{"id":10169,"date":"2023-02-26T06:19:34","date_gmt":"2023-02-26T06:19:34","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=10169"},"modified":"2026-01-15T18:05:05","modified_gmt":"2026-01-15T18:05:05","slug":"use-pension-post-employment-benefit-disclosures-assess-companys-assumptions-impact-financial-statements-ratios","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/use-pension-post-employment-benefit-disclosures-assess-companys-assumptions-impact-financial-statements-ratios\/","title":{"rendered":"Use of Pension and Other Post-employment Benefit Disclosures to Assess a Company\u2019s Assumptions and their Impact on the Financial Statements and Ratios"},"content":{"rendered":"<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"Pension and post-retirement benefits: impact of using actual vs expected return on plan assets\",\r\n    \"text\": \"Given the following note to the pensions and post-retirement benefits for a company, the components of the amount recognized in net operating expenses are:\\n\\nPension \/ OPB \/ Total\\n\\nCurrent service costs:\\nPension $(20), OPB $(11), Total $(31)\\n\\nExpected return on plan assets:\\n$26\\n\\nTotal:\\nPension $(35), OPB $(29)\\n\\nActual return (loss) on plan assets:\\n$60\\n\\nWhat is most likely to be the total P&L expense and the change in adjusted pre-tax income if the actual return rather than the expected return on plan assets is used?\\n\\nA. Total P&L expense of $(1) and an increase in the adjusted profit of $34.\\n\\nB. Total P&L expense of $(21) and a decrease in the adjusted profit of $60.\\n\\nC. Total P&L expense of $(121) and an increase in the adjusted profit of $86.\",\r\n    \"answerCount\": 3,\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"A. Total P&L expense of $(1) and an increase in the adjusted profit of $34.\\n\\nTotal periodic pension cost using the expected return is (20 + 41 \u2212 26) = $35. If the actual return on plan assets is used instead, the total P&L expense becomes (20 + 41 \u2212 60) = $1. Adjusted profit before tax increases by the difference between actual and expected returns, which is $60 \u2212 $26 = $34.\"\r\n    },\r\n    \"suggestedAnswer\": [\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"B. Total P&L expense of $(21) and a decrease in the adjusted profit of $60.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"C. Total P&L expense of $(121) and an increase in the adjusted profit of $86.\"\r\n      }\r\n    ]\r\n  }\r\n}\r\n<\/script>\r\n\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/qIEMq5H3QEI\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n\r\n<p>Assumptions and estimates made when calculating pension-related amounts can affect comparative financial analysis using some ratios based on financial statements.<\/p>\r\n<h2>Assumptions<\/h2>\r\n<p>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 <b>higher discount rate<\/b> as compared to its peers may indicate a <b>less conservative bias.<\/b><\/p>\r\n<h2>Gross vs. Net Reporting of Pension Assets &amp; Liabilities<\/h2>\r\n<p>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.<\/p>\r\n<h2>IFRS vs. US GAAP Method of Recognizing Pension Expenses<\/h2>\r\n<p>Actuarial gains\/loss and past service costs are treated separately under US GAAP and IFRS. The analyst has to adjust them for comparison purposes.<\/p>\r\n<h2>Reporting of the Periodic Pension Costs in P&amp;L<\/h2>\r\n<p>Under US GAAP, a company reports all of the components of pension costs in the P&amp;L in operating expenses on the income statement. However, under IFRS, the components of the periodic pension costs in P&amp;L can be included in various line items.<\/p>\r\n<h2>Different Treatment of Contributions<\/h2>\r\n<p>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.<\/p>\r\n<p>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 <b>ultimate health care trend rate.<\/b><\/p>\r\n<p>Each of the following assumptions would lead to a higher benefit obligation and a higher periodic cost holding everything else constant:<\/p>\r\n<ul>\r\n\t<li style=\"font-weight: 400;\">A higher assumed near-term increase in healthcare costs.<\/li>\r\n\t<li style=\"font-weight: 400;\">A higher assumed ultimate healthcare cost trend rate.<\/li>\r\n\t<li style=\"font-weight: 400;\">A later year in which the ultimate health care cost trend is assumed to be reached.<\/li>\r\n<\/ul>\r\n<p>The converse is also true.<\/p>\r\n<h4>Example 1: Comparison of Assumptions about Trends in a Hypothetical Country\u2019s Health Care Costs<\/h4>\r\n<p>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.<\/p>\r\n<h5>Scenario A: Assumptions and Reported Amounts for the Country\u2019s Post-Employment Health Care Benefit Plans<\/h5>\r\n<p>$$\\small{\\begin{array}{l|ccc|cc}\u00a0 &amp;{\\textbf{Assumptions about}\\\\ \\textbf{Health Care Costs}}&amp;&amp;&amp;{\\textbf{Amounts Reported for}\\\\ \\textbf{Other Post-Employment}\\\\ \\textbf{Benefits in}\\quad \\$\\textbf{Millions}}\\\\\u00a0 \\hline {}&amp;{\\text{Initial Health}\\\\ \\text{Care Cost}\\\\ \\text{Trend Rate}\\\\ {2012}}&amp; {\\text{Ulitimate}\\\\ \\text{Health Care}\\\\ \\text{Cost Trend}\\\\ \\text{Rate}}&amp;{\\text{Year}\\\\ \\text{Ultimate}\\\\ \\text{Trend Rate}\\\\\\text{ Attained}} &amp;{\\text{Accumulated}\\\\ \\text{Benefit Obligation}\\\\ \\text{Year-End 2011}}&amp;{\\text{Periodic}\\\\ \\text{Expense for}\\\\ \\text{Benefits for 2011}}\\\\ \\hline\\text{Dudley Ltd}&amp;\\text{14%}&amp;\\text{10%}&amp;\\text{2019}&amp;\\$\\text{2,000}&amp;\\$\\text{80}\\\\ \\hline\\text{Bartley Ltd}&amp;\\text{12%}&amp;\\text{10%}&amp;2018&amp; \\$\\text{5,000}&amp;\\$\\text{300}\\\\\u00a0 \\end{array}}$$<\/p>\r\n<h5>Scenario B: Effects of Changing the Assumed Health Care Cost Trend Rates by a 2% Increase on 2011 Total Accumulated Obligations and Periodic Expense<\/h5>\r\n<p>$$\\begin{array}{l|c|c}\u00a0 {} &amp; \\textbf{Obligation (Million)} &amp; \\textbf{Expense (Millions)}\\\\ \\hline\\text{Dudley Ltd} &amp; +\\$147 &amp;+\\$12\\\\ \\hline\\text{Bartley Ltd} &amp;+\\$301 &amp; +\\$27\\\\\u00a0 \\end{array}$$<\/p>\r\n<p>Bartley Ltd.\u2019s assumptions about healthcare costs appear to be <b>less conservative<\/b> as they result in <b>lower healthcare costs<\/b> than Dudley Ltd.\u2019s. Bartley Ltd has an initial assumed healthcare cost increase of 12%, which is lower than Dudley Ltd.\u2019s 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.<\/p>\r\n<p><em><strong>Note:<\/strong> <\/em>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.<\/p>\r\n<p>From the sensitivity disclosures, a 2% increase in the healthcare cost trend rate increases Bartley Ltd.\u2019s post-employment benefits obligation by $301 million and its periodic cost by $27 million.<\/p>\r\n<p>Bartley Ltd.\u2019s initial health care cost trend rate is 2% points lower than Dudley Ltd.\u2019s. 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 <b>sensitivity of the obligation cannot be linear<\/b>.<\/p>\r\n<h4>Example 2: Impact of Changing the Assumed Health Care Cost Trend Rates on 2011 Debt to Equity Ratio<\/h4>\r\n<p>Based on the information in Example 1, what would be the most likely change in each company\u2019s 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.<\/p>\r\n<p>$$\\begin{array}{l|c|c} \\textbf{At 31 December 2011 (US\\$ millions)} &amp; \\textbf{Dudley Ltd}&amp;\\textbf{Bartley Ltd}\\\\ \\hline\\text{total Liabilities} &amp; $50,000 &amp; $145,000 \\\\ \\hline\\text{Total equity} &amp; $21,300 &amp; $24,166\\\\\u00a0 \\end{array}$$<\/p>\r\n<p>Initially, the debt-to-equity ratio for Dudley Ltd is \\(50,000:21,300: = 2.35:1\\).<\/p>\r\n<p>Adjusted total liabilities \\(= $50,000 + $147 = 50,147\\).<\/p>\r\n<p>Adjusted equity \\(= $21,300 &#8211; $147 = $21,153\\).<\/p>\r\n<p>Adjusted debt-to-equity ratio \\(= 2.37:1\\).<\/p>\r\n<p>Therefore, a 2% increase in health care costs increases Dudley Ltd.\u2019s debt-to-equity ratio from 2.35 to 2.37.<\/p>\r\n<p>Similarly, the initial debt-to-equity ratio for Bartley Ltd is \\(6.00:1\\).<\/p>\r\n<p>The adjusted debt-to-equity ratio is \\(6.09:1\\).<\/p>\r\n<p>Therefore, a 2% increase in health care costs increases Bartley Ltd.\u2019s debt-to-equity ratio from 6.00 to 6.09.<\/p>\r\n<h3>Adjustments to Classify Components of Pension Expense between Operating &amp; Non-Operating Expenses<\/h3>\r\n<p>Under US GAAP, the <b>net pension expense<\/b> is reported in <b>operating expenses<\/b>.<\/p>\r\n<p>Under IFRS, the <b>current service cost<\/b> is reported in <b>operating expenses<\/b>, and the <b>actual return on plan assets<\/b> is reported in the <b>non-operating expense<\/b>.<\/p>\r\n<p>To make valid comparisons, the analyst can convert the US GAAP method of accounting to IRFS by:<\/p>\r\n<p>$$ \\text{Adjusted Operating Profit\u00a0= Operating profit + Reported pension expense &#8211; Current service cost} $$<\/p>\r\n<p>Add the interest cost to the interest expense.<\/p>\r\n<p>Add the actual return on plan assets to other income.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>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:<\/p>\r\n<p>$$ \\small{\\begin{array}{l|c|c} {} &amp; \\textbf{Pension} &amp; \\textbf{OPB} &amp; \\textbf{Total}\\\\ \\hline\\text{Current service costs}&amp;\\text\\$(20)&amp;\\$(11)&amp;\\$(31)\\\\ \\hline\\text{Expected return on Plan assets}&amp; \\$26&amp;{}&amp;\\$26\\\\ \\hline\\text{Total}&amp;\\$(35)&amp;\\$(29)&amp;{}\\\\ \\hline \\text{Actual return (loss) on plan assets}&amp;\\$60&amp;{}&amp;{}\\\\ \\hline\\end{array}} $$<\/p>\r\n<p>What is <i>most likely <\/i>to be the total P&amp;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?<\/p>\r\n<p>A. Total P&amp;L expense of $(1) and an increase in the adjusted profit of $34.<\/p>\r\n<p>B. Total P&amp;L expense of $(21) and a decrease in the adjusted profit of $60.<\/p>\r\n<p>C. Total P&amp;L expense of $(121) and an increase in the adjusted profit of $86.<\/p>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is A<\/strong>.<\/p>\r\n<p>Total periodic pension cost \\(=(20+41-26) = $35 \\).<\/p>\r\n<p>If we use the actual return on plan assets instead of the expected return, the total P&amp;L expense (income) \\(=(20+41-60)= $1\\).<\/p>\r\n<p>Profit before taxation adjusted for actual rather than expected return on plan assets is higher by \\(($60 \u2013 $26) = $34 .\\)<\/p>\r\n<\/blockquote>\r\n<p>Reading 12: Employment Compensation: Post-Employment and Share-Based<\/p>\r\n<p><em>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.<\/em><\/p>","protected":false},"excerpt":{"rendered":"<p>Assumptions and estimates made when calculating pension-related amounts can affect comparative financial analysis using some ratios based on financial statements. Assumptions Different companies make different assumptions, e.g., different discount rates, and this affects comparisons across companies. Recall that a company&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,312],"tags":[216,313,113],"class_list":["post-10169","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-financial-reporting-and-analysis-fra","tag-cfa-level-2","tag-financial-reporting-and-analysis-fra","tag-use-of-pension-and-other-post-employment-benefit","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Using Pension Disclosures for Financial Analysis | CFA II<\/title>\n<meta name=\"description\" content=\"Explains how pension and post-employment benefit disclosures are used to evaluate assumptions and their effects on financial statements and ratios.\" 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