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IFT Notes for Level I CFA® Program

R28 Non-current (Long-Term) Liabilities

Part 5


 

4.  Introduction to Pensions and Other Post-Employment Benefits

Instructor’s Note: Pensions are discussed in great detail at Level II.

One common post-employment benefit offered by companies to their employees is pension. Pensions and other post-employment benefits give rise to non-current liabilities reported by many companies. When companies promise its employees certain benefits after a certain period of time, they are obligated to fulfill that promise.

The accounting treatment of pensions depends on the type of pension plan. There are primarily two types of pension plans:

  1. Defined contribution plan: Under this plan, a company contributes an agreed-upon amount to the plan. This contribution is recognized as a pension expense on the income statement and an operating cash outflow. Since there is no future payout or obligation, no liability is reported on the balance sheet. A liability is recognized on the balance sheet if some prior agreed-upon amount is not paid by the end of the fiscal year.
  2. Defined benefit plan: Under this plan, a company promises to pay a certain amount in the future to the employees. The amount of future obligation is based on a lot of assumptions such as retirement age of its employees, last drawn salary before retirement, mortality rate, etc. For example, a company may promise an employee an annual pension payment equal to 60% of his last salary at retirement, until death. The pension obligation is the present value of future payments the company expects to make. A company fulfills this obligation by setting up a pension fund (also known as plan assets) and making payments to this fund. The ongoing pension obligations are paid from this fund. The amount in the fund remains invested until it has to be paid to the retirees.

Disclosures for Defined Benefit Plans

Since the future obligation of defined benefit pension fund cannot be determined with certainty, accounting is more complicated than the defined contribution plan. Listed below are a few rules for you to remember for a defined benefit plan:

  • If the fair value of plan assets > present value of estimated pension obligation, the plan is overfunded (has a surplus). It is called net pension asset.
  • If the present value of estimated pension obligation > fair value of plan assets, the plan is underfunded. It is called net pension liability.

Under both IFRS and US GAAP, the net pension asset or liability is reported on the balance sheet. An underfunded defined benefit pension plan is reported as a non-current liability on the balance sheet.

For each period, the change in net pension asset or liability is recognized either in profit or loss or in other comprehensive income.

Under IFRS, the change in net pension asset or liability has three components:

  • Employee service costs and past service costs: Recognized as pension expense in the income statement.
  • Service cost is the present value of the benefit earned by an employee for one additional year of service. It is the sum of past service costs and present value of the increase in pension benefit earned by working for one more year.
  • Net interest expense or income accrued on the beginning net pension asset or liability represents the change in value of the net defined benefit pension asset or liability: Recognized as pension expense in the income statement.
  • Net interest expense = net pension asset or liability x discount rate used to estimate the present value of the pension obligation.
  • Remeasurements: Recognized in other comprehensive income on the balance sheet.
  • Remeasurements = actuarial gains and losses and the actual return on plan assets minus the net interest expense or income.

The actual return on plan assets includes interest, dividends and other income derived from the plan assets, including realized and unrealized gains or losses.

Under US GAAP, the change in net pension asset or liability has five components:

  • Employees’ service costs for the period.
  • Interest expense accrued on the beginning pension obligation.
  • Expected return on plan assets. It isa reduction in the amount of expense recognized.
  • Past service costs.
  • Actuarial gains or losses.

The first three are recognized in profit and loss during the period incurred. Past service costs and actuarial gains and losses are recognized in other comprehensive income in the period they occur and later amortized into pension expense. Under US GAAP, companies are also allowed to immediately recognize actuarial gains and losses in profit and loss.

Example

On 31 Dec. 2012, a company has a pension obligation of 100 and pension assets are 90. What will the company report on the balance sheet under IFRS and US GAAP?

Solution:

Funded status = pension assets – pension obligation = 90 – 100.

The company will report a net pension liability of 10.

5.  Evaluating Solvency: Leverage and Coverage Ratios

Solvency ratios are used to measure a company’s ability to meet its long-term obligations, including both principal and interest payments. There are two categories of solvency ratios: leverage ratios and coverage ratios.

Leverage Ratios

Leverage ratios focus on the balance sheet and measure the extent to which a company uses debt to finance its assets.

The commonly used leverage ratios are as follows:

Leverage Ratio Numerator Denominator
Debt-to-assets Total debt Total assets
Debt-to-capital Total debt Total debt + shareholders’ equity
Debt-to-equity Total debt Total shareholders’ equity
Financial leverage Average total assets Average total equity

These ratios provide information on how much debt a company has taken. A low leverage ratio implies the company has low leverage and is well positioned to fulfill its debt obligations. The ratios for a particular company should be interpreted in the context of the industry in which it operates.

Coverage Ratios

Coverage ratios focus on the income statement and cash flow to measure a company’s ability to service debt (make interest and other debt-related payments).

Coverage Ratios Numerator Denominator
Interest coverage EBIT Interest payments
Fixed charge coverage EBIT + lease payments Interest payments + lease payments

Unlike leverage ratios, higher values for coverage ratios are better, all else equal.


FRA Non-Current (Long-Term) Liabilities Part 5