LEARNING OUTCOMES

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

• describe the types of post-employment benefit plans and 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 costs;
• explain and calculate the effect of a defined benefit plan's assumptions on the defined benefit obligation and periodic pension cost;
• explain and calculate how adjusting for items of pension and other post-employment benefits that are reported in the notes to the financial statements affects financial statements and ratios;
• interpret pension plan note disclosures including cash flow related information;
• explain issues associated with accounting for share-based compensation;
• explain how accounting for stock grants and stock options affects financial statements, 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.
• 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.
• Both IFRS and US GAAP require 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. The amount of a pension asset that can be reported is subject to a ceiling.
• Under IFRS, the components of periodic pension cost are recognised as follows: Service cost is recognised in P&L, net interest income/expense is recognised in P&L, and remeasurements are recognised in OCI and are not amortised to future P&L.
• Under US GAAP, the components of periodic pension cost recognised in P&L include current service costs, interest expense on the pension obligation, and expected returns on plan assets (which reduces the cost). Other components of periodic pension cost—including past service costs, actuarial gains and losses, and differences between expected and actual returns on plan assets—are recognised in OCI and amortised to future P&L.
• Estimates of the future obligation under defined benefit pension plans and other post-employment 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' interests 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 US 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 such items 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

Developed by Elaine Henry, CFA (Coral Gables, USA), and Elizabeth A. Gordon (Philadelphia, USA). Copyright © 2013 by CFA Institute.

The following information relates to Questions 1–7

Kensington plc, a hypothetical company based in the United Kingdom, offers its employees a defined benefit pension plan. Kensington complies with IFRS. The assumed discount rate that the company used in estimating the present value of its pension obligations was 5.48 percent. Information on Kensington's retirement plans is presented in Exhibit 1.

1. At year-end 2010, £28,879 million represents:
   1. the funded status of the plan.
   2. the defined benefit obligation.
   3. the fair value of the plan's assets.
2. For the year 2010, the net interest expense of £273 represents the interest cost on the:
   1. ending benefit obligation.
   2. beginning benefit obligation.
   3. beginning net pension obligation.
3. For the year 2010, the remeasurement component of Kensington's periodic pension cost represents:
   1. the change in the net pension obligation.
   2. actuarial gains and losses on the pension obligation.
   3. actual return on plan assets minus the amount of return on plan assets included in the net interest expense.
4. Which of the following is closest to the actual rate of return on beginning plan assets and the rate of return on beginning plan assets that is included in the interest income/expense calculation?
   1. The actual rate of return was 5.56 percent, and the rate included in interest income/expense was 5.48 percent.
   2. The actual rate of return was 1.17 percent, and the rate included in interest income/expense was 5.48 percent.
   3. Both the actual rate of return and the rate included in interest income/expense were 5.48 percent.
5. Which component of Kensington's periodic pension cost would be shown in OCI rather than P&L?
   1. Service cost
   2. Net interest (income) expense
   3. Remeasurements
6. The relationship between the periodic pension cost and the plan's funded status is best expressed in which of the following?
   1. Periodic pension cost of –£483 = Ending funded status of –£4,774 – Employer contributions of £693 – Beginning funded status of –£4,984.
   2. Periodic pension cost of £1,322 = Benefits paid of £1,322.
   3. Periodic pension cost of £210 = Ending funded status of –£4,774 – Beginning funded status of –£4,984.
7. An adjustment to Kensington's statement of cash flows to reclassify the company's excess contribution for 2010 would most likely entail reclassifying £210 million (excluding income tax effects) as an outflow related to:
   1. investing activities rather than operating activities.
   2. financing activities rather than operating activities.
   3. operating activities rather than financing activities.

The following information relates to Questions 8–13

XYZ SA, a hypothetical company, offers its employees a defined benefit pension plan. Information on XYZ's retirement plans is presented in Exhibit 2. It also grants stock options to executives. Exhibit 3 contains information on the volatility assumptions used to value stock options.

8. The retirement benefits paid during the year were closest to:
   1. 280.
   2. 3,000.
   3. 4,000.
9. The total periodic pension cost is closest to:
   1. 320.
   2. 1,020.
   3. 1,320.
10. The amount of periodic pension cost that would be reported in P&L under IFRS is closest to:
    1. 20.
    2. 530.
    3. 1,020.
11. Assuming the company chooses not to immediately recognise the actuarial loss and assuming there is no amortisation of past service costs or actuarial gains and losses, the amount of periodic pension cost that would be reported in P&L under US GAAP is closest to:
    1. 20.
    2. 59.
    3. 530.
12. Under IFRS, the amount of periodic pension cost that would be reported in OCI is closest to:
    1. 20.
    2. 490.
    3. 1,020.
13. Compared to 2009 net income as reported, if XYZ 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:
    1. lower.
    2. higher.
    3. the same.

The following information relates to Questions 14–19

Stereo Warehouse is a US 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 US GAAP.

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 4 and the assumptions related to option valuation in Exhibit 5.

14. 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:
    1. lower.
    2. higher.
    3. the same.
15. 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:
    1. net income.
    2. total liabilities.
    3. cash flow from operating activities.
16. Compared to the assumptions Stereo Warehouse used to compute its periodic pension cost in 2008, earnings in 2009 were most favorably affected by the change in the:
    1. discount rate.
    2. estimated future salary increases.
    3. expected long-term rate of return on plan assets.
17. Compared to the pension assumptions Stereo Warehouse used in 2008, which of the following pairs of assumptions used in 2009 is most likely internally inconsistent?
    1. Estimated future salary increases, inflation
    2. Discount rate, estimated future salary increases
    3. Expected long-term rate of return on plan assets, discount rate
18. 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:
    1. net income.
    2. compensation expense.
    3. deferred compensation liability.
19. Compared to the assumptions Stereo Warehouse used to value stock options in 2008, earnings in 2009 were most favorably affected by the change in the:
    1. expected life.
    2. risk-free rate.
    3. dividend yield.