Preparing for the CFA exam: Financial reporting of defined benefit pension plans

The financial reporting and analysis section is one of the more heavily weighted topics on levels 1 and 2, making up 20% and 15-20% of each exam, respectively.

Therefore, it is very important to spend a considerable amount of time on this entire section in order to have success on exam day.

The employee compensation reading falls within the scope of financial reporting and analysis and is one of the more challenging sub-topics for many students. The reading is separated into two further sub-topics: pensions and other post-employment benefits, and share-based compensation. The former topic is much more difficult for students and will be the focus of this blog post.

Post-employment compensation, particularly defined benefit pension plans, involves a great deal of uncertainty. Therefore, the accounting and financial reporting is incredibly convoluted. Additionally, the CFA requires the test taker to know and understand key differences between the financial reporting of defined benefit plans under US GAAP and IFRS.

Here are some steps to follow when approaching this difficult topic.

Step 1: understand the components of pension expense, and what determines the carrying amount of the pension obligation on the balance sheet.

This part of the material does have some intuition. Having a strong understanding of the components that go into pension expense, and understanding the classification of an asset or liability of the pension benefit obligation will be helpful and will spare extra brain capacity for memorizing other important topics. The pension expense is composed of service costs, interest expense, past service costs, actuarial gains and losses, and return on plan assets. All of these components are intuitive and should be understood before moving forward with the material. The CFA exam likes to ask questions that require test takers to reconcile between income statements and cash flows when it comes to pension expense. If the test taker has a comfortable understanding of the components of pension expense, this reconciliation will be straight-forward.

Step 2: memorize differences between financial reporting under US GAAP and IFRS

The CFA exam requires the test taker to know and understand key differences in financial reporting under US GAAP and IFRS. For instance, one of the components of pension expense, past service cost, is accounted for in other comprehensive income under US GAAP and amortized over the expected future time period over which these benefits will be earned, while under IFRS, this past service cost is expensed right away. While in isolation, both of these treatments may have intuition, but regarding why the accounting treatments under US GAAP and IFRS differ, there really isn’t a good explanation (or at least not one that would give a test taker an advantage on the exam).

There are many differences between US GAAP and IFRS when it comes to financial reporting for defined benefit pension plans. Unfortunately, the best course of action here is to memorize! Consider making flash cards or constructing list of all the differences and commit them to memory.

Step 3: understand the impact financial reporting for defined benefit pension plans has on all the financial statements.

Accounting for defined benefit pension plans impacts the income statement, balance sheet (assets, liabilities, and stockholders equity!), and the cash flow statement. The CFA exam will test students on their ability to identify how key assumptions, or reporting differences between US GAAP and IFRS will effect all the aforementioned financial statements. This is why it’s important to have a firm understanding of all the components of pension expense. Take the time to understand the accounting treatment, and the impact on the relevant statements when each of the components of pension expense changes.

If you have a background in accounting, this topic, and many of the others covered in financial reporting and analysis should be familiar to you, and you are lucky! Many students preparing for the CFA are seeing this material for the first time, so don’t get discouraged if things are not making sense – it is an incredibly technical, rule-based topic. If you are having difficulty with the material, consider getting a CFA tutor. There really isn’t time to spin your wheels, and a tutor can provide the right knowledge to move your CFA preparation forward!