,970. Research and development 6,663 − 1,023 = 5,639, or 23 percent. Sales and marketing 9,706 − 516 = 9,190, or 37 percent. General and administrative 4,192 − 326 = 3,866, or 15 percent. Total share-based compensation of 1,882 is 8 percent of revenues.

2. Forecast 20X4 revenues of 62,440 and assume cost of revenues excluding share-based compensation of 8 percent, research and development of 19 percent, sales and marketing of 31 percent, general and administrative of 13 percent and share-based compensation of 12 percent. Build the forecast income statement.

Solution. Apply each percentage to revenues of 62,440.

Workflow Corporation 20X4 estimate, millions of JPY

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 17
Line, excluding share-based compensation	Assumed % of revenues	20X4E amount	20X3 amount	20X2 amount
Cost of revenues	8%	4,995	4,234	3,145
Research and development	19%	11,864	8,010	5,639
Sales and marketing	31%	19,356	13,930	9,190
General and administrative	13%	8,117	5,613	3,866
Share-based compensation, total	12%	7,493	5,751	1,882

Gross profit excluding share-based compensation is 62,440 − 4,995 = 57,445. Total operating expenses are 11,864 + 19,356 + 8,117 + 7,493 = 46,830, where the share-based line is carried in full because the amount sitting in cost of revenues was stripped out above. Operating income is 57,445 − 46,830 = 10,615, against 4,090 in 20X3.

3. Why is it worth carrying share-based compensation as its own line rather than leaving it inside the functional expenses?

Solution. Two reasons. It must be added back on the statement of cash flows, so a model that hides it inside operating expenses cannot produce a correct cash flow statement or a correct cash balance. And it can have a different driver from cash costs, so forcing it to move with the same percentage-of-revenue assumption as salaries can be simply wrong, particularly for a company whose share-based intensity is trending down as it matures.

Forecasting the share count

Shares outstanding is an input to EPS, and share-based compensation is one of its main drivers. The forecast starts with two items for each period, both expressed in common shares: grants of awards net of forfeitures, and settlements of awards. Grants net of forfeitures are usually modelled with growth rates applied to the historical values in the note disclosures, and the result should be consistent with the forecast of share-based compensation expense. Settlements can be modelled the same way, or by assuming a fixed percentage of outstanding awards settles each period.

Settlements covers RSUs vested and share options exercised; other issuance covers secondaries, acquisitions and similar.

Diluted shares are then forecast by adding dilutive securities to forecast basic shares. This is genuinely hard, because the treasury stock method depends on the average share price and note disclosures are thin. The common workaround is to assume a percentage of outstanding awards is dilutive, with the percentage taken from historical observation.

One asymmetry is worth remembering when building the cash flow statement. Option exercises bring cash in, so they affect the financing section and, in turn, the balance sheet. RSU vesting brings no cash and has no material effect on the financial statements beyond the transfer within equity and the increase in the share count.

Some analysts ignore share-based compensation entirely on the grounds that it is not a cash expense and so cannot affect value. That position does not survive contact with the arithmetic. Share-based compensation is a transfer of value from the company to its employees, and it dilutes the interest of existing shareholders. If ignoring it were correct, a company could raise its own value simply by switching from cash pay to share pay, which is absurd. In practice many companies close the loop themselves by repurchasing an equivalent amount of stock in the open market, which makes share-based compensation behave like a cash expense in every respect that matters.

Because the charge is non-cash, a discounted cash flow model does not capture it by default. Two effects have to be introduced deliberately.

Dilution from awards that are outstanding but not yet vested.
Dilution from awards the company has not yet granted but will.

The first is straightforward. Use diluted shares outstanding as the divisor when converting equity value into value per share, and consider increasing that count further by the anti-dilutive securities disclosed in the notes. Spreading equity value over a larger count is exactly what accounting for dilution means. Some analysts regard the treasury stock method as insufficiently conservative, because it assumes repurchases that may never take place. The alternative is to use basic shares plus the gross number of potentially dilutive securities.

The second effect is handled most pragmatically by deducting share-based compensation from free cash flow. This is not theoretically clean, since the expense is not cash, but the alternatives, reducing equity value by an estimated dilution factor or grossing up the share count by a further amount, are laborious and should give the same answer.

For multiples the primary question is whether the denominator is a non-GAAP measure such as adjusted EBITDA or adjusted EPS that excludes share-based compensation. Such measures overstate profit, because the charge is a real cost. But for multiples the governing virtues are transparency and consistency. If an analyst is comparing several companies against industry and sector averages, every figure in the comparison must be on the same basis. GAAP and non-GAAP multiples are not comparable with one another.

The free cash flow trap

Free cash flow is popular precisely because it measures cash profit after reinvestment. Since share-based compensation is not cash, it does not reduce free cash flow at all. That makes free cash flow margins and free cash flow multiples treacherous for companies that pay heavily in shares.

Example 10 · Worked

Consider two hypothetical companies that are identical in every respect except the form in which they pay their employees.

Two companies, one paying in cash and one paying partly in shares

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 18
Item	Company A	Company B
Market capitalisation	10,000	10,000
Revenues	1,000	1,000
Net income	120	120
Share-based compensation expense	0	150
Cash flow from operating activities	420	570
Capital expenditures	300	300

1. Compute net margin, free cash flow margin, the price to earnings multiple and the price to free cash flow multiple for each.

Solution. Free cash flow is operating cash flow less capital expenditure. Company A: 420 − 300 = 120. Company B: 570 − 300 = 270.

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 19
Measure	Company A	Company B
Net margin	12%	12%
Free cash flow margin	12%	27%
Price to earnings multiple	83	83
Price to free cash flow multiple	83	37

Both price to earnings multiples are 10,000 ÷ 120 = 83. Company A trades at 10,000 ÷ 120 = 83 times free cash flow, Company B at 10,000 ÷ 270 = 37 times.

2. Is Company B cheap?

Solution. No. The entire gap between 37 and 83 comes from Company B choosing to pay 150 of compensation in shares rather than cash. Nothing about the underlying economics differs: net income is 120 for both, and the price to earnings multiple is identical at 83. The apparently superior free cash flow is the mirror image of a value transfer to employees and dilution of existing shareholders. Reading the free cash flow multiple as a valuation signal here would be a straightforward mistake.

The general rule follows. Treat free cash flow based profitability measures and free cash flow multiples with suspicion whenever share-based compensation is material, because they overstate profitability and understate valuation for exactly the companies that use shares most heavily.

Post-employment benefits cover cash pensions and non-monetary benefits provided to retired employees. Practice varies enormously with local law and custom. In the United Kingdom companies are required by law to offer pension plans and to enrol employees automatically. The United States does not require employers to provide post-employment benefits but grants tax advantages to those that do. In countries where health care is government-sponsored, employer-provided retiree health cover is much less common.

Defined contribution plans

In a defined contribution plan the sponsoring employer pays agreed contributions into the plan, and employees may contribute too. Employees typically choose among designated investment options, usually mutual funds and exchange traded funds holding equities and bonds. Once the employer has made the agreed contribution, its obligation ends. It is not required to make further contributions, gains and losses on plan investments accrue to the employee, and the employee carries both the investment risk that the assets fall short and the actuarial risk of outliving them. Because the obligation is fixed and short-dated, forecasting it is easy.

The global drift has been towards defined contribution plans, particularly in the private sector, as employers shed risk. The pattern is not universal: in countries such as the Netherlands and Japan defined contribution plans remain rare.

Defined benefit plans

A defined benefit plan is a promise to pay a specified amount after retirement, either as a lump sum or as periodic payments until death. The amount usually comes from a formula built on years of service and pre-retirement compensation. A typical formula pays an annual amount equal to 1 percent of final-year salary multiplied by years of service. Plans normally set a service threshold for qualification, for example five years. Additional service earns additional benefit, but an employee who qualifies and then leaves in year six still keeps the entitlement earned.

Regulation usually requires employers to pre-fund these promises by setting assets aside in a separate legal entity such as a trust. Contributions are made to meet regulatory minimum funding levels or at the discretion of the sponsor. Plan assets are typically invested in bonds, equities, derivatives, cash and other assets, and the combination of contributions and investment returns funds the payments to retirees. In many jurisdictions contributions are tax deductible, so the timing of contributions is often a tax planning decision. A company in a jurisdiction that limits tax loss carryforwards, for instance, may choose to contribute only in years when it has positive taxable income.

Unlike the defined contribution case, the employer here bears the investment risk that plan performance disappoints and the actuarial risks attached to retirement ages, life expectancies and future salaries. Alongside the shift to defined contribution plans, many defined benefit plans have been closed, meaning new employees can no longer join, or frozen, meaning existing beneficiaries no longer accrue additional benefits so their future payments are fixed. Affected employees are usually moved onto defined contribution arrangements.

Other post-employment benefits, abbreviated OPEB, are defined benefit plans that deliver non-monetary benefits such as retiree life insurance and medical care. Regulation often does not require pre-funding of OPEB, partly because governments do not usually insure these benefits, partly because the liability is normally much smaller, and partly because such plans are easier to discontinue if costs become burdensome. Many OPEB plans are therefore unfunded, with the company simply paying benefits as they arise on a pay-as-you-go basis. That does not remove the obligation, and the sponsor still bears investment and actuarial risk.

Three types of post-employment benefit

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 20
Type	Amount of benefit to the employee	Obligation of the sponsoring company	Pre-funding of the future obligation
DC plan	Not defined. Depends on contributions and the investment performance of plan assets. Investment and actuarial risks are borne by the employee.	The obligation, that is the contribution, is defined each period. It is typically paid periodically with no further future obligation.	Not applicable.
DB plan	Defined by the plan formula, often a function of length of service and final-year compensation. Investment and actuarial risks are borne by the company.	The future obligation, based on the formula, must be estimated in the current period.	Companies typically fund by contributing to a pension trust. Regulatory funding requirements vary by country.
OPEB, for example retiree health care	Depends on plan specifications and the type of benefit. Investment and actuarial risks are usually borne by the company.	Eventual benefits are specified. The future obligation must be estimated in the current period.	Companies typically do not fund OPEB obligations.

Reporting for defined contribution plans

The financial reporting mirrors short-term benefits almost exactly. Contributions are recognised as expense, grouped into the relevant functional operating expense category rather than shown on a discrete line. The only balance sheet effect is a current liability for contributions that have vested but not yet been paid. Contributions are a cash outflow in operating activities. The plan itself is a separate legal entity with its own financial statements, so plan assets, plan liabilities and withdrawals by employees never appear on the accounts of the employer.

Example 11 · Worked

Every two weeks a company pays into a defined contribution plan an amount worth 5 percent of salary. One member of the legal team is on SGD 82,200 a year. Payments start on 14 January.

Set out the effect on the financial statements.

Solution. The contribution per pay period is 5% × SGD 82,200 ÷ 26 = SGD 158.

At grant on 1 January there is no financial statement impact, although the plan contribution is estimated at SGD 158. Over the vesting window of 1 to 14 January the income statement carries general and administrative expense of +158 and the balance sheet carries accrued compensation of +158. At settlement on 14 January accrued compensation is reduced by 158 and cash flow from operations shows an outflow of 158.

Set this beside Example 1 and the two are structurally identical. The employer promise is bounded by the contribution, so nothing more complicated is required.

Funded status: the balance sheet number

Under both IFRS and US GAAP, everything that is not explicitly structured as a defined contribution plan is accounted for as a defined benefit plan. That sweeps in OPEB and even informal post-employment arrangements. The balance sheet carries one number, the funded status.

Fair value of plan assets is the assets held by the plan, such as bonds, stocks, cash and derivatives, held exclusively to pay benefits and measured at the price that would be received in an orderly sale, using quoted market prices where available. Two features of plan assets matter for valuation later: they are the property of the plan and not of the sponsor, so once contributed they cannot be withdrawn, and they are legally isolated from the sponsor in bankruptcy.

Pension obligation is the present value, without deducting any plan assets, of the expected future payments required to settle the obligation arising from employee service in the current and prior periods.

A negative funded status means the plan is underfunded and is reported as a net pension liability. A positive funded status means the plan is overfunded and is reported as a net pension asset. This is one of the rare places where accounting standards allow a net rather than a gross presentation. The netting stops at the plan boundary, however: separate plans cannot be netted against each other, so a company that runs an overfunded pension plan and an unfunded OPEB plan will report both a net pension asset and a net pension liability. In practice the amounts may not be discrete balance sheet lines at all, appearing instead inside other non-current assets or other non-current liabilities with detail in the notes.

The discount rate applied to the obligation is the yield on investment grade corporate bonds denominated in the same currency as the benefits, or on government bonds where no liquid corporate bond market exists. Estimating the obligation requires a long list of actuarial assumptions covering salary growth, retirement dates and mortality, which is why IAS 19 encourages sponsors to engage a qualified actuary.

Figure 4: The structure of a funded defined benefit plan

Cash leaves the sponsor when contributions are made, not when benefits are paid. Paying a benefit reduces plan assets and the obligation equally, so it leaves funded status unchanged.

Why a large legacy plan behaves like leverage

A defined benefit promise is deferred compensation for the employee and a long-dated obligation for the sponsor, not unlike debt. The employer takes the benefit of service now and commits to paying for it years later. Like any leverage, it becomes dangerous if the obligation grows too large or the business runs into trouble. General Electric ended 2007 with a surplus of $4 billion on its defined benefit plans. A decade of low interest rates, the simple passage of time and rising longevity assumptions turned that into a deficit that grew beyond $35 billion. Combined with weak results in several businesses, by the end of 2018 the pension deficit represented over 40 percent of the market capitalisation of the company. Note the direction of the interest rate exposure. A company financed with bonds and loans generally benefits when rates fall. A company with a large defined benefit plan generally suffers, because a lower discount rate inflates the pension obligation. Strong returns on plan assets can offset this, and will do so most reliably where the plan holds long-duration fixed income, but in many cases, including this one, the discount rate effect overwhelms the asset return.

Recognising the employer contribution as the expense would breach accrual accounting, because the contribution is not the cost of providing benefits in that period. Contributions need not be made in the period the service is delivered. A sponsor may make no contribution for several years while the plan still meets its payments. Over those same years employees keep earning service, which raises the obligation, and retirement dates draw nearer, which raises the obligation again as the discount unwinds. The expense must track those movements, not the cash.

The IFRS decomposition

Under IFRS the periodic pension cost has three components, two in profit or loss and one in other comprehensive income.

Service cost, in two parts. Current service cost is the increase in the pension obligation caused by employee service in the current period. Since a typical formula pays a percentage of final salary for each year of service, every additional year of service raises future payments. An actuary computes it using the projected unit credit method, the detail of which sits below the level presented to investment analysts. Past service cost arises when a plan amendment changes the obligation relating to service in prior periods. Under IFRS both are operating expenses in profit or loss, grouped with other compensation in the relevant functional category, so service cost for the sales force is expensed within selling, general and administrative expense.
Net interest expense or income, the accretion of the obligation with the passage of time. It is the net pension liability or net pension asset at the beginning of the period multiplied by the discount rate. Under IFRS it sits below the operating income line, with other financing costs.
Remeasurement, which has two parts: the difference between the actual return on plan assets and the amount already assumed in the net interest calculation, and actuarial gains and losses. Actuarial gains and losses arise from changes in assumptions such as the salary growth rate, the discount rate or mortality. An assumption change that increases the obligation is an actuarial loss; one that decreases it is an actuarial gain. Under IFRS remeasurements go to other comprehensive income and never touch earnings.

The asset half of the IFRS remeasurement.

Two things are conspicuously missing from the expense. It contains no employer contribution and no benefit payment. It is a non-cash accrual driven by the change in the net pension liability or asset. Contributions appear on the statement of cash flows, normally in operating activities, which is also where the non-cash expense is added back under the indirect method. So for cash flow purposes defined benefit plans look like defined contribution plans: contributions are operating outflows.

Benefit payments from the plan to retirees do not appear on the accounts of the sponsor at all. The plan is a separate entity with its own statements, and in any case a benefit payment reduces plan assets and the obligation by the same amount, leaving funded status untouched.

Figure 5: What moves funded status over a period

Four items move the balance sheet number. The dashed arrow marks the one that bypasses earnings entirely and goes to other comprehensive income.

Example 12 · Worked

At the start of 20X1 Workflow Corporation sets up a defined benefit pension plan for staff who qualify. The promised amount is 1 percent of salary in the final 12 months before retirement, multiplied by years of service, paid in cash. Recipients may take it as one sum on retiring or as monthly instalments. Workflow puts JPY 710 million into the plan at the start of 20X1, and the trustees place it mainly in fixed income and equity securities. The company reports under IFRS.

1. Set out what each statement shows for the year ended 31 December 20X1. Service cost is JPY 5 million. Long-term investment grade corporate bonds yield 2 percent. Nothing is paid out to members, plan assets actually return −3 percent, no further money goes in, and neither the plan terms nor the actuarial assumptions change.

Solution. Work through the four statements.

Income statement. Operating expense of 5 million for service cost. There is no interest component because the plan obligation at the beginning of the year is zero.

Statement of stockholders equity. Remeasurements of −21.3 million. The actual return on plan assets was −3% × 710 = −21.3 million, against an assumed amount of zero, so the whole of it is a remeasurement recognised in other comprehensive income.

Balance sheet. Cash falls by 710 million on the contribution. The net pension asset is 683.7 million: the opening funded status of 710 reduced by the 21.3 loss on plan assets and by the 5 of service cost, since 710 − 21.3 − 5 = 683.7. Equivalently, plan assets of 710 − 21.3 = 688.7 less an obligation of 5 gives 683.7.

Statement of cash flows. Cash flow from operating activities of −710 million, the contribution to plan assets.

2. Set out what each statement shows for the year ended 31 December 2X18. Service cost is JPY 9 million and benefits of JPY 5 million are paid out. Long-term investment grade corporate bonds yield 2 percent. The obligation opens at 97 and plan assets open at a fair value of 1,010. Plan assets actually return 5 percent. Workflow contributes nothing, amends nothing and revises no actuarial assumption.

Solution. Start with the opening funded status: 1,010 − 97 = 913 million, a net pension asset.

Income statement. Operating expense of 9 million for service cost, and net interest income of 18.3 million, being the opening net pension asset of 913 multiplied by the discount rate of 2 percent. Because the plan is in surplus, the net interest line is income rather than expense, and under IFRS it sits below operating income.

Statement of stockholders equity. Remeasurements of 30.3 million. The actual return on plan assets was 5% × 1,010 = 50.5 million. The amount already captured through the interest calculation is 2% × 1,010 = 20.2 million. The difference, 50.5 − 20.2 = 30.3 million, is the remeasurement.

Balance sheet. Net pension asset of 952.6 million. Take the opening 913, add net interest income of 18.3, add the remeasurement of 30.3 and deduct service cost of 9: 913 + 18.3 + 30.3 − 9 = 952.6. Checking from the components, plan assets end at 1,010 + 50.5 − 5 = 1,055.5 and the obligation ends at 97 + 9 + 1.94 − 5 = 102.94, and 1,055.5 − 102.94 gives the same 952.6. Benefits paid of 5 cancel out of both sides, exactly as expected.

Statement of cash flows. No impact, because no contributions were made.

Where US GAAP differs

US GAAP matches IFRS on the balance sheet and on the statement of cash flows. The income statement and other comprehensive income are materially different, and the expense is split into five components rather than three.

Current service cost, computed on the projected unit credit method as under IFRS and typically reported as an operating expense.
Interest cost, the discount rate multiplied by the pension obligation at the beginning of the year. This is a gross interest expense rather than a net figure, and it is normally presented within interest expense below operating income.
Expected return on plan assets, management estimate of a return rate applied to opening plan assets measured at fair value. It is not netted directly against interest cost in the manner of IFRS net interest, but recognised separately as an offset within earnings. The expected rate is usually derived from historical returns on asset classes and therefore depends on the asset allocation of the plan.
Amortisation of past service cost. Past service cost goes first to other comprehensive income in the period the change occurs, then is amortised into the income statement over the average service lives of the affected employees.
Amortisation of net gains or losses. Actuarial gains and losses, together with the difference between the expected and the actual return on plan assets, may go straight to profit or loss, but the more common choice is other comprehensive income with subsequent amortisation into earnings under the corridor approach.

The corridor approach compares the net cumulative unrecognised gains and losses at the start of the reporting period with the pension obligation and the fair value of plan assets at that date. If the cumulative unrecognised amount exceeds 10 percent of the greater of those two figures, the excess is amortised over the expected average remaining working lives of participating employees and included in periodic pension cost in earnings. The word corridor refers to that 10 percent band, and only the amount outside it must be amortised. The purpose is to smooth earnings against large swings in estimates or in plan asset values.

Measured at the beginning of the period. Only cumulative unrecognised gains and losses above this threshold are amortised.

Components of periodic defined benefit pension cost

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 21
IFRS component	IFRS recognition	US GAAP component	US GAAP recognition
Service costs	Recognised in profit or loss.	Current service costs	Recognised in profit or loss.
		Past service costs	Recognised in OCI and subsequently amortised to profit or loss over the service life of employees.
Net interest income or expense	Recognised in profit or loss as net pension liability or asset multiplied by the discount rate.	Interest expense on the pension obligation	Recognised in profit or loss.
		Expected return on plan assets	Recognised in profit or loss as plan assets multiplied by the expected return.
Remeasurements: net return on plan assets and actuarial gains and losses	Recognised in OCI and not in profit or loss. Net return on plan assets equals actual return less plan assets multiplied by the interest rate. Actuarial gains and losses are changes in the obligation arising from changes in actuarial assumptions.	Actuarial gains and losses including differences between actual and expected returns on plan assets	Recognised immediately in profit or loss or, more commonly, recognised in OCI and subsequently amortised to profit or loss using the corridor or a faster method. The asset difference equals actual return less plan assets multiplied by the expected return.

Two comparisons are worth committing to memory. IFRS applies the discount rate to plan assets inside net interest, whereas US GAAP applies management estimate of the expected return. Management can therefore flatter US GAAP earnings by raising the expected return assumption, a lever that does not exist under IFRS. And IFRS parks remeasurements permanently in other comprehensive income, whereas US GAAP recycles them into earnings over time through the corridor, so US GAAP earnings carry an echo of past actuarial surprises that IFRS earnings do not.

What the disclosures give you

Defined contribution disclosure requirements are minimal. IAS 19 requires only the amount recognised as an expense, typically given in a note headed Employee Compensation, Post-Employment Benefits or similar. Shell plc, the Amsterdam-based integrated oil company, limits its defined contribution disclosure to the amounts recognised on the income statement for each of the last three years.

Defined benefit disclosure, including OPEB, is another matter. For sponsors of large plans this is often the longest note in the accounts. Under IAS 19 management must explain the characteristics of the plans and the risks attached to them, identify and explain the amounts in the financial statements arising from the plans, and describe how the plans may affect the amount, timing and uncertainty of future cash flows.

Shell plc provides retirement benefits in most of the countries where it operates, through funded and unfunded defined benefit plans and through defined contribution plans, with the most significant pension plans in the Netherlands, the United Kingdom and the United States, and OPEB comprising retirement health care and life insurance in certain countries. The narrative shows how varied the position can be inside one group. The principal Dutch plan, a funded career-averaged arrangement paying annuities, reported a surplus of $1,756 million at 31 December 2021 against a surplus of $405 million a year earlier; it was closed to employees hired or rehired after 1 July 2013 but remains open for ongoing accrual by existing active members, who represent 26 percent of the overall Dutch defined benefit liability against 31 percent in 2020. The three largest UK plans, funded final salary arrangements, together reported a surplus of $3,807 million at 31 December 2021 against a deficit of $76 million in 2020, after netting unfunded plans of $473 million reported within non-current liabilities. All three UK plans are closed to new hires, two remain open for ongoing accrual, and active members account for 20 percent of the overall UK defined liability against 23 percent in 2020. Crucially, those three plans are separate and independent and cannot be netted against one another. In the United States the principal funded final average pay plan reported a surplus of $182 million at 31 December 2021 against a deficit of $1,846 million in 2020, alongside an unfunded defined benefit plan with a deficit of $1,129 million against $1,475 million in 2020, with active members representing 24 percent of the funded plan liability against 25 percent in 2020. The unfunded US OPEB plans, which provide medical, dental, vision and life insurance benefits and share costs between the company and retirees, reported a deficit of $4,067 million at 31 December 2021 against $4,497 million in 2020, with the medical plan closed to employees hired or rehired on or after 1 January 2017.

Shell plc aggregate funded status, millions of US dollars

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 22
Item	31 December 2021	31 December 2020
Pension obligations	(107,336)	(115,792)
Plan assets	104,495	102,678
Effect of asset ceilings	(13)	(17)
Surplus (deficit)	(2,854)	(13,131)
Recognised as non-current assets	8,471	2,474
Recognised as non-current liabilities: pensions	(6,458)	(10,237)
Recognised as non-current liabilities: OPEB	(4,867)	(5,368)
Total recognised	(2,854)	(13,131)

The aggregate deficit narrowed from 13,131 to 2,854 over the year. Note that a group-level net figure of 2,854 conceals a non-current asset of 8,471 and non-current liabilities of 11,325, because separate plans cannot be netted.

Shell plc pension asset allocation

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 23
Asset class	31 December 2021	31 December 2020
Equities	32%	33%
Debt securities	57%	57%
Real estate	7%	6%
Investment funds	3%	3%
Cash	1%	1%
Total	100%	100%

Contributions to defined benefit pension plans were estimated at $900 million for 2022.

Shell plc assumptions and sensitivity of the defined benefit obligation

FSA 2 – Employee Compensation_ Post-Employment and Share-Based — table 24
Actuarial input	Value at 31 December 2021	Sensitivity range	Change in the obligation
Growth rate applied to pensions already being paid	2.0%	−1% to +1%	(9,908) to 12,171
Discount rate applied to the pension plans	2.0%	−1% to +1%	18,954 to (14,599)
Assumed inflation	2.1%	−1% to +1%	(10,691) to 13,325
Life expectancy, men currently aged 60	87	−1 year to +1 year	(1,946) to 1,937
Life expectancy, women currently aged 60	89	−1 year to +1 year	(1,863) to 1,972

The discount rate row runs in the opposite direction to the others: a one percentage point fall in the discount rate raises the obligation by 18,954, which is larger than any other single sensitivity in the table.

Two analytical habits follow. Track the disclosed assumptions over time and against peers. Management looking to flatter the numbers can use a high discount rate, a low salary growth rate, low life expectancy, a low inflation rate and, for medical OPEB, a low health care cost growth rate, all of which shrink the obligation and the expense. Under US GAAP there is one further lever: raising the expected return on plan assets.

Modelling a defined contribution plan is easy and normally done implicitly. Because such expenses are usually structured as a percentage of salaries and paid in cash, they share drivers with short-term benefits and the rest of operating expenses, so forecasting selling, general and administrative expense also forecasts the defined contribution expense for staff in those functions. Cash flow matches the recognised expense, and the only balance sheet effect is an accrued liability already captured by working capital ratios.

Defined benefit plans, including OPEB, need four items forecast explicitly: service cost, net interest expense or income, remeasurements, and employer plan contributions. Those four generate the income statement charge, the net pension asset or liability on the balance sheet, and the contribution outflow on the statement of cash flows.

There is a materiality threshold that saves a great deal of wasted effort. Where a company has small, well funded plans, meaning the net pension liability is no more than 5 percent of equity market capitalisation, and particularly where those plans are closed or frozen, detailed forecasting is not worth the time. The plan is not part of the investment case.

Two effects in a valuation

A valuation has to reflect the funded status and the future service cost.

The funded status is handled asymmetrically, and the asymmetry is not simply conservatism. An underfunded plan is treated as debt in the enterprise value calculation and in the bridge from enterprise value to equity value. An overfunded plan is ignored. The justification lies in the legal structure described earlier. The sponsor of an underfunded plan is obliged to pay the benefits whatever the shortfall, so the deficit is a genuine claim ranking alongside debt. But a surplus is an asset only in a nominal sense, because plan assets cannot be withdrawn and handed to shareholders or lenders. They exist solely to pay benefits. Several data providers follow this convention and include net pension liabilities in their debt and enterprise value figures.

An overfunded plan contributes nothing to this bridge.

Future service costs are a separate matter, because they are not inside the funded status at all. They are compensation the employee earns in future periods in place of short-term benefits. Treat them as you would treat share-based compensation: even though service cost is not a cash expense, deduct it from free cash flow, which in practice means leaving it expensed and not adding it back to EBIT when building free cash flow. This applies unless the plans are frozen, in which case no further benefits accrue from service and there is nothing to deduct.

Net interest expense or income should be excluded from the discounted cash flow model. It is the unwinding of the discount on an obligation already stated at present value. The valuation is being performed on a present value basis, and the present value of an underfunded plan has already been dealt with by deducting the net pension liability from enterprise value. Including net interest as well would count the same obligation twice.

Pulling the two halves of the lesson together

The two forms of compensation in this lesson look very different on the page and behave the same way in a valuation. Both are non-cash charges that a naive discounted cash flow model would ignore. Both represent genuine transfers of value away from existing shareholders. And in both cases the recommended treatment is the same: leave the expense in when computing free cash flow, and deal separately with the balance sheet consequence, dilution for share-based awards and the funded status deficit for defined benefit plans. The instinct to add back every non-cash charge is the single most common error in this material.

Check yourself

1. A company grants RSUs on 1 January 20X1 with a three-year service condition. The share price triples by December 20X2. What happens to the expense recognised on that grant in 20X2 and 20X3?

Nothing at all. The award is measured at grant-date fair value and that measurement is never revisited. The tripling will raise the aggregate fair value of grants made in 20X2 and 20X3, so reported total expense will rise, but only through new grants and only one-third of each new grant enters the first year.

2. An employee exercises 2 million options with a strike price of 50 when the share price is 90. The grant-date fair value per option was 14. What are the entries?

There is no income statement effect. Financing cash inflow is 2 million × 50 = 100 million. The share-based compensation reserve falls by 2 million × 14 = 28 million and paid-in capital rises by 100 + 28 = 128 million. The price of 90 determines only whether the employee exercises, not the amounts recorded.

3. Under US GAAP, a company settles RSUs when its share price is well below the grant-date price. What happens to reported income tax expense and the effective tax rate?

The tax deduction falls short of the cumulative accounting expense, which is a tax shortfall. Under US GAAP that increases income tax expense on the income statement and pushes the effective tax rate up, potentially well above the statutory rate. An IFRS reporter would take the same amount straight to equity and report a more stable effective rate.

4. Why can a fall in the share price reduce the diluted share count?

Assumed proceeds under the treasury stock method are fixed by strike prices and by unrecognised expense measured at grant-date fair values. A lower average share price means those fixed proceeds buy back more shares, so the net addition to the share count shrinks and can fall to zero, at which point the award is anti-dilutive.

5. A plan has opening plan assets of 2,000 and an opening obligation of 2,300. The discount rate is 4 percent, service cost is 60, the actual return on plan assets is 130 and the employer contributes 90. Under IFRS, what is net interest and what is the remeasurement on plan assets?

The opening funded status is 2,000 − 2,300 = −300, a net pension liability, so net interest expense is 300 × 4% = 12. The remeasurement on plan assets is the actual return less plan assets multiplied by the discount rate: 130 − (2,000 × 4%) = 130 − 80 = 50, recognised in other comprehensive income.

6. Two companies are identical except that one runs an overfunded pension plan with a surplus of 500 and the other runs an underfunded plan with a deficit of 500. How should each be treated in a bridge from enterprise value to equity value?

The deficit of 500 is deducted as if it were debt, because the sponsor must pay the benefits regardless. The surplus of 500 is ignored, because plan assets are legally isolated and cannot be withdrawn for the benefit of shareholders or lenders. The treatment is deliberately asymmetric.

7. A technology company reports a free cash flow margin far above its net margin and trades on a much lower price to free cash flow multiple than its peers. What should you check first?

How much of its compensation is paid in shares. Share-based compensation reduces net income but not operating cash flow, so a heavy user will show inflated free cash flow and a flattering free cash flow multiple, with no difference in underlying economics. Compare on a consistent basis, either GAAP throughout or the same non-GAAP measure throughout, and deduct share-based compensation from free cash flow in any discounted cash flow model.

End of lesson.

Back to 04 Financial Statement Analysis

FSA 2 – Employee Compensation_ Post-Employment and Share-Based

Types of employee compensation and the principle behind the accounting

The five categories

One principle, three dates

Short-term benefits, and the capitalisation exception

Why the other categories are harder

Why companies grant shares

Employee stock options: measurement, expense and exercise

Measuring fair value

Settlement is where options differ

The shift from options to restricted stock

Post-employment benefit plans: defined contribution and defined benefit

Defined contribution plans

Defined benefit plans

Reporting for defined contribution plans

Funded status: the balance sheet number

Periodic pension cost under IFRS and US GAAP

The IFRS decomposition

Where US GAAP differs

What the disclosures give you

Modelling and valuing post-employment benefits

Two effects in a valuation

Pulling the two halves of the lesson together

FSA 2 – Employee Compensation_ Post-Employment and Share-Based

Types of employee compensation and the principle behind the accounting

The five categories

One principle, three dates

Short-term benefits, and the capitalisation exception

Why the other categories are harder

Why companies grant shares

How share-based compensation reaches the financial statements

Vesting conditions

The instruments

Employee stock options: measurement, expense and exercise

Measuring fair value

Settlement is where options differ

The shift from options to restricted stock

Tax effects, share counts and disclosure for share-based awards

Share-based compensation and the share count

When anti-dilutive securities matter most

What the disclosures give you

Forecasting share-based compensation and shares outstanding

The percentage-of-revenues approach

Forecasting the share count

Share-based compensation in valuation

The free cash flow trap

Post-employment benefit plans: defined contribution and defined benefit

Defined contribution plans

Defined benefit plans

Reporting for defined contribution plans

Funded status: the balance sheet number

Periodic pension cost under IFRS and US GAAP

The IFRS decomposition

Where US GAAP differs

What the disclosures give you

Modelling and valuing post-employment benefits

Two effects in a valuation

Pulling the two halves of the lesson together

Related lessons