CHAPTER 14
Employee Compensation: Post-Employment and Share-Based

Solutions

  1. B is correct. The £28,879 million year-end benefit obligation represents the defined benefit obligation.
  2. C is correct. The net interest expense of £273 million represents the interest cost on the beginning net pension obligation (beginning funded status) using the discount rate that the company uses in estimating the present value of its pension obligations. This is calculated as −£4,984 million times 5.48 percent = −£273 million; this represents an interest expense on the amount that the company essentially owes the pension plan.
  3. C is correct. The remeasurement component of periodic pension cost includes both actuarial gains and losses on the pension obligation and net return on plan assets. Because Kensington does not have any actuarial gains and losses on the pension obligation, the remeasurement component includes only net return on plan assets. In practice, actuarial gains and losses are rarely equal to zero. The net return on plan assets is equal to actual returns minus beginning plan assets times the discount rate, or £1,302 million − (£23,432 million × 0.0548) = £18 million.
  4. A is correct. The actual return on plan assets was 1,302/23,432 = 0.0556, or 5.56 percent. The rate of return included in the interest income/expense is the discount rate, which is given in this example as 5.48 percent.

    The rate of 1.17 percent, calculated as the net interest income divided by beginning plan assets, is not used in pension cost calculations.

  5. C is correct. Under IFRS, the component of periodic pension cost that is shown in OCI rather than P&L is remeasurments.
  6. A is correct. The relation between the periodic pension cost and the plan’s funded status can be expressed as Periodic pension cost = Ending funded status − Employer contributions − Beginning funded status.
  7. B is correct. Kensington’s periodic pension cost was £483. The company’s contributions to the plan were £693. The £210 difference between these two numbers can be viewed as a reduction of the overall pension obligation. To adjust the statement of cash flows to reflect this view, an analyst would reclassify the £210 million (excluding income tax effects) as an outflow related to financing activities rather than operating activities.
  8. B is correct. The total periodic pension cost is the change in the net pension liability adjusted for the employer’s contribution into the plan. The net pension liability increased from 3,000 to 3,020, and the employer’s contribution was 1,000. The total periodic pension cost is 1,020. This will be allocated between P&L and OCI.
  9. B is correct. Under IFRS, the components of periodic pension cost that would be reported in P&L are the service cost (composed of current service and past service costs) and the net interest expense or income, calculated by multiplying the net pension liability or net pension asset by the discount rate used to measure the pension liability. Here, the service costs are 320 (= 200 + 120), and the net interest expense is 210 [= (42,000 − 39,000) × 7%]. Thus, the total periodic pension cost is equal to 530.
  10. A is correct. Under US GAAP—assuming the company chooses not to immediately recognise the actuarial loss and assuming there is no amortization of past service costs or actuarial gains and losses—the components of periodic pension cost that would be reported in P&L include the current service cost of 200, the interest expense on the pension obligation at the beginning of the period of 2,940 (= 7.0% × 42,000), and the expected return on plan assets, which is a reduction of the cost of 3,120 (= 8.0% × 39,000). Summing these three components gives 20.
  11. B is correct. The component of periodic pension cost that would be reported in OCI is the remeasurements component. It consists of actuarial gains and losses on the pension obligation and net return on plan assets. Here, the actuarial loss was 460. In addition, the actual return on plan assets was 2,700, which was 30 lower than the return of 2,730 (= 39,000 × 0.07) incorporated in the net interest income/expense. Therefore, the total remeasurements are 490.
  12. A is correct. In 2009, XYZ used a lower volatility assumption than it did in 2008. Lower volatility reduces the fair value of an option and thus the reported expense. Using the 2008 volatility estimate would have resulted in higher expense and thus lower net income.
  13. C is correct. The assumed long-term rate of return on plan assets is not a component that is used in calculating the pension obligation, so there would be no change.
  14. B is correct. A higher discount rate (5.38 percent instead of 4.85 percent) will reduce the present value of the pension obligation (liability). In most cases, a higher discount rate will decrease the interest cost component of the net periodic cost because the decrease in the obligation will more than offset the increase in the discount rate (except if the pension obligation is of short duration). Therefore, periodic pension cost would have been lower and reported net income higher. Cash flow from operating activities should not be affected by the change.
  15. B is correct. In 2009, the three relevant assumptions were lower than in 2008. Lower expected salary increases reduce the service cost component of the periodic pension cost. A lower discount rate will increase the defined benefit obligation and increase the interest cost component of the periodic pension cost (the increase in the obligation will, in most cases, more than offset the decrease in the discount rate). Reducing the expected return on plan assets typically increases the periodic pension cost.
  16. A is correct. The company’s inflation estimate rose from 2008 to 2009. However, it lowered its estimate of future salary increases. Normally, salary increases will be positively related to inflation.
  17. B is correct. A higher volatility assumption increases the value of the stock option and thus the compensation expense, which, in turn, reduces net income. There is no associated liability for stock options.
  18. C is correct. A higher dividend yield reduces the value of the option and thus option expense. The lower expense results in higher earnings. Higher risk-free rates and expected lives result in higher call option values.
  19. B is correct. Plan B is a defined contribution (DC) pension plan because the amount of future benefit is not defined and SKI has an obligation to make only agreed-upon contributions. The actual future benefits depend on the investment performance of the individual’s plan assets, and the employee bears the investment risk.

    A is incorrect because Plan A is a defined benefit (DB) pension plan. In a DB plan, the amount of future benefit is defined based on the plan’s formula (i.e., 1% of the employee’s final salary for each year of service). With a DB pension plan, SKI bears the investment risk.

    C is incorrect because Plan C is a health care plan and is classified as a DB plan. Under IFRS and US GAAP, all plans for pensions and other post-employment benefits (OPB) other than those explicitly structured as DC plans are classified as DB plans. The amount of future benefit depends on plan specifications and type of benefit, and it represents a promise by the firm to pay benefits in the future. SKI, not the employee, is responsible for estimating future increases in costs, such as health care, over a long time horizon.

  20. B is correct. Plan B is a DC pension plan. SKI’s financial obligation is defined in each period, and the employer makes its agreed-upon contribution to the plan on behalf of the employee in the same period during which the employee provides the service. SKI is current on this obligation and has no additional financial obligation for the current period.
  21. B is correct. SKI’s DB pension plan is overfunded by €1.18 billion, the amount by which the fair value of the pension plan assets exceeds the defined benefit obligation (€5.98 billion − €4.80 billion). When a company has a surplus in a DB pension plan, the amount of assets that can be reported is the lower of the surplus or the asset ceiling (the present value of future economic benefits, such as refunds from the plan or reductions in future contributions). In this case, the asset ceiling is given as €1.50 billion, so the amount of SKI’s reported net pension asset is the amount of the surplus, because this amount is lower than the asset ceiling.
  22. A is correct. A higher percentage of employees is expected to leave before the full 10-year vesting period, which would decrease the present value of the DB obligation. If the employee leaves the company before meeting the 10-year vesting requirement, she may be entitled to none or a portion of the benefits earned up until that point. In measuring the DB obligation, the company considers the probability that some employees may not satisfy the vesting requirements (i.e., may leave before the vesting period) and use this probability to calculate the current service cost and the present value of the obligation.
  23. B is correct. Operating income is adjusted to include only the current service costs, the interest cost component is reclassified as interest expense, and the actual return on plan assets is added as investment income. Profit before taxation adjusted for actual rather than expected return on plan assets will decrease by €94 million (205 − 299).
    Total (€ millions)
    Current service costs − €40
    Interest costs − €263
    Expected return on plan assets + €299
    Total of pension and OPB expenses − €4 million
    Actual return (loss) on plan assets €205 million

    Because the actual return on plan assets is less than the expected return on plan assets, operating income will be adjusted downward by 299 − 205 = 94. Alternatively, the adjustments to the individual pension cost components are as follows:

    Line Items to Adjust Adjustments
    (€ millions)
    Revenue —
    Net operating expenses +4 − 40 = −36
    Operating profit —
    Interest expense −263
    Interest and investment income +205
    Share of post-tax results of associates −
    Adjustment to profit before taxation −€94 million
  24. B is correct. The final year’s estimated earnings at the end of Year 1 for the average participant would decrease by approximately €35,747.71.
    Current Assumptions Case Study Assumptions
    Current salary €100,000 €100,000
    Years until retirement 17 17
    Years of service (includes prior 10) 27 27
    Retirement life expectancy 20 20
    Annual compensation increases 6% 5%
    Discount rate 4% 4%
    Final year’s estimated earnings €254,035.17 €218,287.46
    Estimated annual payment for each of the 20 years €68,589.50 €58,937.61
    Value at the end of year 17 (retirement date) of the estimated future payments €932,153.69 €800,981.35
    Annual unit credit €34,524.21 €29,665.98

    Because there are now 17 years until retirement, there are 16 years until retirement from the end of Year 1. The final year’s estimated earnings, estimated at the end of Year 1, are as follows:

    Current year’s salary × [(1 + Annual compensation increase)Years until retirement]

    Annual compensation increase of 6%: €100,000 × [(1.06)16] = €254,035.17

    Annual compensation increase of 5%: €100,000 × [(1.05)16] = €218,287.46

    The estimated annual payment for each of the 20 years (retirement life expectancy) is

    (Estimated final salary × Benefit formula) × Years of service

    Annual compensation increase of 6%: (€254,035.17 × 0.01) × (10 + 17) = €68,589.50

    Annual compensation increase of 5%: (€218,287.46 × 0.01) × (10 + 17) = €58,937.61

    The value at the end of Year 17 (retirement date) of the estimated future payments is the PV of the estimated annual payment for each of the 20 years at the discount rate of 4%:

    Annual compensation increase of 6%: PV of €68,589.50 for 20 years at 4% = €932,153.69

    Annual compensation increase of 5%: PV of €58,937.61 for 20 years at 4% = €800,981.35

    The annual unit credit = Value at retirement/Years of service:

    Annual compensation increase of 6%: €932,153.69/27 = €34,524.21

    Annual compensation increase of 5%: €800,981.35/27 = €29,665.98

    The annual unit credit for the average participant would decrease by €34,524.21 − €29,665.98 = €4,858.23.

  25. B is correct. An increase in the retirement life expectancy (from 20 to 28 years) will increase the DB pension obligation, because Plan A pays annual payments for life.
  26. A is correct. Current service cost is the present value of annual unit credit earned in the current period.

    Annual unit credit (benefit) per service year = Value at retirement/Years of service

    Years of service = 15 (vested years of past service) + 7 (expected years until retirement) = 22

    Annual unit credit = $393,949/22 = $17,906.77.

    Current service cost (for 1 year) = Annual unit credit/[(1 + Discount rate)(Years until retirement at the end of Year 1)

    = $17,906.77/(1+0.04)6 = $14,151.98.

  27. A is correct. To estimate the PVDBO, the company must make a number of assumptions, such as future compensation increases, discount rates, and expected vesting. If changes in assumptions increase the obligation, the increase is referred to as an actuarial loss.

    B is incorrect because the PVDBO does not include the value of plan assets in the calculation.

    C is incorrect because the expected long-term rate of return on plan assets is not used to calculate the PVDBO. The interest rate used to calculate the PVDBO 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.

  28. B is correct. The funded status of a pension plan is calculated as follows:
  29. A is correct. A decrease in the assumed future compensation growth rate will decrease a company’s pension obligation when the pension formula is based on the final year’s salary. Lowering the assumed future compensation growth rate decreases the service and interest components of periodic pension costs because of a decreased annual unit credit.
  30. B is correct. A change in the assumed future compensation growth rate is a change in the plan’s actuarial assumptions. The remeasurement cost component includes actuarial gains and losses resulting from changes in the future compensation growth rate.
  31. A is correct. Rickards’ task is to adjust the balance sheet and cash flow statement information to better reflect the economic nature of certain items related to the pension plan. When a company’s periodic contribution to a plan is lower than the total pension cost of the period, it can be viewed as a source of financing. To reflect this event, the deficit amount is adjusted by the effective tax rate and should be reclassified from an operating cash flow to a financing cash flow. The company’s contribution to the pension plan was $66 million, which is $30 million less than the pension cost of $96 million. The $30 million difference is $21 million on an after-tax basis, using the effective tax rate of 30%. Therefore, $21 million should be classified as an operating cash outflow (negative value) and a financing cash inflow (positive value).
  32. C is correct. To calculate the debt-to-equity ratio, both liabilities and total equity need to be adjusted for the estimated impact of a 100-bp increase in health care costs. The proposed increase in health care costs will increase total liabilities and decrease equity by the same amount. Consequently, the debt-to-equity ratio changes as follows:

    Sensitivity of benefit obligation to 100-bp increase = $93

    Adjusted liabilities = $17,560 + $93 = $17,653

    Adjusted equity = $6,570 − $93 = $6,477

    Adjusted debt-to-equity ratio = $17,653/$6,477 = 2.7255 ≈ 2.73

    Consequently, a 100-bp increase in health care costs increases the debt-to-equity ratio to approximately 2.73.