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 Sponsor/Employer. I agree to make payments into a fund for future retirement benefits for employee services.
Nature of Pension Plans Participant: Any current/former employee/beneficiary for whom the pension plan provides benefits. As an employee, I agree to serve!
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.
Employer is committed to specified retirement benefits. Retirement benefits are based on a formula = f (compensation, years of service, age, etc.). Retirement benefits are based on a formula = f (compensation, years of service, age, etc.). Employer bears all risk of pension fund performance. “Defined Benefit” Plans 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 off- balance-sheet to the employer.
“Defined Benefit” Plans Actuaries: Professional statisticians that work for insurance companies, etc., to estimate benefits and odds Actuaries deal with the Present Value of the annuities of benefits expected to be paid to participants at some future times.
Year-End Liability –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 Complex computations made by actuaries. Three different measures: PBO, ABO, VBO
“Projected Benefit Obligations” (PBO) versus FMV of Plan Assets: UNDERFUNDED PRESENT VALUE OF PROMISES FMV OF PLAN ASSETS at FYE
“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.
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! Trustee manages the pension Plan Assets-- which are not formally recognized on the Sponsor’s balance sheet. Remember me?
Actual Return Expected Return The Trustee’s Problem! A large difference would create problems!
Return on Plan Assets Actual Return Expected Return FASB: The expected return is the factor to use in computing Pension Expense, in lieu of the actual return (which may be only a temporary N/C/M deviation from expectations).
Trustee’s Return on Plan Assets Actual Return Expected Return Under GAAP, Pension Expense calculations use expected return because the actual return is not considered a good indicator of the long- term return on Plan Assets. 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
+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 components of pension expense must be disclosed in a financial statement note.
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 Actual Return Expected Return Expected return on Plan Assets--per actuaries-- should work to reduce the the amount of funds that the Employer would need to transfer to the Trustee in the quest to meet the PBO as the payments become due. UNCERTAIN!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 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 200420052006 Market price Less SAR threshold Estimated compensation exp $22 (10) 12 $20 (10) 10 $16 (10) 6 Portion of service period To date SAR accrual 1/3 $4 2/3 $7 3/3 $6 Prior recognition Current expense 0 4 3 7 (1)