Finquiz FSA Answer

Reading 17

Employee Compensation: Compensation: Post-Employment and Share-Based

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FinQuiz.com CFA Level II Item-set - Solution Study Session 5 June 2017

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Reading 17


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FinQuiz Level II 2017 – Item-sets Solution Reading 17: Employee Compensation: Post-Employment and Share-Based Share-Based 1. Question ID: 15566 Correct Answer: A Statement 1 is correct. Firms following IFRS would expense the entire cost immediately. Past service costs are generated as a result of plan amendments. Under IFRS past service costs are recognized as an expense in the P&L. In contrast, under U.S. GAAP, past service costs are reported in other comprehensive income in the period in which the change giving rise to the cost occurs.

Statement 2 is incorrect. Under U.S. GAAP, unamortized past service costs are reported in accumulated other comprehensive income and subsequently amortized over the average service lives of the affected employees; the amortized amounts are included in the income statement. 2. Question ID: 15567 Correct Answer: C Under U.S. GAAP, actuarial gains and losses that are recognized immediately are included as a component of pension expense. However, under IFRS, actuarial gains and losses are recognized as part of other comprehensive income and are not subsequently amortized to P&L. If they are treated as other comprehensive income, this can reduce the volatility of pension expense (but increase the volatility of equity).

U.S. GAAP only allows the deferred def erred recognition of actuarial gains and losses using either the c orridor method or the faster recognition method to determine the minimum amount to be reported on the income statement. Park has defined only the corridor method; under the faster recognition method the actuarial gains and losses can be amortized more quickly. 3. Question ID: 15568 Correct Answer: A Estimated final year’s salary: $92,736 Estimated annual payment for each of the 20 years: (92,736×0.025)(10+5) = $34,776 Value at the end of Year 5, of the estimated future payments: $383,179.6 Annual unit credit: 383,179.6/15 = $25,545.30 Benefits attributed to prior years: Annual unit credit (10) = $255,453. Opening obligation: 255,453/(1.065) 5 = $186,450.25 Interest cost = 186.450.25(0.065) = $12,119.269 4. Question ID: 15569 Correct Answer: A Statement 3 is correct. An increase in the assumed discount rate can c an increase the interest cost. However, the interest component of the pension obligation and pension expense may decrease if the decrease in the opening obligation more than offsets the effect of the increase in the discount rate (this is the typical effect).

Statement 4 is incorrect. An increase in life expectancy will have no effect on the promised pension payments because the payments are to be paid over a fixed time period.


Reading 17


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5. Question ID: 15570 Correct Answer: A Total periodic pension costs = Ending funded status – contributions – beginning funded status

Total periodic pension costs = ($25,670 – $24,586) – ($19,615 – $18,956) – $65 = $360 6. Question ID: 15571 Correct Answer: B If Care Medicines complied with IFRS, it would report remeasurement amounts as part of net income:

Remeasurements = net return on plan assets* - actuarial gains and losses *Net return on plan assets = Actual return – (Plan assets × Interest rate)

Remeasurements = [$980 – (12% × $19,615)] + $1,500 = $126.20 $126 ≈

7. Question ID: 15594 Correct Answer: A The amount of pension liability recognized under U.S. GAAP for the year 2009 is 466 million.

Under U.S. GAAP the amount recognized under a defined benefit plan is the pension plan’s funded status. The funded status represents the difference between the fair value of the plan assets and the projected benefit obligation (present value of the pension liabilities). If the projected benefit obligation exceeds the fair value of the plan assets, this suggests that the plan is underfunded. In the case of Hewer Corporation, the projected obligation as at December 31, 2009 exceeds the fair value of the corporation’s plan assets on the same date ($589 million vs. $123 million). 8. Question ID: 15595 Correct Answer: B For both the 2008 and 2009 periods, total periodic pension costs exceeded employer/employee contributions (in 2008 periodic pension costs exceeded contributions by $54 million and in 2009 pension costs exceeded contributions by $75 million). In the event that periodic pension costs exceed contributions, the excess can be viewed from an economic perspective as a source of financing. In the case of both 2008 and 2009, the appropriate adjustment would be to reclassify the excess as an inflow related to financing activities rather than to operating activities, i.e. decrease operating cash flows and increase financing cash flows.

Since the corporation has not made these cash flow adjustments, its operating cash flows are overstated financing flows are understated for both the periods presented. 9. Question ID: 15596 Correct Answer: B The actuarial loss recognized by Hewer Corporation in its 2009 income statement is $7.0 million.

Under the corridor method, the net cumulative unrecognized actuarial gains and losses at the beginning of the reporting period are compared with defined benefit obligation and the fair value of the plan assets at the beginning of the period.


Reading 17


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If this cumulative unrecognized amount exceeds 10% of the greater of the PBO or the fair value of plan assets, the excess is amortized over the expected average remaining working lives of the employees participating in the plan and is included as a component of pension expense. • • • •

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PBO at the beginning of 2009 = $448 million Fair value of plan assets at the beginning of 2009 = $149 million Net cumulative unrecognized actuarial gains/losses at the beginning of 2009 = $150 million PBO balance ($448 million) > Fair value of plan assets ($149 million). Thus the PBO value is used. 10% of the PBO amount = $44.8 million ($448 million × 10%) Unamortized portion of net actuarial loss = $105.2 million ($150 million – $44.8 million) Amortized portion of actuarial loss (recognized in 2009’s income statement) = $7.01 million ($105.2 million ÷ 15 years)

10. Question ID: 15597 Correct Answer: C Amongst the actions listed, a(n):   

increase in the discount rate to 12.2% in 2010 from 12.1% in 2009, will decrease the value of the PBO being reported in 2010. decrease in the actual return on plan assets to 8.5% will not affect the PBO amount as actual return on plan assets are not used in the PBO computation. increase in the rate of compensation increases to 3.8% in 2010 from 3.5% in 2009 will increase the value of PBO being reported in 2010.

11. Question ID: 15598 Correct Answer: C Amongst the rate assumptions listed in Exhibit 2, the discount rate assumptions, expected return on plan assets, and annual compensation rate increases are internally consistent. This is because these rates are all increasing over the periods, 2008 and 2009 and thus correspond to the increase in the expected inflation rate over the two periods. However, the actual return on plan assets is internally inconsistent with these rates (including the expected inflation rate) as this rate of return remains constant at 8% over the two years. 12. Question ID: 15599 Correct Answer: B On January 1, 2008, 2 years of the vesting period have elapsed and 1.5 years remain.

For the year 2008, the compensation expense recognized is $360 million ($540 million ÷ 1.5 years). For the year 2009, the compensation expense recognized is $180 million ($540 million – $360 million). 13. Question ID: 11621 Correct Answer: C The funded status is equal to $17,236 ($87,200 ( $87,200 – $69,964) which the difference between the ending defined benefit obligation and fair value of plan assets,


Reading 17


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14. Question ID: 11622 Correct Answer: B Net interest expense = Change in beginning of period funded status × discount rate

Net interest expense = $(54,500 – 60,000) × 12% = –$660 15. Question ID: 11623 Correct Answer: C Using the sponsor’s 2010 contributions of $15,425 and a $6,000 total pension costs, the sponsor’s contributions exceed the pension expense by a pre-tax amount of $9,425 ($15,425 – $6,000). The after-tax amount by which the sponsor company’s contributions exceed the pension costs is $7,068.75 or approximately $7,069 [$9,425 × (1 – 0.25)].

Since the sponsor’s contributions exceed the total pension costs, the excess is equivalent to a repayment on a loan in excess of the scheduled payment (financing use of funds). This excess is treated as an increase in cash inflow from operating activities and an increase in cash outflow from financing activities by $7,069. Put another way, the $7,069 excess is treated as a decrease in cash outflow from operating activities and a decrease in cash inflow from financing activities. 16. Question ID: 11624 Correct Answer: A Periodic pension costs are calculated as follows:

Total periodic pension costs (income) = Ending funded status – Employer contributions – beginning funded status. Total costs (income) = ($87,200 – $69,964) – $15,425 – ($60,000 – $54,500) = ($3,689) 17. Question ID: 11625 Correct Answer: B Benefit 1: s Stock options have payoffs, which can be characterized as asymmetric or one-sided. In other words, the potential for profits (when the underlying stock price exceeds the option exercise price) is unlimited on the upside and losses (when the stock price falls below the exercise price) are limited to the option premium.

Thus the potential for risk aversion is limited and the potential for returns is unlimited on the upside. This benefit accurately reflects a benefit of issuing stock to firm employees. Benefit 2: Although the issuance of stock option will dilute shareholder ownership in the future, as the options are exercised and underlying shares are issued, the firm does not simultaneously issues shares with its stock options issue. Regardless of whether the stock options dilute shareholdings immediately or in the future, the firm’s e xisting shareholders will be affected by the issue once the options are exercised (and associated shares issued). Thus benefit 2 does not accurately reflect a benefit of issuing stock options to existing firm shareholders. Benefit 3: When stock options are issued an annual c ompensation expense in recorded on the firm’s income statement thereby reducing the firm’s profitability. Additionally, stock options can dilute the firm’s


Reading 17


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earnings per share. Thus the issuance of stock options can reduce the firm’s overall profitability as well an individual shareholder’s share in firm profitability. Benefit 3 misrepresents the benefit as well as effect of issuing stock options on firm profitability. 18. Question ID: 11626 Correct Answer: B The fair value of an option tends to decrease with a(n):  increase in underlying exercise price;  increase in assumed dividend yields; and  decrease in stock price volatilities.

Relative to current estimates for:  underlying exercise price ($52.10), selecting alternative 2 will result in a lower fair value estimate for the option as it assumes a higher exercise price estimate e stimate ($57.45).  dividend yields (3.00%), selecting alternative 2 will result in a lower fair value estimate for the option as it assumes a higher dividend yield estimate (3.85%) whereas alternative 1 will lead to a higher price estimate due to the lower dividend yield estimate.  stock price volatility (23%), selecting alternative 1 will result in a lower fair value estimate as it assumes a lower stock price volatility estimate (22%) whereas alternative 2 will lead to a higher price estimate to the higher volatility estimate. 19. Question ID: 17563 Correct Answer: B Final salary= ($75,000) (1.0525) 14 = $153,522 20. Question ID: 17564 Correct Answer: C Lump Sum Payment at Retirement = (0.025 × 161,581)15 = $60,593. 21. Question ID: 17565 Correct Answer: A Annual Unit Benefit = Value at Retirement/ Years of Service = $56,553/15 = $3,770 22. Question ID: 17566 Correct Answer: A Benefits attributed to prior years in year 5 = Annual unit credit ($3,770) × 4 = $15,080 23. Question ID: 17567 Correct Answer: C Lump Sum Payment at Retirement = (0.025 × $161,581)20 = $80,791. 24. Question ID: 17568 Correct Answer: B Annual Unit Benefit = Value at Retirement/ Years of Service = $20,197/20 = $1,010


Reading 17


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25. Question ID: 17570 Correct Answer: B The number of employees relevant for an accumulated benefit obligation calculation for 10 years = Currently Vested + Expected to meet Vesting V esting Conditions in the next ten years = 25,000+ 125,000 = 150,000. 26. Question ID: 17571 Correct Answer: C The projected benefit obligation is based on the going concern assumption as it assumes the business to maintain its operations for the foreseeable futures. Calc ulations are made using the assumed turnover rates and salary increases in future f uture periods. 27. Question ID: 17572 Correct Answer: A Interest Cost = Discount rate × Beginning pension obligation = 9% * 48 million = £4.32 million. 28. Question ID: 17573 Correct Answer: B Past service costs is the amount a mount by which a company’s pension obligation relating to employees’ service in prior periods changes as a result of plan amendments or plan curtailments. These costs represent an obligation of the company and a re thus included within a company’s pension obligation. 29. Question ID: 17574 Correct Answer: C The return on plan assets does not have any effect on the benefit obligation. The return increases the fair value of the plan assets. 30. Question ID: 17575 Correct Answer: A Curtailment occurs when the number of employees covered by the existing plan is reduced. This reduction may be due to any number of reasons i.e. redundancy, restructuring etc. 31. Question ID: 17577 Correct Answer: A Share based payments are recorded as an expense in the income statement. Regardless of the absence of a cash outflow, the income statement will recognize an expense according to the accrual principle. 32. Question ID: 17578 Correct Answer: A The compensation expense relevant to restricted stock grants is measured based on the fair value of the stock on the grant date. 33. Question ID: 17579 Correct Answer: B When the option price is dependent upon future contingent events to be known after the grant date, the compensation expense is measured at the exercise date.


Reading 17


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34. Question ID: 17580 Correct Answer: A A lower assumed dividend yield would lead to a n increase in the estimated fair value of a stock option according to the option pricing model. 35. Question ID: 17581 Correct Answer: A In 2010, the company will recognize $187.5 million ($750 million/4) as compensation expense. After recognizing this amount, the unrecognized non-vested compensation expense will reduce to $562.5 million ($750 million – $187.5 million) on December 31, 2010. With 3 years remaining, the compensation expense recognized in 2011 is $187.5 million ($562.5 million/3). 36. Question ID: 17582 Correct Answer: B Stock appreciation rights provide the flexibility to employees to benefit from increases in stock price without requiring them to hold shares. They require a current period cash outflow. 37. Question ID: 17584 Correct Answer: A It is compulsory under U.S. GAAP to make individual accounts for each participating employee. 38. Question ID: 17585 Correct Answer: A Under the defined contribution plan, employers are obligated only to make the designated contribution at the required times. The return on the contributions and the overall pension benefit received by the employees is not a responsibility of the employer. 39. Question ID: 17586 Correct Answer: B The defined benefit is funded in advance by the employer over the service life of the employee. Thus, the investment risk is borne only by the employer under defined benefit plans. 40. Question ID: 17587 Correct Answer: A Each additional year of service gives rise to additional benefit which the employee is entitled to at retirement. 41. Question ID: 17588 Correct Answer: B Theoretically, the differences between expected and actual returns arise from short term market fluctuations’ over the long term, these returns should converge. Therefore, in the long term, actuarial gains and losses arising from differences between actual and expected returns on the plan assets should converge. 42. Question ID: 17589 Correct Answer: C The IFRS provides the flexibility of choosing between either converged disclosure of the overall pension expense, or disclosure as separate line items.


Reading 17


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43. Question ID: 17591 Correct Answer: A (All figures in $’000) The company’s pension plan is overfunded by $19,370 ($108,800 – $89,430)

When a company reports a surplus, the amount that can be reported as an asset is the lower of the surplus and asset ceiling (present value of future economic benefits, such as refunds or reductions in future contributions). Since the value of the c eiling ($54,500,000) is greater than the surplus, the asset will be reported at the surplus amount. 44. Question ID: 17592 Correct Answer: A All figures in $’000 The company’s pension plan is overfunded by $19,370 ($108,800 – $89,430)

When a company reports a surplus, the amount that can be reported as an asset is the lower of the surplus and asset ceiling (present value of future economic benefits, such as refunds or reductions in future contributions). Since the value of the c eiling ($54,500,000) is greater than the surplus, the asset will be reported at the surplus amount. 45. Question ID: 17593 Correct Answer: C Given that the company complies with U.S. GAAP, it will include the following items in other comprehensive income, equity: • •

Past service costs Remeasurements: Difference between actual and expected return on plan assets o Actuarial gains and losses – changes arising in a company’s pension obligation due to o changes in actuarial assumptions.

Service costs include current and past service c osts. The former is immediately recognized in profit and loss while the latter is included in other comprehensive income and subsequently amortized to profit and loss. 46. Question ID: 17594 Correct Answer: A A higher discount rate reduces the PV of the defined obligation by a greater amount. This would lead o a lower pension charge because of lower pension obligation. 47. Question ID: 17595 Correct Answer: C When the actual return is lower than the expected return by a significant amount, with the significance being large enough to require amortization, the amortization would lead to a decrease in pension expense. 48. Question ID: 17596 Correct Answer: B When the cumulative unrecognized actuarial gains or losses exceed 10% of either the PV of defined obligation or the FV of the plan asset, the difference is mortised over the service life of the employees.


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