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Finance / Financial Analysis and Valuation: Financing Analysis (2)

Release Time:2022-04-14 Topic:Financial Analysis and Valuation Reading:33 Navigation:Stock Liao information > educate > Finance / Financial Analysis and Valuation: Financing Analysis (2) phone-reading
For Economics and Finance Postgraduate Examination/Postgraduate Examination/Certification
Reference: Jerald E. Pinto, Elaine Henry, Thomas R. Robinson & John D. Stowe. Equity Asset Valuation (3rd edition) CFA Institute Investment Series

FINance / Financial Analysis and Valuation:

Part 2 Financing Activities Analysis (continued)
1. Liabilities Analysis
2. Leases Analysis
3. Pos. Benefits Analysis
4. Contingencies Analysis
5. Commitments Analysis
6. OBS Financing Analysis
7. Equity Financing Analysis

3. Pos. Benefits Analysis

Two kinds of Postretirement Benefits: i) Pension benefits: Employer promises monetary benefits to employees after retirement, e.g., monthly stipend until death. ii) Other Postretirement Employee Benefits (OPEB): Employer-provided non-pension (usually nonmonetary) benefits after retirement, e.g., health care and life insurance.

3.1. Pension Benefits

3.1.1. Pension Basics

1) Pension Plan

agreement by the employer to provide pension benefits involving 3 entities:

i) employer-who contributes to the plan; ii) employee-who derives benefits ; and iii) pension fund.

Pension Fund: account administered by a trustee, independent of employer, entrusted with responsibility of receiving contributions, investing them in a proper manner, & disbursing pension benefits to employees.

Vesting: specifies employee's right to pension benefits regardless of whether employee remains with the company or not; usually conferred after employee has served some minimum period with the employer.

Pension Plan Categories:

i) Defined benefit: a plan specifying amount of pension benefits that employer promises to provide retirees; employer bears risk of pension fund performance.

ii) Defined contribution: a plan specifying amount of pension contributions that employers make to the pension plan; employee bears risk of pension fund performance.

2) Pension Obligation

Alternative Definitions of Pension Obligation:

i) Accumulated benefit obligation (ABO): actual present value of future pension benefits payable t o employees at retirement based on their current compensation and service to-date.

ii) Project benefit obligation (PBO): actual estimate of future pension benefits payable to employees on retirement based on expected future compensation and service to-date.

Relation between Plan Assets and Funded Status:

i) Plan Assets: The funds contributed to the plan are called plan assets because these are invested in capital markets.

ii) Funded Status of the Plan:Difference between the value of the plan assets and the PBO which represents the net economic position of the plan.

Note: Plan is overfunded (underfunded) when value of plan assets exceeds ( is less than) PBO.

3) Pension Cost

Economic pension cost: net cost arising from changes in net economic position (or funded status) for a period; includes both recurring and nonrecurring components along with return on plan assets.

3.1) Recurring Pension Costs

consist of two components:

i) Service cost: actual present value of pension benefit earned by employees. Service cost represents the estimated increase in the pension obligation resulting from employees' service during the period.

ii) Interest Cost: increase in projected benefit obligation arising when pension payments are one period closer to being made; computed by multiplying beginning-period PBO by the discount rate.

3.2) Nonrecurring Pension Costs

consist of two components:

i) Actuarial Gain or Loss: change in PBO that occurs when one or more actuarial assumptions are revised in estimating PBO.

ii) Prior Service Cost: effect of changes in pension plan rules on PBO.

3.3) Return on Plan Assets

Actual return on plan assets: pension plan's earnings, consisting of investment income - capital appreciation and dividend and interest received, less management fees; plus realized and unrealized appreciation (or minus depreciation) of other plan assets; Used to offset cost to arrive at a net economic pension cost.

4) Pension Analysis

Focus of Pension Analysis: Defined benefit plans constitute the major share of pension plans and are the focus of analysis given their implications to future company performance and financial position.

i) Elements of Pension Process:

ii) Illustration of Pension Accumulation and Disbursement for a Defined Benefits Plan:

5 ) Pension Case

Employee A completed 1st year of services:

Salary: 20,000 p.a. (per annum)

Age: 20

Retire at: 60

Expected life span : 85

Discount factor: 7%

Expected Salary growth rate: 1.5% p.a. i.e. last salary = 36,280.37

Pension Plan Term: Every year of services will be granted a 2% of last salary annually after retirement.

At year 1

ABO:

PMT = 20,000 X 2%, FV = 0, N = 25, I = 7%, PV at age of 60 = 4,661.43

PV of this annuity: 4,661.43/ (1.07)40 = 311.29

…at any case, ABO will be calculated using current salary and current entitlement to calculate!!!

PBO:

PMT = 36,280.37 X 2% ; FV = 0; N = 25, I = 7%; PV at age of 60 = 8,455.93

PV of this annuity: 8,455.93/ (1.07)40 = 564.69

Services Cost for year 1 = change in PBO = 564.69

At year 2

Interest cost:

= Year begin PBO X 0.07 = 39.53

Services Cost:

PV at age of 60 when he entitles to 4% payment p.a. = 8,455.93 X 4%/2% = 16,911.86

PV of this annuity now: 16,911.86/(1.07)39 = 1,208.44

Services cost this year: 1,208.44 – (564.69 + 39.53) = 604.22

Actualial change: Use the new actuarial assumption to calculate the year begin PBO. The change in year begin PBO will be actuarial gain/ loss:

At year 2, the life span of employee changes to 88 years, at the beginning of year 2, PBO:

PMT = 36,280.37 X 2% ; FV = 0; N = 28, I = 7%; PV at age of 60 = 8,806.78

PV of this annuity: 8,806.78/ (1.07)40 = 588.12

Change in because of assumption change PBO = (588.12 - 564.69) = 23.43

1) Recognized Funded Status

i) Recognizes the funded status of the pension plans on the balance sheet.

ii) Pension assets and obligations are netted against each other (as funded status) rather than separately reported both as an asset and a corresponding liability.

iii) Companies do not report the funded status of pension plans as a separate line item on the balance sheet, instead, it is embedded in various assets and liabilities.

2) Recognized Pension Cost

The recognized pension cost included in net income (i.e., the net periodic pension cost) is a smoothed version (smoothing process, defers volatile, one-time items) of the actual economic pension cost for the period. Expected return on plan assets is recognized in reported pension expense. Difference between the actual and expected return is deferred. These deferred amounts are gradually recognized through a process of amortization.

Thus, net periodic pension cost includes service cost, interest cost, expected return on plan assets and amortization of deferred items.

3) Articulation of Effects

Articulation of Balance Sheet and Income Statement Effects:

The net deferral for the period is included in other comprehensive income for the period.

The cumulative net deferral is included in accumulated other comprehensive income, a component of shareholders' equity.

4) Impact of Assumptions

In the footnote of financial statement, we can find the disclosure about the major assumptions about pension plan . The following 3 scenarios are regarded as aggressive pension assumptions:

Effect of i) Higher Discount Rate ii) Lower Compensation Increment iii) Higher Expected Return on Asset

3.2. O-P-E Benefits

OPEB Accounting: OPEB accounting is currently governed by SFAS 158.

Accumulated Postretirement Benefit Obligation (APBO): employer's OPEB obligation.

Expected Postretirement Benefit Obligation (EPBO): the present value of future OPEB payments associated with the employees.

Features of OPEB Accounting (similar to pension accounting):

< p data-pid="57-IoFno">i) OPEB costs are recognized when incurred rather than when actually paid out.

ii) Assets of the OPEB plan are offset against the OPEB obligation, and returns from these assets are offset against OPEB costs.

iii) Actuarial gains and losses, prior service costs, and the excess of actual return over expected return on plan assets are deferred and subse amortized.

1) Recognized Funded Status

The total EPBO is allocated over the employees' expected service with the company. The proportionate obligation, termed the accumulated postretirement benefit obligation (APBO), is recognized on the balance sheet. APBO is that portion of the EPBO “earned” by employee services as of a given date.

The funded status of OPEB is the difference between the APBO and the fair value of assets designated to meet this obligation (if any).

2) Recognized OPEB Cost

OPEB cost recognized in net income includes the following components:

i) Service cost: actuarial present value of OPEB “earned” by employees during the period; portion of EPBO attributable to the current year.

ii) Interest cost: imputed growth in APBO during the period using an assumed discount rate.

iii) Expected return on plan assets: equal to the opening fair market value of OPEB plan assets multiplied by the long-term expected rate of return on those assets.

iv) Amortization of net gain or loss: The actuarial gains/losses are added to the difference between actual and expected return on plan assets, and the net amount (termed net gain or loss) is deferred. The cumulative net gain or loss is amortized on a straight-line basis over the employee's service.

v) Amortization of pr ior service cost: Retroactive benefits' changes from plan amendments, or prior service costs, are deferred and amortized on a straight-line basis over the employee's expected remaining service period.

3) Articulation of Effects

Articulation of Balance Sheet and Net Income:

i) As with pensions, the smoothed net postretirement benefit cost will not articulate with changes to the funded status in the balance sheet.

ii) The net deferrals during a year are included in other comprehensive income for that year and the cumulative net deferrals are included in accumulated other comprehensive income.

3.3. Benefits Analysis

Five-step procedure for analyzing postretirement benefits:

1) Determine and reconcile the reported and economic benefit cost and liability (or asset).

2) Make necessary adjustments to financial statements.

3) Evaluate actual assumptions (discount rate, expected return, growth rate) and their effects on financial statements.

4) Examine pension risk exposure (arises to the extent to which plan assets have a different risk profile than the pension obligation).

5) Consider the cash flow implications of postretirement benefit plans.

< p data-pid="-igeH _ 87"> Example:

Passaic Industries is based in France and offers its employees both a d efined benefit pension plan and stock options. Passaic prepares its financial statements in accordance with IFRS. Several of the disclosures related to these plans are presented in the following exhibits.

1. Under U.S. GAAP, the funded status of the plan is reported without adjustment. With regard to its defined benefit plan, Passaic's year-end 2009 balance sheet would report an asset of 621 million. Under IFRS, the balance sheet reflects present value of the benefit obligation at the balance sheet date, plus/less any unrecognized actuarial gains/losses, minus any unrecognized past service cost, minus the fair value of plan assets at the balance sheet date.

2. The net periodic pension cost recorded in the year-end 2009 income statement is 1050 million. Under IFRS, companies are allowed to disclose the individual components within different line items on the income statement. U.S. GAAP re the various components of pension cost to be reported as a net amount.

3. The adjustment (net effect) of the reconciliation of net income to cash flows from operations: net periodic benefit cost (non-cash expense) – company contribution (cash outflow).

4. Service costs represent the estimated increase in the pension obligation resulting from employees' service during the period.

5 . Actual return on plan assets = expected return on plan assets + actuarial gains.

6. Lower expected volatility reduces the fair value of an option and thus the reported expense. If Passaic had used the same volatility assumption as it had used in 2008 for its option grants, the expense would be higher and thus net income would be lower.

(continued)

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Reference: Jerald E. Pinto, Elaine Henry, Thomas R. Robinson & John D. Stowe. Equity Asset Valuation (3rd edition) CFA Institute Investment Series

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