Answers - Reading 9 Employee Compensation

Question #1 of 47 Question ID: 1472452 Wes Livingston is the founder and CEO of Bigwell Corporation. Livingston is interested in Bigwell being acquired by a larger competitor and wants to have his company's financial statements appear as attractive as possible to a potential suitor. In order to decrease the projected benefit obligation (PBO) of the company's pension plan, which of the following changes in actuarial assumptions could be made? A) Increase the discount rate. B) Increase the rate of compensation growth. C) Decrease the discount rate. Explanation Increasing the assumed discount rate of a pension plan will result in lower projected benefit obligation (PBO). Increasing rate of compensation growth and decreasing discount rate would increase the PBO. (Module 9.3, LOS 9.c) Jon Horton, CFA, is the Chief Financial Officer (CFO) for Springtown Corporation, a manufacturer of windows for residential and commercial applications. As part of an ongoing diversification strategy, Springtown Corp. has recently entered into a preliminary agreement to purchase all of the assets of Prime Doors, a manufacturer and distributor of doors to the same residential and commercial market in which Springtown sells its windows. Horton is head of the due diligence team that will fully evaluate Prime Doors' financial statements prior to the proposed acquisition. Prime Doors has been in operation for thirty years, and currently has approximately 800 employees at two operating facilities. Horton observes in the notes to the financial statements that Prime Doors has a defined benefit pension plan, for which all employees are eligible. Employees are vested at the rate of 20% per year of employment, and are fully vested upon completion of five years of employment. Springtown does not offer a pension plan to its employees, but encourages employees to contribute to Individual Retirement Accounts (IRAs) and offers a 401(k) program. Horton wants to fully evaluate the financial implications of Springtown's assumption of Prime Doors' pension assets and the associated future liabilities and expenses. Like most companies, the pension plan for Prime Doors' employees is not fully funded, but Horton wants to review all assumptions used by Prime Doors' accountants in the valuation of the plan's current liabilities. The most current information regarding the pension plans is as follows: Select Pension Plan Information for Prime Doors (as of 12/31/05) Projected benefit obligation (PBO) $15,500,000 Accumulated benefit obligation (ABO) $13,750,000 Market value of plan assets $11,875,000 Horton notices a paragraph in the pension plan footnotes that the original pension plan was amended last year, effectively increasing the level of benefits to be paid to employees with more than ten years of service. However, he is not able to detect what effect, if any, this change in projected benefits has had on Prime Doors' financial statements or is expected to have in the future. Horton is aware that a commonly used method can be used to adjust the income statement and provide a better measure of Prime Doors' economic pension cost than reported pension expense. He is not quite sure which components of the financial statements are utilized to derive an adjusted pension expense, but intends to investigate what analysis he can perform to gain more insight into the company's position with regards to its pension plan. Question #2 - 5 of 47 Question ID: 1472443 When accounting for pension liabilities in the U.S., a company must make fundamental assumptions to estimate the future liability and expense for each employee. How are the following assumptions required to be treated in the pension footnotes? Required Not required to disclosure be disclosed Rate of A) compensation growth Expected length of employment Expected B) Discount rate return on plan assets Rate of C) Discount rate compensation growth Explanation A company must disclose the discount rate, the expected return on plan assets, and the rate of compensation growth. The expected length of employment is not a required disclosure. (Module 9.2, LOS 9.b) Question #3 - 5 of 47 Question ID: 1472444 What effect will an increased discount rate and increased expected rate of return have on a company's projected benefit obligation (PBO) and fair value of plan assets (FVPL) as reflected in the financial statements? A) Both will decrease. B) Both will increase. C) Only one will decrease. Explanation The use of a higher discount rate will decrease a company's PBO. The expected rate of return has no impact on pension obligations or the fair value of plan assets. (Module 9.2, LOS 9.b) Question #4 - 5 of 47 Question ID: 1472445 Prime Doors has recorded a net pension liability of $1.5 million on its balance sheet. According to current U.S. accounting standards, Prime Doors is required to: A) record $375,000 as additional pension expense on its balance sheet. B) immediately recognize $2,125,000 as additional pension expense in its income statement. C) record $2,125,000 as additional pension liability on its balance sheet. Explanation According to current U.S. accounting standards, the funded status must be reported on the balance sheet. The plan is underfunded by $3,625,000 ($11,875,000 Plan assets − $15,500,000 PBO). Since Prime Doors is reporting a liability of $1,500,000, an additional liability of $2,125,000 ($3,625,000 required liability − $1,500,000 reported liability) must be reported. (Module 9.2, LOS 9.b) Question #5 - 5 of 47 Question ID: 1472446 Which of the following statements regarding the treatment of pension plan amendments under U.S. GAAP standards is most accurate? A plan amendment results in: A) B) C) an unrecognized prior service cost that is amortized over the expected remaining service life of the affected employees. the disclosure in the pension plan footnotes of the nature of the amendment and the projected future financial impact. an immediate increase in pension expense equal to the amount of the amendment. Explanation The amendment affects the funded status on the balance sheet immediately. In the income statement, the amendment is amortized as a component of pension expense over the remaining service life of the affected employees. (Module 9.2, LOS 9.b) Question #6 of 47 Question ID: 1472439 The actuarial present value of all future pension benefits earned to date, based on expected future salary increases, is called the: A) pension liability. B) total projected pension cost. C) projected benefit obligation (PBO). Explanation The PBO is the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases. It measures the value of the obligation, assuming the firm is a going concern and that the employees will continue to work for the firm until they retire. Pension cost is periodic and not total projected. Pension liability is the net amount of PBO and fair value of plan assets. (Module 9.2, LOS 9.b) Question #7 of 47 Question ID: 1472436 The financial statements of Pace Industries issued over the past five years show a progressively increasing net difference between the value of its pension fund and the projected future pension liability on the balance sheet. Pace most likely offers which of the following types of pension plans to its employees? A) A 401(k) plan. B) A defined benefit plan. C) A defined contribution plan. Explanation A company with a defined benefit plan will fund a portfolio structured to fulfill future pension obligations. The difference between the current value of the assets and the projected future liability is shown as a net amount on the balance sheet. (Module 9.1, LOS 9.a) Question #8 of 47 Question ID: 1472477 Which of the following is NOT an advantage of share based compensation over cash compensation? A) B) Share based compensation serves to align employee interest with the interests of stockholders. In a share based compensation plan, expense is not recognized, unless the exercise price is set below the market price. C) Share based compensation does not require a cash outlay. Explanation Share based compensation needs to be recognized at fair value under both U.S. GAAP and IFRS. Intrinsic value does not matter. However, the expense does not require a cash outlay and serves to align the interests of employees and stockholders. (Module 9.7, LOS 9.g) Question #9 of 47 Question ID: 1472465 Roberto Perez, CFA, is the Chief Financial Officer for Home Stores, Inc., a large home improvement retailer with stores located across the United States. Home Stores is preparing for a secondary stock offering to secure the necessary capital to pursue an aggressive expansion campaign. Perez has received a directive from his boss to make every legitimate effort to present Home Stores' upcoming financial statements in the best possible light. Perez determines that certain assumptions in the pension plan can be changed to fulfill this request. Which of the following pension plan assumptions can be changed by a firm to manipulate its reported results? Change Result decreased rate A) of decreased compensation service cost growth increased B) expected rate of return C) decreased discount rate decreased service cost increased expected return Explanation The rate of compensation growth is the expected average annual increase in employee compensation. If the rate of growth is lowered, reported results will be improved due to a decrease in service cost. A decrease in service cost will result in lower pension expense. (Module 9.5, LOS 9.d) Question #10 of 47 Q estion ID: 1472468 Question #10 of 47 Question ID: 1472468 Which of the following statements regarding pension accounting under U.S. GAAP standards and/or under International Financial Reporting Standards (IFRS) is most accurate? A) B) Under U.S. GAAP, firms are required to provide a reconciliation of the funded status and the reported net pension asset or liability. Under IFRS, the funded status (difference in the PBO and the plan assets) is reported on the balance sheet. C) Under IFRS and U.S. GAAP, the calculation of pension expense is the same. Explanation The calculation of reported pension expense differs between U.S. GAAP and IFRS. Under U.S. GAAP and under IFRS, the net pension asset or liability reported on the balance sheet is equal to the funded status, without adjustment for unrecognized items. Since balance sheet asset/liability under U.S. GAAP and IFRS reflects funded status, no reconciliation is necessary in the footnotes. (Module 9.6, LOS 9.e) Question #11 of 47 Question ID: 1472453 Wonderful Manufacturing has implemented a change in its pension plan, that will increase the future benefits for all of its current employees. Which of the following is the most likely effect on the company's financial statements of this change in promised benefits under current U.S. GAAP standards? A) B) C) The net pension liability will increase immediately by the projected increase in pension benefits due to employees. The firm’s prior financial statements will be adjusted to reflect the increase in benefits. The pension expense for the next reporting period will increase by the projected increase in pension benefits due to employees. Explanation A plan amendment will result in an immediate increase in the PBO. Under current U.S. accounting standards, an increase in PBO will result in an increase in the net pension liability (decrease in funded status). (Module 9.3, LOS 9.c) Question #12 of 47 Question ID: 1472476 The following information relates to Nazarali Inc. (Nazarali) and its defined-benefit pension plan for the year: Contributions $3.0 million Reported pension expense $2.8 million Total periodic pension cost $3.1 million Based on the information above, which of the following statements is most accurate? A) There is a reduction in the overall pension obligation of $200,000. B) There is a reduction in the overall pension obligation of $100,000. C) There is a source of borrowing of $100,000. Explanation The total periodic pension cost represents the true cost of the pension. The reported pension expense is irrelevant in this case. Since the true pension expense ($3.1 million) exceeds the contributions ($3.0 million), the $100,000 difference can be viewed as a source of borrowing. Alternatively, if the firm's contributions exceed the true pension expense, the difference can be viewed as a reduction in the overall pension obligation, similar to an excess principal payment on a loan. (Module 9.6, LOS 9.f) Question #13 of 47 Question ID: 1472467 Peak Productions is a publicly traded company that manufactures consumer electronics products in the U.S. The company has been in operation nearly fifty years, and has a considerable pension plan liability on its financial statements. Peak has a well-deserved reputation among analysts of utilizing aggressive accounting practices with regard to its pension plan. Which of the treatments of the following actuarial assumptions is the best example of aggressive accounting for a pension plan? A) A high compensation growth rate. B) A high calculated projected benefit obligation (PBO). C) A high discount rate. Explanation The assumption of a high discount rate will result in a lower pension liability and almost always a lower pension expense. The more aggressive the actuarial assumptions for a pension plan are, the lower the quality of earnings for the firm. (Module 9.5, LOS 9.d) Question #14 of 47 Question ID: 1472463 In order to decrease the projected benefit obligation (PBO) of a pension plan, which of the following changes in pension assumptions can be made to yield the desired result? A) Decrease the rate of compensation growth. B) Decrease the discount rate. C) Increase the expected rate of return. Explanation A decrease in the rate of compensation growth will lower future pension payments and in turn, lower the PBO. (Module 9.5, LOS 9.d) Question #15 of 47 Question ID: 1472458 Under U.S. GAAP, capitalized periodic pension costs included in the value of ending inventory is most likely: A) not allowed. B) to be expensed as part of cost of goods sold when the inventory is sold. C) to be amortized over the service lives of employees. Explanation Pension costs included in the cost of production of goods (e.g., labor costs included in the value of work-in-process or finished goods) may be capitalized as part of valuation of ending inventory. When this inventory is eventually sold, such costs are expensed as a component of cost of goods sold. (Module 9.4, LOS 9.c) Question #16 of 47 Question ID: 1472462 Tim Gresham, CFO of Alpha Logistics is concerned about changes in the business environment which could lead to Alpha violating some of the covenants of their outstanding debentures. Specifically Gresham is concerned about leverage and profitability ratios. Gresham reviews Alpha's most recent financial statements and decides that changing the assumptions for the company's defined benefit pension plan may provide some relief in the short-run. Alpha reports under U.S. GAAP. Which of the following changes in the pension plan's assumptions would most likely lead to lower reported leverage and higher reported profitability? A) Increasing expected return on plan assets. B) Increasing the growth rate in compensation expense. C) Increasing the discount rate. Explanation Increasing discount rate leads to lower present values and reduces reported pension liability in the balance sheet and also reduces pension expense by reducing the service cost component. Increasing expected return on plan assets does reduce pension expense but does not affect reported assets or liabilities. Increasing the growth rate in compensation expense increases service cost as well as reported pension liability. (Module 9.5, LOS 9.d) Question #17 of 47 Question ID: 1472466 Which of the following measures is least sensitive to changes in pension plan actuarial assumptions? A) Projected benefit obligation (PBO). B) Total periodic pension cost. C) Balance sheet asset or liability. Explanation Total periodic pension cost is a net (smaller) amount and therefore, is generally quite sensitive to relatively minor changes in actuarial assumptions. Changing an assumption may have a small effect on the projected benefit obligation (PBO) but may have a much larger effect on the funded status (which is a net pension amount) which is the balance sheet asset or liability. (Module 9.5, LOS 9.d) Question #18 of 47 Question ID: 1472480 Which of the following statements about the methods of valuing employee stock options is least accurate? A) B) C) With either method, the offset to compensation expense recognized is an increase in paid-in capital. Once the options are in-the-money, compensation expense is recognized on the income statement. With the fair value method, compensation expense is allocated in the income statement for the period between the grant date and the vesting date. Explanation Compensation expense is based on the fair value of the option on the grant date based on the number of options that are expected to vest. The vesting date is the first date the employee can actually exercise the option. The compensation is allocated in the income statement over the service period (which is the time between the grant date and the vesting date). For any compensation expense recognized, the offset is an expense in paid-in capital, which is a stockholders' equity account. (Module 9.7, LOS 9.h) Jason Moore, CFA, is a credit analyst for Everest Bank in New York in the firm's investment banking division. An existing customer of Everest, Longhorn Partners, which is based in Texas, has approached the bank for a $45 million loan to be used to acquire a smaller competitor. Moore has been appointed head of the credit team that will review Longhorn's current business with Everest as well as Longhorn's current operations, in order to assess Longhorn's request. Overall, Longhorn has achieved consistent profitability over the last decade. The company is appropriately leveraged and appears to be well-run by its senior management team. However, there are a couple of items in the company's financial statements that Moore believes may warrant further analysis. He specifically wants to adjust Longhorn's reported operating profit for comparative analysis with other companies who may not report their entire pension expense as an operating expense. For many years, Longhorn has offered to its fulltime employees a traditional defined-benefit pension plan: eligible employees are promised an annual pension payment of 3% per year of service times their annual salary at retirement. Selected information regarding the pension plan from Longhorn's most recent financial statement is as follows: Pension Benefit Obligation (PBO) (ending) $85,475,000 Accumulated Benefit Obligation (ABO) (ending) 65,250,000 Fair value of plan assets (ending) 71,365,000 Fair value of plan assets (beginning) 66,360,000 Operating income 17,185,000 Interest expense 1,285,000 Pension Expense 5,456,000 Contributions 7,200,000 Service cost 4,114,000 Interest cost 5,342,000 Discount rate 6.25% Additionally, Longhorn has a share-based compensation plan for its senior executives. Question #19 - 22 of 47 Question ID: 1472448 The balance sheet asset/liability related to Longhorn's pension plan is closest to: A) a liability of $14,110,000. B) an asset of $6,115,000. C) a liability of $6,115,000. Explanation Pension plans are underfunded when the PBO exceeds the fair market value of the plan assets. In this case, the PBO exceeds the plan assets by $14,110,000 (= $85,475,000 − 71,365,000) and hence a liability will be reported. (Module 9.2, LOS 9.b) Question #20 - 22 of 47 Question ID: 1472449 Moore reads in the footnotes to Longhorn's financial statements that the pension plan's PBO increased by $5,000,000 last year. Of this amount, approximately 50% was attributed to benefits earned by its employees that year. The remaining 50% was attributed to a change in the pension plan's actuarial assumptions. Which of the following changes to actuarial assumptions is most likely to cause an increase in PBO? A decrease in the: A) rate of compensation growth. B) discount rate. C) expected rate of return. Explanation Decreasing the assumed discount rate used to calculate the present value of the pension obligations will increase the PBO. (Module 9.2, LOS 9.b) Question #21 - 22 of 47 Question ID: 1472450 Longhorn's adjusted operating profit is closest to: A) $14,110,000. B) $18,527,000. C) $15,843,000. Explanation Adjusted operating profit is computed as reported operating profit + reported pension expense − service cost. =17,185,000 + 5,456,000 − 4,114,000 = $18,527,000 (Module 9.2, LOS 9.b) Question #22 - 22 of 47 Question ID: 1472451 Assume for this question only that the actual return on plan assets was $981,200 higher than the expected return of $5,308,800. The amount of benefits paid to plan participants was closest to: A) $5,192,000. B) $8,485,000. C) $1,285,000. Explanation Actual return on plan assets = 5,308,800 + 981,200 = $6,290,000 Beginning Plan assets (given) 66,360,000 (+) Contributions (given) 7,200,000 (+) Actual return on plan assets (computed) 6,290,000 (−) Benefits paid (plug) 8,485,000 (=) End Plan Assets (given) 71,365,000 (Module 9.2, LOS 9.b) Question #23 of 47 Question ID: 1472464 The Board of Directors of Prime Bank has asked management to make changes in the accounting of its pension plan obligations in order to decrease the reported service cost. Management determines that there are two changes in actuarial assumptions that will result in a lower service cost. Which of the following pairs of changes in actuarial assumptions will best achieve the desired effect? Prime Bank can either: A) increase the discount rate or decrease the rate of compensation growth. B) decrease the rate of compensation growth or increase the expected rate of return. C) decrease the discount rate or increase the expected rate of return. Explanation An increase in the discount rate will result in lower service cost. Using a lower rate of compensation growth will yield lower future pension benefits owed, and thus a lower service cost. The expected return has no impact on service cost. (Module 9.5, LOS 9.d) Question #24 of 47 Question ID: 1472456 Which of the following statements regarding total periodic pension cost is least accurate? A) It is equal to the sum of all the changes in projected benefit obligation (PBO) for the period (except for benefits paid) minus the actual return on assets. B) It is equal to the change in the funded status for the period. C) It is a more volatile measure of pension expense than reported pension expense. Explanation Total periodic pension cost (the true or economic pension expense) is equal to the change in the funded status for the period excluding the firm's contributions. Total periodic pension cost is calculated by eliminating the smoothed amounts from reported pension expense and including the actual return on assets. The result is a more volatile measure of pension expense. (Module 9.3, LOS 9.c) Question #25 of 47 Question ID: 1472475 Consider a situation at a firm where the differences in its cash flow and economic pension expense are considered material to the financial statements. The relevant tax rate is 30%. The expected return on plan assets is $120,000, interest cost is $85,000, employer's contribution is $215,000, service cost is $450,000, and the actual return on plan assets is $50,000. Based on the information provided and for analytical purposes only, which of the following statements is most appropriate? A) B) C) There is a reclassification of $189,000 from operating cash flow to financing cash flow. There is a reclassification of $140,000 from operating cash flow to financing cash flow. There is a reclassification of $270,000 from operating cash flow to financing cash flow. Explanation The total periodic pension cost = service cost + interest cost − actual return on plan assets = $450,000 + $85,000 − $50,000 = $485,000. Since the differences in cash flow and economic pension expense are considered material, for analysis purposes we should consider reclassifying the difference from operating activities to financing activities in the cash flow statement. The employer's contribution was only $215,000. Since the total periodic pension cost exceeds the cash flow, the difference, net of tax, is treated as a borrowing in the cash flow statement for analytical purposes. Given a tax rate of 30%, $189,000 is reclassified from operating cash flow to financing cash flow [($485,000 total periodic pension cost − $215,000 employer contribution) ((1 − 30% tax rate)]. (Module 9.6, LOS 9.f) Question #26 of 47 Question ID: 1472438 The projected benefit obligation (PBO) is defined as the: A) actuarial future value of all post-retirement healthcare benefits earned to date. B) C) actuarial present value of all future pension benefits earned to date based on expected future salary increases. actuarial present value of all future pension benefits earned to date and based on current salary levels. Explanation The projected benefit obligation (PBO) is defined as the actuarial present value of all future pension benefits earned to date based on expected future salary increases. (Module 9.2, LOS 9.b) Question #27 of 47 Question ID: 1472478 Which of the following statements about stock-based compensation are correct or incorrect? Statement #1: Statement #2: The grant date of a service-based award is the date when the employees' benefits are fully vested. When two or more performance conditions must be satisfied, the requisite service period ends when the first condition is met. A) Both are incorrect. B) Both are correct. C) Only one is correct. Explanation The grant date is the date an award is approved by the board of directors or compensation committee. When two or more performance conditions must be satisfied, the requisite service period does not end until all conditions are met. (Module 9.7, LOS 9.g) Question #28 of 47 Question ID: 1472481 Which of the following statements about stock appreciation rights, performance stock, and phantom stock is most accurate? A) Performance stock cannot be sold by the employee until vesting has occurred. B) C) Stock appreciation rights never have any dilution effect on the existing shareholders. Phantom stock payoffs are based on the performance of the firm’s actual shares. Explanation Stock appreciation rights do not cause dilution to the existing shareholders since no shares are actually issued. Performance stock is a type of stock grant. It is contingent on meeting performance goals such as accounting earnings or other financial reporting metrics like return on assets or return on equity. Unfortunately, tying performance to accounting earnings and other metrics may result in manipulation by the employee. With restricted stock, the transferred stock cannot be sold by the employee until vesting has occurred. Phantom stock is similar to stock appreciation rights except the payoff is based on the performance of hypothetical stock instead of the firm's actual shares. (Module 9.7, LOS 9.h) Question #29 of 47 Question ID: 1472461 An analyst views the assumptions made by a company reporting under U.S. GAAP regarding its pension liabilities as unrealistic, and thinks the discount rate and expected rate of return should both be increased. The most likely effect of increasing the discount rate and expected rate of return on the pension benefit obligation (PBO) is: Discount rate Expected rate of return A) No effect Decrease B) Decrease No effect C) Increase Decrease Explanation The PBO will decrease because a higher discount rate will cause the present value of the future obligations to decline. There will be no effect from changing the expected rate of return because expected return relates to the pension expense, not to the size of the obligation. (Module 9.5, LOS 9.d) Question #30 of 47 Question ID: 1472479 In determining the fair value of employee stock options, which of the following statements is most appropriate? A) A higher than expected dividend yield will decrease the estimated fair value. B) Absent a market-based instrument, U.S. GAAP and IFRS prefer firms to use the Black-Scholes option-pricing model. C) A lower risk-free rate will usually increase the estimated fair value. Explanation Dividends paid out reduce the value of the underlying shares and therefore, reduce the value of the option. There is no preference of a specific option-pricing model in either IFRS or U.S. GAAP. Acceptable models include the Black-Scholes model or the binomial model. A lower risk-free rate will usually decrease the estimated fair value of the option (refer to the Study Session on derivatives). The sensitivity factor is "Rho" and for call options, there is a positive relationship between the risk-free rate and the estimated fair value of the option. (Module 9.7, LOS 9.h) Question #31 of 47 Question ID: 1472455 Federal Companies reported the following information in the footnotes to its most recent financial statements: Beginning Projected Benefit Obligation (PBO) $65,000,000 Ending PBO 90,000,000 Service Cost 27,000,000 Interest Cost 3,000,000 Benefits Paid 5,000,000 Actual Return on Plan Assets 7,500,000 Expected Return on Plan Assets 8,500,000 Given the information above, calculate Federal's total periodic pension cost for the year. A) $41,000,000.00 B) $22,500,000.00 C) $27,500,000.00 Explanation Total periodic pension cost = service cost + interest cost – actual return on plan assets + plan amendments Therefore, $27,000,000 + 3,000,000 – 7,500,000 = $22,500,000 There are no other actuarial assumptions affecting PBO as evidenced by reconciliation of PBO: Beginning PBO 65 (+) Service cost 27 (+) Interest cost 3 (-) Benefits paid (5) (=) Ending PBO 90 (Module 9.3, LOS 9.c) Paul Roberts, CPA, is a partner in Roberts & Smith, an accounting firm that is located in Chicago. The firm has recently been retained by Midwest Manufacturing, a major producer of heavy machinery and tractor parts in the U.S. Midwest has been in operation since 1965, and currently has approximately 700 full-time employees. The company had its initial public offering in 1986. The company has hired Roberts's firm to ensure that the accounting for Midwest's employee pension plan is fully in compliance U.S. GAAP standards. Selected year-end pension plan information for Midwest Manufacturing 2006 2007 PBO $21 million $23 million Discount Rate 6.0% 7.5% Rate of Compensation Increase 4.0% 4.0% Benefits paid $0.8m $1m Interest cost $1.6m Service cost $3m Roberts will educate Midwest's accounting department on pension plan accounting that would be relevant to their situation. Question #32 - 35 of 47 Question ID: 1472471 As of January 1st, 2007, the fair value of plan assets was $19 million. Which three components are necessary to calculate the fair value of the plan assets at the end of the year? A) actual return on assets, employer contributions, and benefits paid. B) service cost, interest cost, and benefits paid. C) expected return on plan assets, employer and participant contributions, and benefits paid. Explanation Companies are required to disclose a reconciliation of the beginning and ending balances of the fair value of plan assets, which can be calculated as follows: Fair value of plan assets at the beginning of the year + Actual return on assets + Employer contributions − Benefits paid = Fair value of plan assets at the end of the year (Module 9.6, LOS 9.e) Question #33 - 35 of 47 Question ID: 1472472 Current U.S. GAAP pension accounting standards require public companies to report which of the following in the balance sheet? A) The expected return on plan assets. B) The pension liability adjusted for unrecognized items. C) The funded status of the plan. Explanation The current standard requires companies to report the funded status of the plan, which is the difference between the PBO and the fair value of plan assets. (Module 9.6, LOS 9.e) Question #34 - 35 of 47 Question ID: 1472473 As of December 31st, 2007, the fair value of plan assets was $21 million. For this question only, assume that the sum of the unrecognized prior service cost and the unrecognized actuarial losses equals $1.5 million. Calculate the amount attributable to Midwest's pension plan as of December 31st, 2007 that must be reported on the balance sheet under U.S. GAAP. A) $2.0 million. B) −$2.0 million. C) −$500,000. Explanation The funded status is the difference between the PBO and the fair value of plan assets as of the reporting date. For Midwest's plan, $21,000,000 − 23,000,000 = −$2,000,000. PBO figure is already given – and it includes all unrecognized items (and hence need not be adjusted). (Module 9.6, LOS 9.e) Question #35 - 35 of 47 Question ID: 1472474 Which of the following statements regarding the U.S. GAAP pension accounting standards is most accurate? The balance sheet will now reflect the true economic position of the pension A) plan, but the income statement will not necessarily reflect a true measure of economic pension expense. B) C) For most companies, the pension liability will increase while financial leverage may increase or decrease as a result of applying the standard. The changes in GAAP now cause U.S. standards to be consistent with the International Financial Reporting Standards (IFRS) for pension plans. Explanation Because deferred and unrecognized items are required to be reported on the balance sheet but not the income statement, the balance sheet will reflect the true economic position of the pension plan, but the income statement will not necessarily reflect a true measure of economic pension expense. U.S. GAAP and IFRS still differ with respect to reporting pension expense. (Module 9.6, LOS 9.e) Question #36 of 47 Question ID: 1472469 Under current U.S. GAAP, the assets and liabilities of a defined benefit pension plan are: A) B) netted against each other, and only the net asset or liability amount is reported on the company’s balance sheet. reported in the appropriate section of the balance sheet, with pension obligations shown under liabilities and plan assets shown under assets. C) off balance sheet items which are shown only in the footnotes. Explanation Under current U.S. GAAP, companies are required to report only the net asset or liability amount. They cannot show assets and liabilities separately. Although some smoothing details are still disclosed in the footnotes, all major components of pension assets and liabilities are now required to be shown on the balance sheet. (Module 9.6, LOS 9.e) Question #37 of 47 Question ID: 1472440 Which of the following statements regarding the projected benefit obligation (PBO) and the value of the pension plan assets is most accurate? A) B) C) If the PBO and the plan assets are the same, then nothing needs to be reported on the balance sheet. The fair value of plan assets is increased by the amount of the expected return on assets. Plan amendments during the year generally result in a decrease of the PBO at the end of the year. Explanation Neither the PBO nor the plan assets are separately reported on the balance sheet. The funded status is the difference in the PBO and the plan assets. If the PBO exceeds the plan assets, the difference is reported as a liability. If the plan assets exceed the PBO, the difference is reported as an asset. If the amounts are the same, then neither a liability nor asset needs to be reported. Plan amendments (i.e. additional benefits provided that increase the amount of the employer's obligation to plan participants) generally result in an increase of the PBO. The fair value of plan assets at the beginning of the period is increased by the actual return on plan assets as well as any employer contributions. It is reduced by the amount of benefits paid. (Module 9.2, LOS 9.b) Question #38 of 47 Question ID: 1472460 Fly-By-Night Airlines is a U.S. company planning to change its pension plan so that it can reduce its costs. It is considering reducing its defined benefit percentage from 10% to 5% of ending salary, retroactive for 10 years. In addition, since the firm is anticipating substantially reduced salary increases in the future, it is planning to reduce its compensation growth rate assumption. From a pension accounting perspective, the change in the: A) B) C) Benefit percentage is a change in actuarial assumption that will be recognized in full in current period pension expense. Compensation growth rate assumption is a change in actuarial assumption that will reduce the defined benefit obligation and future pension expense. Benefit percentage is a past service cost that will be amortized into and thus increase pension expense over the remaining service lives of its employees. Explanation The change in the compensation growth rate assumption is a change in actuarial assumption that will reduce the defined benefit obligation and future pension expense, as the effect is amortized into pension expense over time. In this question, the change is a reduction in both the defined benefit obligation and pension expense. The change in the contribution percentage is not a change in actuarial assumption but a plan amendment (which would be reflected as negative past service cost and either amortized under US GAAP or recognized in full under IFRS). Amortization of negative past service cost (applicable only under US GAAP) would decrease, not increase, pension expense over the remaining service lives of its employees. (Module 9.5, LOS 9.d) Jason Johnson, CFA, is a principal of a large private equity firm in New York. One of the associates in his firm has identified a potential investment opportunity for the firm: Gasline, Inc. is a major producer of carbon steel pipe used in the transportation of natural gas in the Southwestern United States. Of particular concern to Johnson is Gasline's numerous, complicated transactions related to the company's various stock-based compensation plans and its defined benefit pension plan. For example, the CEO of Gasline was awarded a stock option package at the beginning of 2013. Question #39 - 42 of 47 Question ID: 1472483 For the valuation of the CEO's stock options granted on January 1, 2013, Gasline estimated a fair value of $100,000 by using Monte Carlo simulation. In accordance with SFAS No. 123(R), which of the following statements is most accurate? Gasline's accounting treatment of the options is: A) B) C) in compliance because the firm can elect to use either the intrinsic value model or the fair value model in the valuation of stock option plans. in compliance because a Monte Carlo simulation is an acceptable method of valuing options in the absence of a market-based instrument. not in compliance because the fair value must be established by using the Black-Scholes option pricing model. Explanation Under SFAS No. 123(R), firms are required to use the fair value method of valuing stock option plans. In the absence of a market-based instrument, firms may select and use an option-pricing model such as the Black-Scholes, the binomial model or Monte Carlo. (Module 9.7, LOS 9.h) Question #40 - 42 of 47 Question ID: 1472484 If management increases the assumed discount rate, the least likely effect is that the: A) plan assets will increase. B) funded status will improve. C) pension expense reported in P&L will decrease. Explanation Increasing the discount rate would reduce PBO and not change the plan assets, improving the funded status. Reported pension expense would also decrease in most cases. (Module 9.7, LOS 9.h) Question #41 - 42 of 47 Question ID: 1472485 Regarding Gasline's defined benefit pension plan: if management increases the expected return on plan assets, the most likely effect is that the: A) total periodic pension cost would decrease. B) pension expense reported in P&L would decrease. C) funded status would improve. Explanation Increasing the expected return on plan assets would not affect PBO or plan assets and hence would not affect the funded status. It would however reduce reported pension expense. Total periodic pension cost is based on actual return on plan assets and hence would not be affected. (Module 9.7, LOS 9.h) Question #42 - 42 of 47 Question ID: 1472486 For this question only, assume that Gasline reports under IFRS. If changes in actuarial assumptions affecting the PBO lead to an actuarial gain, the most likely effect is that the: A) pension expense reported in P&L would decrease. B) total periodic pension cost would decrease. C) plan assets would increase. Explanation Changes in actuarial assumptions do not affect plan assets. The funded status would change only due to changes in PBO due to change in actuarial assumptions. Total periodic pension cost would decrease due to actuarial gains. Actuarial gains would be considered remeasurement gains and would be reflected OCI (and not income statement). Under US GAAP if the gains meet the requirements of amortization under corridor approach, the future reported pension expense would be lower. (Module 9.7, LOS 9.h) Question #43 of 47 Question ID: 1472454 Financial analysts can use select data from a company's financial statements to derive total periodic pension cost in order to better reflect the company's true economic pension cost. Which of the following formulas will most accurately calculate a company's true pension expense? A) Service cost + interest cost + plan amendments – actual return on plan assets. B) Beginning fair value of plan assets + service cost + interest cost – ending fair value of plan assets. C) Service cost + interest cost – actual return on plan assets – benefits paid. Explanation The total periodic pension cost, (absent any information on changes in actuarial assumptions) is calculated without reflecting the amortization of unrecognized items and other smoothing mechanisms included in reported pension expense, and in addition uses the plan's actual return on assets, rather than the plan's expected return. (Module 9.3, LOS 9.c) Question #44 of 47 Question ID: 1472459 A company reporting under U.S. GAAP reduced the discount rate for its pension obligation from 10% to 8%, reduced the expected long-term rate of return on the assets in its pension plan from 8% to 6%, and changed its compensation growth rate assumption from 4% to 5%. What is the most likely impact of these changes on the current year ending defined benefit obligation and pension expense? A) B) C) The reduction in the discount rate will decrease the defined benefit obligation and will increase reported pension expense. The decrease in the long-term rate of return will have no impact on the defined benefit obligation and will increase reported pension expense. The decrease in the long-term rate of return on plan assets will decrease reported pension expense. Explanation The decrease in the expected long-term rate of return on plan assets from 8% to 6% will have no effect on the defined benefit obligation (after all, it is an obligation and not an asset). The reduction will, however, increase reported pension expense for current and future periods because the expected return is subtracted while computing pension expense. The reduction in the discount rate from 10% to 8% will increase (not decrease) the defined benefit obligation and will also increase reported pension expense because it will increase the current service cost. Additionally, the actuarial gains and losses resulting from this change (the difference between the defined benefit obligation after the increase and the defined benefit obligation before the increase) will be amortized into pension expense over time using the corridor approach. Amortization will start in the period after the change is made. The decrease in the expected long-term rate of return on its plan assets from 8% to 6% will increase, not decrease, reported pension expense. Expected return reduces pension expense. (Module 9.5, LOS 9.d) Question #45 of 47 Question ID: 1472457 Total Periodic Pension Cost (TPPC) is most likely to: A) be reported on the income statement. B) be computed the same under IFRS and US GAAP. C) take into account expected return on plan assets. Explanation TPPC is the true (i.e., economic) cost of the pension plan; it does not change depending on the accounting system chosen. TPPC uses actual return on plan assets: it is not impacted by our expectations. TPPC is not reported in the income statement. (Module 9.4, LOS 9.c) Question #46 of 47 Question ID: 1472437 When considering the major differences between a defined contribution and a defined benefit pension plan, which of the following statements is most accurate? Among the different types of pension plans, accounting for a pay-related A) defined benefit plan is the most complicated because of the required actuarial assumptions. A company with a defined contribution plan will report on its balance sheet the B) net difference between the value of the pension fund assets and the value of the pension liability. C) Accounting for a defined contribution pension plan is the most complicated because of the many investment options available to the employees. Explanation Three actuarial assumptions (discount rate, expected increase in employee compensation and the expected return on plan assets) must be estimated to project the value of the corporation's pension liability today. Subtle changes to any of the three assumptions can drastically change the estimated liability. (Module 9.1, LOS 9.a) Question #47 of 47 Question ID: 1472441 Which of the following statements regarding pension accounting is most accurate? A) B) C) Changes in the projected benefit obligation (PBO) and plan assets fully and immediately affect the balance sheet. Changes in actuarial assumptions and past service costs fully and immediately affect the income statement. A reconciliation between the funded status and the net pension asset (liability) reported on the balance is required. Explanation Changes in the projected benefit obligation (PBO) and plan assets immediately affect the funded status (difference in PBO and plan assets) and the full amount of the changes is reflected on the balance sheet when the change occurs. Changes in actuarial assumptions and past service costs are recognized in the income statement over time thereby smoothing pension expense. Since the funded status is equal to the net pension asset (liability) reported on the balance sheet under no reconciliation is required. (Module 9.2, LOS 9.b)