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CFA Level II, Financial Reporting and Analysis, Employee Compensation: Post-Employment and Share-Based

pension arrangements

defined contribution: pension expense = employer's contribution
defined benefit plan: employer assumes investment risk

other post-employment benefits

healthcare benefits (future benefit defined today)

difference between other post-employment benefit plans and defined benefit plans

pension plans: funded at some level
other benefits: usually unfunded - expense recognized as benefits earned but no cash flow until actually paid

the equivalent of Projected Benefit Obligation (PBO) in IFRS is

present value of defined benefit obligation (PVDBO)

current service cost

present value of benefits earned during the current period

interest cost

increase in obligation due to passage of time

past service costs

when a plan is amended or initiated

changes in actuarial assumptions

changes in variables such as mortality, employee turnover, retirement age, discount rate...

reconcile beginning and ending balance

obligation at beginning of period
+ current service cost
+ interest cost
+ unrecognized prior service costs
+- actuarial gains and losses
-benefits paid
= obligation at the end of period

how to calculate ending benefit?

= final salary
* percentage
* years of service

funded status

= fair value of plan assets - PBO

what to register in the balance sheet?

US GAAP: funded status
IFRS: option to defer recognition of prior service costs and actuarial gains and losses
B.S. asset (liab) = funded status + unrecognized prior service cost + unrecognized actuarial gains and losses

actuarial gains and losses

result of changing assumptions
differences in expected returns and actual returns

treatment of actuarial gains and losses

recognized on B.S.
also income statement OR comprehensive income (amortized using corridor method)
recognized in F.S.
if in other comprehensive income: never amortized in I.S.
OR off balance sheet (amortized using corridor)

corridor method

once beginning balance of actuarial gains and losses > 10% of the greater of beginning PBO or plan assets - amortization required

amortization of past service costs

US GAAP: reported in comprehensive income, amortized over remaining service life
vested portion: expense immediately
unvested portion: off balance sheet and amortized over vesting period

pension expense

current service cost
+ interest cost
- expected return on assets
+- amortization of actuarial gains and losses
+ amortization of past service costs
= net pension expense


1. discount rate: based on interest rates of high quality fixed income
2. rate of compensation growth
3. expected return on plan assets

effects of increasing discount rate

PBO lower, better funded status, lower pension expense, usually reduce interest cost unless plan is mature

effects of decreasing compensation growth rate

reduce pension pmts, PBO lower, better funded status, reduce current service costs, lower interest cost, lower pension expense

effects of increasing expected return

reduce pension expense
NO effect on obligation or funded status

assumptions for other post-employment benefits

similar except compensation growth rate replaced by healthcare inflation rate: taper off and eventually become constant (ultimate healthcare trend rate)

reconciliation of plan assets

fair value beginning of period
+actual returns on assets
+ employer contributions
- benefits paid
=fair value at end of period

under IFRS can companies fully recognize actuarial gains and losses?

yes, in IS or comprehensive income

economic pension expense

= service cost + interest cost + unrecognized prior service costs - actual returns (sum all changes in PBO except benefits paid and subtract actual returns)
= ending funded status - beginning funded status - contributions

adjustments for analytical purposes

only current service cost is operating expense
interest and actual return should be included in non operating items

differences between US GAAP and IFRS for pension expense

single line item under operating expense: US GAAP
various line items in IS: IFRS

if contributions > economic pension expense

difference is reduction of overall pension obligation similar to excess principal repayment
analytical purposes: reclassify difference (net of taxes) from operating to financing CF.

reasons for netting pension assets and liabilities

1. employer largely controls the plan assets and obligations - bears risks and potential rewards
2. decisions influenced by net pension obligation
so: total firms assets and liabilities lower and can affect ratios
changing assumption may have small effect on PBO, but larger effect on net pension amount

accounting treatment of share based compensation

shares not publicly traded: estimate must be used
market price available: value of stock options must be estimated
if granted with contingencies: expense may be spread over a period of time (service period)

accounting treatment of stock options

intrinsic value method: no compensation is ever recognized because most are out of money (no intrinsic value)
now: fair value (observable market price or using option model) of option on the grant date, expense allocated over the grant date and vesting date (first date of possible exercise)

accounting treatment of stock grants

based on the fair value of the stock on grant date, allocated over employee's service period
(without conditions, restricted stock & performance stock)

other types of compensation

stock appreciation rights (awards based on increase in price of firm, limited downside risk for employee, no dilution to existing shareholders)
phantom stock (based on performance of hypothetical stock, used in privately held firms and illiquid firms)

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