Page 46 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 15.e: Explain and calculate how adjusting for items of pension and
other post-employment benefits that are reported in the notes to the READING 15: EMPLOYEE COMPENSATION: POST-EMPLOYMENT AND SHARE BASED
financial statements affects financial statements and ratios.
Gross vs. net pension assets/liabilities (we net for 2 reasons): MODULE 15.6: ANALYST ADJUSTMENTS
• Employer largely controls plan assets and the obligation and, therefore, bears the risks and potential rewards.
• The company’s decisions regarding funding and accounting for the pension plan are more likely to be affected by the net pension obligation, not the gross amounts,
because the plan assets can only be used for paying pension benefits to its employees.

Total assets and total liabilities are both less than if the firm reported the gross amounts. ROA would likely be lower if the gross amounts were reported on
the balance sheet (higher denominator). In addition, leverage ratios would likely be higher with the gross amounts.

Differences in assumptions used: Two companies in the same industry my offer a defined benefit plan but assume different discount rates. The higher discount rate would
underestimating pension liabilities (i.e., PBO) and underestimating periodic pension cost in P&L (and hence reporting higher net income).

Differences between IFRS and U.S. GAAP in recognizing total periodic pension cost (in income statement vs. OCI): Some components of total periodic pension cost
may be treated differently depending on the accounting standards being followed. An analyst may need to make adjustments to ensure uniform treatment of components.
Alternatively, the analyst could simply use comprehensive income (i.e., net income plus OCI) as the metric for comparison.

Differences due to classification in the income statement: Under U.S. GAAP, the entire periodic pension cost in P&L (including interest) is shown as an operating expense.
Under IFRS, the components of periodic pension cost can be included in various line items. Analysts can adjust GAAP-reported income by adding back the periodic pension
cost in P&L and subtracting only service cost in determining operating income. Interest cost should be added to the firm’s interest expense, and the actual return on plan assets
should be added to nonoperating income. Note: adjustments excludes (ignores) any amortizations.
Answer: Periodic pension cost (in P&L) of $4,000 ($7,000 current service cost + $5,000 interest
cost − $8,000 expected return on assets) is added back to operating profit. Then, service cost of
$7,000 is subtracted from operating profit, interest cost of $5,000 is added to interest expense, and
the actual return on assets of $9,500 is added to other income.

If the firm’s contributions exceed its total periodic pension cost, the difference can be viewed as a
reduction in the overall pension obligation, similar to an excess principal payment on a loan.
Conversely, it can be viewed as a source of borrowing.

If the difference between cash flow and total periodic pension cost is material, analyst should
consider reclassifying from operating activities to financing activities in the cash flow statement.