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Chapter 18

Chapter 18. Employee Benefit Plans. Encompass all types of retiree health and welfare benefits including . . . Medical coverage, Dental coverage, Life insurance, Group legal services, and Other benefits. Postretirement Benefit Plan. Pension Plan Benefits

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Chapter 18

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  1. Chapter 18 Employee Benefit Plans

  2. Encompass all types of retiree health and welfare benefits including . . . Medical coverage, Dental coverage, Life insurance, Group legal services, and Other benefits. Postretirement Benefit Plan

  3. Pension Plan Benefits Usually based on years of service. Identical payments for same years of service. Cost of plan usually paid by employer. Vesting usually required. Postretirement Health Benefits Typically unrelated to service. Payments vary depending on medical needs. Company and retiree share the costs. True vesting does not exist. Postretirement Health Benefits and Pension Benefits Compared

  4. The Net Cost of Benefits Estimated medical costs in each year of retirement Retiree share of cost Medicare payments Less: Estimated net cost of benefits Equals:

  5. The Net Cost of Benefits Estimating postretirement health care benefits is like estimating pension benefits, but there are some additional assumptions required: Current cost of providing health care benefits (per capita claims cost). Demographic characteristics of participants. Benefits provided by Medicare. Expected health care cost trend rate.

  6. Postretirement Benefit Obligation • Expected (EPBO) • The actuary’s estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants. • Accumulated (APBO) • The portion of the EPBO attributed to employee service to date.

  7. Measuring the Obligation On December 31, our actuary estimates that the present value of the expected benefit obligation for your postretirement health care costs is $10,250. You have worked for the company for 6 years and are expected to have 30 years of service at retirement. The actuary uses a 6% discount rate. Let’s calculate the APBO.

  8. Fraction attributed to service to date × = EPBO APBO 6 30 $10,250 × = $2,050 APBO at the beginning of the year. Measuring the Obligation

  9. EPBO Beginning of Year EPBO End of Year × = (1 + Discount Rate) $10,250 × 1.06 = $10,865 7 30 APBO End of Year $10,865 × = $2,535 Measuring the Obligation To calculate the APBO at the end of the year. We start by determining the ending EPBO.

  10. APBO may also be calculated like this: Measuring the Obligation The APBO increases because of interest and the service fraction (service cost).

  11. Attribution The process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by employees.

  12. Postretirement Benefit Expense

  13. Postretirement Benefit Expense Interest accrues on the APBO as time passes. APBO at the beginning of the year times the assumed discount rate equals the interest cost.

  14. Postretirement Benefit Expense Unlike pension plans, many postretirement benefitplans are not funded currently. For funded plans, the earnings on plan assets reduce postretirementbenefit expense.

  15. Postretirement Benefit Expense Delayed recognition of prior service cost is attributed to the service of active employees from the date of the amendment to the full eligibility date, not the expected retirement date.

  16. Postretirement Benefit Expense The amount subject to amortization is the net gain or loss at the beginning of the year in excess of 10% of the APBO or 10% of the plan assets. The excess is amortized over the average remaining service period of active employees.

  17. Amortize Net Losses or Gains

  18. Postretirement Benefit Expense Amortization of the transition amount is part of expense in the current period. For financial reporting, the amortization reduces current earnings. For income tax purposes, income is reduced when actual payments are made. This creates a temporary difference between financial and taxable income.

  19. An employer may choose to recognize: The entire transition obligation immediately,or Amortize the transition obligation on a straight-line basis over the plan participants’ future service periods (or 20 years if that is longer). Amortization of Transition Amount

  20. Determining the Expense Recall our example of your postretirement benefits. Let’s calculate postretirement benefits expense.

  21. Determining the Expense Because most postretirement health plans are not funded, there are no fund assets, no credit for prior service, and no net loss. The beginning APBO ($2,050) is the initial transition liability. Your service life is 24 years (30 - 6). The amortization amount is $85 rounded ($2,050 ÷ 24 years).

  22. Required Disclosures • Changes in the APBO. • Changes in the plan assets (if any). • Net periodic postretirement benefit expense and its components. • Reconciliation of the funded status of the plan with amounts reported in the balance. • Weighted average discount rate, rate of compensation, and the expected long-term rate of return used to measure the postretirement benefit obligation.

  23. Stock-Based Compensation Plans Now let’s look at some incentive compensation plans.

  24. Stock Award Plans Restricted stock award plans usually are tied to continued employment of the person receiving the award. • Recognize compensation expense over the service period for which participants receive the shares.

  25. On January 1, 2003, Matrix, Inc. awarded 10,000 shares of its $2 par value common stock to its CEO. The shares will be forfeited if the CEO leaves within the next five years. On January 1, the common stock of Matrix is selling for $62 per share Stock Award Plans

  26. No entry is required on January 1, 2003, but total compensation is calculated as follows: Number of Shares issuable Fair value per share Total Compensation × = 10,000 $62.00 = $620,000 × Stock Award Plans Compensation expense is measured on the date of grant. Subsequent changes in the market price of the stock do not impact compensation.

  27. The total compensation of $620,000 will be recognized over the service period of 5 years.On December 31, 2003, through 2007, we will prepare the following journal entry: $620,000 ÷ 5 = $124,000 per year Stock Award Plans

  28. On December 31, 2007, the shares are issued to the CEO, and the following entry will be made: Stock Award Plans

  29. In most cases, employees are not awarded shares of stock. Rather they are given an option to buy shares at some time in the future. Options are usually granted for a specified number of shares, at a specified price, during a specified period of time. Stock Option Plans

  30. Expense – The Great Debate Historically, options have been measured at their intrinsic value – the simple difference between the market price of the shares and the option price at which they can be acquired. If the market and exercise price are equal on the date of grant, no compensation expense is recognized even if the options provide executives with substantial income.

  31. Expense – The Great Debate • Critics to current practice have identified three objections. • Options with no intrinsic value at issue have zero fair value and should not give rise to expense recognition. • It is impossible to measure the fair value of compensation on the date of grant. • Current practices have unacceptable economic consequences.

  32. Recognizing Fair Value of Options Companies are encouraged, but not required, to estimatethe fair value of stock options on the grant date. This encouragement requires the use of an optionpricing model that deals with the:1.Exercise price of the option.2. Expected term of the option3. Current market price of the stock.4. Expected dividends.5. Expected risk-free rate of return.6. Expected volatility of the stock.

  33. Stock Option Plans On January 1, 2003, Matrix, Inc. grants options to purchase 100,000 shares of the company’s $1 par value common stock to four key executives. The options may be exercised during the next 10 years, but not before December 31, 2007. The exercise and market price of the stock on January 1 is $57 per share. The fair value of the options, estimated using an options pricing model is $5 per option.

  34. January 1, 2003: Calculate total compensation expense. Stock Option Plans $2,000,000 ÷ 5 years (2003 through 2007) = $400,000.

  35. The following entry will be made on December 31, 2003 through 2007, the service period. Stock Option Plans

  36. On May 2, 2008, two executives exercise their options when the market price of the stock is $92 per Stock Option Plans 200,000 shares × $57 per share = $11,400,000

  37. If no options were exercised during the 10-year exercise period, the following entry would be made when the options expire: Stock Option Plans

  38. For incentive plans . . . The recipient pays no tax at the time of the grant or when the options are exercised. Tax is paid on the difference between the market price and exercise price on the date of subsequent sale. Stock Option Plans and Taxes

  39. Intrinsic Value of Options Many companies refuse to recognize the fair value of options. The value of the options is measured at the grant date in an amount equal to the difference between the market price of the shares and the exercise price at which they can be acquired.

  40. Performance Stock Option Plans In some cases, option plans are structured so that the number of options received and/or the exercise price per share may be based on the occurrence of some future event. For example, the CEO may receive options to purchase 100,000 common shares at $10 per share only if the market price of the company’s stock reaches $50 or more per share. This is known as a variable option plan.

  41. The recipient is awarded the share appreciationwhich is the amount by which the market price on the exercise date exceeds the option price. Stock Appreciation Rights $ $ $

  42. Stock Appreciation Rights Payable in Shares The fair value of the SARs is estimated at the date of grant and accrued to expense over the service period. Alternatively, the compensation may be measured at the end of the accounting period. Stock Appreciation Rights

  43. Stock Appreciation Rights Payable in Cash (Liability) The compensation, and related liability, is estimated each period and continually adjusted to reflect changes in the market price of stock until the compensation is finally paid. Stock Appreciation Rights

  44. Stock Appreciation Rights On January 1, 2003, Matrix, Inc. granted 10,000 stock appreciation rights to 2 key executives. Each is to receive cash for the difference between a base price of $60 per share and the market value of the stock on December 31 for each of the next 3 years. The first payment will be made on December 31, 2003. Let’s see how to account for these SARs.

  45. On December 31, 2003, Matrix common shares closed at $64.50 per share. Stock Appreciation Rights Let’s look at the entry to recognize the compensation expense for 2003.

  46. Stock Appreciation Rights On December 31, 2003, Matrix common shares closed at $64.50 per share. $90,000 ÷ 3 years = $30,000

  47. On December 31, 2004, the stock closed at $75 per share. Stock Appreciation Rights

  48. Stock Appreciation Rights On December 31, 2004, the stock closed at $75 per share.

  49. Broad-based plans offer stock options to all employees rather than a select few. No compensation involved if . . . All employees meeting employment qualifications participate. Equal offers of stock to all eligible employees. Exercise period is reasonable. Only modest discount from the market price is available. Noncompensatory Plans

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