MANAGEMENT DECISIONS
AND FINANCIAL
ACCOUNTING REPORTS
Baginski & Hassell
Chapter 12
SPECIAL COMPENSATION
ARRANGEMENTS
• Topics
– Compensated absences
– Pensions and other post-retirement
benefits
– Stock compensation plans
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).
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.
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.).
Nature of Pension Plans
I agree to make payments into
. retirement
a fund for future
benefits for employee
services.
Sponsor/Employer
Nature of Pension Plans
As an employee,
I agree to serve!
Participant: Any current/former employee/beneficiary for
whom the pension plan provides benefits.
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.
“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
– 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.
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 offbalance-sheet to the employer.
“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
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
“Projected Benefit Obligations”
(PBO) versus FMV of Plan Assets:
UNDERFUNDED
FMV OF PLAN
ASSETS at FYE
PRESENT VALUE
OF PROMISES
“Projected Benefit Obligations”
(PBO) versus FMV of Plan Assets:
OVERFUNDED
PRESENT VALUE
OF PROMISES
FMV OF PLAN
ASSETS at FYE
Accumulated benefit obligation (ABO)
• Based on estimates of how many employees
will actually retire
• Based on current salary levels
• Minimum liability computation is based on ABO
Vested benefit obligation (VBO), the smallest
amount computed
• Computed only for employees who have
vested
• Based on current salary levels
Vested Rights in Benefits
Rights to receive earned pension benefits are
vested when such rights are no longer
contingent on continued employment.
Reconciliation of PBO
The components of PBO are
calculated each period by actuaries:
-
Beginning balance
Service cost (currently earned by folks)
Interest cost (for any underfunding of plans)
Prior service cost (almost always an addition)
Actuarial losses (gains) related to changes in
assumptions made by actuaries
Benefit payments to employees
=
Ending Balance
+
+


The reconciliation must be disclosed in
footnotes to the financial statements.
The components of change in fair
value of plan assets are:
+

=
Beginning balance
Employer contributions
Actual positive (negative) return on plan
assets
Benefit payments to employees
Ending balance
This reconciliation must be disclosed in
footnotes to the financial statements.
Employer Accounting During
Period
• Pension expense is 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 cost
• If cumulative expense < cumulative
contributions, report as
prepaid pension cost
Pension Plan Assets
and the Trustee’s Return!
Remember me?
Trustee manages the
pension Plan Assets-which are not formally
recognized on the
Sponsor’s balance sheet.
The Trustee’s Problem!
Actual
Return
Expected
Return
A large difference would create problems!
Return on Plan Assets
FASB: The
expected return is
Actual
the factor
to use in
Return
computing
Pension Expense,
in lieu of the actual
return (which may
be only a temporary
N/C/M deviation
from expectations).
Expected
Return
Trustee’s Return on Plan Assets
Under GAAP, Pension
Expense calculations
use expected return
Actual
because the actual
return Return
is not
considered a good
indicator of the longterm return on Plan
Assets.
Expected
Return
Opening FMV of Plan Assets
× Expected L/T ROI =
Expected Return on Plan Assets
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.
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
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
The components of pension expense must be
disclosed in a financial statement note.
+
+
-
Service cost
Interest cost
Expected return on plan assets

Amortization of the following:
Unrecognized prior service cost
Unrecognized transition loss (gain)
Unrecognized loss (gain)
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
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.
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.
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.
Trustee’s Return on Plan Assets
Expected return on Plan
Assets--perActual
actuaries-should work
to
reduce
Return
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.
Expected
Return
UNCERTAIN!
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.
Required Disclosures
Reconciliation from amount plan
is over (under) funded to the
balance sheet amount!
AND ...
Fair value of plan assets at FYE
Net benefit obligation at FYE
Funded status at FYE
Unrecognized net actuarial loss
Unrecognized prior service credit
Unrecognized net transition status
Net prepaid (accrued) pension cost
CAUTION
To discourage understating of pension
liabilities, SFAS No. 87 requires recognition
of an additional minimum pension liability
under certain circumstances.
Minimum Liability
Minimum liability equals …
the excess of ABO over
FMV of plan assets.
Measurement
Accumulated Benefit Obligation (ABO)
Less: FMV of Plan Assets =
Minimum Pension Liability
This amount is also called the
underfunded ABO.
• 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)
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
Other Postretirement Employee
Benefits
• Principally health care premiums paid by
employer
• Accounting treatment parallels that of defined
benefit pensions
– A major difference is that other postretirement
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
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
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
– The intrinsic value is used by virtually all
companies
• If structured correctly, no compensation
expense is recognized
– Set option price equal to market price on
the measurement date, presumed to be
the grant date
• The FASB requires a footnote that indicates
what the effect on net income and EPS
would have been if the fair value method
had been used
Stock Appreciation Rights
• Compensation is remeasured each period
• Adjustments to SAR liability
– Excess of stock FV over pre-determined
threshold value times portion of service period
– Less previous recognitions
SAR Example
2004 2005
Market price
Less SAR threshold
Estimated compensation exp
Portion of service period
To date SAR accrual
Prior recognition
Current expense
2006
$22
(10)
12
$20
(10)
10
$16
(10)
6
1/3
$4
0
4
2/3
$7
4
3
3/3
$6
7
(1)
End of Chapter 12