Learning Module 2: Employee Compensation Post-Employment and Share-Based

Learning Module 2 Employee Compensation: Post-Employment and Share-Based EXAMPLE 1 Determination of Amounts to be Reported on the Balance Sheet 1. The following information pertains to two hypothetical companies' defined benefit pension plans as of 31 December 2010: For company ABC, the present value of the company's defined benefit obligation is €6,723 and the fair value of the pension plan's assets is €4,880. For company DEF, the present value of the company's defined benefit obligation is €5,485 and the fair value of the pension plan assets is €5,998. In addition, the present value of available future refunds and reductions in future contributions is €326. Calculate the amount each company would report as a pension asset or liability on its 2010 balance sheet. Solution: Company ABC would report the full underfunded status of its pension plan (i.e., the amount by which the present value of the defined benefit obligation exceeds the fair value of plan assets) as a liability. Specifically, the company would report a pension liability of €1,843. Present value of defined benefit obligation Fair value of plan assets Net pension liability €6,723 (4,880) €1.843 Company DEF's pension plan is overfunded by €513, which is the amount by which the fair value of the plan's assets exceed the defined benefit obligation (€5,998€5,485). However, when a company has a surplus in a defined benefit plan, the amount of asset that can be reported is the lower of the surplus and the asset ceiling (the present value of future economic benefits, such as refunds from the plan or reductions of future contributions). In this case. the asset ceiling is given as €326, so the amount of company DEF's reported net pension asset would be limited to €326. EXAMPLE 2 Calculation of Defined Benefit Pension Obligation for an Individual Employee The following information applies to each of the four scenarios. Assume that a (hypothetical) company establishes a DB pension plan. The employee has a salary in the coming year of €50,000 and is expected to work five more years before retiring. The assumed discount rate is 6 percent, and the assumed annual compensation increase is 4.75 percent. For simplicity, assume that there are no changes in actuarial assumptions, all compensation increases are awarded on the first day of the service year, and no additional adjustments are made to reflect the possibility that the employee may leave the company at an earlier date. Current salary €50,000.00 Years until retirement 5 Annual compensation increases 4.75% Discount rate 6.00% Final year's estimated salary" €60,198.56 Final year's estimated salary = Current year's salary[(1+ Annual compensation increase) Years until retirement At the end of Year 1, the final year's estimated salary = €50,000 x [(1+0.0475)] = €60,198.56, assuming that the employee's salary increases by 4.75 percent each year. With no change in assumption about the rate of increase in compensation or the date of retirement, the estimate of the final year's salary will remain unchanged. At the end of Year 2, assuming the employee's salary actually increased by 4.75 percent, the final year's estimated salary = €52,375 x [(1+0.0475)³] = €60,198.56. EXAMPLE 4 Comparison of Assumptions about Trends in US Health Care Costs In addition to disclosing assumptions about health care costs, companies also disclose information on the sensitivity of the measurements of both the obligation and the periodic cost to changes in those assumptions. Exhibit 5 presents information obtained from the notes to the financial statements for CNH Global N.V. (a Dutch manufacturer of construction and mining equipment) and Caterpillar Inc. (a US manufacturer of construction and mining equipment, engines, and turbines). Each company has US employees for whom they provide post-employment health care benefits. Panel A shows the companies' assumptions about health care costs and the amounts each reported for post-employment health care benefit plans. For example, CNH assumes that the initial year's (2010) increase in health care costs will be 9 percent, and this rate of increase will decline to 5 percent over the next seven years to 2017. Caterpillar assumes a lower initial-year increase of 7 percent and a decline to the ultimate health care cost trend rate of 5 percent in 2016. Panel B shows the effect of a 100 basis point increase or decrease in the assumed health care cost trend rates. A 1 percentage point increase in the assumed health care cost trend rates would increase Caterpillar's 2009 service and interest cost component of the other post-employment benefit costs by $23 million and the related obligation by $220 million. A 1 percentage point increase in the assumed health care cost trend rates would increase CNH Global's 2009 service and interest cost component of the other post-employment benefit costs by $8 million and the related obligation by $106 million. EXAMPLE 6 Adjusting Cash Flow Vassiliki Doukas is analysing the cash flow statement of a hypothetical company. GeoRace plc. as part of a valuation. Doukas suggests to her colleague. Dimitri Krontiras, that the difference between the company's contributions to the pension plan and the total pension costs incurred during a period is similar to a form of borrowing or a repayment of borrowing, depending on the direction of the difference, this affects the company's reported cash from operating activities and cash from financing activities. Based on information from the company's 2009 annual report (currency in & millions), she determines that the company's total pension cost was £437; however, the company also disclosed that it made a contribution of £504. GeoRace reported cash inflow from operating activities of £6,161 and cash outflow from financing activities of 61,741. The company's effective tax rate was 28.7 percent. Use the information provided to answer the following questions: 1. How did the company's 2009 contribution to the pension plan compare with the total pension cost for the year? Solution: The company's contribution to the pension plan in 2009 was £504, which was £67 more than the total pension cost of £437. The £67 difference is approximately £48 on an after-tax basis, using the effective tax rate of 28.7 percent. Total pension costs 6437 Company's contribution €504 Amount by which the sponsoring compa ny's contribution exceeds total pension cost (pre-tax) Tax cate 28.7% The after-tax amount by which the sponsoring company's contribution exceeds total pension COSt £48 667x(1-0.2870)) 2. How would cash from operating activities and financing activities be adjust ed to illustrate Doukas interpretation of the difference between the company's contribution and the total pension cost? Solution: The company's contribution to the pension plan in 2009 was £67 (£48 after tax) greater than the 2009 total pension cost. Interpreting the excess contribution as similar to a repayment of borrowing (financing use of funds) rather than as an operating cash flow would increase the company's cash outflow from financing activities by £48, from £1,741 to £1,789, and increase the cash inflow from operations by £48, from £6,161 to £6,209, EXAMPLE 7 Disclosure of Stock Options' Current Compensation Expense, Vesting, and Future Compensation Expense Using information from Coca Cola, Inc's Note 9 to financial statements, given below, determine the following: Excerpts from Note 9: Stock Compensation Plans in the Notes to Financial Statements of Coca Cola, Inc. NOTE 9: STOCK COMPENSATION PLANS Our Company grants stock options and restricted stock awards to certain employees of the Company. Total stock-based compensation expense was approx- imately $241 million in 2009, $266 million in 2008 and $313 million in 2007 and was included as a component of selling, general and administrative expenses in our consolidated statements of income. The total income tax benefit recognized in our consolidated statements of income for share-based compensation arrangements was approximately $68 million, $72 million and $91 million for 2009, 2008 and 2007, respectively. As of December 31, 2009, we had approximately $335 million of total unrecognised compensation costs related to nonvested share-based compensation arrangements granted under our plans. This cost is expected to be recognized over a weighted average period of 1.7 years as a stock-based compensation expense. This expected cost does not include the impact of any future stock-based compensation awards. Source: Coca Cola, Inc. Form 10-K filed 26 February 2010, 1. Total compensation expense relating to options already granted that will be recognised in future years as options vest. Solution: Coca Cola, Inc. discloses that unrecognised compensation expense relating to stock options already granted but not yet vested totals $335 million. 2. Approximate compensation expense in 2010 and 2011 relating to options already granted. Solution: The options already granted will vest over the next 1.7 years. Compensation expense related to stock options already granted will be $197 million ($335/1.7 years) in 2010 and $138 million in 2011 ($335 total less $197 expensed in 2010). New options granted in the future will likely raise the total reported compensation expense.