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					Special Compensation Arrangements                                                                      1



                                          CHAPTER 12
                                Special Compensation Arrangements

                                Answers to End-of-Chapter Assignments

Questions

Q1. Compensated Absences. What two primary conditions must be present to trigger the accrual of
    compensated absences that are both vested and related to services already rendered?

      Answer. The conditions are the payment is probable, and the amount of the payment is
      reasonably estimable.

Q2. Compensated Absences. If all conditions for the accrual of compensated absences are present
    except for an estimable amount of payment, should the accrual take place? If not, what kind of
    disclosure is necessary?

      Answer. Since the amount cannot be estimated, accrual is improper, but note disclosure is
      required.

Q3. Sick Pay. When sick days accumulate but do not vest, the accrual of sick pay related
    compensation expense is allowable but not required. Why?

      Answer. Sick pay compensation is not required because the benefit depends upon a future event:
      an employee must be sick and absent before the benefits are paid. The authors believe that accrual
      is appropriate when sick pay compensation accumulates but does not vest.

Q4. Defined Contribution Versus Defined Benefit Pension Plans. Compare and contrast defined
    contribution plans and defined benefit pension plans.

      Answer. The goal of both defined contribution and defined benefit pension plans is to provide
      retirement benefits to employees. In a defined contribution plan (e.g., a 401(k) plan), the
      employer makes a defined contribution each period on behalf of the employee to a company
      designated by the employee and that company invests the contribution for the employee. Fidelity
      Investments is a company with which many employees invest their defined contributions. The
      employer’s obligation is met each period by making the appropriate contributions to the
      employees’ designated companies. The employer does not guarantee that the employee will
      receive a defined retirement benefit. The amount of the retirement benefit is based upon the
      investment success of the company investing for the employee. In a defined benefit payment the
      employer’s obligation is to provide a certain defined benefit to the employee when the employee
      retires. A pension plan administrator invests the company’s contributions and makes payments to
      retired employees. The employer makes a contribution to the pension plan each period. The
      amount of the payment is determined by government mandate (a minimum amount required by
      ERISA), tax law (a maximum amount that is tax deductible), and the company’s own cash
      management policy. The employer’s obligation does not end by making a contribution to the
      pension plan because the employer is responsible (at least contingently) for the defined payments
      to employees at retirement.

Q5. Defined Benefit Pension Plan Formula. Give an example of a typical pension plan formula for a
    defined benefit pension plan.
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     Answer. A typical benefit plan formula is based upon the following three parameters: years of
     service, salary level at some point (or period) in time, percent of salary per year of service. For
     example, a plan might grant an employee a retirement benefit equal to one percent of the average
     of the last three years’ salary immediately prior to retirement for each year of service. In most
     organizations, the terms of the plan formula are negotiated by management with a union
     representing the employees.

Q6. Pension Plan Obligations. List and explain the three possible measures of the economic pension
    obligation.

     Answer. The three measures are projected benefit obligation (PBO), accumulated benefit
     obligation (ABO), and vested benefit obligation (VBO). PBO is the actuarially determined
     present value of estimated retirement payments calculated according to the pension plan benefit
     formula (using expected future salary levels) expected to be paid to employees because employees
     have worked and earned benefits until the current date. ABO is the same as PBO, except current
     salary levels are used (i.e., the actuary does not make a provision for future salary increases). Both
     ABO and PBO are based on the amounts expected to be paid. These amounts may not be vested
     (i.e., legally owned by the employee if the employee leaves the company). VBO is the vested
     portion of ABO. Therefore, ABO is larger than VBO if any current employees have earned
     retirement benefits that have not yet vested.

Q7. Settlement Rate. What is the settlement interest rate? How is it used in pension accounting?

     Answer. Under certain circumstances, a pension plan can be terminated by an employer. In
     general, if the pension plan is terminated, it must provide annuities to the employees that will
     provide for a defined pension benefit during retirement equal to what would have been provided by
     the current pension plan. These annuities are normally purchased from an insurance or finance
     company. The interest rate associated with the annuity is called the settlement rate. Note that the
     settlement rate is associated with current market conditions, and it can change over time. The end-
     of-period settlement rate is used by the actuary to compute projected benefit obligation,
     accumulated benefit obligation, and vested benefit obligation.

Q8. Pension Plan Assets. What is the basis for measuring pension plan assets?

     Answer. A pension plan’s assets are reported at fair market value at the end of each period.

Q9. Economic Status of Pension Plan. If someone states that the economic status of the pension plan
    is a “net asset,” what do they mean? What does a “net obligation” mean?

     Answer. In this “net asset” case, the fair market value of plan assets exceeds the projected benefit
     obligation. Thus, the pension plan is overfunded, and a net asset results. If the fair market value of
     plan assets is less than the projected benefit obligation, then the plan is underfunded, and a net
     obligation results.

Q10. Events Affecting PBO. List and describe the five events that change the PBO during a given
     period. Indicate whether the events receive no recognition, immediate recognition, or delayed
     recognition in determining GAAP-based pension expense.
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      Answer
      1. Service Cost. Service cost is the actuarially determined present value of the increase in future
         benefits because an employee worked during the current year. Service cost receives immediate
         recognition as a component of pension expense, and it increases pension expense.

      2. Interest Cost. Interest cost is the increase in PBO because of the passage of time during the
         period. Interest cost equals the beginning-of-the-period PBO times the beginning-of-the-period
         settlement interest rate. Interest cost receives immediate recognition as a component of pension
         expense, and it increases pension expense.

      3. Prior Service Cost. The increase in PBO from amending a pension plan and retroactively
         granting benefits is defined as prior service cost. Prior service cost receives delayed
         recognition as a component of pension expense by being amortized over the average remaining
         service life of current employees. Normally, prior service is related to a plan amendment that
         increases PBO; therefore, prior service cost amortization increases pension expense. However,
         a plan amendment could decrease PBO, and in that case amortizing the prior service credit
         would decrease pension expense.

      4. Liability (Actuarial) Gain/Loss. The liability (actuarial) gain/loss may either increase PBO
         (liability loss) or decrease PBO (liability gain). The liability gain/loss results from the actuary
         using new actuarial assumptions. Each period, the actuary estimates PBO using the most
         current assumptions about items such as interest rates, mortality, pay increases, and job
         classifications. The liability gain/loss is accumulated as part of the unrecognized gain/loss
         amount. The unrecognized gain/loss may receive either delayed recognition (if the
         unrecognized gain/loss is greater than the corridor amount) or no recognition (if the
         unrecognized gain/loss is less than the corridor amount).

      5. Benefit Payments. When benefit payments are made to retired employees, PBO decreases.
         Benefit payments do not affect pension expense.

Q11. Events Affecting the FMV of Pension Plan Assets. List and describe the three events that
     change the FMV of pension plan net assets during a given period. Indicate whether the events
     receive no recognition, immediate recognition, or delayed recognition in determining GAAP-based
     pension expense.

      Answer
      1. Employer’s Contribution to Pension Plan. The employer’s contribution to the pension plan
         increases pension plan assets. The contribution is in the nature of a capital contribution to the
         pension plan, and it does not affect pension expense.

      2. Benefit Payments. When benefit payments are made to retired employees, the FMV of plan
         assets decreases. Benefit payments do not affect pension expense.

      3. Actual Return on Plan Assets. The actual return on plan assets may either increase the FMV
         of plan assets (a positive return) or decrease the FMV of plan assets (a negative return). To
         compute the actual return on plan assets, subtract the adjusted beginning FMV of plan assets
         (beginning FMV of plan assets + employer contributions - benefit payments to employees)
         from the ending FMV of plan assets.
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     The actual return on plan assets is separated into two components: the expected return on plan
     assets and an asset gain/loss. The expected return on plan assets (beginning FMV of plan assets
     times the long-term expected rate of return on plan assets) receives immediate recognition as a
     component of pension expense, and it decreases pension expense. The unexpected return on plan
     assets (actual return on plan assets - expected return on plan assets), also referred to as the asset
     gain/loss, is accumulated as part of the unrecognized gain/loss amount. The unrecognized
     gain/loss may receive either delayed recognition (if the unrecognized gain/loss is greater than the
     corridor amount) or no recognition (if the unrecognized gain/loss is less than the corridor amount).


Q12. Components of Actual Return on Plan Assets. What are the two components of the actual return
     on plan assets? How are they accounted for in determining pension expense?

     Answer. The two components of the actual return on plan assets are (1) the expected return on
     plan assets and (2) unexpected return on plan assets (asset gain/loss). The expected return on plan
     assets is computed as the beginning FMV of plan assets times the long-term expected rate of return
     on plan assets, and it receives immediate recognition as a component of pension expense
     (decreasing pension expense). The unexpected return on plan assets (actual return on plan assets
     - expected return on plan assets), also referred to as the asset gain/loss, is accumulated as part of
     the unrecognized gain/loss amount. The unrecognized gain/loss may receive either delayed
     recognition (if the unrecognized gain/loss is greater than the corridor amount) or no recognition (if
     the unrecognized gain/loss is less than the corridor amount).

Q13. Recognition of Prior Service Cost. Why is prior service cost given delayed recognition treatment
     in computing pension cost?

     Answer. The logic is that an employer offers to amend a pension plan (assume the amendment
     increases employee pensions) as an incentive to employees to motivate them to work harder (more
     efficiently, etc.) such that profits are increased in future periods. Therefore, we assume that the
     benefits from amending a pension plan affect future periods, which results in delayed recognition
     of prior service cost over the future periods benefitted.

Q14. Pension Cost versus Pension Expense. Are pension cost and pension expense always equal?
     Explain.

     Answer. Although we use pension expense and pension cost synonymously during most of the
     text (by assuming pension expense equals pension cost), the amounts are not necessarily equal.
     For each period, net periodic pension cost is computed and reported in financial statement
     footnotes. Some portions of the pension cost may be capitalized as part of inventory if the
     employer is a manufacturing company. In this case, the portion of inventory cost attributable to
     pension cost is capitalized as part of inventory cost and eventually expensed as cost of goods sold.
     The portion not capitalized as inventory cost is expensed as pension expense. If the employer is
     not a manufacturing company, then pension expense usually equals pension cost.

Q15. Stock Options. What are the two methods in accounting for fixed stock options? Which method
     do companies use? Why?
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      Answer. A company may use either the fair value method (the preferred method, described in
      SFAS No. 123) or the intrinsic value method (described in APB No. 25). Under the fair value
      method, a company would almost always have compensation expense. However, under the
      intrinsic value method, the company can construct the stock option so that no compensation
      expense is recognized. For these reasons, companies choose the intrinsic value method to
      report stock options.

Q16. Stock Options. Why do companies offer stock options?

      Answer. Modern finance holds that shareholder wealth is maximized if shareholders create
      agreements with managers to align the interests of managers with shareholders. This is best
      accomplished by tying a significant portion of manager wealth to the company’s stock price.
      Because much of a manager’s personal wealth is tied to stock options, management actions that
      increase stock price increase the wealth of both managers and nonmanager stockholders. In the
      1990s, a large number of start-up, mostly high technology firms awarded stock options to almost
      all employees. Employees worked extremely hard to make the start-ups successful so that the
      company could be taken public and employees could “get rich.”

Q17. Stock Options Versus Stock Appreciation Rights. What are the similarities and the major
     differences in stock options and stock appreciation rights (SARs)?

      Answer. Both provide the ability for employees to benefit from increased stock price. With a
      stock option, an employee must buy the stock at the option price and then sell it at the higher
      market price in order to reap the financial benefit. In a SAR plan, the employee receives in cash
      the excess of market price over a predetermined price. Therefore, in a SAR plan, employees
      benefit without needing large amounts of cash to exercise stock options.

Short Problems

1.    Reconcile PBO and FMV of Plan Assets. Given the following information, compute the
      December 31, 2001 projected benefit obligation (PBO) and the fair market value (FMV) of plan
      assets for Rogers Co.:

      Prior service cost granted in 2001              $110,000
      Interest on PBO                                    70,000
      Actual return on plan assets                     100,000
      Service cost                                       80,000
      Contribution sent to plan trustee                  60,000
      Benefit payments to retirees                       20,000
      Liability loss (gain)                            (30,000)
      FMV of plan assets, 1/1/01                       750,000
      PBO, 1/1/01                                      800,000
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     Answer
     Projected Benefit Obligation
     PBO, 1/1/01                                            $800,000
     Service cost                                             80,000
     Interest cost                                            70,000
     Prior service cost                                      110,000
     Liability loss (gain)                                   (30,000)
     Benefit payments                                        (20,000)
     PBO, 12/31/01                                        $1,010,000

     Fair Market Value of Plan Assets
     FMV, 1/1/01                                            $750,000
     Company contribution                                     60,000
     Actual return on plan assets: positive (negative)       100,000
     Benefit payments                                        (20,000)
     FMV, 12/31/01                                          $890,000

2.   Reconcile PBO and FMV of Plan Assets, and Compute Pension Cost. Given the following
     information, compute the December 31, 2001, PBO and FMV of net assets for Roy Co. Also,
     compute 2001 pension cost:

     Prior service cost due to 2001 amendment                      $60,000
     PBO, 1/1/01                                                $1,000,000
     FMV, 1/1/01                                                $1,200,000
     Settlement interest rate                                           7%
     Expected return on plan assets                                     9%
     Actual return on plan assets                                       8%
     Liability loss (gain)                                       $(40,000)
     Year-end contribution to plan trustee                        $100,000
     Service cost                                                 $115,000
     Payments to retiring employees                                $30,000
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      Answer
      Projected Benefit Obligation
      PBO, 1/1/01                                                                 $1,000,000
      Service cost                                                                   115,000
      Interest cost *                                                                  70,000
      Prior service cost                                                               60,000
      Liability loss (gain)                                                          (40,000)
      Benefit payments                                                               (30,000)
      PBO, 12/31/01                                                               $1,175,000

       * $1,000,000 (1/1/01 PBO) x 7% (settlement rate) = $70,000.

      Fair Market Value of Plan Assets
      FMV, 1/1/01                                                                 $1,200,000
      Company contribution                                                           100,000
      Actual return on plan assets: positive (negative) **                             96,000
      Benefit payments                                                               (30,000)
      FMV, 12/31/01                                                               $1,366,000
      ** $1,200,000 (1/1/01 FMV) x 8% (actual return) = $96,000.


      Pension Cost
      Service cost                                                                  $115,000
      Interest cost (1)                                                               70,000
      Expected return on plan assets: (positive) negative (2)                       (108,000)
      Amortization: transition amount                                                       0
                          prior service cost                                                0
                          deferred losses (gains)                                           0
      Pension cost                                                                   $77,000

      (1)   $1,000,000 (1/1/01 PBO) x 7% (settlement rate) = $70,000.
      (2)    $1,200,000 (1/1/01 FMV) x 9% expected return = $108,000. The actual return
             =$1,200,000 (1/1/01 FMV) x 8% (actual return) = $96,000, which leads to an asset
             loss of $12,000: $108,000 expected return - $96,000 actual return.
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Note: Problems 3 and 4 are related.

3.   Reconcile PBO and FMV of Plan Assets, Compute Pension Cost. Given the following
     information, compute pension cost for 2001 for the Wong-on-Wing company.

     Service cost                                          $ 25,000
     PBO, 1/1/01                                          $400,000
     PBO, 12/31/01                                        $484,000
     FMV of plan assets, 1/1/01                           $500,000
     Balance sheet prepaid pension cost, 1/1/01           $130,000
     Unamortized transition amount, 1/1/01                      $0
     Unamortized gain (loss), 1/1/01                        $20,000
     Unamortized prior service cost, 1/1/01                 $50,000
     Current year prior service cost                            $0
     Actual return on plan assets                         $100,000
     Contribution to trustee                                $25,000
     Prior service cost amortization                        $10,000
     Benefit payments to retirees                           $15,000
     Settlement interest rate                                   6%
     Expected return on plan assets                             8%
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      Answer
      Projected Benefit Obligation
      PBO, 1/1/01                                                                 $400,000
      Service cost                                                                   25,000
      Interest cost (1)                                                              24,000
      Prior service cost                                                                  0
      Liability loss (gain) (2)                                                      50,000
      Benefit payments                                                             (15,000)
      PBO, 12/31/01                                                               $484,000

      (1)   $400,000 (1/1/01 PBO) x 6% (settlement rate) = $24,000.
      (2)   This amount must be computed in this problem. In order for ending PBO to be
                 $484,000, the liability loss (gain) must be a $50,000 loss.
      Fair Market Value of Plan Assets
      FMV, 1/1/01                                                                 $500,000
      Company contribution                                                           25,000
      Actual return on plan assets: positive (negative)                            100,000
      Benefit payments                                                             (15,000)
      FMV, 12/31/01                                                               $610,000
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     Pension Cost
     Service cost                                                                     $25,000
     Interest cost (3)                                                                 24,000
     Expected return on plan assets: (positive) negative (4)                          (40,000)
     Amortization: transition amount                                                          0
                         prior service cost                                            10,000
                         deferred losses (gains) (5)                                          0
     Pension cost                                                                     $19,000
     (3)   $400,000 (1/1/01 PBO) x 6% (settlement rate) = $24,000.

     (4)   The expected return on plan assets = $500,000 (1/1/01 FMV) x 8%= $40,000. The
           actual return = $100,000. The asset gain/loss = actual return of $100,000 - $40,000
           expected return= $60,000 gain because the actual return is greater than the
           expected return.
     (5)   The beginning of the period corridor = 10% x $500,000 FMV of plan assets =
           $50,000. The beginning of the period deferred gain = $20,000, which is less than
           the corridor; so, no 2001 amortization occurs.

4.   Defined Benefit Pension Plan Footnote Disclosures. Using the information provided in problem
     (3), compute the following footnote disclosures for Wong-on-Wing: (1) reconcile from the
     beginning to ending the balances of PBO and FMV of plan assets, and (2) reconcile from the
     amount that the pension plan is over(under) funded to the balance sheet prepaid (accrued) pension
     cost amount. Ignore minimum liability provisions.

     Answer. Note Disclosures
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      Projected Benefit Obligation
      PBO, 1/1/01                                     $400,000
      Service cost                                       25,000
      Interest cost                                      24,000
      Prior service cost                                      0
      Liability loss (gain)                              50,000
      Benefit payments                                 (15,000)
      PBO, 12/31/01                                   $484,000

      Fair Market Value of Plan Assets
      FMV, 1/1/01                                     $500,000
      Company contribution                               25,000
      Actual return on plan assets: positive           100,000
      (negative)
      Benefit payments                                 (15,000)
      FMV, 12/31/01                                   $610,000


      Reconciliation of 12/31/01 Pension Plan Status to Balance Sheet Amounts
      PBO                                                                $(484,000)
      FMV of plan assets                                                    610,000
      Excess of FMV pension plan assets over PBO                            126,000
      Unamortized:     Transition amount                                          0
                       Prior service cost (1)                                40,000
                       Loss (gain) (2)                                     (30,000)
      Prepaid (accrued) pension cost (3)                                  $136,000

      Documentation for computations:

      (1) The beginning of the period balance = $50,000 (given). Ending unamortized prior service cost
          balance = $50,000 beginning balance - $10,000 current year amortization = $40,000.

      (2) The beginning of the period balance = $20,000 unamortized gain. During the year, the
          company experienced a liability loss of $50,000 (see problem (3) answer) and a $60,000 asset
          gain ($100,000 actual gain - $40,000 expected gain). The ending unamortized gain/loss
          balance = $30,000 [$20,000 (gain beginning balance) - $50,000 (liability loss) + $60,000 (the
          asset gain) = $30,000 (unamortized gain ending balance)].
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     (3) To check the ending prepaid (accrued) pension cost balance, the beginning prepaid pension
         cost = $130,000 + additional prepaid pension cost incurred in current period of $6,000 [cash
         contribution to pension plan of $25,000 - pension expense $19,000] = $136,000 ending prepaid
         pension balance.

5.   Compute Pension Cost. Given the following information for Hernandez Co., compute pension
     cost for 2001:

     Payments to retiring employees              $500,000
     Contribution to plan trustee                 400,000
     Interest on PBO                               50,000
     Expected return on plan assets                75,000
     Service cost                                 100,000
     Loss amortization                             45,000

     Answer
     Pension Cost
     Service cost                                           $100,000
     Interest cost                                            50,000
     Expected return on plan assets:                         (75,000)
     Amortization: transition amount                                0
                       prior service cost                           0
                       deferred losses (gains)                45,000
     Pension cost                                           $120,000
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      Answer
      Pension Cost
      Service cost                                           $100,000
      Interest cost                                             50,000
      Expected return on plan assets:                         (75,000)
      Amortization: transition amount                                0
                       prior service cost                            0
                       deferred losses (gains)                  45,000
      Pension cost                                           $120,000

6.    Prepaid (Accrued) Pension Cost. Ignoring the minimum liability, compute the December 31,
      2003, balance in prepaid (accrued) pension cost under the following two scenarios. (Assume a
      January 1, 2001, prepaid (accrued) pension cost amount of zero for each scenario.)

                                                     Scenario One        Scenario Two

      Pension expense, 2001                                $40,000           $ 65,000
      Contributions to plan trustee, 2001                   30,000             95,000
      Pension expense, 2002                                 40,000             70,000
      Contributions to plan trustee, 2002                   40,000                  0
      Pension expense, 2003                                 40,000             80,000
      Contributions to plan trustee, 2003                   45,000            150,000
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     Answer
                                                                   Prepaid (Accrued) Pension Cost

                                                                    Scenario One        Scenario Two

     January 1, 2001, beginning balance                                    $     0            $       0

     2001: change:      $40,000 - $30,000                                   10,000

                        $65,000 - $95,000                                                    $(30,000)
     December 31, 2001, ending balance                                    $10,000            $(30,000)
     2002: change:     $40,000 - $40,000                                         0

                       $70,000 - $0                                                               70,000
     December 31, 2002, ending balance                                    $10,000              $40,000

     2003: change:     $40,000 - $45,000                                   (5,000)
                       $80,000 - $150,000                                                     (70,000)
     December 31, 2003, ending balance                                     $ 5,000           $(30,000)

7.   Minimum Liability. Given the following information, compute Bell Co.’s minimum liability to
     be reported as of December 31, 2001.

     Cumulative recognitions of pension expense for all years through 12/31/01              $ 800,000
     Cumulative payments to plan trustee for all years through 12/31/01                        850,000
     PBO, 12/31/01                                                                           2,000,000
     ABO, 12/31/01                                                                           1,800,000
     FMV of plan assets, 12/31/01                                                            1,500,000

     Answer. At 12/31/01, prepaid (accrued) pension cost account a $50,000 prepaid balance
     ($800,000 cumulative pension expense - $850,000 cumulative payments to trustee). The minimum
     liability equals $300,000 ($1,800,000 ABO - $1,500,000 FMV of plan assets). Therefore, a
     minimum liability of $300,000 will be reported, and an additional pension liability of $350,000 (to
     move from $50,000 prepaid pension cost asset to $300,000 minimum liability) is required.

8.   Minimum Liability. Marony Inc. adopted a defined benefit pension plan on January 1, 2000. On
     that date, Marony granted benefits to employees based on prior service to the company totaling
     $50,000 (Marony had no prior pension plan assets or liabilities). Because employees benefitting
     from the initial grant were expected to be with the company for the next ten years, $5,000 prior
     service cost is to be amortized each year, beginning with 2000. The following additional
     information relates to Marony’s plan:
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                                                2000                2001              2002              2003

      PBO, 12/31                              $60,000         $90,000           $120,000          $120,000
      ABO, 12/31                               40,000          60,000             80,000               80,000
      FMV of plan assets, 12/31                    0                   0          50,000           110,000
      Pension expense                          10,000          15,000             20,000               15,000
      Contributions to trustee                     0                   0          50,000               50,000

      Assume no asset or liability gains or losses for the 2000-2003 period. For each year-end (2000-
      2003), indicate what pension-related amounts will be shown on Marony’s balance sheet. Note that
      to simplify this problem, we assumed no plan assets at year-end 2000 and 2001. This situation
      would almost certainly violate ERISA provisions that require minimum funding each period. The
      scenario could also occur if all assets contributed were paid out to employees.

      Answer
                                                            2000              2001             2002              2003
      ABO                                                $40,000           $60,000           $80,000        $80,000
      FMV of plan assets                                       0                 0            50,000        110,000
      Minimum liability                                  $40,000           $60,000           $30,000              N/A
      PBO                                               $(60,000)      $(90,000)       $(120,000)        $(120,000)
      FMV of plan assets                                       0                 0            50,000        110,000
      Amount of pension plan underfunding               $(60,000)      $(90,000)        $(70,000)         $(10,000)
      Unamortized:     transition amount                       0                 0                0                 0
                 prior service cost                       45,000            40,000            35,000            30,000
                 loss (gain)                                   0                 0                0                 0
      Prepaid (accrued) pension cost                    $(15,000)      $(50,000)        $(35,000)           $20,000

      Required additional pension liability             $(25,000)      $(10,000)                 $0                $0
      Balance sheet deferred pension cost               $ 25,000           $ 10,000              $0                $0
      Balance sheet total pension liability              $40,000           $60,000           $35,000
      Balance sheet prepaid pension cost                                                                    $20,000

9.    Pension Plan Note Disclosure. Using the following information, prepare the note reconciliation
      between the economic status of Bradshaw Co.’s defined benefit pension plan and the balance sheet
      amount at December 31, 2001:
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     PBO, 12/31                                                 $ 191,000
     ABO, 12/31                                                   160,000
     FMV of net assets, 12/31                                     125,000
     Unamortized losses (gains), 12/31                             67,000
     Unamortized prior service cost, 12/31                        148,000
     Unamortized transition amount, 12/31                                0
     Cumulative contributions to plan trustee                      80,000
     Cumulative pension expense recognitions                       65,000

     Answer
     PBO                                                                          $(191,000)
     FMV of plan assets                                                              125,000
     Pension plan over (under)funding                                              $ (66,000)
     Unamortized:    transition amount                                                         0
                     prior service cost                                              148,000
                     losses (gains)                                                 (67,000)
     Prepaid (accrued) pension cost (1)                                             $ 15,000
     Additional pension liability (2)                                               (50,000)
     Minimum liability (2)                                                         $ (35,000)

     (1)   Check: cumulative pension expense of $65,000 - cumulative cash contributions of
           $80,000 = $15,000 prepaid pension cost.
     (2)   ABO of $160,000 - FMV of plan assets of $125,000 = $35,000 minimum liability.
           The additional pension liability amount is the amount necessary to reconcile to a
           $35,000 net balance sheet liability. To go from a $15,000 net asset to a $35,000
           net liability position requires additional pension liability of $50,000.
Special Compensation Arrangements                                                                           17




10.   Amortization of Unrealized Gain/Loss. Montego Corporation had the following pension-related
      amounts (in $ thousands) at the beginning and the end of the first year of the company’s pension
      plan:

                                         Beginning               End

      PBO                                        $0        $10,000
      FMV of plan assets                          0         12,000
      Unamortized gains                           0          3,000

      a.     Assuming a 10-year amortization period, how much of the first-year gain was amortized in
             the first year?

      Answer. Zero. The amount of any amortization of losses (gains) depends upon the beginning
      amount, and the beginning amount equals zero.

      b.     Assuming a 10-year amortization period, how much of the first-year gain should be
             amortized in the second year?

      Answer. At the beginning of the second year, the corridor amount equals 10% of the greater of
      PBO or FMV of plan assets. Therefore, the corridor amount equals $1,200 ($12,000 x 10%). In
      the second year, one-tenth of the excess of the beginning unamortized gain amount over the
      corridor is amortized (i.e., 1/10 x $1,800 is amortized, where $3,000 - $1,200 = $1,800), resulting
      in second year amortization of $180.

11.   Amortization of Unrealized Gain/Loss. Assume that Terry Corp. had the following expected
      and actual PBOs and FMVs of plan assets (in millions of dollars):

                           Actual                     Expected
      Dec. 31          PBO          FMV          PBO             FMV

      2000             $100          $ 90         $110            $ 95
      2001               160          160          120            110
      2002               200          130          140            160
      2003               250          260          250            220

      a. Compute the gain/loss amortization included as a component of pension expense for each year
         of the 2000-2003 period. Assume no unamortized loss (gain) on January 1, 2000. Assume that
         gains/losses are amortized over a 10-year period for any year in which unrecognized
         gains/losses are amortized.

      b. Compute the unrecognized gain/loss for the note reconciliations at December 31 for each year
         of the 2000-2003 period. Assume that gains/losses are amortized over a 10-year period for any
         year in which unrecognized gains/losses are amortized.
18                                                                                                              Chapter 12



Answer
                                                                               Unamortized
                                            Current Year FMV of Plan           Loss (Gain)
                Current Year PBO                     Assets                      Balance

 Year       Actual    Expect.     Loss      Actual    Expect.      Loss      Beg        End        Corridor**        Current
 End                              (gain)                           (gain)                                            Amort.***

 2000         $100        $110      $(10)      $ 90        $ 95       $5        $0        $ (5)              $0              $0

 2001          160         120         40      160          110      (50)        (5)       (15)                 10               0

 2002          200         140         60      130          160        30      (15)           75                16               0

 2003          250         250          0      260          220      (40)          75         35                20           5.5

 Total         710         620         90      640          585      (55)      N/A        N/A               N/A              N/A

 *        Beginning balance adjusted for current year changes

 **       10% of larger of beginning of the year PBO or FMV of plan assets

 ***      The excess of the beginning of the year unamortized loss (gain) balance over the beginning of the year corridor
          divided by 10


12.      Transition Amount. Wege Welders adopted SFAS No. 87 on January 1, 1990, to account for its
         pension plan that had been in place since 1980. At that date, Wege’s plan had assets with a FMV
         of $6,000,000 and a PBO of $6,800,000. Under APB Opinion No. 8, Wege had an accrued pension
         cost of $500,000 on January 1, 1990, which is treated as part of the transition amount.

         a. Compute the transition amount.

         Answer. The January 1, 1990, transition amount equals a $300,000 deferred charge: $800,000
         (which represents a deferred charge related to the transition liability for the excess of PBO over
         FMV of plan assets) less $500,000 (which represents the accrued pension cost at transition). The
         $300,000 difference represents a net deferred charge.

         b. Compute the 1990 amortization of the transition amount included in pension cost (stating
            whether the amortization increased or decreased pension cost), and the unamortized amount to
            be included as a December 31, 1990, reconciling item.

         Answer. The transition amount can be amortized over the remaining service life of the current
         employees at transition (which is not provided) or 15 years. Using 15 years results in $20,000
         amortization each year ($300,000 ÷ 15). The amortization of the transition deferred charge
         increases pension cost. At December 31, 1990, the unamortized transition deferred charge equals
         $280,000 ($300,000 - $20,000, the 1990 amortization).

13.      Transition Amount. Jaworski Brothers Pipeline adopted SFAS No. 87 on January 1, 1990, to
         account for its pension plan. At that date, Jaworski’s plan had assets with a FMV of $100,000 and
         a PBO of $60,000. Under APB Opinion No. 8, Jaworski had a prepaid pension cost of $5,000 on
         January 1, 1990, which is treated as part of the transition amount.
Special Compensation Arrangements                                                                          19



      a. Compute the transition amount.

      Answer. The January 1, 1990, transition amount equals a $35,000 deferred credit: $40,000
      (which represents a transition deferred credit related to the excess of FMV of plan assets over
      PBO) less $5,000 (which represents the prepaid pension cost at transition).

      b. Compute the 1990 amortization of the transition amount included in pension cost (stating
         whether the amortization increased or decreased pension cost), and the unamortized amount to
         be included as a December 31, 1990, reconciling item.

      Answer. The transition amount can be amortized over the remaining service life of the current
      employees at transition, which is not provided, or 15 years. Using 15 years results in $2,333
      amortization each year ($35,000 ÷ 15). The amortization of the transition deferred charge
      increases pension cost. At December 31, 1990, the unamortized transition deferred charge equals
      $32,667 ($35,000 - $2,333, the 1990 amortization).

14.   Post-Retirement versus Defined Benefit Pension Plan Accounting. What are two main
      differences between the accounting for other post-retirement plans and the accounting for defined
      benefit pension plans?

      Answer. Unlike defined benefit pension plans, other post-retirement plans are not regulated by the
      Federal government. Consequently, minimum funding is not required, and most post-retirement
      plans are unfunded (i.e., they are funded on a pay-as-you-go basis). A second major difference is
      that at transition employers accounting for post-retirement benefit plans had the option of either
      immediately expensing or deferring and amortizing any difference between the FMV of plan assets
      and the post-retirement benefit obligation, while at transition, employers offering defined benefit
      pension plans do not have the choice to immediately expense the transition amount. Also,
      additional note disclosures are required for other post-retirement plans than those for pension plans
      (e.g., the assumed health care cost trend rate).

15.   Fixed versus Performance Stock Options. Explain the difference between fixed options and
      performance options.

      Answer. In a fixed stock option plan, the number of options available to employees is determined
      at the grant date, and the number of options does not depend upon future performance. In a
      performance option plan, the number of options ultimately available to the employee depends upon
      reaching some future performance standards (e.g., return on investment, EPS, number of minority
      hired).

16.   Cliff versus Graded Vesting in Stock Option Plans. Explain the difference between cliff vesting
      and graded vesting of stock option plans.

      Answer. In cliff vesting, all options vest at a particular point in time (e.g., at the end of three
      years). In graded vesting, a portion of the stock option periodically vests over time (e.g., one-third
      of the options vest each year over the next three years).
20                                                                                          Chapter 12



Note: Problems 17 and 18 are related.

17.   Stock Options: Intrinsic Value Versus Fair Value Methods. On January 1, 2001, Cowboy
      Company entered into an agreement whereby Cowboy’s president, John Jones, was granted stock
      options. The option agreement stated that Mr. Jones could purchase up to 10,000 shares of
      Cowboy’s $5 par common on January 1, 2003, for $30 per share, if Mr. Jones still worked for
      Cowboy on that date. On January 1, 2001, Cowboy’s stock sold for $50 per share. An appropriate
      option model valued the options at $15,000. Assuming Jones exercises the options on January 1,
      2003, when the stock is selling at $53 per share, show all financial statement effects of the plan for
      2001-2003 (a) under the intrinsic value approach of APB No.25 and (b) under the fair value
      approach of SFAS No. 123.

      Answer (a). This is a compensatory situation because the fair market value ($50) exceeds the
      option price ($30) on the grant date. The total compensation expense = $200,000 [10,000 shares x
      ($50 - $30)]. On January 1, 2001, $200,000 is recorded as deferred compensation expense (a
      contra stockholders’ equity account) and the offsetting effect is to increase paid-in capital--stock
      options. Assuming that the company benefits from the option during the 2001-2002 period,
      compensation expense of $100,000 is recorded each year, which eventually decreases retained
      earnings, and the offsetting balance sheet effect is to decrease deferred compensation expense.


      On the date that the options are exercised, (1) cash increases by $300,000 [10,000 options x $30];
      (2) paid-in capital--stock options decreases by $200,000; (3) common stock increases by $50,000
      [10,000 shares x $5 par value]; and (4) paid-in capital in excess of par increases by $450,000
      [$300,000 + $200,000 - $50,000].

      Additionally, since the company did not use the fair value approach, footnote disclosure is required
      to report the effects as if the fair value method had been used. Those effects are described in the
      answer to part (b).

      Answer (b). The amount of compensation expense =$15,000, which is equally allocated over the
      two-year period of 2001 and 2002. Therefore, in each year, compensation expense of $7,500 is
      recorded, and the offsetting balance sheet effect is to paid-in capital--stock options.

      On the date that the options are exercised, (1) cash increases by $300,000 [10,000 options x $30];
      (2) paid-in capital--stock options decreases by $15,000; (3) common stock increases by $50,000
      [10,000 shares x $5 par value]; and (4) paid-in capital in excess of par increases by $265,000
      [$300,000 + $15,000 - $50,000].

18.   Stock Options: Intrinsic Value versus Fair Value Methods. Repeat problem (17) assuming that
      on the date of grant, January 1, 2001, Cowboy’s common stock trades at $30 per share.

      Answer (a). This is a noncompensatory situation because the fair market value equals the option
      price on the grant date. Therefore, compensation expense is $0. Because the company did not use
      the fair value approach, footnote disclosure is required to report the effects as if the fair value
      method had been used. The footnote disclosure would report that $7,500 in compensation expense
      would have been recorded in each year (2001 and 2002) if the fair value method had been used.

      On the date that the options are exercised, (1) cash increases by $300,000 [10,000 options x $30];
      (2) common stock increases by $50,000 [10,000 shares x $5 par value]; and (3) and paid-in capital
Special Compensation Arrangements                                                                          21



      in excess of par increases by $250,000 [ $300,000 - $50,000].

      Answer (b). The answer is the same as that to (17b). The amount of compensation expense =
      $15,000, which is allocated equally over the two year period of 2001 and 2002. Therefore, in each
      year, compensation expense of $7,500 is recorded, and the offsetting balance sheet effect is to
      paid-in capital--stock options.

      On the date that the options are exercised, (1) cash increases by $300,000 [10,000 options x $30];
      (2) paid-in capital--stock options decreases by $15,000; (3) common stock increases by $50,000
      [10,000 shares x $5 par value]; and (4) paid-in capital in excess of par increases by $265,000
      [$300,000 + $15,000 - $50,000].

19.   Stock Appreciation Rights (SARs). On January 1, 2000, Ranger Enterprises issues 900,000
      stock appreciation rights, which are exercisable on December 31, 2002, and expire on January 1,
      2006. Each SAR allows Ranger’s key employees to receive the excess of the stock price at
      exercise over a predetermined price of $50. The company believes that it will benefit from
      improved employee performance over the period January 1, 2000 - December 31, 2002. The year-
      end stock prices for 2000, 2001, and 2002 are $60, $54, and $51, respectively. Assuming the key
      employees exercise the SARs at December 31, 2002, show all financial statement effects of the
      plan for 2000-2002.
22                                                                                        Chapter 12




     Answer
                                                          Balance Sheet Liability - SAR
                                                             Liability, December 31

                                                             Total          Current
                                                           Estimated       Year-End       Compensation
                                                           Amount*         Balance**       Expense***

     2000: 900,000 SARs x ($60 - $50)                       $9,000,000

               $9,000,000 x 1/3                                            $3,000,000

               Ending liability - beginning liability                                        $3,000,000

     2001: 900,000 SARs x ($54 - $50)                        3,600,000

               $3,600,000 x 2/3                                             2,400,000

               Ending liability - beginning liability =                                        (600,000)
               ($2,400,000 - $3,000,000)

     2002: 900,000 SARs x ($51 - $50)                          900,000

               $900,000 x 3/3                                                 900,000

               Ending liability - beginning liability =                                      (1,500,000)
               ($900,000 - $2,400,000)

           Note: At December 31, 2002, the exercise of the 900,000 SARs results in a decrease in the
           SAR liability to $900,000 and a decrease in cash of $900,000.

     *   The total liability is estimated at the end of each period using the current year-end stock
         price.
     ** The current year-end liability represents that portion of the total estimated liability incurred
         to date. Since the compensation is accrued over the 2000-2002 period, 1/3 of the total
         estimated liability is accrued at 12/31/00, 2/3 accrued at 12/31/01, and 3/3 accrued at
         12/31/02.
     *** Compensation expense equals the change in the accrued SAR liability during the period.

     Analytical and Comprehensive Problems

     20. Financial Statement Effects of Alternative Stock Options Methods. Using I = increases; D
         = decreases; NE = no effect, identify the effects of the following transactions or conditions on
         the various financial statement amounts.
Special Compensation Arrangements                                                                           23




                                                  Contributed Capital                   Retained Earnings

 Situation: (situations 1-4 are the same across                                                  Indirect Effect
 all three events, and the situation pertain to              Additional   Other                  (Through Net
 the relationship between market price and        Common     Paid-in      Contributed   Direct   Income)
 option price on the grant date)                  Stock      Capital      Capital       Effect

 Granting of stock options:

 1.   Market price exceeds exercise price         NE         NE           I             NE       NE
      (APB No. 25 intrinsic value rules)

 2.   Market price exceeds exercise price         NE         NE           NE            NE       NE
      (SFAS No. 123 fair value rules)

 3.   Market price equals exercise price (APB     NE         NE           NE            NE       NE
      No. 25 intrinsic value rules)

 4.   Market price equals exercise price          NE         NE           NE            NE       NE
      (SFAS No. 123 fair value rules)

 Employee performs service, thus earning
 any compensation implied by stock
 options:

 1.   Market price exceeds exercise price         NE         NE           NE            NE       D
      (APB No. 25 intrinsic value rules)

 2.   Market price exceeds exercise price         NE         NE           I             NE       D
      (SFAS No. 123 fair value rules)

 3.   Market price equals exercise price (APB     NE         NE           NE            NE       NE
      No. 25 intrinsic value rules)

 4.   Market price equals exercise price          NE         NE           I             NE       D
      (SFAS No. 123 fair value rules)

 Employee exercises stock options:

 1.   Market price exceeds exercise price         I          I            D             NE       NE
      (APB No. 25 intrinsic value rules)

 2.   Market price exceeds exercise price         I          I            D             NE       NE
      (SFAS No. 123 fair value rules)

 3.   Market price equals exercise price (APB     I          I            NE            NE       NE
      No. 25 intrinsic value rules)

 4.   Market price equals exercise price          I          I            D             NE       NE
      (SFAS No. 123 fair value rules)
24                                                                                        Chapter 12



21. Financial Statement Effects of Pension Plan Events. Using I = increases; D = decreases; NE = no
    effect, identify the current year effects of the following transactions or conditions on the various
    financial statement elements. (Note that the questions pertain to the employer’s financial statements,
    not to the pension plan’s financial statements.)

                                                                               Owners’
                                               Assets      Liabilities*        equity       Net Income

 Pension plan effect of employees              NE          I                   NE           D**
 performing current service

 Plan amendment grants retroactive             NE          NE                  NE           NE
 benefits

 Projected benefit obligation accrues          NE          I                   NE           D**
 interest at the settlement rate

 Unexpected increases in PBO due to            NE          NE                  NE           NE
 changes in actuarial assumptions

 Retiring employees are paid                   NE          NE                  NE           NE

 Contributions made to plan trustee            D           NE                  NE           NE

 Plan assets increase by expected return       NE          D                   NE           I (2)
 from investing

 Unexpected decrease in FMV of plan            NE          NE                  NE           NE
 assets due to an asset loss

 Amortization of prior service cost            NE          I                   NE           D**

 Amortization of gain                          NE          D                   NE           I**

 Amortization of transition amount             NE          D (or I)            NE           I (or D)**

 * Primarily “accrued pension cost.”
 ** This amount affects pension expense in the current period.

22.   Prior Service Cost. HopeForTheBest Corporation decides not to fund a plan amendment granting
      prior service to a current employee group. Discuss the effects of this decision on pension expense
      and the balance sheet disclosures over the next several years. Make sure to consider the direct and
      indirect effects.

      Answer. This situation illustrates a fundamental decision that must be made by employers that
      have defined benefit plans: how should pension obligations be funded over time. If the amounts
      are funded earlier, then cash is decreased in the current period but the invested funds will earn a
      return, which means that in future periods the employer’s obligation to fund pension plan costs will
      be lower. This is the choice that HopeForTheBest made. Recall that the current year’s decision
      about pension plan funding is constrained by ERISA (minimum amount) and IRS regulations
      (maximum amount). Within those constraints, the company’s cash management policies and
      alternative investment opportunities will affect the current year’s pension plan contribution.
      HopeForTheBest’s decision means that during the next few years the pension plan will be more
Special Compensation Arrangements                                                                         25



      underfunded or less overfunded than if the prior service cost had been funded in the current period.
       Thus, pension expense will be greater in subsequent periods (because of a lower return on plan
      assets) than if the prior service cost had been funded in the current period.

23.   Pension Plan Funding. You have recently been informed that stock market conditions in the
      current period have dramatically (and unexpectedly) increased the FMV of your company’s
      pension plan assets by more than 50%. Investment advisors indicate that this effect is a one-time
      effect that is not expected to reverse. Draft a memo explaining how this event will affect pension
      expense and the balance sheet disclosures over the next several periods. Make sure to consider the
      direct and indirect effects.

      Answer
      MEMO

      This year’s unexpected increase in the FMV of pension plan assets is a one-time event, and the
      increase in FMV of plan assets is expected to be permanent. Thus, the event does not change the
      future long-term expected rate of return, but the expected return on plan assets will be higher over
      the life of the plan than previously projected because of earnings on the windfall increase in assets.
       Because the one-time event increased pension plan assets, the unexpected windfall does mean that
      the company can decrease its funding over the future life of the plan by the combined amount of
      the one-time gain plus the increased earnings on the windfall assets. We should review our current
      pension plan funding schedule, cash management policies, and alternative investment opportunities
      to determine when we should schedule decreased pension plan contributions.

      Over the next few periods, the windfall gain will increase the overfunded amount or decrease the
      underfunded pension plan amount. The expected return on plan assets will increase, which will
      decrease pension expense. By increasing the FMV of pension assets, the corridor amount may
      increase (if FMV is greater than PBO), which means that it is less likely that amortization of
      deferred gains/losses will occur in future periods.

24.   Fair Value versus Intrinsic Value Method of Accounting for Stock Options. Your employer
      has decided to offer a fixed stock option plan to certain key executives. It is be necessary to decide
      whether to use the intrinsic value method or the fair value method to account for the stock options.
      Briefly describe the financial statement effects of both methods.

      Answer. The fair value method is preferred by the FASB. On the grant date, the fair value of the
      stock options is computed using an appropriate option pricing model. This approach is consistent
      with the general rule of recording transactions at their fair market values. The fair value of the
      options is allocated to the periods benefitted, with a charge to compensation expense and an
      increase in other contributed capital.

      The intrinsic value method is not the method preferred by the FASB. However, almost all
      companies use the intrinsic value method.

          If the option price on the grant date is set equal to the stock’s fair market value on the grant
          date, then the option is noncompensatory, and no compensation expense is recorded. If the
          intrinsic value method is used, the company must disclose in financial statement footnotes the
          amount of compensation expense that would have been recorded if the fair value method had
          been used.
26                                                                                           Chapter 12




          If the option price on the grant date is less than the stock’s fair market value on the grant date,
          then the option is compensatory, and compensation expense is allocated over the periods
          benefitted. Because almost all companies adopt the intrinsic value method for the primary
          purpose having the option be treated as noncompensatory (see previous paragraph),
          compensatory stock options under the intrinsic value method are virtually nonexistent.

25.   Texas Instruments. The financial statements for Texas Instruments are provided at the text Web
      site at http://baginski.swcollege.com. Review the balance sheet liabilities (both current and
      noncurrent) related to accrued retirement costs; the statement of changes in stockholder’s equity;
      the stockholder’s equity note; the stock option note; and the retirement and incentive plan note.

      a. Stock options. Does the company use the fair value or intrinsic value for stock option plans?
         What would be the pro forma 1998 net income and earnings per share effects if the fair value
         method had been used? How many shares were issued in 1998 related to the exercise of stock
         options?

      Answer. TI uses the intrinsic value method (see stock option note). If the fair value method had
      been used, net income would have declined from $407 million (income statement) to $328 million
      (note), and diluted EPS would have declined from $1.02 (income statement) to $.81 per share
      (note). The stock option note shows that during 1998, 4,076,607 shares were issued related to
      long-term incentive stock options, and 1,570,521 shares were issued related to employee stock
      option and stock purchase plans. Of these, 2,039,118 were unissued shares and 3,608,010 were
      treasury shares.

      b. Benefit plans. Did TI offer defined contribution, defined benefit plans, or both? Did TI offer
         any other post-retirement benefit plans? How much are the defined benefit plan and retiree
         health care plan over(under) funded in 1998? What was the 1998 expense associated with the
         two plans? Was TI’s 1998 actual return on pension plan assets greater or lesser than the
         expected return? What was the 1998 asset gain/loss? What was the amount of TI’s 1998
         pension plan contribution? How much was paid in benefits for the defined benefit and retiree
         health care plans?

      Answer. TI offered all three plans (retirement and incentive plan note). The defined benefit plan
      is underfunded by $176 million, and the retiree health care plan is underfunded by $352 million.
      Defined benefit expense is $44 million, and retiree health care expense is $24 million. TI’s 1998
      actual return on plan assets is $88 million, and its expected return was $38 million. Therefore, TI
      had a 1998 asset gain of $50 million. TI’s 1998 contribution to the defined benefit plan was $26
      million, and in 1998, TI paid $38 million in benefits under the defined benefit plan and $25 million
      in benefits under the retiree health care plan.
Special Compensation Arrangements                                                                       27



      26. Comprehensive Defined Benefit Pension Plan Problem. The Peters Co. sponsors a defined
          benefit pension plan for its 500 employees. The company's actuary provided the following
          information about the plan, for which SFAS No. 87 was adopted on January 1, 2001. (Note that
          the example is artificially created with a beginning PBO and FMV of plan assets on January 1,
          2001, in order to include a transition amount.) Amortize the transition amount over ten years.


                                               Peters Co.
                        Defined Benefit Pension Plan Information (in $ thousands)

                                                             January 1            December 31
                                                                  2001            2001             2002
      PBO                                                   $2,000,000     $3,850,000        $4,600,000
      ABO                                                   $1,975,000     $2,630,000        $3,100,000
      FMV plan assets                                       $1,900,000     $2,800,000        $2,300,000
      Current Settlement Rate                                      11%            11%                8%
      Long-term Expected Return on Plan Assets                     10%            10%              10%
      Service Cost                                                 N/A       $400,000          $475,000
      Liability Loss (Gain)                                          $0    $1,230,000        $(148,500)
      Pension Plan Contribution (made on 12/31)                    N/A       $500,000          $550,000
      Actual Return on Plan Assets: Positive                       N/A       $400,000      $(1,050,000)
      (Negative)
      Benefit Payments to Retirees                                   $0             $0                $0
      Average Expected Time Until Workers Retire              10 Years        10 Years         10 Years


      Required: Present the four main SFAS No. 132 pension disclosures for 2001 and 2002: (1) the
      reconciliation of PBO and FMV of plan assets, (2) the reconciliation of funded status (adjusted for
      any minimum liability), and (3) the computation of pension expense for 2001 and 2002.

      Note: These requirements are not independent--computations from part (1) are used in part (3), and
      amounts in the part (3) computations are used in part (1).
28                                                                                    Chapter 12



     Answer. (Note: Computations are provided for documentation.)

                                                 Peters Co.
                                   Pension Plan Disclosures (in thousands)
                                                                              2001                 2002

     Reconciliation of Projected Benefit Obligation
     Beginning balance, 1/1                                                  $2,000              $3,850
     Service Cost                                                              400                  475
     Interest Cost (1)                                                         220                  424
     Prior Service Cost                                                          0                    0
     Liability loss (gain)                                                    1,230               (149)
     Benefit payments                                                            0                    0
     Ending Balance, 12/31                                                   $3,850              $4,600
     (1) 2001 = $2,000 x 11% = $220; and 2002 = $3,850 x 11% =
     $424 (rounded).

     Reconciliation of Fair Market Value of Plan Assets
     Beginning balance, 1/1                                                  $1,900               2,800
     Employer contributions                                                    500                  550
     Actual return on plan assets: positive (negative) (2)                     400           (1,050)
     Benefit payments                                                            0                    0
     Ending balance, 21/31                                                   $2,800              $2,300
     (2)   Not part of required reconciliation. For completeness,
           the components of actual return on plan assets are:
     Expected return:        $1,900 x 10%                                    $ 190
                             $2,800 x 10%                                                    $      280
     Asset gain (loss)                                                         210           (1,330)
     Actual return on plan assets: positive (negative)                       $ 400          $(1,050)
Special Compensation Arrangements                                                                    29




                                          Peters Co.
       Reconciliation--Pension Plan Funded Status to Balance Sheet Amount (in thousands)

                                                                               2001           2002
 Projected benefit obligation                                              $(3,850)        $(4,600)
 Fair market value of plan assets                                             2,800           2,300
 Amount pension plan is over (under) funded                                 (1,050)         (2,300)
 Unamortized: Transition amount (1)                                                90            80
                 Prior service cost                                                 0                0
                 Unamortized loss (gain) (2)                                  1,020           2,137
 Prepaid (accrued) pension cost (3)                                          $ 60              (83)
 Additional pension liability                                                     N/A         (717)
 Minimum liability (4)                                                            N/A       $ (800)

 (1) The 1/1/01 beginning balance = $100 deferred charge ($2,000 PBO - $1,900 FMV of plan assets).
     The amount is amortized over 10 years; therefore, $10 is amortized each period.

 (2) Unamortized loss (gain): 1/1 balance                                     $     0       $1,020
 Amortization *                                                                     0          (64)
 Liability loss (gain) (see PBO reconciliation)**                             1,230           (149)
 Asset (gain) loss (see FMV of plan asset reconciliation)**                   (210)           1,330
 12/31/balance                                                               $1,020         $2,137

 *  The 2001 amortization = $0, because beginning balance = $0. The 2002 amortization = $64
    thousand, with the beginning corridor = 10% of 1/1/02 PBO, and $3,850 thousand x 10% = $385
    thousand. The excess of the unamortized loss (gain) beginning balance of $1,020 thousand - the
    $385 thousand corridor = $635 thousand, which is amortized over 10 years, therefore, yielding
    2002 amortization of $64 thousand (rounded).
 ** Note that liability gains/losses and assets gains/losses are combined.
 (3) Check: beginning balance, prepaid (accrued) pension cost                  $ 0            $ 60
 Pension expense (see computation below in next section)                      (440)           (693)
 Cash contribution                                                                500          550
 Prepaid (accrued) pension cost                                                $ 60           $(83)

 (4) Minimum liability = excess of ABO over FMV of plan assets
 2001: ABO of $2,630 thousand is less than FMV of plan assets of                  N/A
 $2,800 thousand.
 2002: ABO of $3,100 thousand is greater than FMV of plan assets of                           $800
 $2,300 thousand.
30                                                                                    Chapter 12




                                              Peters Co.
                                    Pension Expense (in thousands)
                                                                              2001                 2002

 Service Cost (given)                                                         $400                 $475
 Interest Cost (1)                                                              220                 424
 Expected Return on Plan Assets: negative (positive) (2)                      (190)            (280)
 Amortization:       unamortized transition deferred charge (3)                  10                  10
                     unamortized prior service cost                               0                   0
                     unamortized gain/loss (4)                                    0                  64
 Total Pension Expense                                                        $440                 $693
 (1) 2001 = $2,000 beginning PBO x 11% = $220; and 2002 = $3,850 beginning PBO x 11% = $424
     (rounded)
 (2) 2001 = $1,900 x 10% = $190; and 2002 = 2,800 x 10% = $280
 (3) At transition, the plan was underfunded by $100 ($2,000 PBO - $1,900 FMV of plan assets). Per
     the instructions, this amount is amortized over 10 years.
 (4) The 2001 amortization = $0, because beginning balance = $0. The 2002 amortization = $64
     thousand. The beginning corridor = 10% of PBO, or $3,850 thousand x 10% = $385 thousand.
     The excess of the unamortized loss (gain) beginning balance of $1,020 thousand - the $385
     corridor thousand = $635 thousand, which is amortized over 10 years and; yielding 2002
     amortization of $64 thousand (rounded).
Special Compensation Arrangements                                                                          31



CFA Exam-Type Problems

Answers only (see text for problems)

27.   a.    $30,600

      PBO, 1/1                                                           $25,000
      Service cost                                                          3,300
      Interest cost ($25,000 x 8% discount rate)                            2,000
      Prior service cost                                                      700
      Liability gain / loss                                                     0
      Benefit payments                                                      (400)
      PBO, 12/31                                                         $30,600

28.   c     Items (a), (b), and (d) pertain to PBO, while item (c) pertains to the FMV of plan assets.

29.   d     As the assumed rate of compensation increases, the difference between ABO and PBO
            increases: therefore, answer (d) is true and answer (a) is false. Answer (b) is incorrect
            because the discount rate is tied to current market conditions while the expected long-term
            rate of return on plan assets is based upon long-run assumptions. Answer (c) is incorrect
            because it does not make sense--benefits are related to years of service as specified in the
            plan formula. Therefore, answer (d) is correct.

30.   a     The answer to this question depends, in part, on the ability to use slightly different
            terminology from that in the text. In answer (a), the term pension benefit obligation is being
            used to mean projected benefit obligation. This interpretation is correct because PBO is the
            benefit obligation amount used to compute the over(under) funded amount in the footnote
            disclosure and on which service cost, interest cost, and prior service cost are based. Answer
            (b) is incorrect because the two rates do not affect the FMV of plans assets. The answers to
            (c) and (d) seem to be unclear. The term experience gains/losses in answer (d) refers to
            liability gains/losses. Increasing the assumed rate of compensation increases PBO in 1999
            and increases the computation of service cost in 2000, while increasing the discount rate
            decreases PBO in 1999 and decreases the computation of service cost in 2000. Because the
            increase in discount rate is greater than the increase in compensation, the discount rate effect
            swamps the compensation effect, and answers (c) and (d) are incorrect.

31.   d     Companies almost always prefer to use the intrinsic value method because the plans can be
            set up so that they are not noncompensatory and no compensation expense results.
            Therefore, answers (a) and (c) are incorrect and answer (d) is correct. Answer (b) is
            incorrect because employee stock options are not traded on listed exchanges. Rather, the fair
            value method uses appropriate option pricing models (such as the Black-Scholes model) to
            compute the fair value of options.
32                                           Chapter 12




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