Sign up  |  Log in

Defined benefit: Why do we adjust equity when calculating debt-to-equity ratio based on results of sensitivity analyses?

My questions (at the bottom of the post) relate to end-of-chapter question #33 from Reading 15 (Employee Compensation: Post Employment and Share Based), which is as follows:

In the solution (below), we adjust liabilities upward by $93m and equity downward by $93m. 

[question removed by moderator]

My questions:

(1) Why do we adjust equity downward when making this adjustment?  Why is it incorrect to simply assume higher liability and unchanged equity?

(2) Shouldn’t we take into account the impact on benefit expense (i.e., +$12m as per Exhibit 3), as it would hit retained earnings, which is a component of equity?  Why is it okay to ignore this figure when making the analytical adjustments?

The best just got better. Schweser's upgraded content and redesigned study platform are exactly what you need to pass the Level III exam. Save 10% when you preorder a Premium Package for a limited time.
  1. Because if you increase your liability, something needs to go down (a liability or equity) or up (asset) in order to balance your balance sheet.
  2. Because the benefit obligation already took into account the benefit expense.

To expand on the answer to your first question, the reason equity declines is because the change in health care rate represents a change in actuarial assumption. These losses are reflected in OCI which flow to equity, hence the reason for the decrease in equity.

Thanks snfuenza & mdlynch3, makes sense to me now