Employee Compensation (Pensions/Stock Options)
READING 9
EMPLOYEE COMPENSATION: POST-EMPLOYMENT AND SHARE-BASED
EXAM FOCUS
This topic can be complicated, but do not be intimidated. Share-based compensation expense is measured at the fair value on the grant date, often estimated using an option-pricing model. Understand the dilutive effects of share-based compensation plans. Accounting for pension plans may be complex in measurement and presentation, but the economic reasoning is straightforward. Despite significant convergence between U.S. GAAP and IFRS, differences remain-particularly in recognition of pension cost in the income statement. You should be able to explain how reported results are affected by management's assumptions.
Employee compensation costs comprise cash plus the value of benefits employers provide to employees. It is important to understand the accounting treatment for different types of compensation and the related analytical issues.
MODULE 9.1: SHARE-BASED COMPENSATION
Video covering this content is available online.
LOS 9.a: Contrast types of employee compensation.
Different types of employee compensation include:
- Short-term (less than 12 months): salaries, wages, bonus, health insurance, company match in defined contribution plans, and paid leave.
- Long-term (greater than 12 months): long-term disability and long-term paid leave.
- Stock-based: options or stock grants.
- Post-retirement: defined benefit pensions and health care.
Employees earn compensation as services are rendered and vest it at the end of a vesting period. For ordinary salaries and wages the vesting period may be a couple of weeks; for stock and option grants vesting commonly spans several years. At the end of the vesting period, compensation is settled-either by payment in cash or by issuance of stock-on the settlement date.
Short-term compensation is expensed to the income statement as it vests; any unpaid amount at the end of the year is shown as a current liability. Compensation expense is not always separately disclosed; it is embedded in appropriate expense categories. For example, wages for factory workers are included in cost of goods sold (COGS). Compensation expense associated with unsold inventory is capitalized as part of ending inventory. Compensation expense for employees engaged in research is included in R&D expense.
Share-based compensation plans-often offered to managers-include stock options and outright share grants. Such plans can motivate and retain key employees and reward employees without an immediate cash outlay by the firm. Drawbacks include dilution of existing shareholders' interests. Because most employees' actions have minimal impact on the stock price, the motivational value of share-based grants may be limited. Stock options have an asymmetric upside-only payoff, which may incentivise managers to take excessive risk. Stock grants can tie managers' personal wealth strongly to the company and may discourage optimal risk-taking.
LOS 9.b: Explain how share-based compensation affects the financial statements.
Stock Options
Employees are granted non-tradable call options. If the stock price exceeds the exercise price (the option is in-the-money) when the option vests (but before maturity), the employee can exercise and capture the difference. Compensation expense for option grants is based on the fair value of the options on the grant date. The expense is allocated on a straight-line basis (amortized in equal instalments) to the income statement over the vesting period (grant date to vesting date). The compensation expense reduces net income and retained earnings; the offsetting entry increases the share-based compensation reserve (an equity component). Because retained earnings decrease by the same amount that the reserve increases, total equity does not change at recognition.
Determining Fair Value
The fair value of a stock option is determined using the observable market price of a comparable option when available. If no comparable market instrument exists, a firm can use an option-pricing model such as Black-Scholes. Neither IFRS nor U.S. GAAP mandates a specific valuation model; however, the chosen model should be consistent with fair value measurement principles and reflect substantive grant features. Fair value is estimated only on the grant date; subsequent changes in fair value are not recognised in compensation expense.
Companies must disclose assumptions used to estimate fair value. Many inputs are observable (grant date, stock price, maturity, exercise price, risk-free rate), but the expected volatility of the stock price is subjective. Firms often use implied volatility from traded options on their stock or historical volatility. A lower assumed volatility reduces estimated option value and hence reduces reported compensation expense and increases reported earnings.
Employees exercise options only when they are in-the-money. Employees who leave before options vest forfeit the grant.
Conditional Grants and Stock Grants
Grants often carry conditions for vesting. Restricted stock grants have sale restrictions and commonly a service condition specifying a required number of years of employment before vesting. Performance conditions base vesting on achieving a target (for example, a specified EPS). Market conditions are also possible (for example, vesting linked to stock price). Performance-based restricted stocks are called performance shares.
Restricted stock units (RSUs) are similar to performance shares but are exchanged for stock upon vesting rather than delivering shares upfront. Employees with RSUs do not accrue dividends during the vesting period. Employees generally prefer RSUs over options because RSUs retain value when the stock price is above zero, are simpler for tax calculations, and do not require exercise outlays.
The value of a stock grant equals the stock price on the grant date multiplied by the number of shares granted. For RSUs, the stock price is reduced by the estimated present value of dividends expected during the vesting period. Total value is expensed over the vesting period and taken to equity as part of the share-based compensation reserve.
Upon settlement, amounts in the share-based compensation reserve are reclassified to common stock and paid-in capital. For option exercises, the strike price paid by employees generates a cash inflow reported in financing activities; that cash, together with the reserve amount, is allocated to common stock/paid-in capital. If options expire out-of-the-money, no further accounting beyond expiry is required.
EXAMPLE: Stock and option grant
Zephire, Inc., has an employee stock option and RSU grant plan for its senior management team. On January 1, 20X1, the company made a grant of 2 million at-the-money options (maturing in five years) and 1 million shares. The fair value of the options was $2.85 and the stock price on the date of the grant was $23. Both awards vest after 4 years.
Calculate the annual expense for the options and the stock grant, and the effect on the balance sheet and cash flow statement.
Answer:
Value of the options on grant date = $2.85 × 2 million = $5.70 million
Value of stock grant = $23 × 1 million = $23 million
Both are amortized straight-line over 4 years.
Expense = ($5.70 million + $23 million) / 4 = $7,175,000 per year
Increase in the share-based compensation reserve (in equity) will exactly offset the reduction in retained earnings; hence, there is no change in the value of total equity. Also, there will be no impact on the statement of cash flows on the grant date.
Tax Implications
For financial reporting, compensation expense is based on grant-date fair value for both option and stock grants. For tax purposes, the deduction for stock-based compensation is generally allowed only upon settlement.
Tax deduction for stock grants = share price on settlement date × number of shares vested
Tax deduction for options = intrinsic value on settlement date × number of options vested
= (stock price on settlement date - strike price) × number of options
If the stock price on the settlement date exceeds the grant-date price, the tax deduction will be larger than the cumulative compensation expense reported for accounting purposes, producing a tax windfall (excess tax benefit). Conversely, if the settlement-date price is lower than the grant-date price, there will be a tax shortfall.
Under IFRS, tax windfalls and shortfalls are reported directly to equity. Under U.S. GAAP, tax windfalls (shortfalls) reduce (increase) tax expense in the income statement. The U.S. GAAP approach causes volatility in reported net income and in the effective tax rate.
Dilution Effects
Upon settlement, stock issued and options exercised increase the number of basic shares outstanding. Prior to settlement, these grants are potentially dilutive. Dilutive securities reduce fully diluted EPS; if dilutive, they are included in diluted shares outstanding using the treasury stock method. If a company reports a net loss, basic EPS and fully diluted EPS are the same (dilutive securities = 0).
Determining whether performance shares are potentially dilutive may be subjective. Performance shares that vest based solely on service are usually considered dilutive unless the stock price has declined substantially. Vesting tied to other performance metrics (for example, EPS growth) is more subjective.
Unvested options that are in-the-money are considered dilutive. RSUs and restricted stock grants are antidilutive only if the current stock price is significantly less than the grant-date price (i.e., when the unrecognized compensation expense per share is higher than the current market price).
The treasury stock method nets the number of hypothetically repurchased shares against the total number of potentially dilutive securities. The number of hypothetically repurchased shares is based on the average share price during the reporting period.
EXAMPLE: Stock and option grant (dilution calculation)
Zephire, Inc., has an employee stock option and an RSU plan for its senior management team. On January 1, 20X1, the company made a grant of 2 million at-the-money options (maturing in 5 years) and 1 million shares. On that date, the fair value of the options was $2.85, and the stock price was $23. Both vest after 4 years. The average stock price was $24.50 during 20X1 and $25 at the end of that year.
The unrecognized value of the compensation expense was $4,275,000 for the options and $17,250,000 for the stock grant.
Calculate number of dilutive shares.
Answer:
Options:
Note: Since the plan was started on January 1, 20X1, the unrecognized amount was $0 at the prior year-end.
Stock Grant:
Note: We are given the value of unrecognized share-based compensation directly here. Using the data from the previous example, the value of the option grant and stock grant was $5.70 million and $23 million, respectively. Both vest over 4 years and, hence, the annual recognized cost = 5.70 / 4 = $1.425 million and 23 / 4 = $5.75 million, respectively. After the first year, the unrecognized cost = 5.70 - 1.425 = $4.275 million and 23 - 5.75 = $17.25 million for the option and stock grant, respectively.
Companies report antidilutive securities in the footnotes to their financial statements. Analysts should pay attention to these disclosures when the company reports a loss or when there is a large decline in earnings: both conditions will make the grants antidilutive for the current year (but potentially dilutive in subsequent years).
IFRS requires disclosure of the nature and extent of the compensation arrangement, how fair value was determined, and the arrangement's impact on earnings.
LOS 9.c: Explain how to forecast share-based compensation expense and shares outstanding in a financial statement model and their use in valuation.
Share-based compensation expense is not separately reported on the face of the income statement; it is embedded within COGS (for manufacturing employees), R&D expense (for research employees), and SG&A (for management). If the relationship between each expense category and revenue is expected to remain stable, separating share-based compensation may not be necessary for forecasting. If proportions change, subtract amounts attributable to share-based compensation from each relevant category, forecast individual expenses as a proportion of revenues (based on historical trends), and forecast share-based compensation separately.
Sources of information for forecasting changes in share-based compensation include historical data, management guidance, and assumptions about reversion to industry mean.
A further reason to separate share-based compensation is its cash-flow treatment: in the forecast statement of cash flows, share-based compensation should be added back to net income to arrive at cash flow from operating activities. Expected cash inflow from option exercise should be reflected in financing activities.
Analysts should also forecast increases in shares outstanding (dilution). Unvested grants can be accounted for by using the diluted number of shares as reported. A conservative analyst might add the gross number of potentially dilutive shares rather than using the treasury stock method.
Estimating dilution from future grants is challenging. Dilution from future grants can be estimated by discounting the estimated value of equity by a dilution factor or by estimating an increase in the number of shares outstanding.
Because share-based compensation is non-cash, companies with higher non-cash compensation components will report higher free cash flow. Ratios such as P/FCF used in relative valuation can be misleading if there are significant differences in compensation structure (cash pay versus share-based pay) among comparables.
MODULE QUIZ 9.1
1.
Which of the following are necessary inputs in order to compute share-based compensation expense using an option pricing model?
A.
The exercise price and the stock price one year after the grant date.
B.
The expected dividend yield and the firm's cost of capital.
C.
The maturity of the option and the expected volatility of the stock price.
2.
Which of the following statements about share-based compensation is most accurate?
A.
Compensation expense is only recognized if an employee stock option has intrinsic value on the grant date.
B.
In a restricted stock plan, the employer recognizes compensation expense when the employee sells the stock.
C.
The compensation expense for employee stock options is allocated over the employee's service period.
3.
Which of the following is least accurate? Short-term compensation:
A.
is expensed to the income statement as it vests.
B.
includes bonuses, health insurance, retirement contributions, and paid leave.
C.
is subject to high measurement error in estimating costs.
4.
A company has both employee stock options and RSU grants as part of its compensation plan. For 20X1, the stock options and RSU grants had an equal number of unvested underlying shares. Suppose that the company reports positive basic EPS and the same unrecognized compensation expense. Relative to the RSU plan, the options grants are most likely to result in:
A.
more dilutive securities.
B.
fewer dilutive securities.
C.
the same number of dilutive securities.
MODULE 9.2: POST-EMPLOYMENT BENEFITS
Video covering this content is available online.
LOS 9.d: Explain how post-employment benefits affect the financial statements.
A pension is deferred compensation earned over time through employee service. The most common pension arrangements are defined-contribution plans and defined-benefit plans.
A defined-contribution plan requires the firm to contribute a specified amount each period to the employee's retirement account. Contributions may be based on service years, age, compensation, profitability, or a percentage of employee contributions. The firm makes no promise about future values-the employee bears investment risk. Financial reporting is straightforward: pension expense equals the employer's contribution; nothing else is reported on the balance sheet for the plan.
A defined-benefit plan promises to pay a specified periodic payment or lump sum to the employee after retirement. Payments are often based on years of service and final salary. For example, a benefit formula of 2% of final salary per year of service implies that an employee with 20 years of service and a final salary of $100,000 receives $40,000 per year (2% × 20 × $100,000) until death. Under this plan the employer bears the investment risk.
Accounting for defined-benefit plans is more complex because the employer must estimate the value of future obligations. This requires forecasts of future compensation, turnover, retirement age, mortality rates, and selection of an appropriate discount rate.
Defined-benefit plans are often funded by contributions to a separate legal entity (a trust). Plan assets are invested to generate returns to meet future benefit payments as they fall due.
The difference between plan assets and benefit obligation is the funded status of the plan: if plan assets exceed the obligation, the plan is overfunded; if the obligation exceeds assets, the plan is underfunded. Other post-employment benefits (for example, retiree health care) are measured similarly to defined-benefit pensions but are often unfunded. For unfunded plans the employer recognises an expense as benefits are earned, while actual cash outflows occur when benefits are paid.
Balance Sheet
The projected benefit obligation (PBO) is the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, using expected future salary increases. It measures the obligation assuming the firm continues as a going concern and employees work to retirement.
funded status = fair value of plan assets - PBO
Under both U.S. GAAP and IFRS the balance-sheet presentation is:
balance sheet asset (liability) = funded status
If the funded status is negative it is reported as a liability; if positive it is reported as an asset.
Income Statement
Pension expense comprises several elements, and accounting differs between U.S. GAAP and IFRS. Components are:
- Current service cost: the present value of benefits earned by employees during the current period; it represents the increase in PBO from employees working one more period. It is recognised in the income statement before EBIT.
- Past (prior) service costs: when a firm amends its pension plan retroactively (granting increased benefits for prior service), the PBO is increased by the present value of the increased benefits already earned. Under U.S. GAAP, past service cost is initially reported in other comprehensive income and amortised over the remaining service life of affected employees. Under IFRS, past service costs are recognised immediately in profit or loss.
Interest cost
Under U.S. GAAP:
interest cost = [beginning PBO + past service cost] × discount rate
Under IFRS:
net interest income (expense) = [beginning funded status - past service cost] × discount rate
If the resulting amount is negative (plan underfunded) it is reported as an expense; if positive, it is reported as net interest income.
Expected return on plan assets
The employer contributes assets to a trust to satisfy pension obligations in future. The expected return on plan assets is used to offset the computation of reported pension expense. Expected return does not affect the PBO or the fair value of plan assets. The difference between expected and actual return is part of actuarial gains and losses.
PROFESSOR'S NOTE
Under IFRS the expected rate of return on plan assets is implicitly assumed to equal the discount rate; net interest cost/(income) is reported as a single net amount.
Actuarial gains and losses (Remeasurements in IFRS)
Actuarial gains and losses have two components: (1) the change in PBO due to changes in actuarial assumptions (for example, changes in life expectancy or salary growth), and (2) the difference between actual and expected return on plan assets. Actuarial gains and losses are recognised in other comprehensive income (OCI).
Under IFRS, actuarial gains and losses are not amortised. Under U.S. GAAP, actuarial gains and losses are amortised using the corridor approach.
Corridor Approach (U.S. GAAP only)
Under U.S. GAAP, if the beginning balance of unrecognised actuarial gains and losses exceeds 10% of the greater of beginning PBO or beginning plan assets, the excess-the amount outside the "corridor"-must be amortised over the remaining service life of active employees. Amortising an actuarial gain reduces pension cost; amortising a loss increases pension cost.
From one period to the next, the benefit obligation changes because of current service cost, interest cost, past service cost, changes in actuarial assumptions, and benefits paid.
Cash Flow Statement Impact
Actual cash flow effect is the employer contributions during the year, reported in operating activities.
EXAMPLE: Defined benefit pension plan
The following information is provided for the defined benefit pension plan of Zenith Industries for the fiscal year ending 20X5:
Calculate:
1. Beginning and ending funded status.
2. Pension cost reported under U.S. GAAP.
3. Pension cost reported under IFRS.
Answer:
While not necessary for answering the questions, reconciliation of beginning PBO to ending PBO and beginning plan assets to ending plan assets would be informative.
Note: Since there is no past service cost, it is not included in the formula for computing interest cost/net interest cost.
1. Beginning and ending funded status
Beginning funded status = beginning plan assets - beginning PBO
= 28,322 - 38,870 = - €10,548
Ending funded status = ending plan assets - ending PBO
= 30,682 - 43,619 = - €12,937
2. Pension cost in P&L (U.S. GAAP)
Corridor approach:
Because beginning PBO > beginning plan assets, take 10% of beginning PBO: €3,875.
Because unamortised actuarial losses do not exceed 10% of beginning PBO, no amortisation is necessary.
Pension cost in P&L:
3. Pension cost in P&L (IFRS)
(Section heading preserved; the detailed numeric computation steps for IFRS pension cost as provided in the source are preserved here as textual structure for the solution.)
Disclosures
Under IFRS plans must:
- disclose the main characteristics of the plan and the risks involved,
- identify and explain the figures in the financial statements arising from the plans, and
- describe the amount, timing, and uncertainty of future cash flows.
Estimates of pension cost and funded status rely on numerous assumptions disclosed in footnotes. Analysts must compare assumptions across time and firms to assess earnings quality. Aggressive accounting choices that reduce reported pension expense and PBO include low life expectancy, low future inflation, low salary growth, and a high discount rate. Under U.S. GAAP, assuming a higher expected rate of return on plan assets reduces reported pension expense but does not affect PBO or fair value of plan assets.
LOS 9.e: Explain financial modeling and valuation considerations for post-employment benefits.
Pension costs are usually embedded within relevant expense categories (for example, SG&A, COGS) and can be modelled as a percentage of revenues because pension expense typically varies with wages and salaries. If plan changes are expected (for example, closure or freezing of a plan), separate forecasts are needed. Detailed forecasts are not needed for small plans that are well funded or closed/frozen.
For valuation, underfunded pension liabilities should be deducted from enterprise value.
MODULE QUIZ 9.2
1.
The total service cost and interest cost for Carlingson Bakery's pension plan for 20X3 was $38 million. The fair market value of plan assets on January 1, 20X3, was $159 million. The projected benefit obligation (PBO) on January 1, 20X3, was $193 million, and the PBO on December 31, 20X3, was $220 million. There are no effects of foreign currency exchange rate changes, changes in assumptions affecting the PBO, business combinations, divestitures, curtailments, settlements, special terminations, or contributions by the employer or plan participants. Actual return on assets in 20X3 was $32 million. The expected return on plan assets for 20X3 was 10%. The fair value of plan assets on December 31, 20X3, is closest to:
A.
$148 million.
B.
$164 million.
C.
$180 million.
2.
Company Z has a defined-benefit plan. The projected benefit obligation is $60 million, and the fair value of the plan's assets is $40 million. Under U.S. GAAP, what amount should Company Z report on its balance sheet as a result of the pension plan?
A.
$10 million liability.
B.
$10 million asset.
C.
$20 million liability.
3.
Jacklyn King has been asked to do some accounting for Alexeeff Corp.'s pension plan. Alexeeff reports under U.S. GAAP. At the beginning of the period, the PBO was $12 million, and the fair market value of plan assets totaled $8 million. Long-term investment-grade corporate bonds yield 9%, expected return on plan assets is $0.96 million, and the anticipated compensation growth rate is 4%. At the end of the period, it was determined that the actual return on assets was 14%, plan assets equaled $9 million, and the service cost for the year was $0.9 million. Ignore amortization of unrecognized prior service costs and actuarial gains and losses. Pension cost reported in the income statement for the year should be closest to:
A.
$0.72 million.
B.
$0.86 million.
C.
$1.02 million.
4.
The most likely impact of an increase in the compensation growth rate is:
A.
retained earnings will be lower.
B.
PBO will be lower.
C.
plan assets will be higher.
5.
All else equal, a decrease in the discount rate is most likely to result in the funded status:
A.
increasing.
B.
decreasing.
C.
remaining unchanged.
6.
SCP Incorporated disclosed the following information related to its defined-benefit pension plan:
SCP's pension assumptions are internally consistent with regard to:
A.
inflation expectations but not asset returns.
B.
asset returns but not inflation expectations.
C.
neither asset returns nor inflation expectations.
KEY CONCEPTS
LOS 9.a
Employee compensation categories:
- Short-term (less than 12 months): salaries, wages, bonuses, health insurance, retirement contributions, and paid leave.
- Long-term (greater than 12 months): long-term disability and long-term paid leave.
- Stock-based: option or stock grants.
- Post-retirement: pensions.
Share-based compensation plans aim to motivate and retain key employees. Disadvantages include dilution, potentially limited motivational value, options incentivising excessive risk-taking, and stock grants encouraging excessively conservative behaviour by management.
LOS 9.b
Recognition: Share-based compensation expense is measured at grant-date fair value of the option or stock and amortised over the service (vesting) period. The corresponding credit is to the share-based compensation reserve (equity). Upon exercise of options or vesting of shares, amounts are transferred from the reserve to common stock/additional paid-in capital.
Many option-pricing model inputs are subjective and can materially affect estimated option fair value and compensation expense. Lower assumed volatility reduces option value and compensation expense. Tax deduction equals intrinsic value (options) or share price on settlement (stock grants). If settlement-date price > grant-date price, a tax windfall arises; if settlement-date price < grant-date price, a tax shortfall occurs. Under IFRS, tax windfalls/shortfalls are recorded in shareholders' equity; under U.S. GAAP they affect tax expense in the income statement.
Share-based compensation can increase the number of dilutive securities and thus reduce diluted EPS. The treasury stock method is applied to measure dilutive effects.
Assumed proceeds = cash proceeds + average unrecognised expense
Treasury stock = assumed proceeds ÷ average stock price during the year
Number of dilutive securities = (options or RSUs granted) - treasury stock
LOS 9.c
Share-based compensation can be modelled as a percentage of revenues. However, anticipated changes in expense behaviour (for example, discontinued plans) must be incorporated into forecasts. Useful information sources include historical data, management guidance, and reversion towards industry norms.
LOS 9.d
Projected benefit obligation (PBO) is the actuarial PV of future pension benefits earned to date, using expected future salary increases.
Balance sheet presentation:
balance sheet asset (liability) = fair value of plan assets - PBO
Components of pension cost:
- Current service cost: PV of benefits earned in the period; expensed in income statement.
- Interest cost (U.S. GAAP): discount rate × beginning PBO.
- Net interest cost (IFRS): discount rate × beginning funded status.
- Expected return on plan assets: offsets reported pension cost (U.S. GAAP assumes an expected return; IFRS treats expected return implicitly as equal to the discount rate resulting in net interest).
- Actuarial gains and losses: recognised in OCI; under U.S. GAAP they may be amortised via the corridor method; under IFRS they are not amortised.
- Past service cost: under U.S. GAAP amortised; under IFRS recognised immediately in P&L.
Firms can present more favourable results by increasing the discount rate, lowering compensation growth rate, reducing beneficiary life expectancy, or, under U.S. GAAP, assuming a higher expected return on plan assets.
LOS 9.e
Pension expense is often included in expense categories such as COGS and SG&A and can be forecast as a percentage of revenue. Projections must reflect anticipated plan changes. For valuation, an underfunded liability is deducted from enterprise value.
ANSWER KEY FOR MODULE QUIZZES
Module Quiz 9.1
1.
C The stock price after the grant date and the firm's required cost of capital are not inputs to option pricing models. (LOS 9.b)
2.
C For share-based compensation, expense is recognised based on the fair value of the compensation as of the grant date and is allocated over the employee's service period. No expense is recognised when the option is exercised or the stock is sold. (LOS 9.b)
3.
C Short-term employee compensation vests in less than 12 months and includes salaries, wages, bonuses, health insurance, retirement contributions, and paid leave. Because it is settled in cash, there is limited scope for measurement error. Short-term compensation is expensed to the income statement as it vests, and any unpaid amount at the end of the year is shown as a current liability. (LOS 9.a)
4.
B Option grants include cash proceeds from exercise (while RSUs do not) in the calculation of estimated proceeds. This results in a greater amount of treasury stock-reducing the number of dilutive securities. (LOS 9.c)
Module Quiz 9.2
1.
C The first step is to solve for benefits paid. The beginning PBO balance plus the cost components minus benefits paid equals the ending PBO balance: $193 + $38 - benefits paid = $220 million, which implies benefits paid = $11 million. The question specifies no employer contributions during the year; thus the ending fair value of plan assets equals beginning assets plus actual return on assets less benefits paid: $159 + $32 - $11 = $180 million. (LOS 9.d)
2.
C The funded status equals plan assets minus PBO. This plan is underfunded by $20 million ($40 million plan assets - $60 million PBO), which is reported as a liability on the balance sheet. (LOS 9.d)
3.
C
4.
A A higher compensation growth rate will increase periodic pension cost reported in P&L and, thus, lower net income. Lower net income results in lower retained earnings. A higher compensation growth rate will increase the PBO. The compensation growth rate does not affect plan assets. (LOS 9.d)
5.
B A decrease in the discount rate will increase the PBO. A higher PBO lowers the funded status (plan assets - PBO). (LOS 9.d)
6.
C Neither inflation expectations nor asset returns are internally consistent. The discount rate is increasing despite the inflation rate decreasing. There is usually a direct relationship between the discount rate and inflation. Furthermore, in 20X3 the expected rate of return increased despite SCP decreasing its allocation to equity investments. Generally, reducing exposure to equity investments in favour of debt investments will decrease expected returns. (LOS 9.d)
