Our Compensation Cost Petition With The SEC Moved The Needle But Not By Enough

The FASB has given us aggregated employee compensation disclosure but there is no progress on detailed breakdown of compensation, disclosure of contractor costs, labor turnover, employee tenure or the “maintenance” v/s “growth” component of labor cost.

Readers, especially my past students, know that I have droned on about how a modern day income statements of even our trillion dollar market cap companies make it close to impossible to get basic answers to questions we pose in a high school economics class on the financial performance and prospects of a firm.

All talk and no action is what we academics are known for! To break that mold, Colleen Honigsberg of Stanford Law School, and I co-led a petition filed with the SEC, supported by many like-minded and concerned investors, NGOs and ex-SEC commissioners from both sides of the political aisle. In particular, the petition asked that the SEC to require publicly listed firms to call out compensation costs, embedded in every line of their income statements. This is a big deal because barely 15% of US companies currently identify their compensation costs publicly. The petition resulted in a congressional hearing where Prof. Honigsberg, Cambria Allen and I motivated the need for such disclosures.

In the SEC petition, we had asked for a standardized grid of human capital disclosure, reproduced below, that companies could be expected to disclose.

So what did we get?

The FASB has proposed in its board meeting on January 11, 2023 to require companies to disaggregate and hence call out employee compensation. In particular, the FASB decided that the term “employee” should be defined consistent with the existing definition in “Topic 718, Compensation—Stock Compensation.”

Who is an employee as per the FASB?

PWC, in its guidance, states, ‘Under the ASC 718 definition of an employee, the primary consideration is whether or not the individual is considered an employee under common law. A leased individual must also be a common law employee, but the definition of an employee in ASC 718-10-20 includes additional criteria that need to be met for a leased individual to be considered an employee, including that the leased individual be eligible to participate in the lessee’s employee benefit plans, the lessee has the exclusive right to determine the economic value of the services performed by the lessee (including wages and the number of units and value of stock compensation granted), and the lessee has the right to hire, fire, and control the activities of the individual. If an individual does not meet those criteria, the individual would be considered a nonemployee.”

Who is a common law employee?

This gets tricky, as you can perhaps imagine. The Social Security Administration states, “the common-law control test is used to determine whether a worker is an employee. The test involves a great degree of subjectivity, and even with all the facts, it may still be difficult to say whether the services rendered were performed as an employee. Finding that a worker is an employee is a finding that the person was subject to control over when, where, and how (the means and methods) to perform the work. This finding does not mean the control is actually exercised—only that the employer has the right to exercise it.”

So, my guess is that the new guidance associated with disclosing employee compensation from the FASB does not apply to contractors. I would also guess that in borderline cases, contracts will be rewritten to keep contractors out of the purview of the FASB’s proposed rule.

This is regrettable because the disclosure rule will create new incentives for firms to move labor from their employee payroll to contractors. More important, money spent by the company on contractors is also labor cost from an investor’s perspective. The FASB usually takes the position that its job is not to worry about the real effects of its decisions. Even if we grant them that, excluding the totality of labor deployed would distort the reporting of resources expended on labor, employees and contractual, and hence provide only a partial view to the investor of what a firm spends on its human capital.

What about part time employees?

PWC’s guidance on ASC 718 states, “part-time employees generally meet ASC 718’s definition of an employee because they are considered employees under common law.” So, the FASB’s rule will cover compensation paid to part time employees but that dollar number will not be explicitly identifed, as asked for in our table.

What about pass through entities?

PWC’s guidance on ASC 718 states “we believe that the share-based payments awards of a pass-through entity should generally be considered employee awards if the grantee qualifies as a common law employee. The fact that the pass-through entity does not classify the grantee as an employee for payroll tax purposes is generally not relevant given the combined service and ownership relationship of owners in a pass-through entity (e.g., a partnership or a limited liability company).” I was interested in pass through entities on account of my earlier piece which suggests that hotels appear to offload labor to arguably pass through entities. So, we are back to the common law employee definition discussed earlier.

What is compensation, as per the FASB?

The Board decided that the definition of compensation is as follows:

“At a minimum, all forms of cash consideration (including deferred cash compensation), share- based payments, medical care benefits, retirement benefits, and other postemployment benefits, given by an entity in exchange for service rendered by employees or for the termination of employment. This includes wages, salaries, social security contributions, compensated absences, profit-sharing, bonuses, one-time employee termination benefits, nonretirement postemployment benefits, and any compensation cost recognized in accordance with the guidance in Topic 710, Compensation—General. Other postretirement benefits include postemployment life insurance and postemployment medical care. For defined benefit plans within the scope of Topic 715, Compensation—Retirement Benefits, employee compensation includes only the service cost component.”

This looks quite comprehensive and I can quibble a bit about why include just the service components of defined benefit plans but I am not going to. I have two bigger concerns. First, these components of compensation will be aggregated and reported as one number, unlike the breakdown we had asked for in our grid. Second, expenditure on training does not seem to be covered by the proposed dislcosure rule.

What about employee tenure, turnover and our ambitious ask related to what portion of labor cost was meant to support “maintenance” versus “growth” of the business?

It was not clear whether the FASB stayed out of disclosure related to tenure and turnover because these are not strictly financial statement disclosures. Perhaps the new SEC human capital rule expected soon will cover that. The “maintenance” versus “growth” part of labor cost was an admittedly big ask but I wonder whether CEOs and CFOs of companies are even aware of these estimates for their internal decision making and resource allocation.

Will the rule require firms to produce information they do not already collect?

A recent Wall Street Journal article announcing the FASB’s intention to ask for employee compensation disclosure seems to suggest that, “the income-statement proposal could require executives to disclose information that they don’t already have and would need to accumulate.” Surely, a firm knows how much it pays W-2 and 1099 workers at least for tax reporting purposes. Is it too much to then ask firms to publicly report compensation expenses accrued to W-2 workers separately from 1099 workers?

Cambria Allen of JUST Capital observes, “some of the companies commenting on the CEO-to-worker pay ratio state they could not calculate labor costs, which is basically required to comply with that rule. No executive should feel comfortable signing the SOX disclosures if the company can’t even calculate its own labor costs.”

In sum, we have made progress but the advocacy journey towards pushing for better human capital disclosure continues.