Reading 20 - Employee Compensation

Question 1

In regards to a defined benefits plan, what does the funded status of the plan refer to ?

Answer 1

The difference between the benefit obligation and the plan assets

Question 2

What is the projected benefit obligation (PBO) aka present value of defined benefit obligation (PVDBO) under IFRS?

Answer 2

The actuarial present value of all future pensions benefits earned to date, based on expected future salary increases.

Question 3

What is the** service cost**?

Answer 3

Is the present value of benefits earned by the employees during the current period

**Is immediately recognized in the income statement**

Question 4

What is the interest cost?

Answer 4

Is the increase in the obligation due to the passage of time

= Beg. of period PBO * Discount Rate

**Is immediately recognized as a component of pesion expense**

Question 5

What are past (prior) service costs?

Answer 5

Retroactive benefits awarded to employees when a plan is initiated or amended

IFRS: costs are expensed immediately

GAAP: costs are amortized over the average service life of the employee

Question 6

What are Changes in actuarial assumptions?

Answer 6

The gains and losses that result from changes in variables such as mortality , employee turnover, retirement age, and the discount rate

Question 7

What is the formula to calculate the Fair Value of Plan Assets?

Answer 7

Question 8

What is the formula to calculate the value of the Projected Benefit Obligation (PBO) for a given yr?

Answer 8

Question 9

What are the 3 assumptions a firm discloses about its pension calculations?

Answer 9

1. The discount rate : is based on interest rates for high quality dixed income investments with a maturity profile simialr to the future obligation
2. The rate of compensation growth : the avg annual rate by which employee compensation is expected to increase over time
3. The expected return on plan assets : the assummed long-term rate of return on the plan’s investments

Question 10

What will increasing the discount rate do to a defined benefit obligation?

Answer 10

• Reduce present values, hence a lower PBO. Lower PBO improves the funding status
• Usually results in lower pension expense b/c of lower current service cost.
• Reduce interest cost

Question 11

What will decreasing the compensation growth rate do to a defined benefit obligation?

Answer 11

• Reduce future pension payments
• Reduce current service costs and lower interest cost

Question 12

How is the amount of Pension expense on the income statement calculated?

Answer 12

Net Periodic Benefit Costs

+ Service Cost

+ Interest Cost

• Expected return on plan assets

+/- Amort of actuarial (gains) loss

+ Amortization of prior service costs

= Pension expense on income statement

Question 13

What will increasing the expected return on plan assets do to a defined benefit obligation?

Answer 13

• Reduce pension expense
• Not affect the benefit obligation or the funded status of the plan

Question 14

What are some things analysts may want to consider when comparing firms who use different accounting treatments for pensions?

Answer 14

1. Gross vs. net pension assets/liabilities
2. Differences in assumptions used (ie…different discount rates, investment returns)
3. Differences between IFRS and GAAP in recognizing pension expense
4. Diffferences due to classification in the income statement

Question 15

What are 2 reasons for netting pension assets and liabilities?

Answer 15

1. The employer largely controls the plan assets and the obligation, therefore bears the risks and potential rewards
2. Company’s decisions regarding funding and accounting for the pension plan are more likely to be affected by the net pension obligation

***netting the assets/liabilties reduces the firm’s total assets which results in higher ROA

Question 16

How are stock options accounted for the financial statements?

Answer 16

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

Question 17

Option pricing models typically incorporate the following 6 inputs….

Answer 17

1. Exercise price
2. Stock price at the grant date
3. Expected return
4. Expected volatility
5. Expected dividends
6. Risk-free rate

Question 18

What are stock appreciation rights?

Answer 18

An award that gives the employee the right to receive compensation based on the increase in the price of the firm’s stock over a predetermined amount

Question 19

How do GAAP and IFRS differ in how they treat the recognition of the different pension components?

Answer 19

Current serivce cost, Interest cost and Expected return are treated the same for both. They are recognized on the Income Statement

**Past Service **cost: **

GAAP -> OCI, amortized over service life

IFRS -> Income Statement

Actuarial Gains/Losses:

GAAP -> Amortized portion on the income statment, unamortized in OCI

IFRS -> All in OCI, not amortized

Question 20

How can an analyst reclassify pension expense for analytical purposes?

Answer 20

Background:

Under GAAP, net pension expense (including interest) is shown as an operating expense.

Action:

1. Add back the pension expense and subtract only service cost in determining operating income
2. Interest should be added to the firm’s interest expense
3. Actual return on plan assets should be added to nonoperating income

Question 21

What is the formula to calculate the total periodic pension cost?

Answer 21

Total periodic pension cost

= service cost + interest cost – actual return on plan assets + plan ammendments

or

= ending PBO - beginning PBO + benefits paid - actual return on plan assets

Question 22

What is the Corridor Approach?

Answer 22

• Refers to actuarial gains/losses
• Only allowed in US GAAP
• Gains & losses outside a “corridor” are amortized
• The corridor is a 10% threshold, gains >10% and losses > -10% are presumed to be permanent and are amortized.
• Amortization of an acturial gain reduces pension expense and the opposite is true for losses