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Assumptions and estimates made when calculating pension-related amounts can affect comparative financial analysis using some ratios based on financial statements.
Different companies make different assumptions, e.g., different discount rates, and this affects comparisons across companies. Recall that a company with a higher discount rate results in a lower estimated pension obligation. Therefore, a company that uses a higher discount rate as compared to its peers may indicate a less conservative bias.
Companies recognize amounts in the balance sheet as net amounts. Adjustments to include gross amounts change specific financial ratios such as debt to equity ratio.
Actuarial gains/loss and past service costs are treated separately under US GAAP and IFRS. The analyst has to adjust them for comparison purposes.
Under US GAAP, a company reports all of the components of pension costs in the P&L in operating expenses on the income statement. However, under IFRS, the components of the periodic pension costs in P&L can be included in various line items.
Under US GAAP, companies treat contributions as an operating activity. Under IFRS, they may treat some portion of contributions as a financing activity rather than an operating activity.
Companies with other post-employment benefits also disclose information about the benefits assumptions made to estimate the expense and the obligation, e.g., assumptions about the fluctuations in the inflation rate for health care costs. The future inflation rate is called the ultimate health care trend rate.
Each of the following assumptions would lead to a higher benefit obligation and a higher periodic cost holding everything else constant:
The converse is also true.
Consider two companies, Dudley Ltd and Bartley Ltd. Each company has employees for whom they provide post-employment healthcare benefits. The following are the post-employment health care plan disclosures for the companies.
$$\small{\begin{array}{l|ccc|cc} &{\textbf{Assumptions about}\\ \textbf{Health Care Costs}}&&&{\textbf{Amounts Reported for}\\ \textbf{Other Post-Employment}\\ \textbf{Benefits in}\quad \$\textbf{Millions}}\\ \hline {}&{\text{Initial Health}\\ \text{Care Cost}\\ \text{Trend Rate}\\ {2012}}& {\text{Ulitimate}\\ \text{Health Care}\\ \text{Cost Trend}\\ \text{Rate}}&{\text{Year}\\ \text{Ultimate}\\ \text{Trend Rate}\\\text{ Attained}} &{\text{Accumulated}\\ \text{Benefit Obligation}\\ \text{Year-End 2011}}&{\text{Periodic}\\ \text{Expense for}\\ \text{Benefits for 2011}}\\ \hline\text{Dudley Ltd}&\text{14%}&\text{10%}&\text{2019}&\$\text{2,000}&\$\text{80}\\ \hline\text{Bartley Ltd}&\text{12%}&\text{10%}&2018& \$\text{5,000}&\$\text{300}\\ \end{array}}$$
$$\begin{array}{l|c|c} {} & \textbf{Obligation (Million)} & \textbf{Expense (Millions)}\\ \hline\text{Dudley Ltd} & +\$147 &+\$12\\ \hline\text{Bartley Ltd} &+\$301 & +\$27\\ \end{array}$$
Bartley Ltd.’s assumptions about healthcare costs appear to be less conservative as they result in lower healthcare costs than Dudley Ltd.’s. Bartley Ltd has an initial assumed healthcare cost increase of 12%, which is lower than Dudley Ltd.’s assumed healthcare increase of 14%. Further, Bartley Ltd assumes that the ultimate health care cost trend rate of 10% is reached a year earlier than assumed by Dudley Ltd.
Note: In addition to disclosing assumptions on health care costs, companies also disclose information on the sensitivity for measurement of both obligation and the periodic cost to changes in those assumptions.
From the sensitivity disclosures, a 2% increase in the healthcare cost trend rate increases Bartley Ltd.’s post-employment benefits obligation by $301 million and its periodic cost by $27 million.
Bartley Ltd.’s initial health care cost trend rate is 2% points lower than Dudley Ltd.’s. Therefore, the impact of a 2% point change for Bartley Ltd multiplied by 2 gives an approximation of the adjustment required for comparability with Dudley Ltd. However, this adjustment is only an approximation, as the sensitivity of the obligation cannot be linear.
Based on the information in Example 1, what would be the most likely change in each company’s 2018 debt- to-equity ratio, assuming that the healthcare cost trend increases by 2%? You have total liabilities and total equity as at December 31, 2018. Assume that there is no impact on taxes.
$$\begin{array}{l|c|c} \textbf{At 31 December 2011 (US\$ millions)} & \textbf{Dudley Ltd}&\textbf{Bartley Ltd}\\ \hline\text{total Liabilities} & $50,000 & $145,000 \\ \hline\text{Total equity} & $21,300 & $24,166\\ \end{array}$$
Initially, the debt-to-equity ratio for Dudley Ltd is \(50,000:21,300: = 2.35:1\).
Adjusted total liabilities \(= $50,000 + $147 = 50,147\).
Adjusted equity \(= $21,300 – $147 = $21,153\).
Adjusted debt-to-equity ratio \(= 2.37:1\).
Therefore, a 2% increase in health care costs increases Dudley Ltd.’s debt-to-equity ratio from 2.35 to 2.37.
Similarly, the initial debt-to-equity ratio for Bartley Ltd is \(6.00:1\).
The adjusted debt-to-equity ratio is \(6.09:1\).
Therefore, a 2% increase in health care costs increases Bartley Ltd.’s debt-to-equity ratio from 6.00 to 6.09.
Under US GAAP, the net pension expense is reported in operating expenses.
Under IFRS, the current service cost is reported in operating expenses, and the actual return on plan assets is reported in the non-operating expense.
To make valid comparisons, the analyst can convert the US GAAP method of accounting to IRFS by:
$$ \text{Adjusted Operating Profit = Operating profit + Reported pension expense – Current service cost} $$
Add the interest cost to the interest expense.
Add the actual return on plan assets to other income.
Question
Given the following note to the pensions and post-retirement benefits for a given company, the components of the amount recognized in net operating expenses are as follows:
$$ \small{\begin{array}{l|c|c} {} & \textbf{Pension} & \textbf{OPB} & \textbf{Total}\\ \hline\text{Current service costs}&\text\$(20)&\$(11)&\$(31)\\ \hline\text{Expected return on Plan assets}& \$26&{}&\$26\\ \hline\text{Total}&\$(35)&\$(29)&{}\\ \hline \text{Actual return (loss) on plan assets}&\$60&{}&{}\\ \hline\end{array}} $$
What is most likely to be the total P&L expense and the change in the adjusted pre-tax income if the actual return rather than the expected return on plan assets is used?
A. Total P&L expense of $(1) and an increase in the adjusted profit of $34.
B. Total P&L expense of $(21) and a decrease in the adjusted profit of $60.
C. Total P&L expense of $(121) and an increase in the adjusted profit of $86.
Solution
The correct answer is A.
Total periodic pension cost \(=(20+41-26) = $35 \).
If we use the actual return on plan assets instead of the expected return, the total P&L expense (income) \(=(20+41-60)= $1\).
Profit before taxation adjusted for actual rather than expected return on plan assets is higher by \(($60 – $26) = $34 .\)
Reading 12: Employment Compensation: Post-Employment and Share-Based
LOS 12 (e) 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.