Reading 08 - Employee Compensation

Question 1

What is the formula for calculating the number of treasury shares when calculating dilutive securities?

Explain in simple terms

Answer 1

The number of shares you could buy back with the cash proceeds you could get at the average share price from exercising the option

Question 2

What are dilutve securities?

Answer 2

Financial instruments that can increase the number of outstanding shares. and therefore reduce their value/dilute the ownership % of existing s/h and reduce EPS

i.e. how many shares will be lost upon vesting?

Question 3

What is the formula for calculating assumed proceeds?

Answer 3

Assumed proceeds = cash proceeds + average unrecognised compensation expsense

Question 4

Explain assumed proceeds in simple terms

Answer 4

What you pay upon exercise + compensation cost that hasnt been recognised yet in the F/S as has not vested (needs to reduce EPS like recognised compensation so should be included)

Question 5

What is the formula for calculating cash proceeds?

Answer 5

cash proceeds = number of options x exercise price (zero for stock grants)

Question 6

What is the formula for calculating the ending PBO?

OSIPAB

Answer 6

Question 7

Pension Accounting:
What is:
* PBO
* Current service cost
* interest cost incl formula?

Answer 7

PBO (projected benefit obligation):
* Present value of all future pension payments earned to date based on expected salary increases over time

Current service cost:
* The change in PBO attributed to employees’ efforts during the year; the actuarial PV of pension benefits earned in a year

Interest cost:
* The increase in PBO resulting from the passage of time; PBO at the start of the period x discount rate

Question 8

What is:
* actuarial gains/losses
* past service costs
* benefits paid?

Answer 8

Actuarial gains/losses:
* Gains and losses resulting from changes in actuarial assumptions

Past service costs:
* Changes in the PBO due to amendments to the pension plan that grant benefits for employee service in prior periods. e.g. changing the payout from 60% to 65% of final salary

Benefits paid:
* Payments made from the fund to existing retirees

Question 9

Pension accounting:
What is the formula for calculating the FV of plan assets?

Answer 9

Question 10

Pension Accounting IFRS vs. US GAAP:
What are the two main delayed events in the income statement?

Answer 10

Remeasurements:
* IFRS and US GAAP
* Actuarial gains and losses (affecting PBO) plus differences in actual and expected return on assets
* note: IFRS exp. return = discount rate

Past service costs:
* US GAAP ONLY - PBO changes due to plan amendements amortised over avg service life of plan participants
* IFRS - expensed immediately

Question 11

Pension Accounting:
What is the formula for calculating the net period benefit costs under US GAAP?

Where do unamortised costs go and what are they?

Answer 11

Unamortised past service cost and actuarial gains and losses in OCI

Question 12

Pension Accounting:
What is the formula for calculating the net period benefit costs under IFRS?
Where are remeasurements reflected and which are amortised?

Answer 12

Remeasurements are reflected in OCI and are not amortised

Question 13

How is net interest expense/income calculated? And what does a positive or negative net cost mean?

Answer 13

+ve net cost = underfunded (adding to costs) -ve net cost = overfunded (reducing costs)

Question 14

What rates are needed for IFRS and US GAAP calculations of benefit costs and what are they used to calculate?

Answer 14

US GAAP (different rates):
* discount rate: opening pbo x disocunt rate = interest expense
* %expected return: opening plan assers x %exoected return = $expected return

IFRS (ONE RATE ONLY)
* expected return = discount rate
* opening funded status x discount rate = net interest expense/income

Question 15

In regards to a defined benefits plan, what does the funded status of the plan refer to ?

Answer 15

The difference between FV of plan assets and PBO

Question 16

What is the** service cost**?

Answer 16

Is the present value of benefits earned by the employees during the current period

**Is immediately recognized in the income statement**

Question 17

What is the interest cost?

Answer 17

Is the increase in the obligation due to the passage of time

= Beg. of period PBO * Discount Rate

**Is immediately recognized as a component of pesion expense**

Question 18

What are past (prior) service costs?

Answer 18

Retroactive benefits awarded to employees when a plan is initiated or amended

IFRS: costs are expensed immediately

GAAP: costs are amortized over the average service life of the employee

Question 19

What are Changes in actuarial assumptions?

Answer 19

The gains and losses that result from changes in variables such as mortality , employee turnover, retirement age, and the discount rate

Question 20

What is the formula to calculate the Fair Value of Plan Assets?

Answer 20

Question 21

What is the formula to calculate the value of the Projected Benefit Obligation (PBO) for a given yr?

Answer 21

Question 22

What are the 3 assumptions a firm discloses about its pension calculations?

Answer 22

1. The discount rate : is based on interest rates for high quality dixed income investments with a maturity profile simialr to the future obligation
2. The rate of compensation growth : the avg annual rate by which employee compensation is expected to increase over time
3. The expected return on plan assets : the assummed long-term rate of return on the plan’s investments

Question 23

What will increasing the discount rate do to a defined benefit obligation?

Answer 23

• Reduce present values, hence a lower PBO. Lower PBO improves the funding status
• Usually results in lower pension expense b/c of lower current service cost.
• Reduce interest cost

Question 24

What will decreasing the compensation growth rate do to a defined benefit obligation?

Answer 24

• Reduce future pension payments
• Reduce current service costs and lower interest cost

Question 25

How is the amount of Pension expense on the income statement calculated (US GAAP)?

Answer 25

**Net Periodic Benefit Costs** + Service Cost + Interest Cost - Expected return on plan assets +/- Amort of actuarial (gains) loss _+ Amortization of prior service costs_ **= Pension expense on income statement**

Question 26

What will increasing the expected return on plan assets do to a defined benefit obligation?

Answer 26

* Reduce pension expense * Not affect the benefit obligation or the funded status of the plan

Question 27

What are some things analysts may want to consider when comparing firms who use different accounting treatments for pensions?

Answer 27

1. Gross vs. net pension assets/liabilities 2. Differences in assumptions used (ie...different discount rates, investment returns) 3. Differences between IFRS and GAAP in recognizing pension expense 4. Diffferences due to classification in the income statement

Question 28

What are 2 reasons for netting pension assets and liabilities?

Answer 28

1. The employer largely controls the plan assets and the obligation, therefore bears the risks and potential rewards 2. Company's decisions regarding funding and accounting for the pension plan are more likely to be affected by the net pension obligation \*\*\*netting the assets/liabilties reduces the firm's total assets which results in higher ROA

Question 29

How are stock options accounted for the financial statements?

Answer 29

The compensation expense is allocated in the income statement over the service period, which is the time between the grant date and the vesting date.

Question 30

Option pricing models typically incorporate the following 6 inputs....

Answer 30

1. Exercise price 2. Stock price at the grant date 3. Expected return 4. Expected volatility 5. Expected dividends 6. Risk-free rate

Question 31

What are **stock appreciation rights**?

Answer 31

An award that gives the employee the right to receive compensation based on the increase in the price of the firm's stock over a predetermined amount

Question 32

How do GAAP and IFRS differ in how they treat the recognition of the different pension components?

Answer 32

Current serivce cost, Interest cost and Expected return **are treated the same for both. They are recognized on the Income Statement** ## Footnote **Past Service ****cost: ** GAAP -\> OCI, amortized over service life IFRS -\> Income Statement **Actuarial Gains/Losses:** GAAP -\> Amortized portion on the income statment, unamortized in OCI IFRS -\> All in OCI, not amortized

Question 33

How can an analyst reclassify pension expense for analytical purposes?

Answer 33

Background: Under GAAP, net pension expense (including interest) is shown as an operating expense. Action: 1. Add back the pension expense and subtract only service cost in determining operating income 2. Interest should be added to the firm's interest expense 3. Actual return on plan assets should be added to nonoperating income

Question 34

What is the formula to calculate the **_total periodic pension cost_**?

Answer 34

Total periodic pension cost = service cost + interest cost – actual return on plan assets + plan ammendments or = ending PBO - beginning PBO + benefits paid - actual return on plan assets

Question 35

What is the **Corridor Approach?**

Answer 35

* Refers to actuarial gains/losses * Only allowed in US GAAP * Gains & losses outside a "corridor" are amortized * **The corridor is a 10% threshold, gains \>10% and losses \> -10% are presumed to be permanent and are amortized.** * **Amortization of an acturial gain reduces pension expense and the opposite is true for losses**