11/02/2021 CFA Exam Review - Level 2 - Lesson 4: Disclosures of Pension and Other Post-Employment Benefits, and Cash Flow

ash Flow Related Info…

Overview
Lesson 4: Disclosures of Pension and Other Post-Employment Benefits, and Cash Flow Related Information

This lesson includes printable lecture slides. Download

Upon completion of this lesson, candidates should be able to:

LOS 14e: 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.

LOS 14f: Interpret pension plan note disclosures including cash flow related information.

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Study Guide
Lesson 4: Disclosures of Pension and Other Post-Employment Benefits, and Cash Flow Related Information

LOS 14e: 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. Vol 2, pp 80–90

LOS 14f: Interpret pension plan note disclosures including cash flow related information. Vol 2, pp 80–90

4.1  Disclosures of Pension and Other Post-Employment Benefits

When comparing financial results of different companies using ratios, analysts should consider the impact of pensions
and other post-employment benefits on the financial statements. Comparisons across companies can be affected by:

Differences in key assumptions.

Amounts reported on the balance sheet at net amounts (net pension liability or asset). Adjustments to
incorporate gross amounts would impact financial ratios.
Noncomparability of periodic pension expense. Pension expense may not be comparable as IFRS and U.S. GAAP
differ with regards to how periodic pension costs can be recognized on the P&L vs. OCI.
Differences across IFRS and U.S. GAAP regarding the reporting of components of pension expense on the income
statement. Recall that under IFRS, companies may report the different components of pension expense within
different line items on the income statement. On the other hand, under U.S. GAAP, companies are required to
aggregate all components of pension expense and report the net amount within a single line item on the income
statement under operating expenses.
Differences across IFRS and U.S. GAAP regarding the classification of pension contributions on the cash flow
statement. Under IFRS, a portion of contributions may be treated as financing cash flows rather than operating
cash flows. Under U.S. GAAP, all contributions are treated as operating cash flows.

4.2  Assumptions
Companies disclose their assumptions about discount rates, expected compensation increases, medical expense
inflation rates, and (for U.S. GAAP companies) expected return on plan assets. Analysts should examine these
assumptions over time and across companies to assess whether a company is becoming increasingly conservative or
aggressive in accounting for its DB obligations. A company could employ aggressive pension-related assumptions to
improve reported financial performance by assuming:

A higher discount rate.

A lower compensation growth rate.
A higher expected rate of return on plan assets.

Note that if a company assumes a higher discount rate than its peers when accounting for its DB obligations, it does not
necessarily mean that the company is being relatively aggressive in its accounting practices. This is because the
appropriate discount rate depends on the timing of the company's pension obligations (i.e., the relative maturity of its
DB plan), which could be different from its peers. It is also possible that the company may be operating in a different
country (with higher interest rates) than its peers.

Further, analysts should confirm that a company's pension-related assumptions are internally consistent. For example,
the assumed discount rate and compensation growth rate should reflect a consistent view of inflation. A relatively high
discount rate and a relatively low compensation growth rate would be inconsistent because high discount rates are
associated with high-inflation environments, while a low compensation growth rate implies low inflation.

Finally, analysts should also evaluate the reasonableness of the assumed expected return on plan assets (made by U.S.
GAAP companies) in light of the plan's target asset allocation (which companies are required to disclose). A higher
expected return on plan assets is consistent with a greater proportion of plan assets being allocated to relatively risky
investments.

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Note that most post-employment health care plans are unfunded. Therefore, the expected rate of return on plan
assets is irrelevant.

Accounting for other post-employment benefits also requires companies to make several assumptions. For example, in
order to estimate the medical obligation and associated periodic cost for post-employment health care plans,
companies must make assumptions regarding the health care inflation rate, life expectancy, and so on. Typically,
companies assume that the health care inflation rate will eventually taper off towards a lower, constant ultimate health
care trend rate (see Example 4.1). All other things constant, each of the following assumptions will lead to an increase in
the company's medical obligation and associated periodic cost:

A higher health care inflation rate.

A higher ultimate health care trend rate.
A longer time to reach the ultimate health care trend rate.

Example 4.1
Comparisons about Trends in Health Care Costs
An analyst is evaluating the assumptions made by two companies (Company A and Company B) relating to their
post-employment health care plans. The table below shows the companies’ assumptions about health care costs
and health care plan-related amounts:

The table below shows the effects of a 100bp increase or decrease in the assumed health care cost trend rates on
2009 accumulated post-employment benefit obligations and periodic costs.

Based on the information above, answer the following questions:

1. Which company's assumptions regarding health care costs appear less conservative?
2. What would be the effect of adjusting the less conservative company's post-employment benefit obligation
and periodic post-employment benefit costs for a 1% increase in health care cost trend rates? Would this make
the two companies more comparable?
3. Compute the change in each company's D/E ratio assuming a 1% increase in the health care cost trend rate.
Assume that there are no taxes. Total liabilities and total equity as on the end of 2009 for the two companies
are given below:

Solution:
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1. Company B's assumptions about the trend in health care costs appear less conservative as they result in lower
health care costs. This is because Company B assumes:
A lower initial health care cost increase of 6%, which is significantly lower than the initial health care cost
increase assumed by Company A (8%).
That the rate of health care cost increases will level off at 5% (the ultimate health care trend rate) sooner
(in 2017) than Company A (in 2018).
2. The sensitivity disclosures indicate that a 1% increase in the assumed health care cost trend rate would
increase Company B's accumulated post-employment benefit obligation by $502 million and its periodic cost
by $47 million. However, this adjustment is not enough to make the two companies comparable. The size of
the adjustments to post-employment benefit obligation and periodic cost must be multiplied by 2 to reflect
the 2 percentage point difference in the companies’ assumed health care cost trend rates (Company A: 8%;
Company B: 6%). Note that this adjustment would only be an approximation because the sensitivity of benefit
obligations and periodic costs to changes in the assumed health care cost trend rate would not be exactly
linear. Also note that the differences in the companies’ assumed health care trend rates may be justifiable
based on their respective locations (i.e., Company B may be located in a country with lower inflation than
Company A).
3. The D/E ratio before and after adjusting for a 1% increase in the health care cost trend rate are calculated
below:
Company A:
D/E (reported) = $14,487 / $5,765 = 2.51
D/E (after adjustment) = ($14,487 + $240) / ($5,765 − $240) = 2.67
Company B:
D/E (reported) = $44,394 / $7,518 = 5.91
D/E (after adjustment) = ($44,394 + $502) / $7,518 − $502) = 6.40
A 1% increase in the health care cost trend rate:
Increases Company A's D/E ratio by 6.3% (from 2.51 to 2.67).
Increases Company B's D/E ratio by 8.3% (from 5.91 to 6.40).

4.3  Net Pension Liability (Asset)

We learned previously that under both IFRS and U.S. GAAP, the DB pension plan-related amount reported on the
balance sheet is a net amount (net pension liability or net pension asset). Analysts should examine the notes to the
financial statements and (1) add the gross amount of plan assets to the company's total assets and (2) add the gross
amount of pension obligation to the company's total liabilities to reflect the underlying economic assets and liabilities
of the sponsor. Analysts should compare the gross amount of pension obligation to the sponsoring company's (1) total
assets (including gross plan assets), (2) shareholders’ equity, and (3) earnings. The larger the ratio of gross plan
obligations to any of these items, the greater the financial impact that a small change in pension liability will have on
the sponsoring company's overall financial position.

4.4  Periodic Pension Costs Recognized in P&L versus OCI

Total periodic pension cost recognized under IFRS and U.S. GAAP is the same. However, the two sets of standards differ
in their provisions regarding which components are recognized in P&L and which ones are recognized in OCI. These
differences are important for analysts when evaluating companies that use different sets of standards.

Under IFRS, current and past service costs are recognized in P&L. Under U.S. GAAP, the P&L only reflects current
service costs (and amortization of any past service costs).
Under IFRS, pension expense on the P&L incorporates a return on plan assets equal to the discount rate (used for
measuring the pension obligation) times the value of plan assets. Under U.S. GAAP, pension expense on the P&L
incorporates a return on plan assets equal to an estimated rate of return on plan assets times the value of plan
assets.

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Under IFRS, the P&L would never show amortization of pension-related amounts previously recognized in OCI.
Under U.S. GAAP, the P&L would reflect amortization of any past service costs, and may reflect amortization of
actuarial gains and losses if they were initially recorded in OCI and if the “corridor” has been exceeded.

An analyst comparing the financial statements of a company that follows IFRS to one that follows U.S. GAAP would
have to make adjustments to reported amounts to achieve comparability. To make a U.S. GAAP-following company's
P&L comparable to the P&L of a company following IFRS, she would:

Include past service costs on the P&L as pension expense.

Exclude the effects of amortization of past service costs arising in previous periods.
Exclude the effects of amortization of unrecognized actuarial gains and losses arising in previous periods.
Incorporate the effects of the expected return on plan assets based on the discount rate (rather than the expected
rate).

Alternatively, she could use total periodic pension cost as the basis for comparison by focusing on comprehensive
income (which includes net income and other comprehensive income).

4.5  Classification of Periodic Pension Costs Recognized in P&L

Periodic pension costs recognized on the P&L are referred to as pension expense, which is generally treated as an
operating expense. Conceptually however, the components of pension expense can be classified as operating and/or
nonoperating. For example:

Only current service costs should be treated as operating expenses.

Interest expense should be treated as a nonoperating expense.
The return on plan assets should be treated as nonoperating income.

These classification issues also apply to OPB costs.

Analysts should make the following adjustments to reflect a company's operating performance more accurately on the
income statement:

1. Add back the entire amount of pension costs recognized on the P&L (pension expense) to operating income.
2. Subtract service costs before determining operating profit.
3. Add the interest component of pension expense to the company's interest expense.
4. Add the return on plan assets to nonoperating income.

The first two adjustments combined effectively exclude (1) amortization of past service costs, (2) amortization of
actuarial gains and losses, (3) interest expense, and (4) return on plan assets from operating income.

Further, analysts may also make adjustments to reflect the actual return on plan assets. Recall that:

Under IFRS, net interest expense/income on the P&L incorporates a return on plan assets based on the discount
rate. The difference between this return and the actual return is a part of remeasurement, which is included in
OCI.
Under U.S. GAAP, pension expense incorporates a return on plan assets based on an expected rate of return
assumption. The difference between the actual and expected return is a source of actuarial gains (losses), which
are typically initially reported in OCI.

Note that adjusting the P&L to incorporate the actual return on plan assets introduces an element of volatility in net
income. However, reclassification of interest expense has no impact on net income. See Example 4.2.

Example 4.2
Reclassifying Pension Expense
An analyst gathers the following information regarding a company:

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Selected information from the income statement:

Operating profit $550,000
 Less: Interest expense $125,000
 Add: Other income $70,000
Income before tax $495,000
Selected information from notes to the financial statements:
Current service costs $75,000
 Add: Interest costs $50,000
 Less: Expected return on plan assets $85,000
Total $40,000

Difference between actual and expected return on plan assets = $5,000.

Based on the information provided, reclassify the components of pension expense between operating and
nonoperating items.
Solution:
We determine adjusted operating profit by adding back the total amount of pension expense recognized during the
period ($40,000) to operating income and subtracting only current service costs ($75,000).

Adjusted operting profit = 550,000 + 40,000 − 75,000 = $515,000

The interest component of pension expense ($50,000) is added to reported interest expense ($125,000).

Adjusted interest expense = 125,000 + 50,000 = $175,000

The actual return on plan assets is added to other income ($70,000).

Actual return on plan assets = Expected return + (Actual return − Expected return)

= $85,000 + $5,000 = $90,000

Adjusted other income = 70,000 + 90,000 = $160,000

Finally, income before taxes is computed as adjusted operating profit minus adjusted interest expense plus adjusted
other income.

Income before tax = 515,000 − 175,000 + 160,000 = $500,000

4.6  Cash Flow Information

For a funded plan, the impact of the plan on the sponsoring company's cash flows is the amount of contributions the
company makes to fund the plan. For an unfunded plan, the impact of the plan on the sponsoring company's cash
flows is the amount of benefits paid. Note that in both cases, these cash flows are usually classified as operating cash
flows.

From an economic perspective however, classification of employer contributions to DB pension plans depends on how
they relate to total pension costs for the period. Specifically:

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If a company's contribution to the plan over the period is greater than total pension cost for the period, the
excess may be viewed as a reduction in the overall pension obligation.
Excess contributions are conceptually similar to making a principal payment on a loan in excess of the
scheduled principal payment.
If a company's contribution to the plan over the period is lower than total pension cost for the period, the
shortfall results in an increase in the overall pension obligation.
A shortfall in contributions may be viewed as a source of financing.

If the amount of pension obligation is material, analysts may choose to reclassify the excess (shortfall) in contributions
as a use (source) of cash from financing activities rather than operating activities. See Example 4.3.

Example 4.3
Adjusting Cash Flow
An analyst compiled the following information for XYZ Company's DB pension plan for 2009:

Total pension cost for 2009 = $1,350

Contributions made by the sponsor during 2009 = $580

Tax rate = 30%

How did the company's contributions to the plan during 2009 compare with total pension cost for the period? How
would an analyst adjust cash from operating activities and financing activities?
Solution:

The company contributed $580 to its pension plan, which is $770 less than the total pension cost for the year. This
$770 difference equals $539 [= $770 × (1 − 0.3)] on an after-tax basis.
Since the amount contributed by the sponsor to the plan over the year is lower than total pension cost for the year,
the after-tax shortfall ($539) serves to increase the net pension liability. An analyst would therefore increase cash
flow from financing activities by $539 and decrease cash flow from operating activities by $539.

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Flashcards
Lesson 4: Disclosures of Pension and Other Post-Employment Benefits, and Cash Flow Related Information

1
fc.L2R15L04.0001_1812

List aggressive pension-related assumptions that

improve reported financial performance. A higher discount rate.

A lower compensation growth rate.

A higher expected rate of return on plan assets.

2
fc.L2R15L04.0002_1812

List assumptions that lead to higher periodic

medical costs and associated obligation. Higher health care inflation rate.

Higher ultimate health care trend rate.

A longer time to reach the ultimate health care

trend rate.

3
fc.L2R15L04.0003_1812

Subtract amortization of past service costs from

Explain how to adjust P&L under U.S. GAAP for pension expense; add past service costs to pension
comparison to a P&L under IFRS. expense.

Exclude the effects of amortizing unrecognized

actuarial gains and losses.

Incorporate the effects of the expected return on

plan assets based on the discount rate (rather than
the expected rate).

4
fc.L2R15L04.0004_1812

Add pension expense to operating income.

List the adjustments analysts should make to
reflect a company's operating performance more Reduce operating profit for service costs.
accurately on the income statement.
Add the return on plan assets to nonoperating
income.

Add the interest component of pension expense to

the company's interest expense for calculating net
income.

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