Reading 14 - Employee Compensation: Post Employment and Share-based

LOS a - Describe the types of post-employment benefit plans and implications for financial reports.

1. Defined contribution plan

a. Employer gives a certain amount each year to employees account
b. Accounting is straight forward. Pension expense = amount paid
2. Defined benefit plan
a. Employer promises the employee a certain amount each year upon retirement
b. Usually based on years of service
c. Employer assumes investment risk
d. Usually, employer contributes assets to a trust who manages and invests
e. Funded status of plan is the difference between the benefit obligation (promised amount) and
the plan assets
3. Other post-employment benefits
a. i.e., Health care
b. Are similar to the defined benefit pension plan
c. Usually unfunded
d. Recognize expense as incurred, but only give out cash once used in the future

LOS b - 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).

Projected Benefit Obligation (PBO) under GAAP and Present Value of Defined Benefit Obligation (PVDBO)
under IFRS
1. Actuarial present value (at assumed discount rate) of all future benefits earned to date, based on
expected future salary increases
2. From one period to the next it changes based on
a. Current service cost - present value of benefits earned by the employees during the period
b. Interest cost - increase in the obligation due to the passage of time. Interest cost is equal to the
pension obligation at the beginning of the period multiplied by the discount rate
c. Past (prior) service costs - retroactive benefits awarded to employees due to changes in policy
when a plan is initiated or amended
i. IFRS - expensed immediately
ii. GAAP - amortized over the average service life of employees
d. Changes in actuarial assumptions - gains and losses from changes in variable such as mortality,
employee turnover, retirement age, and the discount rate
e. Benefits paid - reduce the PBO
Balance Sheet Effects

 Funded status = fair value of plan assets - PBO

 If Funded status is negative report funded status as a liability
 If Funded status is positive, report funded status as an asset subject to a ceiling of PV of future
economic benefits (won't have to contribute as much in the future)

LOS c - Describe the components of a company’s defined benefit pension costs.

1) Periodic pension cost (i.e., total periodic pension cost or net periodic pension cost)
a. Employer contributions adjusted for change in funded status
b. Total Periodic Pension Cost (TPPC) = Employer contributions - (ending funded status - beginning
funded status)
c. TPPC = Current Service Cost + Interest Cost - Actual Return on Plan Assets +/- Actuarial
gains/losses due to changes in assumptions + Prior Service Cost
2) Periodic Pension Cost Reported in P&L
a. Current Service Cost
i. Present value of benefits earned by employees in this period
ii. Immediately recognized in income statement
b. Interest Cost
i. PBO at beginning of period X discount rate
ii. Immediately recognized as component pension expense
iii. IFRS - Net interest expense/income = Beginning Funded Status X discount rate
1. If plan is overfunded then it is income
2. If plan is underfunded then it is an expense
c. Expected Return on Plan Assets
i. No effect on PBO
ii. Used as component of pension expense
iii. Difference of actual return and expected return is captured in actuarial gains and losses
iv. IFRS - expected return is assumed to be the discount rate, and net interest
income/expense is calculated like in interest cost
v. Actuarial Gains and Losses
vi. Two components
1. Gains and losses due to changes in assumptions
2. Difference between actuals and expected return on plan assets
 vii.Recognized in Other Comprehensive Income (OCI)
viii.In IFRS they are not amortized
ix.In GAAP They are Amortized using Corridor Approach:
x.Corridor Approach
1. If the beginning balance of actuarial gains and losses exceeds the greater of PBO
or plan assets, amortization is required
2. The excess amount over the "corridor" (10%) is amortized over the service life of
the employees
3. Amortization of gain reduces periodic pension cost in P&L
4. Amortization of loss increases periodic pension cost in P&L
5. Companies can choose to amortize more quickly, but has to be consistent in
gains and losses
xi. IFRS doesn't use corridor so it is never transferred from OCI to income statement
d. Past (prior) service costs
i. GAAP - changes to plan is reported in OCI and amortized over remaining service life of
affected employees
ii. IFRS - recognized immediately in periodic pension cost in P&L
iii. GAAP method tends to smooth costs compared to IFRS

3) Presentation
a. In GAAP must be reported in one line item, in IFRS they may be separated
b. Both require disclosure of all in the notes
4) Capitalizing Pension Costs
a. Pension costs included in the cost of production of good (labour costs) may be capitalized as
part of the valuation of ending inventory
b. When goods are sold these costs are expenses as COGS
LOS d - Explain and calculate the effect of a defined benefit plan’s assumptions on the defined benefit
obligation and periodic pension cost.

1) Discount rate
a. Based on interest rate of high-quality fixed income investments with a similar maturity
structure
b. Increasing the discount rate will
i. Reduce present values, hence PBO is lower, and therefore improves funded status
ii. Usually results in lower total periodic pension cost, because of lower service cost
iii. Usually reduces interest cost, unless the plan is mature
2) Rate of compensation growth
a. Decreasing compensation growth will
i. Reduce future benefit payments, therefore PBO is lower, improves funded status
ii. Reduce current service cost and lower interest cost; thus, TPPC reduces
3) Expected return on plan assets
a. Reduces periodic pension cost in P&L
b. Difference between actual and expected return are deferred
c. Expected return is assumed under GAAP.... Under IFRS it is the same as the discount rate
d. Increasing the expected return will
i. Reduce periodic pension cost reported in P&L, but will leave total periodic pension cost
the same
ii. Not affect benefit status or funded status of the plan

4) Other post-employment benefits

a. Compensation growth rate replaced with health care inflation rate
b. Assumes inflation will taper off and it will become constant – Called the ultimate health care
trend rate
c. All else equal, firms can reduce post-employment benefit obligations and periodic cost by
reducing the ultimate health care trend rate or reducing the time it takes to reach this rate
5) Analysts must compare these assumptions across time and across firms to assess quality of earnings
6) Discount rate and expected return on plan assets should reflect reality and firm’s current status
LOS e - 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.

Adjustments needed for comparability

1) Gross vs Net Pension Asset/Liability
a. Two reasons why assets and liabilities are netted
i. Employer controls plan assets and the obligation and bears risk and potential rewards
ii. The company's decision about funding and accounting for the plan are more likely to be
affected by the net pension obligation
b. Netting them out changes ratios because they are less than if the company showed both assets
and liabilities
2) Differences in assumptions used
a. Two companies in same industry but 1 uses a higher discount rate. The higher discount rate
would underestimate pension liabilities and periodic pension cost in the P&L
3) Differences between IFRS and GAAP
a. Components of TPCC are treated differently under the two
b. Either make adjustments for comparability or just use other comprehensive income, because
that is the same
4) Differences due to classification in the income statement
a. GAAP - The entire periodic pension cost in P&L is shown as an operating expense
b. IFRS - the components can be included in various line items
c. To adjust GAAP to IFRS
i. Added back periodic pension cost in P&L and only subtracting service cost in operating
add back TPCC use formula
ii. Interest cost added to interest expense
iii. Actual return on plan assets added to non-operating income

LOS f - Interpret pension plan note disclosures including cash flow related information.

 If the firm’s contributions > TPCC, the difference can be viewed as reduction in the overall obligation
 If TPCC > Contributions, then it can be viewed as a form of borrowing
 If the difference between cash flow and TPCC is material, the analyst may reclassify the difference from
operating to financing activities
 If TPCC > Contributions increase financing and decrease operating cash flow by the difference * (1-T)
 If TPCC < Contributions increase operating and decrease financing cash flow by the difference * (1-T)

LOS g - Explain issues associated with accounting for share-based compensation.

 I.e., stock options and share grants

 Purpose: attempting to motivate employees and retain them (they have ownership) without any cash
outlays

Issues with accounting

1) If stock isn't public, then the price must be estimated
2) If market price of options is unavailable, then must use an options valuation model
3) Shares may be awarded with contingency (can't sell for a while, or have to vest them)
a. Must spread out compensation expense over the time period where employee is rewarded –
i.e., the Service Period
LOS h - Explain how accounting for stock grants and stock options affects financial statements, and the
importance of companies’ assumptions in valuing these grants and options

Similar under IFRS and GAAP

Stock Options
1) Compensation expense is based on fair value of options on the grant date, based on number of options
expected to vest
2) Expense is allocated over the service period (time between grant date and service date)
3) Recognition of compensation expense will decrease net income and retained earnings, but paid in
capital is increased by an identical amount

Determining Fair Value

1) Fair value should be based on value of a comparable market option
a. Since market options differ from custom terms of employee options, this is often difficult
2) Use either Black-Scholes model or binomial pricing model
a. There is no preference for either in IFRS or GAAP
3) Option pricing models typically use the following inputs
a. Exercise Price
b. Stock price at the grant date
c. Expected term
d. Expected volatility
e. Expected dividends
f. Risk-free rate

Stock Grants
1) Compensation value is based on price of stock at grant date
a. Allocated over employee’s service period
2) Can take form of
a. Outright transfer
b. Restricted stock
i. Cannot be sold until after vesting period
c. Performance stock
i. Depends on the company performing a certain way
ii. Tying performance to accounting earnings may cause manipulation

Stock Appreciation Rights

1) Employee has right to receive compensation based on increase in the price of stock over a certain
amount
2) Employee receives the money not the stock
3) No downside risks
4) No dilution to existing shareholders

Phantom Stock
1) Same as stock appreciation rights, but based on a hypothetical stock instead of firm’s own shares
2) Used in private firms or firms with highly illiquid stock