CHAPTER 13

EMPLOYEE COMPENSATION: POSTEMPLOYMENT AND SHARE-BASED

Elaine Henry, CFA

Coral Gables, FL, U.S.A.

Elizabeth A. Gordon

Philadelphia, PA, U.S.A.

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• Describe the types of postemployment benefit plans and the implications for financial reports.
• Explain and calculate measures of a defined benefit pension obligation (i.e., present value of the defined benefit obligation and projected benefit obligation) and net pension liability (or asset).
• Describe the components of a company’s defined benefit pension expense.
• Explain and calculate the impact of a defined benefit plan’s assumptions on the defined benefit obligation and periodic expense.
• Calculate and explain the effects on financial statements of adjusting for items of pension and other postemployment benefits that are reported in the notes to the financial statements.
• Interpret pension plan note disclosures including cash flow related information.
• Evaluate the underlying economic liability (or asset) of a company’s pension and other postemployment benefits.
• Calculate the underlying economic pension expense (income) and other postemployment expense (income) based on disclosures.
• Explain issues involved in accounting for share-based compensation.
• Explain the impact on financial statements of the accounting for stock grants and stock options, and the importance of companies’ assumptions in valuing these grants and options.

1. INTRODUCTION

This chapter covers two complex aspects of employee compensation: postemployment (retirement) benefits and share-based compensation. Retirement benefits include pensions and other postemployment benefits such as health insurance. Examples of share-based compensation are stock options and stock grants.

A common issue underlying both aspects of employee compensation is the difficulty in measuring the value of the compensation. One factor contributing to the difficulty is that employees earn the benefits in the periods that they provide service, but typically receive the benefits in future periods—so measurement requires a significant number of assumptions.

This chapter provides an overview of the methods companies use to estimate and measure the benefits they provide to their employees and how this information is reported in financial statements. There has been some convergence between international financial reporting standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP) in the measurement and accounting treatment for pensions, other postemployment benefits, and share-based compensation; but some differences remain. Although this chapter focuses primarily on IFRS, instances where U.S. GAAP significantly differ are discussed.

The chapter is organized as follows: Section 2 addresses pensions and other postemployment benefits, and Section 3 covers share-based compensation with a primary focus on the accounting for and analysis of stock options. A summary and practice problems conclude the chapter.

2. PENSIONS AND OTHER POSTEMPLOYMENT BENEFITS

This section discusses the accounting and reporting of pensions and other postemployment benefits by the companies that provide these benefits (accounting and reporting by pension and other retirement funds are not covered in this chapter). Under IFRS, IAS 19, Employee Benefits, provides the principal source of guidance in accounting for pensions and other postemployment benefits. Under U.S. GAAP, the guidance is spread across several sections of the FASB Codification.1

The discussion begins with an overview of the types of benefits and measurement issues involved, including the accounting treatment for defined contribution plans. It then continues with financial statement reporting of pension plans and other postemployment benefits including an overview of critical assumptions used to value these benefits. The section concludes with a discussion of evaluating defined benefit pension plan and other postemployment benefit disclosures.

2.1. Types of Postemployment Benefit Plans

Companies (sponsors) may offer various types of benefits to their employees following retirement, including pension plans, health care plans, medical insurance, and life insurance. Some of these benefits involve payments in the current period but many are promises of future benefits. The objectives of accounting for employee benefits is to measure the cost associated with providing these benefits and to recognize these costs in the sponsoring company’s financial statements during the employees’ periods of service. Complexity arises because the sponsoring company must make assumptions to estimate the value of future benefits. The assumptions required to estimate and recognize these future benefits can have a significant impact on the company’s reported performance and financial position. In addition, differences in assumptions can reduce comparability across companies.

Pension plans, as well as other postemployment benefits, may be either defined contribution plans or defined benefit plans. Under a defined contribution (DC) pension plan, specific (or agreed-upon) contributions are made to an employee’s pension plan. The agreed-upon amount is the pension expense. Typically, in a DC pension plan, an individual account is established for each participating employee. The accounts are generally invested through a financial intermediary such as an investment management company or an insurance company. The employees and the employer may each contribute to the plan. After the employer makes its agreed-upon contribution to the plan on behalf of an employee—generally in the same period in which the employee provides the service—the employer has no obligation to make payments beyond this amount. The future value of the plan’s assets depends on the performance of the investments within the plan. Any gains or losses related to those investments accrue to the employee. Therefore, in DC pension plans, the employee bears the risk that plan assets will not be sufficient to meet future needs. The impact on the company’s financial statements of DC pension plans is easily assessed, because the company has no obligations beyond the required contributions.

In contrast to DC pension plans, defined benefit (DB) pension plans are essentially promises by the employer to pay a defined amount of pension in the future. As part of total compensation, the employee works in the current period in exchange for a pension to be paid after retirement. In a DB pension plan, the amount of pension benefit to be provided is defined, usually by reference to age, years of service, compensation, and so forth. For example, a DB pension plan may provide for the retiree to be paid, annually until death, an amount equal to 1 percent of the final year’s salary times the number of years of service. The future pension payments represent a liability or obligation of the company. To measure this obligation, the employer must make various actuarial assumptions (employee turnover, average retirement age, life expectancy after retirement) and computations. The assumptions should be evaluated for their reasonableness, and the impact of the assumptions on the financial reports of the company should be analyzed.

Under IFRS and U.S. GAAP, all plans for pensions and other postemployment benefits other than those explicitly structured as DC plans are classified as DB plans.2 DB plans include both formal plans and those informal arrangements that create a constructive obligation by the employer to its employees.3 The employer must estimate the total cost of the benefits promised and then allocate these costs to the periods in which the employees provide service. This estimation and allocation further increases the complexity of pension reporting because the timing of cash flows (contributions into the plan and payments from the plan) can differ significantly from the timing of accrual-basis reporting. The accrual-basis reporting is based on when the services are rendered and the benefits earned.

Most DB pension plans are funded through a separate legal entity, typically a pension trust, and the assets of the trust are used to make the payments to retirees. The sponsoring company is responsible for making contributions to the plan. The company also must ensure that there are sufficient assets in the plan to pay the ultimate benefits promised to plan participants. Regulatory requirements usually specify minimum funding levels for DB pension plans, but those requirements vary by country. The funded status of a pension plan—overfunded or underfunded—refers to whether the amount of assets in the pension trust is greater than or less than the estimated liability. If the amount of assets in the DB pension trust exceeds the present value of the estimated liability, the DB pension plan is said to be overfunded; conversely, if the amount of assets in the pension trust is less than the estimated liability, the plan is said to be underfunded. Because the company has promised a defined amount of benefit to the employees, it is obligated to make those pension payments when they are due regardless of whether the pension plan assets generate sufficient returns to provide the benefits. In other words, the company bears the investment risk. Many companies are reducing the use of DB pension plans because of this.

Similar to DB pension plans, other postemployment benefits (OPB) are promises by the company to pay benefits in the future, such as life insurance premiums and all or part of health care insurance for its retirees. OPB are typically classified as DB plans with accounting treatment similar to DB pension plans. However, the complexity in reporting for OPB may be even greater than for DB pension plans because of the need to estimate future increases in costs, such as health care, over a long time horizon. Unlike DB pension plans, however, companies may not be required by regulation to fund an OPB in advance to the same degree as DB pension plans. This is partly because governments, through some means, often insure DB pension plans but not OPB, partly because OPB may represent a much smaller financial liability, and partly because OPB are often easier to eliminate should the costs become burdensome. It is important that an analyst determine what OPB are offered by a company and the obligation these represent.

Types of postemployment benefits offered by employers differ across countries. For instance, in countries where government-sponsored universal health care plans exist (such as Germany, France, Canada, Brazil, Mexico, New Zealand, South Africa, India, Israel, Bhutan, and Singapore), companies are less likely to provide postretirement health care benefits to employees. The extent to which companies offer DC or DB pension plans also vary by country.

Exhibit 13-1 summarizes these three types of postemployment benefits.

EXHIBIT 13-1 Types of Postemployment Benefits

The following sections provide additional detail on how DB pension plan liabilities and periodic costs are measured, the financial statement impact of reporting pension and other postemployment benefits, and how disclosures in the notes to the financial statements can be used to gain insights about the underlying economics of a company’s defined benefit plans. Section 2.2 describes how a DB pension plan’s obligation is estimated and the key inputs into and assumptions behind the estimate. Section 2.3 describes financial statement reporting of pension and OPB plans and demonstrates the calculation of defined benefit obligations and current costs and the effects of assumptions. Section 2.4 describes disclosures in financial reports about pension and OPB plans. These include disclosures about assumptions that can be useful in analyzing and comparing pension and OPB plans within and among companies. The disclosures are also useful in assessing the underlying economic pension liability (or asset) and expense (or income).

2.2. Measuring a Defined Benefit Pension Plan’s Obligations

Both IFRS and U.S. GAAP measure the pension obligation as the present value of future benefits earned by employees for service provided to date. The obligation is called the present value of the defined benefit obligation (PVDBO) under IFRS and the projected benefit obligation (PBO) under U.S. GAAP.4 This measure is defined as “the present value, without deducting any plan assets, of expected future payments required to settle the obligation arising from employee service in the current and prior periods” under IFRS and “the actuarial present value as of a date of all benefits attributed by the pension benefit formula to employee service rendered prior to that date” under U.S. GAAP. In the reminder of this chapter, the term “pension obligation” will be used to generically refer to PVDBO and PBO.

In determining the pension obligation, a company estimates the future benefits it will pay. To estimate the future benefits, the company must make a number of assumptions5 such as future compensation increases and levels, discount rates, and expected vesting rate. For instance, an estimate of future compensation is made if the pension benefit formula is based on future compensation levels (examples include pay-related, final-pay, final-average-pay, or career-average-pay plans). The expected annual increase in compensation over the employee service period can have a significant impact on the defined benefit obligation. The determination of the benefit obligation implicitly assumes that the company will continue to operate in the future (the “going concern assumption”) and recognizes that benefits will increase with future compensation increases.

Another key assumption is the discount rate—the interest rate used to calculate the present value of the future benefits. This rate is based on current rates of return on high quality corporate bonds (or government bonds in the absence of a deep market in corporate bonds) with currency and durations consistent with the currency and durations of the benefits. Under both DB and DC pension plans, the benefits that employees earn may be conditional on remaining with the company for a specified period of time. “Vesting” refers to a provision in pensions plans whereby an employee gains rights to future benefits only after meeting certain criteria such as a prespecified number of years of service. If the employee leaves the company before meeting the criteria, they may be entitled to none or a portion of the benefits they have earned up until that point. However, once the employee has met the vesting requirements, they are entitled to receive the benefits they have earned in prior periods (i.e., when the employee has become vested, benefits are not forfeited if the employee leaves the company). In measuring the defined benefit obligation, the company considers the probability that some employees may not satisfy the vesting requirements (i.e., may leave before the vesting period) and uses this probability to calculate the current service cost and the present value of the obligation. Current service cost is the increase in the present value of a defined benefit obligation as a result of employee service in the current period. Current service cost is not the only cause of change in the present value of a defined benefit obligation.

The estimates and assumptions about future salary increases, discount rate, and expected vesting rate can change. Of course, any changes in these estimates and assumptions will change the estimated pension obligation. If the changes increase the obligation, the increase is referred to as an actuarial loss. If the changes decrease the obligation, the change is referred to as an actuarial gain. Section 2.3.3 further discusses estimates and assumptions and the effect on the pension obligation and expense.

2.3. Financial Statement Reporting of Pension Plans and Other Postemployment Benefits

Sections 2.3.1 to 2.3.3 describe how pension plans and other postemployment benefits are reported in the financial statements of the sponsoring company and how assumptions affect the amounts reported. Disclosures related to pensions plans and OPB are described in Section 2.4.

2.3.1. Defined Contribution Pension Plans

The accounting treatment for defined contribution pension plans is relatively simple. From a financial statement perspective, the employer’s obligation for contributions into the plan, if any, is recorded as an expense on the income statement. Because the employer’s obligation is limited to a defined amount that typically equals its contribution, no significant pension related liability accrues on the balance sheet. An accrual (current liability) is recognized at the end of the reporting period only for any unpaid contributions.

2.3.2. Defined Benefit Pension Plans

The accounting treatment for defined benefit pension plans is more complex, primarily because of the complexities of measuring the pension obligation and expense. U.S. GAAP takes a simpler approach to measuring the amount reported on the balance sheet; for this reason, U.S. GAAP is discussed first in the next section on balance sheet presentation.

2.3.2.1. Balance Sheet Presentation

Under U.S. GAAP, a pension plan’s funded status is reported on the balance sheet. The funded status is determined by netting the pension obligation against the fair value of the pension plan assets. If the pension obligation exceeds the pension plan assets, then a liability equal to the net pension obligation or underfunded pension obligation is reported. If the plan assets exceed the pension obligation, then an asset equal to the overfunded pension obligation is reported.

Similarly under IFRS, a net amount is reported on the balance sheet but the net amount may differ from what would be reported under U.S. GAAP. First, IFRS does not immediately recognize all changes in the pension obligation due to plan amendments, which change the pension benefit for existing employees. These changes are referred to as past service costs (PSC) under IFRS and prior service costs under U.S. GAAP. Under IFRS, the change in the liability related to PSC for vested employees is recognized in the financial statements in the current period. Any PSC related to unvested employees is deferred and recognized as a liability as benefits vest. Therefore, the deferred PSC is not recorded in the balance sheet measure of the net pension liability (or net pension asset).

Second under IFRS, changes in pension obligations and plan assets that result from changing actuarial estimates and assumptions may or may not be fully recognized. A company may opt to fully recognize these changes, termed actuarial gains and losses, in the reported net pension liability (or net pension asset). A company’s other option is to defer recognizing the actuarial gains and losses (AGLs) until certain conditions are met. If a company chooses to fully recognize the AGLs, its reported net pension obligation (or net pension asset) is calculated as the pension obligation less fair value of pension plans assets less unrecognized past service costs. If a company chooses to defer recognizing the AGLs, its net pension liability (or net pension asset) is calculated as the pension obligation less fair value of pension plans assets less unrecognized past service costs plus unrecognized actuarial gains less unrecognized actuarial losses.6 Note that if the resulting number is positive a liability is reported, and if the resulting number is negative an asset is reported. Putting the preceding information in equation form, we see that:

The funded status is the amount reported on the balance sheet under U.S. GAAP as the net pension liability (asset).

The net pension liability (asset) after removing unrecognized past service costs and actuarial gains/losses is the amount reported on the balance sheet under IFRS, subject to limits on the amount of net plan assets that may be reported when a company defers AGLs. Specifically, IFRS restricts the amount of the net plan assets that can be reported on the balance sheet to the lower of:

• The pension obligation less fair value of pension plans assets less unrecognized past service costs plus unrecognized actuarial gains less unrecognized actuarial losses (as given earlier).
• The total of any cumulative unrecognized net actuarial losses and past service costs plus the present value of any economic benefits available in the form of refunds from the plan or reductions in future contributions to the plan.7

Under IFRS and U.S. GAAP, disclosures in the notes provide additional information about the net pension liability or asset reported on the balance sheet.

The IASB and the FASB have identified accounting for postemployment benefits, including pensions, as a project in their collaborative efforts towards convergence. Subsequent changes in accounting standards are expected to address those aspects of current accounting standards that differ.

2.3.2.2. Income Statement: Pension Expense

The periodic cost of a company’s DB pension plan can be thought of as the increase in its pension obligations, offset by earnings on the pension plan’s assets. However, IFRS and U.S. GAAP do not require companies to reflect this entire amount as the pension expense. Pension expense under IFRS and U.S. GAAP is generally composed of five items: current service costs, interest expense accrued on the pension obligation, return on plan assets, past service costs, and actuarial gains or losses. Current and past service costs, interest expense accrued on the pension obligation, and actuarial losses increase the pension expense; return on plan assets and actuarial gains reduce the pension expense. Additionally, some companies report losses on curtailments or settlements as part of the pension expense.8

Items Immediately and Fully Recognized in Pension Expense. Under IFRS and U.S. GAAP, current service costs and interest expense on the pension obligation are fully and immediately reflected as components of a company’s defined benefit pension expense. However, under IFRS, the components of pension expense can be included in various line items including interest expense and, under U.S. GAAP, the components of pension expense are reported within operating expense.

The expected return on the pension plan’s assets, including interest income, dividend income, gains or losses on sales of securities, and unrealized gains and losses (i.e., changes in the value of the assets held by the plan) offsets these costs. Using an expected return decreases volatility in the pension expense, basically smoothing earnings. Standard setters justify using an expected rather than actual return, because pension assets are usually a long-term investment matched to employee retirement. In certain years, actual returns can be more or less than the long-term expected rate of return. To decrease volatility and reflect the long-term nature of the investment, an expected rate of return is used.

In addition to allowing the use of an expected rate of return to smooth earnings, both IFRS and U.S. GAAP include other provisions (sometimes referred to as smoothing mechanisms because they result in a smoother pattern of income). These provisions allow some of the effects of past service costs and of other actuarial gains and losses to be reflected in a company’s DB pension expense over time.

Smoothed Expense Recognition: Past Service Costs. Under IFRS, past service costs (PSC) for vested employees are recognized in the current period when the change to the pension plan is made. For unvested employees, the PSC is amortized over future periods as the employees become vested. Therefore, past service costs are recognized over the vesting period despite the fact that the cost refers to employee service in previous periods. Past service costs are measured as the change in the defined benefit obligation resulting from the plan amendment. Amendments that increase benefits payable also increase pension expense, and those that reduce benefits payable (referred to as negative past service costs) reduce pension expense. Unrecognized past service costs are disclosed in the notes to the financial statements and used to calculate the pension liability or asset that is reported on the balance sheet.

Under U.S. GAAP, past (prior) service costs are reported in other comprehensive income (which in turn increases accumulated other comprehensive income, a component of equity) in the period in which the change occurs. In subsequent periods, these costs are amortized over the average service lives of the affected employees and reported as a component of pension expense. Unamortized past service costs are reported in accumulated other comprehensive income and are not included in the determination of the pension liability or asset.

Smoothed Expense Recognition: Actuarial Gains or Losses. Actuarial gains and losses (AGLs) result from two sources: changes in the actuarial assumptions used in determining the benefit obligation, and differences between the expected and actual returns on pension plan assets. In theory, the differences between expected and actual returns come from short-term fluctuations in market returns; over the long term, expected and actual returns should converge. Therefore, in the long term, actuarial gains and losses arising from differences between the expected and actual returns on plan assets should offset one another.

Under IFRS, companies may recognize actuarial gains and losses immediately either on the income statement or in other comprehensive income, or defer recognition until certain conditions are met under the corridor approach discussed later. If a company chooses to recognize the AGLs in other comprehensive income, they are never reported in income.

Under U.S. GAAP, all actuarial gains and losses are included in the net pension liability or net pension asset and can be reported either in net income or as other comprehensive income. Typically, companies report actuarial gains and losses in other comprehensive income, recognizing the gains or losses in income only when certain conditions are met under the corridor approach discussed later.

Under the IFRS deferred recognition and U.S. GAAP, in the recognition of actuarial gains and losses, companies use either the corridor method or a faster recognition method to determine the minimum amount to be reported on the income statement.

Under the corridor method, the net cumulative unrecognized actuarial gains and losses at the beginning of the reporting period are compared with the defined benefit obligation and the fair value of plan assets at the beginning of the period. If the cumulative amount of unrecognized actuarial gains and losses becomes too large (i.e., exceeds 10 percent of the greater of the defined benefit obligation or the fair value of plan assets), then the excess is amortized over the expected average remaining working lives of the employees participating in the plan and is included as a component of pension expense. The term “corridor” refers to the 10 percent range, and it is only amounts in excess of the corridor that must be amortized.

To illustrate the corridor approach, say the beginning balance of the defined benefit obligation is $5,000,000, the beginning balance of fair value of plan assets is $4,850,000, and the beginning balance of unrecognized actuarial losses is $610,000. The expected average remaining working lives of the plan employees is 10 years. In this scenario, the corridor is $500,000, which is 10 percent of the larger defined benefit obligation. Because the balance of unrecognized actuarial losses exceeds the $500,000 corridor, amortization is required. The amount of the amortization is $11,000, which is the excess of the unrecognized actuarial loss over the corridor divided by the expected average remaining working lives of the plan employees [($610,000 − $500,000) ÷ 10 years].

Actuarial gains or losses can also be amortized more quickly than under the corridor method; companies may use a faster recognition method, provided the company applies the method of amortization to both gains and losses consistently in all periods presented.

Reporting the Pension Expense. IFRS does not require companies to present the various components of pension expense as a net amount (i.e., within a single line item) on the income statement. Instead, companies may disclose portions of net pension expense within different line items on the income statement. For example, companies can record the interest cost and the expected return on plan assets as a part of financing costs on the income statement. U.S. GAAP, however, requires all components of net periodic pension expense (cost) to be aggregated and presented as a net amount within the same line item on the income statement. Both IFRS and U.S. GAAP require total pension expense to be disclosed in the notes to the financial statements.

To summarize, an income statement prepared under IFRS will include current service costs, interest cost, the expected return on plan assets, all past service costs for vested employees and amortized past service costs of unvested employees, the effect of any settlement or curtailment, and perhaps actuarial gains and losses (if the company does not choose to recognize them as other comprehensive income or defer recognizing them).

Under U.S. GAAP, the net periodic pension expense reported on the income statement will include current service costs, interest cost, the expected return on plan assets (or the actual return), the amortization of past service costs, actuarial gains and losses to the extent not reported as other comprehensive income, and the effect of settlement or curtailment gains or losses.9 In summary, the components of a company’s defined benefit pension expense are listed in Exhibit 13-2.

EXHIBIT 13-2 Components of a Company’s Defined Benefit Pension Expense

Component	Effect on Defined Benefit Pension Expense	Direction of Effect
Service costs: Estimated increase in the pension obligation resulting from employees’ service during the period.	Immediately and fully recognized.	Increases the expense.
Interest expense on the opening pension obligation.	Immediately and fully recognized.	Increases the expense.
Past service costs: Increase in the pension obligation resulting from changes to the terms of a pension plan applicable to employees’ service during previous periods.	IFRS: Vested employees’ portion expensed immediately; unvested employees’ portion expensed over average period until vesting.	Typically increases the expense.
	U.S. GAAP: Portion not immediately recognized as an expense is shown in other comprehensive income and subsequently amortized over service life of employees.
Actuarial gains and losses, including changes in a company’s pension obligation arising from changes in actuarial assumptions and differences between the actual and expected returns on plan assets.	IFRS: (1) Recognized immediately either in the income statement or as other comprehensive income (equity); or (2) deferred and amortized using the corridor or a faster recognition method. If the cumulative unrecognized amount of actuarial gains and losses exceeds specified levels, a portion of the excess is recognized as an expense.a U.S. GAAP: Recognized immediately as an expense or deferred and amortized using the corridor or faster recognition method.a All amounts not immediately recognized as an expense are included in other comprehensive income.	May increase or decrease the expense.
Return on plan assets.	Expected return on plan assets is immediately and fully recognized as a reduction of pension expense. Any differences between expected and actual return is considered part of actuarial gains and losses and treated as described previously.	Decreases the expense.b

aIf the cumulative amount of unrecognized actuarial gains and losses exceeds 10 percent of the greater of the value of the plan assets or of the present value of the DB obligation (under U.S. GAAP, the projected benefit obligation), the difference must be amortized over the service lives of the employees.

bIf the actual return on plan assets is lower than the expected return on plan assets such that the cumulative difference becomes large enough to require amortization, the amortization of the difference increases pension expense.

2.3.3. More on the Effect of Assumptions and Actuarial Gains and Losses on Pension and Other Postemployment Benefits Expense

As noted, a company’s pension obligation for a DB pension plan is an estimate based on many estimates and assumptions. The amount of future pension payments requires assumptions about employee turnover, length of service, and rate of increase in compensation levels. The length of time the pension payments will be made requires assumptions about employees’ life expectancy post employment. Finally, the present value of these future payments requires assumptions about the appropriate discount rate and the rate at which interest will subsequently accrue on the pension liability.

Changes in any of the assumptions will increase or decrease the pension obligation. An increase in pension obligation resulting from changes in actuarial assumptions is considered an actuarial loss, and a decrease is considered an actuarial gain. The estimate of a company’s pension liability affects several components of annual pension expense, apart from actuarial gains and losses. First, the service cost component of annual pension expense is essentially the amount by which the pension liability increases as a result of the employees’ service during the year. Second, the interest cost component of annual pension expense is based on the amount of the liability. Third, the past service cost component of annual pension expense is the amount by which the pension liability increases because of changes to the plan.

Estimates related to plan assets also affect annual pension expense. Because a company’s pension expense includes the expected return on pension assets rather than the actual return, the assumptions about the expected return on plan assets can have a significant impact. Also, the expected return on plan assets requires estimating in which future period the benefits will be paid. As noted earlier, a divergence of actual returns on pension assets from expected returns results in an actuarial gain or loss.

Understanding the effect of assumptions on the estimated pension obligation and on periodic expenses is important both for interpreting a company’s financial statements and for evaluating whether a company’s assumptions appear relatively conservative or aggressive.

The projected unit credit method is the IFRS approach to measuring the DB obligation. Under the projected unit credit method, each period of service (e.g., year of employment) gives rise to an additional unit of benefit to which the employee is entitled at retirement. In other words, for each period in which an employee provides service, they earn a portion of the postemployment benefits that the company has promised to pay. An equivalent way of thinking about this is that the amount of eventual benefit increases with each additional year of service. The employer measures each unit of service as it is earned, to determine the amount of benefits it is obligated to pay in future reporting periods.

The objective of the projected unit credit method is to allocate the entire expected retirement costs (benefits) for an employee over the employee’s service periods. The defined benefit obligation represents the actuarial present value of all units of benefit (credit) to which the employee is entitled (i.e., has earned) as a result of prior and current periods of service. This obligation is based on actuarial assumptions about demographic variables such as employee turnover and life expectancy, and on estimates of financial variables such as future inflation and the expected long-term return on the plan’s assets. If the pension benefit formula is based on employees’ future compensation levels, then the unit of benefit earned each period will reflect this estimate.

Under both IFRS and U.S. GAAP, the assumed rate of increase in compensation—the expected annual increase in compensation over the employee service period—can have a significant impact on the defined benefit obligation. Another key assumption is the discount rate used to calculate the present value of the future benefits. It represents the rate at which the defined benefit obligation could be effectively settled. This rate is based on current rates of return on high quality corporate bonds with durations consistent with the durations of the benefit.

The following example illustrates the calculation of the defined benefit pension obligation and current service costs, using the projected unit credit method, for an individual employee under four different scenarios. The fourth scenario is used to demonstrate the impact on a company’s pension obligation of changes in certain key estimates.

Example 13-4 illustrates that an increase in the assumed discount rate will decrease a company’s pension obligation. In the Solution to 1, there is a slight increase in the interest component of the pension obligation and pension expense. However, the interest component of the pension obligation and pension expense (calculated as the discount rate times the obligation at the beginning of the year) may decrease because the decrease in the opening obligation may more than offset the effect of the increase in the discount rate; an exception occurs when the pension obligation is of a short duration; i.e., time to retirement is short.

Example 13-4 also illustrates that an increase in the assumed rate of annual compensation increase will increase a company’s pension obligation when the pension formula is based on final year’s salary. In addition, a higher assumed rate of annual compensation increase will increase the service components and the interest component of a company’s periodic pension expense because of an increased annual unit credit and the resulting increased obligation. An increase in life expectancy also will increase the pension obligation unless the promised pension payments are independent of life expectancy; e.g., paid as a lump sum or over a fixed period.

Finally, because the expected return on plan assets reduces pension expense, a higher expected return will decrease pension expense. Exhibit 13-3 summarizes the impact of some key estimates on the balance sheet and the periodic benefit-related expense.

EXHIBIT 13-3 Impact of Key DB Pension Assumptions on Balance Sheet and Periodic Expense

Assumption	Impact of Assumption on Balance Sheet	Impact of Assumption on Periodic Expense
Higher discount rate.	Lower obligation.	Pension expense will typically be lower because of lower opening obligation and lower service costs.
Higher rate of compensation increase.	Higher obligation.	Higher service costs.
Higher expected return on plan assets.	No effect, because fair value of plan assets are used on balance sheet	Lower pension expense.

Accounting for other postemployment benefits also requires assumptions and estimates. For example, assumed trends in health care costs are an important component of estimating costs of postemployment health care plans. A higher assumed medical expense inflation rate will result in a higher postemployment medical obligation. Companies also estimate various patterns of health care cost trend rates—for example, higher in the near term, but becoming lower after some point in time. For postemployment health plans, an increase in the assumed inflationary trends in health care costs or an increase in life expectancy will increase the obligation and associated periodic expense of these plans.

The previous sections have explained how the amounts to be reported on the balance sheet are calculated, how the pension expense on the income statement reflects the five components, and how changes in assumptions can affect pension-related amounts. The next section evaluates disclosures of pension and other postemployment benefits, including disclosures about key assumptions.

2.4. Disclosures of Pension and Other Postemployment Benefits

Several aspects of the accounting for pensions and other postemployment benefits described earlier can affect comparative financial analysis using ratios based on financial statements.

• Differences in key assumptions can affect comparisons across companies.
• Differences between IFRS and U.S. GAAP in how the reported net pension liability (or net pension asset) and pension expense are determined can affect comparisons.
• The smoothing mechanisms within the accounting standards can obscure the underlying economic expense.
• Under U.S. GAAP, all of the components of pension expense are reported in operating expense on the income statement, even though some of the components are of a financial nature (specifically, interest expense and the expected return on assets). However, under IFRS the components of pension expense can be included in various line items.
• Cash flow information may not be comparable. Under IFRS, some portion of the amount of contributions might be treated as a financing activity rather than an operating activity and under U.S. GAAP, the contribution is treated as an operating activity.

Information related to pensions can be obtained from various portions of the financial statement note disclosures and appropriate analytical adjustments can be made. In the following sections, we examine pension plan note disclosures to address analytical issues.

2.4.1. Assumptions

Companies disclose their assumptions about discount rates, expected compensation increases, medical expense inflation, and expected return on plan assets. Comparing these assumptions over time and across companies provides a basis to assess any conservative or aggressive biases. Some companies also disclose the effects of a change in their assumptions.

Exhibit 13-4 presents the assumed discount rates (Panel A) and assumed annual compensation increases (Panel B) to estimate pension obligations for four companies operating in the automotive and equipment manufacturing sector. Fiat S.p.A. (an Italian-based company) and The Volvo Group11 (a Swedish-based company) use IFRS. General Motors and Ford Motor Company are U.S.-based companies that use U.S. GAAP. All of these companies have both U.S. and non-U.S. defined benefit pension plans, which facilitates comparison.

EXHIBIT 13-4

The assumed discount rates used to estimate pension obligations are generally based on the market interest rates of high quality corporate fixed income investments with a maturity profile similar to the timing of a company’s future pension payments. The trend in discount rates across the companies (in both their non-U.S. plans and U.S. plans) is generally similar. In the non-U.S. plans, discount rates increased from 2005 to 2008 and then decreased in 2009 except for Fiat, which increased its discount rate in 2009. In the U.S. plans, discount rates increased from 2005 to 2007 and held steady or decreased in 2008. In 2009, Fiat and Ford’s discount rates increased while Volvo and GM’s discount rates decreased. Ford had the highest assumed discount rates for both its non-U.S. and U.S. plans in 2009. Recall that a higher discount rate assumption results in a lower estimated pension obligation. Therefore, the use of a higher discount rate compared to its peers may indicate a less conservative bias.

Explanations for differences in the level of the assumed discount rates, apart from bias, are differences in the regions/countries involved and differences in the timing of obligations (for example, differences in the percentage of employees covered by the DB pension plan that are at or near retirement). In this example, difference in regions/countries might explain the difference in rates used for the non-U.S. plans, but would not explain the difference in the rates shown for the companies’ U.S. plans. The timing of obligations under the companies’ DB pension plans likely varies, so the relevant market interest rates selected as the discount rate will vary accordingly. Because the timing of the pension obligations is not disclosed, differences in timing cannot be ruled out as an explanation for differences in discount rates.

An important consideration is whether the assumptions are internally consistent. For example, do the company’s assumed discount rates and assumed compensation increases reflect a consistent view of inflation? For Volvo, both the assumed discount rates and the assumed annual compensation increases (for both its non-U.S. and U.S. plans) are lower than those of the other companies, so the assumptions appear internally consistent. The assumptions are consistent with plans located in lower inflation regions. Recall that a lower rate of compensation increase results in a lower estimated pension obligation.

In Ford’s U.S. and non-U.S. pension plans, the assumed discount rate is increasing and the assumed rate of compensation increase is decreasing or holding steady in 2009. Each of these will reduce the pension obligation. Therefore, holding all else equal, Ford’s pension liability is decreasing because of the higher assumed discount rate and the reduced assumed rate of compensation increase.

Exhibit 13-5 presents a comparison of the four companies’ assumptions about the expected return on U.S. pension plan assets. Recall that a higher expected return on plan assets lowers the periodic pension expense. (Of course, a higher expected return on plan assets presumably reflects more risky investments, so it would not be advisable for a company to simply invest in riskier investments to reduce periodic pension expense.) Analysts should compare the company’s assumptions in the context of its chosen asset allocation.

EXHIBIT 13-5 Assumed Expected Return on U.S. Plan Pension Expense (percent)

EXHIBIT 13-6 Allocation of Plan Assets (Equity/Debt/Other; in percent)

Although the disclosures for Fiat and Volvo do not separately reveal plan assets for the U.S. plans, comparison of the overall asset allocations (Exhibit 13-6) yields some insights. From Exhibit 13-5, General Motors assumes the highest expected return and Volvo assumes the lowest expected returns. A higher expected return is consistent with a greater portion of plan assets being allocated to riskier investments such as equities. However, this does not seem to be the case as Volvo’s 49 percent allocation to equity is actually higher than two of its peers (Fiat and General Motors) and very close to the other (Ford). However, GM has much higher allocation to “Other” and these assets might be expected to earn a high return. Recall that a higher expected return on plan assets lowers a company’s pension expense.

2.4.1.1. Assumptions: Other Postemployment Benefits

Companies with other postemployment benefits disclose information about these benefits, including assumptions made to estimate the obligation and expense. For example, postemployment health care plans, a type of defined benefit plan, disclose assumptions about increases in health care costs. The assumptions are typically that the inflation rate in health care costs will taper off to some lower, constant rate at some year in the future. That future inflation rate is known as the ultimate health care trend rate. Holding all else equal, each of the following assumptions would result in a higher benefit obligation and a higher periodic expense:

• A higher assumed near-term increase in health care costs.
• A higher assumed ultimate health care trend rate.
• A later year in which the ultimate health care trend rate is assumed to be reached.

Conversely, holding all else equal, each of the following assumptions would result in a lower benefit obligation and a lower periodic expense:

• A lower assumed near-term increase in health care costs.
• A lower assumed ultimate health care trend rate.
• An earlier year in which the ultimate health care trend rate is assumed to be reached.

Example 13-5 examines two companies’ assumptions about trends in U.S. health care costs.

This section has explored the use of pension and other postemployment benefits disclosures to assess a company’s assumptions and explore how the assumptions can affect comparisons across companies. The following sections describe the use of disclosures to analyze the underlying economics of a company’s pension and other postemployment benefits.

2.4.2. Underlying Economic Pension Liability (or Asset)

Because the accounting and reporting of DB pension plans differ between IFRS and U.S. GAAP and companies have different options under IFRS, it is useful to be able to assess a company’s underlying pension liability (or asset) as the pension obligation less plan assets (funded position or funded status). U.S. GAAP reports this net amount on the balance sheet, so additional adjustments are not needed to reflect the underlying economics. IFRS requires additional adjustments to reflect the underlying economic liability (or asset) if a company defers AGLs and/or does not report the obligation for all past service costs. In addition, IFRS includes a limitation on the amount of a pension asset that can be reported. Thus, the amount reported under IFRS is not necessarily equivalent to the economic perspective of the net funded position. Analysts look at the notes to the financial statements to find the gross benefit obligation and the fair value of the assets allocated to pay the obligation to determine the economic net funded position.

Another consideration is that under both standards, the amount appearing in the balance sheet is a net amount. Analysts can use information from the notes to adjust a company’s assets and liabilities for the gross amount of the benefit plan assets and the gross amount of the benefit plan liabilities. An argument for making such adjustments is that they reflect the underlying economic liabilities and assets of a company; however, it should be recognized that actual consolidation is precluded by laws protecting a pension or other benefit plan as a separate legal entity.

At a minimum, an analyst will compare the gross benefit obligation (i.e., the benefit obligation without deducting related plan assets) to the sponsoring company’s total assets including the gross amount of the benefit plan assets, shareholders’ equity, and earnings. Although presumably infrequent in practice, if the gross benefit obligation is large relative to these items, a small change in the pension liability can have a significant financial impact on the sponsoring company.

2.4.3. Underlying Economic Expense (or Income)

As illustrated in Exhibit 13-8, the two main reasons for changes in the economic net funded status of a DB pension plan are the economic periodic costs (as opposed to reported periodic costs) of the pension plan, and contributions to the plan by the sponsoring company. Benefits paid to retirees decrease the pension obligations and the plan assets by an identical amount and thus have no impact on the net funded status. The economic periodic costs of a company’s DB pension plan comprise net increases in pension obligations (excluding the impact of benefits paid) offset by earnings on pension plan assets. The economic periodic costs of a company’s DB pension plan can be calculated in either of the following ways: by summing each item (other than benefits paid) that increases or decreases the pension obligation and deducting actual returns on pension plan assets; or equivalently, by taking the contributions made by the sponsoring company and adjusting for the change in the plan’s net funded status over the period. Because the computations yield equivalent results, analysts can use the approach they consider most intuitive to determine the economic pension expense.

EXHIBIT 13-8 Summary of Underlying Economic Liability (or Asset) and Economic Expense of the Period

Example 13-7 illustrates the estimation of economic pension expense for the J.M. Smucker Company (NYSE: SJM), which prepares its financial statements in accordance with U.S. GAAP. The estimation of pension expense is shown first for U.S. GAAP because the reported and economic net funded positions are equivalent; this allows the use of the format of Exhibit 13-8 to estimate the economic pension expense.

As illustrated, the pension expense shown on a company’s income statement does not reflect the economic expense of the period primarily because, under certain conditions, accounting standards permit several components of pension expense to be smoothed into income over time. The components of the cost that may be smoothed include past service costs and actuarial gains and losses. Recall that actuarial gains and losses result from two sources: changes in the actuarial assumptions used to determine the benefit obligation, and differences between the expected and actual returns on pension plan assets. Analysts can adjust for these items and determine the underlying economic expense (or income).

The economic pension expense of the period effectively includes the following: actual returns on plan assets, all actuarial gains and losses arising in the period, and all service costs arising in the period (whether they relate to current service or past service). Further, the economic pension expense of the period effectively excludes any amortization of past service costs, any amortization of net actuarial gains and losses, and the amount of expected returns on plan assets.

Example 13-8 illustrates the estimation of economic pension expense for Novartis Group [NYSE (ADR): NVS], which prepares its financial statements in accordance with IFRS.

Another issue with the reported periodic pension or benefit expense is that conceptually the components of pension expense could be classified as operating, investing, or financing costs. However, the expense is generally treated as a single item and deducted as an operating expense. It can be argued that only the current service cost component of the pension expense is an operating expense, whereas the interest component and asset returns are both nonoperating. The interest cost component of pension expense is conceptually similar to the interest cost on any of the company’s other liabilities. The pension liability is essentially equivalent to borrowing from employees, and the interest costs of that borrowing can be considered financing costs. Similarly, the return on pension plan assets is conceptually similar to returns on any of the company’s other financial assets.

To better reflect a company’s operating performance, an adjustment can be made to operating income by adding back the full pension expense and then subtracting the service costs or the total of service costs and settlements and curtailments. Note that this approach excludes from operating income the amortization of past service costs and the amortization of net actuarial gains and losses. This adjustment also eliminates the interest cost component and the return on plan assets component from the company’s operating income. The interest cost component would be added to the company’s interest expense, and the return on plan assets would be treated as nonoperating income. Recall that the expected return on plan assets is included as a component of pension expense. The difference between the actual and expected return is shown as a component of other comprehensive income. This difference can be taken to the current year so that current year earnings reflect the actual return on plan assets. This adjustment changes net income, and potentially introduces earnings volatility. The reclassification of interest expense would not change net income. Example 13-9 illustrates adjustments to operating and nonoperating incomes.

2.4.4. Cash Flow Information

For a sponsoring company, the cash flow impact of pension and other postemployment benefits is the amount of contributions that the company makes to fund the plan; or for unfunded plans, the amount of benefits paid. The amount of contributions a company makes to fund a pension or other postemployment benefit plan is partially determined by regulations of the countries in which the company operates. In the United States, for example, the amount of contributions to DB pension plans is governed by ERISA (the Employee Retirement and Income Security Act) and depends on the funded status of the plan. Companies may choose to make contributions in excess of those required by regulation.

The previous section described the economic pension expense of a period. If a sponsoring company’s periodic contributions to a plan exceed the economic pension expense of the period, the excess can be viewed from an economic perspective as a reduction of the pension obligation. The contribution covers not only the pension obligation arising in the current period, but also the pension obligations of another period. Such a contribution would be similar in concept to making a principal payment on a loan in excess of the scheduled principal payment. Conversely, a periodic contribution that is less than the economic pension expense of the period can be viewed as a source of financing.

In Example 13-8, Novartis had a negative economic expense (economic income) of $912 million and company contributions to the plan of $268 million for fiscal 2009. The net funded position increase (excess) of $1,180 million can be viewed as a reduction of the benefit obligation. The company covered not only the benefit obligation arising during the year, but also part of the benefit obligation from other periods. Where the amounts of benefit obligations are material, an analyst may choose to adjust the cash flows that a company presents in its statement of cash flows. In this instance, the adjustment would reclassify the excess as an outflow related to financing activities rather than to operating activities. Example 13-10 describes such an adjustment.

3. SHARE-BASED COMPENSATION

In this section, we provide an overview of executive compensation, other than pension plans and other postretirement benefits, focusing on share-based compensation. First, we briefly discuss common components of executive compensation packages, their objectives, and advantages and disadvantages of share-based compensation. The discussion of share-based compensation then moves to accounting for and reporting of stock grants before concentrating on stock options. The explanation includes discussion of fair value accounting, the choice of valuation models, assumptions used, common disclosures, and important dates in measuring and reporting compensation expense.

Employee compensation packages are structured to achieve varied objectives including satisfying employees’ needs for liquidity, retaining employees, and motivating employees. Common components of employee compensation packages are salary, bonuses, nonmonetary benefits, and share-based compensation.12 The salary component provides for the liquidity needs of an employee. Bonuses, generally in the form of cash, motivate and reward employees for short- or long-term performance or goal achievement by linking pay to performance. Nonmonetary benefits, such as medical care, housing, and cars, may be provided to facilitate employees performing their jobs. Salary, bonuses, and nonmonetary benefits are short-term employee benefits.

Share-based compensation is intended to align employees’ interest with those of the shareholders and is typically a form of deferred compensation. Both IFRS and U.S. GAAP 13 require a company to disclose in their annual report key elements of management compensation. Regulators may require additional disclosure. The disclosures enable analysts to understand the nature and extent of compensation including the share-based payment arrangements that existed during the reporting period. Following are examples of descriptions of the components and objectives of executive compensation programs for companies that report under IFRS and under U.S. GAAP. Exhibit 13-9 shows excerpts of the disclosure for the executive compensation program of SABMiller plc (London Stock Exchange: SAB); SABMiller plc reports under IFRS and includes a nine page Remuneration Report as part of its Annual Report.

In the United States, similar disclosures are required in a company’s proxy statement that is filed with the SEC. Exhibit 13-10 shows the disclosure of American Eagle Outfitters, Inc.’s (NYSE: AEO) executive compensation program including a description of the key elements and objectives.

Share-based compensation, in addition to theoretically aligning the interests of employees (management) with shareholders, has the advantage of potentially requiring no cash outlay.14 Share-based compensation arrangements can take a variety of forms including those that are equity-settled and those that are cash-settled. However, share-based compensation is treated as an expense and thus as a reduction of earnings even when no cash changes hands. In addition to decreasing earnings through compensation expense, stock options have the potential to dilute earnings per share.

Although share-based compensation is generally viewed as motivating employees and aligning managers’ interests with those of the shareholders, there are several disadvantages of share-based compensation. One disadvantage is that the recipient of the share-based compensation may have limited influence over the company’s market value (consider the scenario of overall market decline), so share-based compensation does not necessarily provide the desired incentives. Another disadvantage is that the increased ownership may lead managers to be risk-averse. In other words, fearing a large market value decline (and loss in individual wealth), managers may seek less risky (and less profitable) projects. An opposite effect, excessive risk-taking, can also occur with the awarding of options. Because options have skewed pay out that rewards excessive risk-taking, managers may seek more risky projects. Finally, when share-based compensation is granted to employees, existing shareholders’ ownership is diluted.

For financial reporting, a company reports compensation expense during the period in which employees earn that compensation. Accounting for cash salary payments and cash bonuses is relatively straightforward. When the employee has earned the salary or bonus, an expense is recorded. Typically, compensation expense for managers is reported in sales, general, and administrative expenses on the income statement.

Share-based compensation is more varied and includes items such as stock, stock options, or stock appreciation rights and phantom shares. By granting shares or share options in addition to other compensation, companies are paying additional compensation for services rendered by employees. Under both IFRS and U.S. GAAP, companies use the fair value of the share-based compensation granted to measure the value of the employees’ services for purposes of reporting compensation expense. However, the specifics of the accounting depend on the type of share-based compensation given to the employee. Under both IFRS and U.S. GAAP, the usual disclosures required for share-based compensation include: (1) the nature and extent of share-based compensation arrangements during the period, (2) how the fair value of a share-based compensation arrangement was determined, and (3) the effect of share-based compensation on the company’s income for the period and on its financial position.

Two common forms of equity-settled share-based compensation are discussed here: stock grants and stock options.

3.1. Stock Grants

A company can grant stock to employees outright, with restrictions, or contingent on performance. For an outright stock grant, compensation expense is reported based on the fair value of the stock on the grant date—generally the market value at grant date. Compensation expense is allocated over the period benefited by the employee’s service, referred to as the service period. The employee service period is presumed to be the current period unless there are some specific requirements, such as three years service in the future, before the employee is vested (has the right to receive the compensation).

Another type of stock award is a restricted stock which requires the employee to return ownership of those shares to the company if certain conditions are not met. Common restrictions include the requirement that employees remain with the company for a specified period or that certain performance goals are met. Compensation expense for restricted stock grants is measured as the fair value (usually market value) of the shares issued at the grant date. This compensation expense is allocated over the employee service period.

Shares granted contingent on meeting performance goals are called performance shares. The amount of the grant is usually determined by performance measures other than the change in stock price, such as accounting earnings or return on assets. Basing the grant on accounting performance addresses employees’ potential concerns that stock price is beyond their control and thus should not form the basis for compensation. However, performance shares can potentially have the unintended impact of providing incentives to manipulate accounting numbers. Compensation expense is equal to the fair value (usually market value) of the shares issued at the grant date. This compensation expense is allocated over the employee service period.

3.2. Stock Options

Like stock grants, compensation expense related to option grants is reported at fair value under both IFRS and U.S. GAAP. Both require that fair value be estimated using an appropriate valuation model.

Whereas the fair value of stock grants is usually based on the market value at the date of the grant, the fair value of option grants must be estimated. Companies cannot rely on market prices of options to measure the fair value of employee stock options because features of employee stock options typically differ from traded options. To measure the fair value of employee stock options, therefore, companies must use a valuation model. The choice of valuation or option pricing model is one of the critical elements in estimating fair value. Several models are commonly used, such as the Black–Scholes option pricing model or a binomial model. Accounting standards do not prescribe a particular model. Generally, though, the valuation method should be (1) consistent with fair value measurement, (2) based on established principles of financial economic theory, and (3) reflect all substantive characteristics of the award.

Once a valuation model is selected, a company must determine the inputs to the model, typically including exercise price, stock price volatility, estimated life of each award, estimated number of options that will be forfeited, dividend yield, and the risk free rate of interest.15 Some inputs, such as the exercise price, are known at the time of the grant. Other critical inputs are highly subjective—such as stock price volatility or the estimated life of stock options—and can greatly change the estimated fair value and thus compensation expense. Higher volatility, longer estimated life, and higher risk-free interest rate increase the estimated fair value, while a higher assumed dividend yield decreases the estimated fair value.

Combining different assumptions with alternative valuation models can significantly impact the fair value of employee stock options. Following is an excerpt from Glaxo SmithKline explaining the assumptions and model used in valuing its stock options. (Although not discussed in the disclosure, from 2007 to 2009 the trends of decreasing interest rates, lower share price, and increasing dividend yield would decrease estimated fair values and thus lower option expense. In contrast, the trend of increasing volatility would increase the estimated fair values.)

EXHIBIT 13-11 Assumptions Used in Stock Options Pricing Models

In accounting for stock options, there are several important dates including the grant date, vesting date, exercise date, and expiration date. The grant date is the day that options are granted to employees. The service period is usually the period between the grant date and the vesting date.

The vesting date is the date that employees can first exercise the stock options. The vesting can be immediate or over a future period. If the share-based payments vest immediately (i.e., no further period of service is required), then expense is recognized on the grant date. If the share-based awards do not vest until a specified service period is completed, compensation expense is recognized and allocated over the service period. If the share-based awards are conditional upon the achievement of a performance condition or a market condition (i.e., a target share price), then compensation expense is recognized over the estimated service period. The exercise date is the date when employees actually exercise the options and convert them to stock. If the options go unexercised, they may expire at some predetermined future date, commonly 5 or 10 years from the grant date.

The grant date is also usually the date that compensation expense is measured if both the number of shares and option price are known. If facts affecting the value of options granted depend on events after the grant date, then compensation expense is measured at the exercise date. In the following example, Coca-Cola, Inc. (NYSE: KO) reported, in the 2009 Form 10-K, $241 million of compensation expense from option grants.

As the option expense is recognized over the relevant vesting period, the impact on the financial statements is to ultimately reduce retained earnings (as with any other expense). The offsetting entry is an increase in paid-in capital. Thus, the recognition of option expense has no net impact on total equity.

3.3. Other Types of Share-Based Compensation

Both stock grants and stock options allow the employee to obtain direct ownership in the company. Other types of share-based compensation, such as stock appreciation rights (SARs) or phantom stock, compensate an employee based on changes in the value of shares without requiring the employee to hold the shares. These are referred to as cash-settled share-based compensation. With SARs, an employee’s compensation is based on increases in a company’s share price. Like other forms of share-based compensation, SARs serve to motivate employees and align their interest with shareholders. Two additional advantages of SARs are:

A disadvantage is that SARs require a current-period cash outflow. Similar to other share-based compensation, SARs are valued at fair value and compensation expense is allocated over the service period of the employee. While phantom share plans are similar to other types of share-based compensation, they differ somewhat because compensation is based on the performance of hypothetical stock rather than the company’s actual stock. Unlike SARs, phantom shares can be used by private companies or business units within a company that are not publicly traded, or by highly illiquid companies.

4. SUMMARY

This chapter discussed two different forms of employee compensation: postemployment benefits and share-based compensation. While different, the two are similar in that they are forms of compensation outside of the standard salary arrangements. They also involve complex valuation, accounting, and reporting issues. While IFRS and U.S. GAAP are converging on accounting and reporting, it is important to note that differences in a country’s social system, laws, and regulations can result in differences in a company’s pension and share-based compensation plans that may be reflected in the company’s earnings and financial reports.

Key points include the following:

• Defined contribution pension plans specify (define) only the amount of contribution to the plan; the eventual amount of the pension benefit to the employee will depend on the value of an employee’s plan assets at the time of retirement.
• Balance sheet reporting is less analytically relevant for defined contribution plans because companies make contributions to defined contribution plans as the expense arises and thus no liabilities accrue for that type of plan.
• Defined benefit pension plans specify (define) the amount of the pension benefit, often determined by a plan formula, under which the eventual amount of the benefit to the employee is a function of length of service and final salary.
• Accounting for a defined benefit pension plan entails:
  • Estimating the defined benefit obligation (the amount of future benefits) using actuarial assumptions and demographic variables;
  • Estimating the present value of the defined benefit obligation and the related current service costs using the project unit credit method;
  • Determining the actuarial gains and losses and the amount of these actuarial gains and losses to be recognized;
  • Estimating any past service costs; and
  • Determining the fair value of plan assets.
• Defined benefit pension plan obligations are funded by the sponsoring company contributing assets to a pension trust, a separate legal entity. Differences exist in countries’ regulatory requirements for companies to fund defined benefit pension plan obligations.
• IFRS requires companies to report on their balance sheet a pension liability or asset equal to the defined benefit obligation minus the fair value of plan assets, with optional adjustments for unrecognized actuarial gains or losses and required adjustments for any past service costs. However, IFRS restricts the amount of a pension asset that can be reported.
• U.S. GAAP requires companies to report on their balance sheet a pension liability or asset equal to the projected benefit obligation minus the fair value of plan assets, with no additional adjustments. There is no limit on the amount of a pension asset that can be reported.
• Pension expense includes the following components: current service costs, interest expense, past service costs, actuarial gains and losses, and expected return on plan assets (which reduces pension expense). IFRS does not require companies to present the various components of pension expense as a net amount (i.e., one line item) on the income statement. Instead, companies may disclose portions of net pension expense within different line items on the income statement. U.S. GAAP, however, requires all components of net periodic pension expense to be aggregated and presented as a net amount (a single line item) on the income statement.
• Estimates of the future obligation under defined benefit pension plans and other postemployment benefits are sensitive to numerous assumptions, including discount rates, assumed annual compensation increases, expected return on plan assets, and assumed health care cost inflation.
• Employee compensation packages are structured to fulfill varied objectives including satisfying employees’ needs for liquidity, retaining employees, and providing incentives to employees.
• Common components of employee compensation packages are salary, bonuses, and share-based compensation.
• Share-based compensation serves to align employees’ interest with those of the shareholders. It includes stocks and stock options.
• Share-based compensation has the advantage of requiring no current-period cash outlays.
• Share-based compensation expense is reported at fair value under IFRS and U.S. GAAP.
• The valuation technique, or option pricing model, that a company uses is an important choice in determining fair value and is disclosed.
• Key assumptions and input into option pricing models include items such as exercise price, stock price volatility, estimated life of each award, estimated number of options that will be forfeited, dividend yield, and the risk-free rate of interest. Certain assumptions are highly subjective, such as stock price volatility or the expected life of stock options, and can greatly change the estimated fair value and thus compensation expense.

PROBLEMS

The following information relates to Questions 1 through 6.

Kensington plc is based in the United Kingdom and offers its employees a defined benefit pension plan. Kensington complies with IFRS. The company’s effective tax rate for 2009 is 28 percent. Excerpts from a financial statement note on Kensington’s retirement plans are presented in Exhibit A.

EXHIBIT A Kensington Plc Defined Benefit Pension Plan

(in millions)	2009
Components of net periodic benefit cost
Service cost	£96
Interest cost	1,557
Expected return plan assets	−1,874
Recognized past service cost	169
Recognized net actuarial loss	95
Net periodic pension cost	£43
Change in benefit obligation
Benefit obligations at beginning of year	£28,416
Service cost	96
Interest cost	1,557
Actuarial (gains) losses	−306
Past service costs	132
Foreign exchange impact	−42
Benefits paid	−1,322
Benefit obligations at end of year	£28,531
Change in plan assets
Fair value of plan assets at beginning of year	£23,432
Expected return plan assets	1,874
Actuarial loss	−572
Employer contributions	693
Benefits paid	−1,322
Fair value of plan assets at end of year	£24,105
Funded Status	−£4,426
Unrecognized past service cost	185
Unrecognized actuarial gain	−318
Net asset (liability) in the balance sheet	−£4,559

1. At year-end 2009, £28,531 million represents:

A. the funded status of the plan.

B. the defined benefit obligation.

C. the fair value of the plan’s assets.

2. The economic pension expense for Kensington’s defined benefit plan is closest to:

A. £135 million.

B. £1,251 million.

C. £2,509 million.

3. The difference between Kensington’s estimated economic pension expense for the period and its reported net periodic pension cost is closest to:

A. £92 million.

B. £1,208 million.

C. £1,302 million.

4. To adjust Kensington’s reported net income to reflect the company’s underlying economic pension expense, the decrease in net income would be closest to:

A. £26 million.

B. £66 million.

C. £92 million.

5. To reflect the funded status of Kensington’s defined benefit pension plan, Kensington’s 2009 reported balance sheet liabilities would be decreased by an amount closest to:

A. £104 million.

B. £133 million.

C. £639 million.

6. An adjustment to Kensington’s statement of cash flows to reclassify the company’s excess contribution for 2009 would most likely entail reclassifying £558 million (excluding income tax effects) as an outflow related to:

A. investing activities rather than operating activities.

B. financing activities rather than operating activities.

C. operating activities rather than financing activities.

The following information relates to Questions 7 through 12.

Passaic Industries is based in France and offers its employees both a defined benefit pension plan and stock options. Passaic prepares its financial statements in accordance with IFRS. Several of the disclosures related to these plans are presented in Exhibits B, C, and D.

EXHIBIT B Components of Pension Cost (Income)

EXHIBIT C Funded Status of Plan

	At 31 December
(in millions)	2009	2008
Change in benefit obligation
Beginning balance	€45,183	€42,781
Service cost	908	910
Interest cost	2,497	2,457
Plan participants’ contributions	9	12
Amendments	156	270
Actuarial (gain) loss	(925)	2,778
Settlement/curtailment/acquisitions/dispositions, net	85	(1,774)
Benefits paid	(2,331)	(2,251)
Ending balance	€45,582	€45,183
Change in plan assets
Beginning balance at fair value	€43,484	€38,977
Expected return on plan assets	3,455	3,515
Actuarial gain	784	1,945
Company contribution	526	2,604
Plan participants’ contributions	9	12
Settlement/curtailment/acquisitions/dispositions, net	216	(1,393)
Benefits paid	(2,286)	(2,208)
Exchange rate adjustment	15	32
Ending balance at fair value	€46,203	€43,484
Funded Status	€621	(€1,699)
Unrecognized past service cost	104	218
Unrecognized actuarial loss (gain)	237	(115)
Net asset (liability) in the balance sheet	€962	(€1,596)

EXHIBIT D Volatility Assumptions Used to Value Stock Option Grants

Grant Year	Weighted Average Expected Volatility
2009 valuation assumptions
2005–2009	21.50%
2008 valuation assumptions
2004–2008	23.00%

7. If Passaic had reported under U.S. GAAP, with regard to its defined benefit pension plan, Passaic’s year-end 2009 balance sheet most likely would report a:

A. €621 million asset.

B. €962 million asset.

C. €621 million liability.

8. The net periodic pension cost reported on the Passaic Industries income statement for the year ending 31 December 2009 is closest to:

A. €908 million.

B. €1,050 million.

C. €2,331 million.

9. The Passaic Industries statement of cash flows for the year ended 31 December 2009 shows the reconciliation of net income to cash flows from operating activities for the period. The associated net adjustment to net income related to the defined benefit pension plan is closest to:

A. €524 million.

B. €526 million.

C. €1,050 million.

10. The estimated increase in the pension obligation due to benefits earned by current employees in 2009 is closest to:

A. €908 million.

B. €1,050 million.

C. €2,331 million.

11. In 2009, the actual return on Passaic’s plan assets is closest to:

A. −€1,760 million.

B. €3,445 million.

C. €4,239 million.

12. Compared to 2009 net income as reported, if Passaic Industries had used the same expected volatility assumption for its 2009 option grants that it had used in 2008, its 2009 net income would have been:

A. lower.

B. higher.

C. the same.

The following information relates to Questions 13 through 18.

Stereo Warehouse is an Australian retailer that offers employees a defined benefit pension plan and stock options as part of its compensation package. Stereo Warehouse prepares its financial statements in accordance with International Financial Reporting Standards (IFRS).

Peter Friedland, CFA, is an equity analyst concerned with earnings quality. He is particularly interested in whether the discretionary assumptions the company is making regarding compensation plans are contributing to the recent earnings growth at Stereo Warehouse. He gathers information from the company’s regulatory filings regarding the pension plan assumptions in Exhibit E and the assumptions related to option valuation in Exhibit F.

EXHIBIT E Assumptions Used for Stereo Warehouse Defined Benefit Plan

EXHIBIT F Option Valuation Assumptions

13. Compared to the 2009 reported financial statements, if Stereo Warehouse had used the same expected long-term rate of return on plan assets assumption in 2009 as it used in 2007, its year-end 2009 pension obligation would most likely have been:

A. lower.

B. higher.

C. the same.

14. Compared to the reported 2009 financial statements, if Stereo Warehouse had used the same discount rate as it used in 2007, it would have most likely reported lower:

A. net income.

B. total liabilities.

C. cash flow from operating activities.

15. Compared to the assumptions Stereo Warehouse used to compute its net periodic pension cost in 2008, earnings in 2009 were most favorably impacted by the change in the:

A. discount rate.

B. estimated future salary increases.

C. expected long-term rate of return on plan assets.

16. Compared to the pension assumptions Stereo Warehouse used in 2008, which of the following pair of assumptions used in 2009 are most likely internally inconsistent?

A. Estimated future salary increases, inflation

B. Discount rate, estimated future salary increases

C. Expected long-term rate of return on plan assets, discount rate

17. Compared to the reported 2009 financial statements, if Stereo Warehouse had used the 2007 expected volatility assumption to value its employee stock options, it would have most likely reported higher:

A. net income.

B. compensation expense.

C. deferred compensation liability.

18. Compared to the assumptions Stereo Warehouse used to value stock options in 2008, earnings in 2009 were most favorably impacted by the change in the:

A. expected life.

B. risk-free rate.

C. dividend yield.

The following information relates to Questions 19 through 24.

Andreas Kordt is an equity analyst examining the financial statements of Aero Euro. Aero Euro is based in Belgium and complies with IFRS. Kordt is concerned that the accounting guidelines for defined benefit pension plans do not reflect the underlying economic financial conditions and he intends to adjust Aero Euro’s financial statements accordingly. He also wants to compare the reported financial statements to those of a company that follows U.S. GAAP. As an initial step, he collected certain information relating to the plans, which is presented in Exhibits G and H.

EXHIBIT G Pension Plan Assumptions for Aero Euro

EXHIBIT H Information Related to Aero Euro’s Defined Benefit Plans

19. At year-end 2009, €11,582 million represents the total present value of benefits Aero Euro’s employees:

A. would receive if they left the company.

B. are expected to earn during their career.

C. have earned in the current and past periods.

20. Aero Euro’s underlying economic pension expense for 2009 is closest to:

A. €118 million.

B. €143 million.

C. €323 million.

21. The 2009 net periodic pension cost recognized in Aero Euro’s income statement is closest to:

A. €143 million.

B. €423 million.

C. €1,155 million.

22. Adjusting Aero Euro’s 2009 balance sheet to reflect the underlying economic position of the company’s defined benefit pension plan would result in a €667 increase in:

A. assets.

B. liabilities.

C. shareholders’ equity.

23. Compared to the reported 2009 financial statements, if Aero Euro used the 2007 expected rate of salary increase assumption in 2009 it would have most likely reported higher:

A. net income.

B. benefit obligation.

C. recognized past service costs.

24. Compared to the reported 2009 financial statements, if Aero Euro used the 2007 expected long-term rate of return on plan assets in 2009 it would have most likely reported higher:

A. net assets.

B. net income.

C. pension expense.

1Guidance on pension and other postemployment benefits is included in FASB ASC Topic 712 [Compensation-Nonretirement Postemployment Benefits]; FASB ASC Topic 715 [Compensation-Retirement Benefits]; FASB ASC Topic 960 [Plan Accounting-Defined Benefit Pension Plans]; and FASB ASC Topic 965 [Plan Accounting-Health and Welfare Benefit Plans].

2Multi-employer plans are an exception under IFRS. These are defined benefit plans to which many different employers will contribute on behalf of their employees, such as an industry association pension plan. For multiemployer plans, the employer may not have the information available from the plan administrator to meet the reporting requirement of a defined benefit plans. So IFRS allows these plans to be reported as defined contribution plans.

3For example, a company has a constructive obligation if the benefits it promises are not linked solely to the amount of its contributions, or if it indirectly or directly guarantees a specified return on pension assets.

4In addition to the projected benefit obligation, U.S. GAAP identify two other measures of the pension liability. The vested benefit obligation is the “actuarial present value of vested benefits” (FASB ASC Glossary). The accumulated benefit obligation is “the actuarial present value of benefits (whether vested or nonvested) attributed, generally by the pension benefit formula, to employee service rendered before a specified date and based on employee service and compensation (if applicable) before that date. The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation levels” (FASB ASC Glossary). Both the vested benefit obligation and the accumulated benefit obligation are based on the amounts promised as a result of an employee’s service up to a specific date. Thus, both of these measures will be less than the projected benefit obligation (VBO<ABO<PBO).

5These assumptions are referred to as “actuarial assumptions.” Thus, losses or gains due to changes in these assumptions, or due to differences between these assumptions and what actually occurs, are referred to as “actuarial gains or losses.”

6The pension obligation includes past service costs and actuarial losses/gains, so the portions that are not to be recognized in the net pension liability (or net pension asset) are removed.

7IAS 19, Employee Benefits, paragraph 58. The refunds and reductions in future contributions reflect overfunding of the plan. As a result of overfunding, companies may be able to withdraw funds (get refunds) or reduce contributions to the plan in the future.

8Actuarial gains, curtailment gains, and settlements gains would decrease a company’s pension liability.

9The unamortized portion of the transition asset or liability is included in accumulated other comprehensive income.

10This is a simplification of the valuation process for illustrative purposes. For example, the actuarial valuation would use mortality rates, not just assumed life expectancy. Additionally, annualizing the present value of an ordinary annuity probably understates the liability because the actual benefit payments are usually made monthly or biweekly rather than annually.

11The Volvo Group primarily manufactures trucks, buses, construction equipment, and engines and engine components for boats, industry, and aircraft. The Volvo car division was sold to Ford Motor Co. in 1999, and Ford sold Volvo Car Corporation to the Zhejiang Geely Holding Group in 2010.

12An extensive overview of different employee compensation mechanisms can be found in Lynch and Perry (2003).

13IAS 24, paragraph 17 Related Party Disclosures FASB ASC Section 718-10-50 [Compensation-Stock Compensation-Overall-Disclosure].

14While issuing employee stock options requires no initial cash outlay, the company implicitly foregoes issuing new shares of stock (and receiving cash) when the options are exercised.

15The estimated life of an option award incorporates such assumptions as employee turnover, and is usually shorter than the expiration period.