Expensing Employee Profit Sharing
Written By: Irene Wen
I. Effects on Corporations
Harmonization of Taiwan's standards for the accounting treatment of employee stock options would not only affect the profits corporations report in their financial statements; it would also likely have a substantial impact on employee remuneration. The possibility of such an impact has set off a lively debate in many circles over changing employee compensation systems and related topics.
Prior to its amendment, Article 64 of the Business Accounting Law specified that a distribution of a business's earnings, in the form of a stock dividend, say, or employee profit sharing, could not be claimed as an expense or loss. The granting of shares in connection with employee profit sharing plans was held to be a distribution of earnings, and as such, according to the above regulation, it did not count as part of a business's expenses. However, where so-called profit sharing amounts to employees receiving shares in exchange for providing their services, then it is part of employee remuneration no different from annual cash bonuses. By expensing annual bonuses but not employee profit sharing bonuses, there were two distinctly different accounting treatments for rewards that were equally forms of compensation, making financial statements incapable of fully reflecting employee compensations costs.
Under international financial reporting standards, as long as remuneration is paid because labor is provided by employees, whether the form of payment is cash or stock, it is uniformly required to be recognized as a business expense. After the revisions passed in June 2006, Article 64 of the Business Accounting Law continued to bar companies from recognizing distributions of earnings as expenses or losses, but the rule stating that distributions for employee profit sharing could not be claimed as an expense was excluded, and it stated that director and supervisor compensation must also be treated as an expense.
Since the Business Accounting Law did not spell out the particulars of recognizing employee profit sharing as an expense, such as when to recognize them and how to calculate the amount, the Securities and Futures Bureau of the Financial Supervisory Commission formulated the following related detailed rules:
- In its statutory financial statements for the then current period and for the end of the year, an enterprise must enter the estimated amounts of employee profit sharing and director/supervisor compensation that will be given in accordance with its articles of association. If, after the end of a period, the board of directors resolves to issue a significantly different amount, expenses in the then current period must be adjusted to reflect the change. If there is a change resulting from a resolution adopted by the annual shareholders' meeting, that change will be treated as one arising from a change in accounting estimates and entered in the following year's income statement.
- The basis for calculating the number of shares to distribute for employee profit sharing shall be fair market value. Regular listed companies must use the market price on the day prior to that of the shareholders' meeting (taking into account ex-rights and ex-dividend effects) to calculate the number of shares in its stock bonuses. So-called emerging stock companies - companies whose stock is traded on the Gretai Securities Market as "emerging stock" - and private limited companies must calculate the number of shares for bonuses using net value as given in independently audited and certified financial statements for the most recent period prior to the shareholders' meeting.
- In order to accommodate the share issue, companies need to raise any matters related to the revision of their articles of association at a shareholders' meeting, which they are advised to do beginning January 1st, 2008. Before doing so, they may continue not recognizing such share distributions as expenses.
One accounting treatment being considered would change the current practice, which uses face value to calculate the number of shares to be distributed for employee bonuses, to one that uses market price instead. Under this principle, any effect that expensing employee stock bonuses has on a company's reported profit would be felt through the proportions of shares to be given in director/supervisor compensation and employee bonuses, as determined by the company's articles of association. It would be unrelated to the market price of the stock. However, if the market price is used to calculate the number of shares to distribute in employee bonuses, there would be a very large impact on employees, especially those receiving stock bonuses from companies with elevated stock prices.
II. Changing Employee Compensation Systems
In order to lower the impact on corporations of expensing employee profit sharing, and to achieve employee motivation and talent retention objectives, the Securities and Futures Bureau consulted opinion on all sides before formulating a set of supporting measures, including: relaxation of employees' stock option exercise prices, relaxation of the exercise price at which corporations can buy back shares to serve as treasury shares for assignment to employees, and a restricted stock system.
To accompany implementation of the above measures, the Securities and Futures Bureau also formulated a rule under which companies using stock options as employee compensation must adopt as their accounting treatment an options pricing model that uses fair value to assess compensation costs.
Meanwhile, Taiwan's Accounting Research and Development Foundation also consulted the provisions of International Financial Reporting Standards 2 (IFRS 2) "Share-based Payment", issued by the International Accounting Standards Board, before setting about drafting Statement of Financial Accounting Standards 39 regarding the accounting treatment of employee compensation costs. IFRS 2 standards are based on an entity's equity instruments, which are used to calculate the price paid for goods purchased or services rendered, and they provide the related accounting treatment for share-based income earned by employees for the labor services they provide. This includes accounting treatment for compensation in cash (such as cash from exercising stock appreciation rights, thus dependent on the share price) or shares, or where the employer or the employee (or supplier) has the right to choose either cash or stock compensation. The scope of applicability covers assignment of stock by a company's shareholders to its employees or suppliers in order to secure services or product transactions needed by the company.
In principle, the accounting treatment of share-based compensation paid to suppliers is to enter the products or services provided by suppliers on a fair value basis, unless the fair value cannot be estimated reasonably, and so the fair value of the equity instruments is used. In the case of transactions involving employees, stock may be just one part of total remuneration, and it is very difficult to estimate the fair value of the benefit a company receives from retaining employees and enhancing productivity. For this reason, IFRS 2 provides that the basis for measuring the cost of employee share-based compensation must be the fair value of equity instruments on the day they are granted. Then, according to the number of options employees are expected to exercise, the expense is to be recognized over a limited period in conjunction with increases in shareholders' equity.
Where payment is in cash, the fair value of equity instruments must be measured on the day the cash is given, and the expense and liability must be recognized over a limited period. Then, on each financial statement reporting date and actual payment date, recognized expenses and relative liability amounts must be adjusted based on the re-measured fair value of the equity instruments. Where the company or employee has the right to choose the payment method and chooses cash, reference should be made to the accounting treatment of payments in cash.
In contrast to the IFRS 2 rules described above, the set of measures The Securities and Futures Bureau is considering for amending the law only governs those instances where stock or equity instruments like options are used to compensate employees. If a company elects to pay in cash based on a quantity of stock, then it would seem that doing so could skip over the legal limitations, and it would revert to being an internal corporate governance issue.
To summarize, in the future, any grant to employees of stock options, treasury shares or restricted stock may have to be recognized as employee compensation costs. This is irrespective of whether the company issues options at parity or below market, or whether shares are assigned to employees at below the average cost of buying back stock for treasury shares, and it even extends to where shareholders establish a stock trust and transfer the interest to employees. This naturally will affect profit in the financial statements.
III. For Corporations, the Way Forward
After expensing of employee stock bonuses takes effect, corporations will have to consider the effect of reflecting employee compensation costs fully in their financial statements. More importantly, each must think about how to establish an employee compensation system that is best suited to the corporation - one that will retain and motivate elite talent and create a triple win scenario benefiting the enterprise, its shareholders and employees alike.
All instruments for rewarding and compensating employees add to employee compensation costs. In the case of treasury stock and restricted stock, the employee immediately takes possession of the stock, so the compensation cost is the difference, on the day it is granted, between the fair value of the stock and the price paid by the employee. Employee stock options also have time value, so in theory they should be a costlier form of compensation. However, because restricted stock and employee stock options have restricted periods and holding periods, their cost may be amortized annually. In terms of the effect on earnings per share, while there is a positive effect when shares are bought back for treasury stock, thereby lowering the number of shares in circulation, other instruments have a diluting effect. Hence, enterprises had better choose instruments carefully, and devise compensation plans with proper terms and conditions that lesson the expense but still effectively motivate employees to produce results.
When an enterprise wishes to select a suitable compensation method, it should take into consideration what stage in the life of a company it happens to be at: newly founded and expanding companies will typically find it advantageous to offer instruments aimed at long-term motivation, such as employee stock options or restricted stock; more mature companies tend to have relatively stable profits, so they may consider adopting an instrument yielding shorter-term rewards, such as employee profit sharing stock bonuses. For a company that is in decline, on the other hand, it is more appropriate to rely mainly on salary and other standard employee benefits.
Legal restrictions are also important factors for corporations to consider. For example, some instruments used as incentives have legal restrictions on who the recipients can be. For instance, cash profit sharing bonuses may not be distributed to a company's employees, whereas stock bonuses may. As another example, a public company can issue employee stock options or buy back treasury shares and grant them to the full-time employees of the issuing company or its subsidiaries in Taiwan or abroad, but a non-public company is not allowed to give the same to its own employees. The amount of options issued, and the number of treasury shares that may be assigned, are all covered by statutory regulations. Also, a resolution by a shareholders' meeting or amendment of the articles of association is required in order to issue employee stock options with strike prices below the stock's market price on the issue date, or below the stock's net value per share, or else to assign to employees treasury shares for a price that is below the average price actually paid to buy back the stock. And if a company intends to raise or lower the proportions by which employee share bonuses are allocated, one may not use the same shareholders' meeting to resolve to allocate profit according to the amended proportions. The result is that the articles of association must be amended in the preceding year's shareholders' meeting.
Corporations also need to pay attention to the effect a new employee compensation system will have on cash flow. Issuing restricted shares can bring an immediate cash inflow, while those issuing options have to wait until employees exercise them before they can see a shift of funds. Where an assignment of treasury shares is the chosen approach, the corporation needs to experience an initial cash outflow before the shares are assigned to employees. And where employee profit sharing bonuses are used along with an issue of shares, there is no effect on cash flow. In addition, corporations must also take care that their employees' interests and shareholders' equity are not in mutual conflict, especially where the compensation system provides equity-type securities to employees at below their fair value and dilution of shareholders' equity is a potential issue.
In summary, achieving an optimal balance in wealth transfer relationships and outcomes between shareholders, corporate executives and employees, is an important issue for corporate decision makers.