Unfortunately, the limited time we have won’t allow us to go over everything you need to know within the topic areas of the Level 2 CFA exam. I will try to hit some of the more difficult areas and focus in on some of the stuff you need to know.
To me, the level 2 exam seemed extremely detailed and was quantitatively intense. This sucks when you are trying to cram everything into your brain for a six-hour test, but the curriculum has proved an excellent resource since the exam. Save your level 2 books or study notes, they will come in handy if you do any equity analysis. With the size and complexity of the material at level 2, I would suggest a condensed study notes provider to help work through the questions and formulas. (Obviously, we’re biased to FinQuiz here. Check out the free sample notes on the website.)
Pensions and pension reporting is a big section in the level 2 exam. Learn the differences between defined-benefit (DB)/defined-contribution (DC) in level 2 because you will need it for level 3 as well. Most of the curriculum deals with DB plans because the responsibility for assets remains with the corporation. You really only need to know the basic idea for DC plans.
For pension reporting at level 2 you need to understand and be able to calculate:
- Pension Expense
- Economic Expense
- Reconciliation of Defined Benefit Obligation and Assets
- Determine if the plan is Over/Under-funded
- Impact of assumptions: discount rate, expected return of assets, growth rate of compensation
Start with pensions by understanding the three measures of plan liability: projected benefit obligation (PBO), accumulated benefit obligation (ABO), and vested benefit obligation (VBO). The PBO is the present value of nested and non-vested benefits based on projected salaries and what you will use for most calculations.
The ABO is the benefit obligation at current salaries while the VBO is only the obligations for vested employees and at current salaries. Understand these two measures, but focus on PBO.
There are (5) five components of Pension Expense. You need to understand each of these and be able to calculate pension expense for the current period.
Current Service Cost
+ Interest Costs
– Expected Return on Plan Assets
+/- Amortization Past Service Cost or Benefit
+/- Amortization of Actuarial Losses or Gains
= Pension Expense
Reconciliation of Plan Assets is pretty straight forward and just adds the actual returns on assets and employer contributions to the beginning fair value of assets, then deducts any benefits paid to arrive at the end-of-period fair value of assets.
Reconciliation of Defined Benefit Obligation (disclosed in the footnotes):
+ Service Costs
+ Interest Costs
+ Past Service Costs (from Changing Amendments)
+/- Actuarial Losses or Gains
– Benefits Paid
= DBO, end
Differences between IFRS and GAAP is pretty important at level 2 and you’ll see a lot of stuff here in pensions. In the curriculum, the calculation stuff seemed to center around GAAP treatment while you were only expected to know the reporting differences between GAAP and IFRS.
Discount Rate- Used to determine the DBO (increases in discount rate–> decrease in DBO and increase plan funded status)
Expected Return on Plan Assets– Understand how manipulation of this can lead to manipulation in earnings (increasing expected return–> decreases pension expense on income statement and increases reported earnings)
Compensation Growth Rate- Affects service costs and pension obligation (increase compensation growth –> increases both service costs and pension obligation)
Really the key to the level 2 exam is practice problems. There is so much material and so many formulas that you cannot just expect to memorize them with flash cards or reading. I hated pension material and really put off doing practice problems until the last couple of weeks. It seems like you are being asked to be an accountant, but this stuff is important to analyzing the future responsibilities of companies.
The best way to approach the FRA material and calculations in level 2 is to first UNDERSTAND what is happening and the relationships. Why would a company want to increase/decrease the expected return assumed? How would this change the income statement and balance sheet? Unless you are some kind of savant, trying to memorize the formulas is a ticket to the bottom 50%. Understanding the ‘why’ will help to make sense out of the calculations.
The fortunate part here, and with a lot of the detailed FRA material on the CFA level 2, is that it will truly make you a better analyst. I’ve seen a lot of equity research that doesn’t begin to scratch the surface of the Financial Reporting & Analysis covered in the level 2 curriculum. Dig into this stuff and you will add value for your employer and your clients.
Looking forward to your comments,
Joseph Hogue, CFA
P.S. be sure to let me know if there is a particular topic area you want covered. Thanks.