MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

1. MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell Electronic presentation adaptation by Dr. Barbara L. Hassell & Dr. Harold O. Wilson

2. Chapter 12 SPECIAL COMPENSATION ARRANGEMENTS

3. SPECIAL COMPENSATION ARRANGEMENTS • Topics • Compensated absences • Pensions and other post-retirement benefits • Stock compensation plans

4. Compensated Absences • Vacation Pay and/or Sick Pay, etc. • Most are related to current service, but may be related to future services. • Vests and accumulates (under most employers’ policies).

5. Recognition of Compensated Absences • Accrual of compensation expense and liability should take place when ALL of the following conditions are met: • The obligation is related to services already rendered. • The rights are vested regardless of whether employment continues or the rights accumulate from period to period if not taken. • The payment is probable and amount estimable.

6. Pension Plans • Defined contribution (e.g., 401k, 403b) • Employer’s obligation is to make a certain contribution this period (e.g., 7% of salary) • Defined benefit • Employer’s obligation is to make future retirement payments to employees as specified by plan formula in contract (e.g., in light of years of service, current and projected pay, “points earned,” etc.).

7. Nature of Pension Plans I agree to make payments into a fund for future retirement benefits for employee services. . Sponsor/Employer

8. Nature of Pension Plans As an employee, I agree to serve! Participant: Any current/former employee/beneficiary for whom the pension plan provides benefits.

9. Pensions prompt many interesting queries. We will probe the more basic issues of PENSION EXPENSE. We shall assume we are dealing with a Defined Benefit plan of a firm that has been in business for several years.

10. “Defined Benefit” Plans Employer is committed to specified retirement benefits. Retirement benefits are based on a formula = f (compensation, years of service, age, etc.). Employer bears all risk of pension fund performance. TRUSTEE pressured to meet Pension Benefit Obligations

11. Regulated by ERISA • Minimum funding requirements • Requirements that set minimum periods for vesting. • Complex IRS regulations. • May be administered by company, employee union, or third party trustee.

12. Economics of Defined Benefit Plans • Year-end liability, compared to ... • Year-end FMV of pension plan assets. • At year-end, pension plan is not likely to be perfectly funded. Because of having a separate trustee, FYE liability and fair value of plan assets are off-balance-sheet to the employer.

13. “Defined Benefit” Plans Actuaries deal with the Present Value of the annuities of benefits expected to be paid to participants at some future times. Actuaries: Professional statisticians that work for insurance companies, etc., to estimate benefits and odds

14. Year-End Liability Complex computations made by actuaries. Three different measures: PBO, ABO, VBO • Projected benefit obligation (PBO), the largest amount computed • Based on estimates of how many employees will actually retire • Based on estimates of salary levels at retirement • Pension expense and most pension disclosures are based on PBO

15. “Projected Benefit Obligations” (PBO) versus FMV of Plan Assets: UNDERFUNDED FMV OF PLAN ASSETS at FYE PRESENT VALUE OF PROMISES

16. “Projected Benefit Obligations” (PBO) versus FMV of Plan Assets: OVERFUNDED PRESENT VALUE OF PROMISES FMV OF PLAN ASSETS at FYE

17. Accumulated benefit obligation (ABO) • Based on estimates of how many employees will actually retire • Based on current salary levels • Minimum liability computation based on ABO • Vested benefit obligation (VBO), the smallest amount computed • Computed only for employees who have vested • Based on current salary levels

18. Vested Rights in Benefits Rights to receive earned pension benefits arevested when such rights are no longer contingent on continued employment.

19. Reconciliation of PBO

21. Pension Expense: Current Changes in the PBO includes ... Service cost: The increase in the PBO, as per actuaries, attributable to employee service performed during the current period [year].

22. Pension Expense: Current Changes in the FMV of Plan

23. Employer Accounting During Period • Pension expense recognized, and there are ... • Employer contributions made to pension plan. • Any difference is reflected in the account “Prepaid/ accrued pension costs.” • If cumulative expense > cumulative contributions, report as accrued pension costs. • If cumulative expense < cumulative contributions, report as prepaid pension costs.

24. Pension Plan Assetsand the Trustee’s Return! Remember me? Trustee manages the pension Plan Assets--which are not formally recognized on the Sponsor’s balance sheet.

25. Actual Return Expected Return The Trustee’s Problem! A large difference would create problems!

26. Actual Return Expected Return Return on Plan Assets FASB: The expected returnis the factor to use in computing Pension Expense, in lieu of the actual return (which may be only a temporary N/C/M deviation from expectations).

27. Actual Return Expected Return Trustee’s Return on Plan Assets Under GAAP, Pension Expense calculations use expected returnbecause the actual return isnot considered a good indicator of the long-term return on Plan Assets. Opening FMV of Plan Assets X Expected L/T ROI =Expected Return on Plan Assets

28. Pension Expense Recognition • In the accounting model, recognition of expense occurs “because” liabilities increase or assets decrease. • Although the trusteed pension plan’s assets and debts are off-balance-sheet to the employer ... • Pension expense recognized by the employer is impacted by changes in any off-balance-sheet amounts.

29. The Effect of Pension Plan Liability (Assets) on Pension Expense • Some changes in pension plan liabilities (assets) are recognized as a component of pension expense in the period incurred: • PBO • Service cost • Interest cost • Fair value of plan assets • Expected return on plan assets

30. Some changes in pension plan liabilities (assets) are “capitalized” (reported) off-balance-sheet in the period incurred, then amortized into components of pension expense in future periods: • PBO • Prior service cost (PSC), if any. • Actuarial gains/losses • Fair value of plan assets • Unexpected return on plan assets

31. The components of pension expense must be disclosed in a financial statement note.

32. The Granting of “Prior Service Credit” • Initial [or amended] plans may grant vesting • Improves morale • Improves production • Improves retention • “Improves” pay plan • Benefits all future periods

33. FAQs? Given that a company grants credits for PSC, (a) when should PSC be recognized as an expense on the Income Statement? (b) when should PSC be recognized as a liability on the Balance Sheet? Although the theory is controversial, the amount is “capitalized off-balance-sheet” in a footnote, and reported gradually (amortized) through the financial statements.

34. Prior Service Cost • PSC: The present value of retroactive benefits granted to current employees. • Prior service cost component of change in PBO in any period is capitalized. • Unrecognized PSC is disclosed in footnotes, and will be amortized until such balance reaches zero.

35. Transition Amount • Thetransition amount equals difference between PBO and fair value of plan assets at the time of the adoption of GAAP for defined pension plans. The transition asset or liability account is the amount that equates the pension asset or liability balance reported under GAAPand the plan’s funded status at transition date.

36. Transition Cost The transition asset or liability account is amortizedon a straight-line basis over the average remaining service period of employees expected to receive benefits under the plan, beginning in the transition year.

37. Note on Unrecognized Transition Loss (Gain) Since the unrecognized transition amount is capitalized at date SFAS No. 87 was adopted, then amortize, as of 2000, this amount will have disappeared from most companies’ financial statements.

38. Unrecognized Loss (Gain) of Plan • Arises from two amounts: • Unexpected positive/negative return on plan assets • Actuarial gains/losses • Amortized only if the unrecognized amount exceeds a “corridor amount.” • The Corridor equals 10% of the greater of beginning of period PBO or fair value of plan assets.

39. Actual Return Expected Return Trustee’s Return on Plan Assets Expected return on Plan Assets--per actuaries--should work to reduce the the amount of funds that the Employer would need to transfer to the Trustee in the quest to meet the PBO as the payments become due. UNCERTAIN!

40. Example: Which of the following is greater at the beginning of the year? • Assume the PBO is $640,000. • Assume the FMV of the plan’s assets is $550,000. The corridor limit is 10% of the greater of the two, or $64,000, a very conservative approach by the FASB to “hedge the bet” that funding covers the PBO when the time to pay participants arrives.

41. Required Disclosures Reconciliation from amount plan is over (under) funded to the balance sheet amount! AND ...

43. CAUTION To discourage understating of pension liabilities, SFAS No. 87 requires recognition of an additional minimum pension liability under certain circumstances.

44. Minimum Liability Minimum liability equals … the excess of ABO over FMV of plan assets.

45. Measurement Accumulated Benefit Obligation (ABO) Less: FMV of Plan Assets = Minimum Pension Liability This amount is also called the underfunded ABO.

46. If minimum liability exists at year end, the balance sheet must report a liability at least as large as the minimum liability • If any additional pension liability is needed to reach a minimum liability on the balance sheet, two amounts are created • Additional pension liability (a liability account) • Deferred pension cost (an intangible asset)

47. Minimum Liability and Other Comprehensive Income • If minimum liability exists at year end, and • If additional pension liability is necessary to achieve the minimum liability amount, and • If the additional pension liability amount is greater than the unrecognized prior service cost • Then the excess of additional pension liability over unrecognized prior service cost is treated as a component of other comprehensive income

48. Other Post-Retirement Employee Benefits • Principally health care premiums paid by employer • Accounting treatment parallels that of defined benefit pensions • A major difference is that other post-retirement plans are not required to be funded • Plans are on a pay-as-you-go basis • Plan has almost no assets at year end • Plans are underfunded

49. Stock Compensation • Stock options are awarded to employees to encourage future performance that will increase stock price • This aligns the goals of stockholders and employees • Stock options may • Be fixed options or performance options • Have cliff or graded vesting

50. Accounting for Stock Options • Two methods are allowed • The fair value method is preferred by the FASB • This method requires compensation expense to be recognized