2. Employee Compensation: Post-Employment And Share-Based

Question 1

Define and calculate “funded status of the plan”.

Answer 1

Funded status os the plan is the difference in the benefit obligation and the plan assets.

Funded status = fair value of plan assets - PBO

Question 2

Define and calculate PBO.

Answer 2

PBO (projected benefit obligation) is the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases.

PBO = beginning PBO
            \+ service cost
            \+ interest cost
            \+ past service cost
            \+/- actuarial losses/gains
             - benefit paid

Question 3

Calculate “fair value of plan assets”.

Answer 3

Fair value of plan assets = beginning value
+contributions
+actual return
-benefits paid

Question 4

Define “current service cost”.

Answer 4

Is the present value of benefits earned by the employees during the current period. Service cost includes an estimate of compensation growth (future salary increases) if the pension benefits are based on future compensation.

Question 5

Define and calculate (from the pension obligation) “interest cost“.

Answer 5

Is the increase in the obligation due to the passage of time. Benefit obligations are discounted obligations; thus, interest accrued on the obligation each period.
Interest cost is equal to the pension obligation (PBO) at the beginning of the period multiplied by the discount rate.

Question 6

Define “past (prior) service costs.” 
In which (IFRS or US GAAP) the past service cost is expensed immediately?

Answer 6

Are retroactive benefits awarded to employees when a plan is initiated or amended. Under IFRS, past service cost are expensed immediately. Under US GAAP, past service cost are amortized over the average service life os employees.

Question 7

Define and calculate (2 ways) “periodic pension cost”.

Answer 7

Is the employer’s contribution adjusted for changes in funded status. In other words, the expense to the company is either paid (via contributions) or deferred (via a worsening of the plan’s funded status).

TPPC = employer contributions
- (ending funded status - beginning f.s)

TPPC = current service cost
+ interest cost
- actual return on plan assets
+/- actuarial losses/gains due changes in assumptions affecting PBO
+ prior service cost

Question 8

Which components of “periodic pension cost” are reported in P&L?

Answer 8

• Current service cost
• Past (prior) service costs ONLY under UFRS
• Interest cost
• Expected return on plan assets
• Actuarial gains and losses: just the amortized portion ONLY under US GAAP.

Question 9

How is recognized and which are the components of “actuarial gains and losses”?

Answer 9

Actuarial gains and losses are recognized in other comprehensive income (OCI). Under IFRS, actuarial gains and losses are not amortized. Under US GAAP, actuarial gains and losses are amortized using the corridor approach.

There are two components within actuarial gains and losses:

1st) Gain (loss) due to decrease (increase) in PBO occurring on account of changes in actuarial assumptions
2nd) Difference between actual and expected return on plan assets

Question 10

What is “corridor approach” and how does it works?

Answer 10

Is the approach to amortize actuarial gains and losses under US GAAP. Under IFRS, actuarial gains and losses are not amortized.

• Corridor Approach
For any period, once the beginning balance of actuarial gains and losses exceed 10% of the greater of the beginning PBO or plan assets, amortization is required. The excess amount over the “corridor” is amortized as a component of periodic pension cost in P&L over the remaining service life of the employees. The amortization of an actuarial gain reduces periodic pension cost in P&L and the amortization of actuarial loss increases the periodic pension cost in P&L.

Question 11

Which components of pension costs are included in OCI?

Answer 11

• Unamortized portion of actuarial gains/losses ONLY AUNDER US GAAP
• All actuarial gains/losses under IFRS

Question 12

Which US GAAP or IFRS presents all components of periodic pension cost aggregated as a single line item in income statement?

Answer 12

US GAAP.

Under IFRS, components may be presented separately.

• both US GAAP and IFRS require disclosure of total periodic pension cost in the notes to financial statement.

Question 13

Could you capitalize pension costs? How does it would be?

Answer 13

Yes. Pension costs included in the cost of production of goods (e.g. labor cost included in the value of work-in-process or finished goods) may be capitalized as part of valuation of ending inventory. When this inventory is eventually sold, such costs are expensed as a component of cost of goods sold.

Question 14

What’s the difference between

1) periodic pension cost in the income statement (I.e. reported pension expense)
2) total periodic pension cost (TPPC)

Answer 14

1) reported pension expense
. is what we report in the income statement
. uses EXPECTED return on plan assets
. is computed differently depending on whether we’re using IFRS or US GAAP

2) total periodic pension cost (TPPC)
. is the true (i.e. economic) cost of the pension plan
. Does not change depending on the accounting system chosen
. uses ACTUAL return on plan assets

Question 15

Which is the three assumptions in a firm’s pension calculations?

Answer 15

. The discount rate
. The rate of compensation growth
. The expected return on plan assets

Question 16

What is “the rate of compensation growth”?

Answer 16

Is the average annual rate by which employee compensation is expected to increase over time. The rate of compensation growth affects both the PBO and periodic pension cost.

Question 17

In which, IFRS or US GAAP, is assumed that the “expected return on plan assets” is always equal to the discount rate?

Answer 17

IFRS.

Under US GAAP, the differences between the expected return and actual return are deferred.

Question 18

What is the effect of an increase discount rate on balance sheet liability?

Answer 18

Decrease.

Increasing discount rate will reduce present values; hence, PBO is lower. A lower PBO improves the funded status of the plan.

Question 19

What is the effect of an increase discount rate on total periodic pension cost (TPPC)?

Answer 19

Decrease.

Increasing discount rate usually results in lower total periodic pension cost because of lower current service cost. Recall that current service cost is a present value calculation; this, an increase in the discount rate reduces the present value of a future sim.

Question 20

What’s the effect of an increase in discount rate on periodic pension cost in P&L?

Answer 20

Increasing discount rate usually reduce interest cost (beginning PBO X the discount rate) unless the plan is mature. Note that beginning PBO is reduced when the discount rate increases. For a non mature plan this decrease more that offsets the impact of the decreased rate at which we compute the interest cost.

Question 21

What’s the effect of a decrease in the rate of compensation growth on balance sheet liability?

Answer 21

Decrease.

Decreasing the compensation growth rate will reduce future benefit payments; hence, PBO is lower. A lower PBO improves the funded status of the plan.

Question 22

What’s the effect of a decrease in the rate of compensation growth on total periodic pension costs (TPPC)?

Answer 22

Decreasing the compensation growth rate will reduce current service cost and lower interest cost; thus, total periodic pension cost will decrease.

Question 23

What’s the effect of a decrease in the rate of compensation growth on periodic pension cost in P&L?

Answer 23

Decreasing the compensation growth rate will reduce current service cost and lower interest cost; thus, the periodic pension cost will decrease.

Question 24

What’s the effect of an increase in expected rate of return on plan assets on balance sheet liability?

Answer 24

No effect.

Increasing the expected return on plan assets (under US GAAP) will not affect the funded status of the plan.

Question 25

What’s the effect of in increase in expected rate of return on plan assets on total periodic pension cost (TPPC)?

Answer 25

No effect.

Increasing the expected return on plan assets (under US GAAP) will reduce periodic pension cost reported in P&L but leave the total periodic pension cost (TPPC) unchanged.

Question 26

What’s the effect of an increase in the expected rate of return on plan assets on periodic pension cost in P&L?

Answer 26

Decrease.

Increasing the expected return on plan assets (under US GAAP) will reduce periodic pension cost reported in P&L but leave the total periodic pension cost (TPPC) unchanged

Question 27

How can firms improve reported results by changing the discount rate, the compensation growth rate and the expected return on plan assets?

Answer 27

Increasing the discount rate

Reducing the compensation growth rate

Increasing the expected return on plan assets

Question 28

What is the differences due to classifications in the income statement under US GAAP and IFRS and how to adjust?

Answer 28

Classification of the components of periodic pension cost in P&L as operating / non-operating differs under IFRS and US GAAP.

• Under US GAAP, the entire periodic pension cost in P&L (including interest) is shown as an operating expense.
• Under IFRS, the components of periodic pension cost can be included in various line items.

Analysts can adjust GAAP-reported income by adding back the periodic pension cost in the P&L and subtracting only service cost in determining operating income. Interest cost should be added to the firm’s interest expense, and the actual return on plan assets should be added to non-operating income. Note that this adjustment excludes (ignores) any amortizations.

Question 29

How to interpret cash flow informations related pension plans (e.g. if the firms contributions exceed its total periodic pension cost)?

Answer 29

If the firm’s contributions exceed its total periodic pension cost, the difference can be viewed as a reduction in the overall pension obligation, similar to an excess principal payment on a loan.

Conversely, if the total periodic pension cost exceeds the contributions, the difference can be viewed as a source of borrowing.

Adjusting:

• if the contributions were Y less than the total periodic pension cost

After tax shortfall = Y * ( 1 - t )

Adjusted CFO = CFO - after tax shortfall

Adjusted CFF = CFF + after tax shortfall

Question 30

How accounting for stock grants and stock options: in which is based the compensation expense and how it is recognized?

Answer 30

Compensation expense is based on the fair value of the options on the grant date based on the number of options that are expected to vest.

The vest date is the first date the employee can actually exercise the options.

The compensation date expense is allocated in the income statement over the service period, which is the time between the grant date and retained earnings.

Question 31

Six typically inputs to option-price models:

Answer 31

1 exercise price

2 stock price at the grant date

3 expected term

4 expected volatility

5 expected dividends

6 risk free rate

The stock price after the grant date and the firm’s required cost of capital are not inputs to option price models.