CHAPTER 13

EMPLOYEE COMPENSATION: POSTEMPLOYMENT AND SHARE-BASED

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.

SUMMARY OVERVIEW

• 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