CFA® Program Curriculum, Volume 2, page 93
Accounting for share-based compensation is similar under IFRS and U.S. GAAP.
Stock Options
Compensation expense is based on the fair value of the options on the grant date based on the number of options that are expected to vest. The vesting date is the first date the employee can actually exercise the options. The compensation expense is allocated in the income statement over the service period, which is the time between the grant date and the vesting date. Recognition of compensation expense will decrease net income and retained earnings;
however, paid-in capital is increased by an identical amount. This results in no change to total equity.
Determining Fair Value
The fair value of the option is based on the observable market price of a similar option if one is available. Absent a market-based instrument, the firm can use an option-pricing model such as Black-Scholes or the binomial model. There is no preference of a specific model in either IFRS or U.S. GAAP.
PROFESSOR’S NOTE
Since market options differ from the custom terms of employee options, a comparable market option is not usually available. See the section on derivatives for a complete discussion of option- pricing models.
Option-pricing models typically incorporate the following six inputs:
1. Exercise price.
2. Stock price at the grant date.
3. Expected term.
4. Expected volatility.
5. Expected dividends.
6. Risk-free rate.
Many of the inputs require subjective estimates that can significantly affect the fair value of the option and, ultimately, compensation expense. For example, lower volatility, a shorter term or a lower risk-free rate, will typically decrease the estimated fair value of the options, decreasing compensation expense. A higher expected dividend yield will also decrease the estimated fair value and compensation expense.
Stock grants. Compensation expense for stock granted to an employee is based on the fair value of the stock on the grant date. The compensation expense is allocated over the employee’s service period.
A stock grant can involve an outright transfer of stock without conditions, restricted stock, and performance stock. With restricted stock, the transferred stock cannot be sold by the employee until vesting has occurred. Performance stock is contingent on meeting
performance goals, such as accounting earnings or other financial reporting metrics like return on assets or return on equity. Unfortunately, tying performance to accounting earnings and other metrics may result in manipulation of the accounting metric used.
Stock appreciation rights. The difference between a stock appreciation right and an option is the form of payment. A stock appreciation award gives the employee the right to receive compensation based on the increase in the price of the firm’s stock over a predetermined amount. With stock appreciation rights, employees have limited downside risk and unlimited upside potential, thereby limiting the risk aversion problem discussed earlier. Also, since no shares are actually issued, there is no dilution to existing shareholders. A disadvantage of stock appreciation rights is that they require current period cash outlay.
Phantom stock. Phantom stock is similar to stock appreciation rights except the payoff is based on the performance of hypothetical stock instead of the firm’s actual shares. Phantom stock can be used in privately held firms and firms with highly illiquid stock.
MODULE QUIZ 14.7
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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 expected term 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.
KEY CONCEPTS
LOS 14.a
In a defined-contribution plan, the firm contributes a certain amount each period to the employee’s retirement account. The firm makes no promise regarding the future value of the plan assets; thus, the employee assumes all of the investment risk. Accounting is straight- forward; pension expense is equal to the firm’s contribution.
In a defined-benefit plan, the firm promises to make periodic payments to the employee after retirement. The benefit is usually based on the employee’s years of service and the
employee’s salary at, or near, retirement. Since the employee’s future benefit is defined, the employer assumes the investment risk. Accounting is complicated because many assumptions are involved.
LOS 14.b
The projected benefit obligation (PBO) is the actuarial present value of future pension benefits earned to date, based on expected future salary increases.
balance sheet asset (liability) = fair value of plan assets − PBO LOS 14.c
Components of periodic pension cost reported in P&L:
Current service cost—the present value of benefits earned by the employees during the current period. Expensed in income statement.
Interest cost—the increase in the PBO due to the passage of time. Expensed in income statement.
Expected return on plan assets—offsets reported pension cost. Under U.S. GAAP, the expected rate of return is assumed. Under IFRS, the expected rate of return is the same as the discount rate.
Amortization of actuarial gains and losses—under U.S. GAAP only, the losses (or gains) during the year due to changes in actuarial assumptions and due to differences between expected and actual return are recognized in OCI and amortized using the corridor method. Under IFRS, the actuarial gains and losses during the year are recognized in OCI and are not amortized.
Amortization of past service cost—under U.S. GAAP only, an increase in PBO resulting from plan amendments granting a retroactive increase in benefits is amortized. Under IFRS, past service costs are immediately expensed in the income statement.
Total periodic pension cost includes costs reflected in the income statement (discussed previously) as well as in OCI.
total periodic pension cost = contributions − change in funded status or
total periodic pension cost = current service cost + interest cost − actual return on plan assets +/− actuarial losses/gains due to changes in assumptions affecting PBO + prior
service cost LOS 14.d
Firms can improve reported results by increasing the discount rate, lowering the
compensation growth rate, or, in the case of U.S. GAAP, increasing the expected return on plan assets.
LOS 14.e
Comparative financial analysis using published financial statements is complicated by differences in accounting treatment for pensions:
Gross vs. net pension assets/liabilities.
Differences in assumptions used.
Differences between IFRS and U.S. GAAP in recognizing periodic pension cost in the income statement.
Differences due to classification in the income statement.
LOS 14.f
If the firm’s contributions exceed the 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, if the total periodic pension cost exceeds the firm’s contributions, the difference can be viewed as a source of borrowing.
If the differences in cash flow and total periodic pension cost are material, the analyst should consider reclassifying the difference from operating activities to financing activities in the cash flow statement.
LOS 14.g
Share-based compensation raises issues about the valuation of the specific compensation as well as about the period in which, or periods over which, the compensation expense should be recorded.
LOS 14.h
Share-based compensation expense is based on the fair value of the option or stock at the grant date. To determine fair value, it is often necessary to use imperfect pricing models.
Many of the option pricing model inputs require subjective estimates that can significantly affect the fair value of the option and, ultimately, compensation expense. For example, lower volatility, a shorter term or a lower risk-free rate, will usually decrease the estimated fair value and compensation expense. A higher expected dividend yield will also decrease the estimated fair value and compensation expense.
ANSWER KEY FOR MODULE QUIZZES
Module Quiz 14.1
1. C In a defined-benefit pension plan, the employer assumes the investment risk. Total periodic pension cost is calculated as a firm’s contributions minus the change in funded status. In a defined-contribution plan, pension expense is equal to the employer’s contribution to the plan. (LOS 14.a)
Module Quiz 14.2
1. A The current service cost is the present value of new benefits earned by the
employee working another year. Current service cost increases the PBO. Note that the interest cost increases every year regardless of whether the employee works another year or not. (LOS 14.b)
Module Quiz 14.3
1. 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. Prior service cost is already included in the PBO (remember, PBO represents present value of all pension payments, whether reported in the income statement or not). (LOS 14.c)
2. C periodic pension cost in P&L = current service cost + interest cost − expected return on assets
current service cost = $0.90 million (given)
interest cost = PBO at the beginning of the period × discount rate
= $12 million × 0.09
= $1.08 million
expected return on plan assets = $0.96 million (given)
periodic pension cost in P&L = $0.90 million + $1.08 million − $0.96 million =
$1.02 million (LOS 14.c) Module Quiz 14.4
1. C The first step is to solve for benefits paid. The beginning PBO balance plus the cost components minus benefits paid is equal to the ending PBO balance: $193 + $38 − benefits paid = $220 million, which implies benefits paid are equal to $11 million. The question specifies that there are no contributions during the year. The ending fair value of plan assets is equal to beginning value plus actual return on assets less benefits paid:
$159 + $32 − $11 = $180 million. (LOS 14.c) Module Quiz 14.5
1. B The use of a higher discount rate will result in lower present values and, hence, lower current service cost. Lower service cost will result in a lower PBO and lower periodic pension cost in P&L. (LOS 14.d)
2. C The expected return on assets does not affect the calculation of the PBO. Periodic pension cost reported in P&L is decreased by the expected return on assets. If the expected return assumption is increased, then periodic pension cost in P&L decreases.
Lower reported pension expense will result in higher net income. (LOS 14.d)
3. A A higher compensation growth rate will increase periodic pension cost reported in P&L (as well as the total periodic pension cost) 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 the plan assets.
(LOS 14.d)
4. B A decrease in the discount rate will increase the PBO. A higher PBO lowers the funded status (plan assets − PBO). (LOS 14.d)
5. C Neither inflation expectations nor asset returns are internally consistent. The discount rate is increasing, but the inflation rate is decreasing. There is usually a direct relationship between the discount rate and the inflation rate. In 2016, the expected rate of return increased; however, SPC decreased its allocation to equity investments.
Normally, reducing exposure to equity investments in favor of debt investments will decrease returns. (LOS 14.d)
Module Quiz 14.6
1. B Where there are no amortizations, the periodic pension cost reported in P&L is equal to service cost + interest cost − the expected return on assets ($63 + $29 − $32 =
$60). (Module 14.3, LOS 14.c)
2. C A plan is overfunded when the fair value of plan assets exceeds the PBO. The Tanner plan is $120 overfunded ($603 − $483). (Module 14.2, LOS 14.b)
3. B Total periodic pension cost = current service cost + interest cost − actual investment return ($63 + $29 − $77 = $15). No figures for actuarial losses and prior service costs were given, so we assume they are zero. (Module 14.2, LOS 14.c) 4. A Tanner’s contributions of $48 exceeded the total periodic pension cost of $15.
Thus, the difference of $33 should be treated similar to an excess principal payment on a loan. Principal payments are reported as financing activities in the cash flow
statement. The adjustment calls for increasing operating cash flow and decreasing financing cash flow. (Module 14.6, LOS 14.f)
5. B An actuarial loss resulting from changes in actuarial assumptions (such as mortality rates) leads to an increase in the PBO. Prior service cost increases the PBO as a result of amendments to the pension plan. (Module 14.2, LOS 14.b)
6. C Beginning of the year funded status = 522 − 435 = 87 (overfunded). Tanner would have reported an asset of $87 million. An increase in discount rate would lower the PBO but would not affect fair value of plan assets—increasing the funded status of the plan (higher reported asset).
Under IFRS, Tanner would report a net interest income of the discount rate multiplied
by the asset value. If Tanner had reported a liability, it would have reported a net interest expense. An increase in discount rate when a pension asset is reported results in an increase in net interest income (because the asset is multiplied by a higher rate).
(Module 14.3, LOS 14.c) 7. A
total periodic pension cost = contributions − change in funded status
= 321 − [(2,232 − 1,915) − (2,015 − 1,822)]
= 197 million
after-tax excess contribution = (1 − 0.3) × (321 − 197) = 86.8 million
adjusted cash flow from operating activities = 469 + 86.8 = 555.8 million (Module 14.6, LOS 14.f)
Module Quiz 14.7
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 14.h)
2. C For share-based compensation, expense is recognized based on the fair value of the compensation as of the grant date and allocated over the employee’s service period. No expense is recognized when the option is exercised or the stock is sold. (LOS 14.h)
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The following is a review of the Financial Reporting and Analysis (1) principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #15.