Chapter 18 Employee Benefit Plans

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 18-1
Usually the “substantive plan” is the written plan. However, sometimes a company’s consistent
practice of providing benefits a certain way is a better indication of the employer’s real plan for
postretirement benefits than the written plan. In those cases, the “substantive plan” should override the
written plan in determining the basis for accounting for postretirement benefits.
Anticipated changes in cost-sharing arrangements (before the plan actually is amended) should be
considered when measuring the obligation and expense when the company (a) can demonstrate the
intent and ability to make the change and (b) has communicated the intended change to plan
participants.

Question 18-2
The expected postretirement benefit obligation (EPBO) is the actuary's estimate of the total
postretirement benefits (at their discounted present value) expected to be received by plan participants.
When a plan is pay-related, future compensation levels are implicitly assumed. The accumulated
postretirement benefit obligation (APBO) measures the obligation existing at a particular date, rather
than the total amount expected to be earned by plan participants. The APBO is conceptually similar to a
pension plan’s projected benefit obligation. The EPBO has no counterpart in pension accounting.

Question 18-3
The cost of benefits are “attributed” to the years during which those benefits are assumed to be
earned by employees. The attribution period spans each year of service from the employee’s date of
hire to the employee’s “full eligibility date,” which is the date the employee has performed all the
service necessary to have earned all the retiree benefits estimated to be received by that employee. The
approach assigns an equal fraction of the EPBO to each of those years. The attribution period does not
include any years of service beyond the full eligibility date, even if the employee is expected to work
after that date.

Question 18-4
The transition obligation could be recognized as part of the compensation expense by either of two
methods. An employer could choose to recognize the entire transition obligation immediately as the
cumulative effect of a change in accounting principle, or on a straight-line basis over the plan
participants' future service periods (or optionally over a 20-year period if that’s longer.)

Question 18-5
The service cost for pensions reflects additional benefits employees earn from an additional year’s
service, whereas the service cost for retiree health care plans is simply an allocation to the current year
of a portion of a fixed total cost.

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Solutions Manual, Vol.2, Chapter 18 18-1
Answers to Questions (continued)
Question 18-6
The attribution period spans each year of service from the employee’s date of hire to the employee’s
“full eligibility date,” 30 years in this case. The APBO is $10,000 which represents the portion of the
EPBO earned after 15 years of the 30-year attribution period: $20,000 x 15/30 = $10,000.

Question 18-7
Restricted stock refers to shares actually awarded in the name of an employee, although the
employer might retain physical possession of the shares. Typically, the employee has all rights of a
shareholder, but the shares are subject to certain restrictions or forfeiture. Usually the employee is not
free to sell the shares during the restriction period. Restricted shares usually are subject to forfeiture by
the employee if employment is terminated between the date of grant and a specified vesting date.
Restrictions provide the employee incentive to remain with the company.
Compensation cost is the fair value of the restricted stock at the grant date and is equal to the market
price of unrestricted shares of the same stock. The fair value of shares awarded under a restricted stock
award plan is accrued to compensation expense over the service period for which participants receive
the shares. This usually is the period from the date of grant to when restrictions are lifted (the vesting
date).

Question 18-8
The fair value of a stock option is determined by employing a recognized option pricing model. The
option pricing model should take into account the (1) exercise price of the option, (2) expected term of
the option, (3) current market price of the stock, (4) expected dividends, (5) expected risk-free rate of
return during the term of the option, and (6) expected volatility of the stock.

Question 18-9
The recipient pays no tax at the time of the grant or the exercise of the options under an incentive
plan. Instead, the tax on the difference between the option price and the market price at the exercise
date is paid on the date any shares acquired are subsequently sold. The employer gets no tax deduction
at all.
The employee cannot delay paying tax under a nonqualified plan. The tax that could be deferred
until the shares are sold under an incentive plan must be paid at the exercise date under a nonqualified
plan. On the other hand, the employer is allowed to deduct the difference between the option price and
the market price on the exercise date. Thus, a nonqualified plan offers favorable tax treatment to the
employer, while an incentive plan offers favorable tax treatment to the employee.

Question 18-10
By the traditional alternative approach GE has chosen, compensation is recorded only when options
have intrinsic value. Under the FASB elective approach, compensation would be accrued in the amount
of the fair value of the options at the grant date.

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18-2 Intermediate Accounting, 3/e
Answers to Questions (continued)
Question 18-11
The vast majority of options are structured as incentive plans for essentially two reasons:
1. The favorable tax treatment incentive plans provide executives allows companies to use the plans
to attract and retain quality management personnel.
2. As a result of Tax Code requirements, incentive plans usually offer an exercise price equal to the
market price on the grant date. On the other hand, the market price usually exceeds the exercise
price in a nonqualified plan. Companies can elect not to report compensation expense for an
incentive plan by not choosing the elective fair value approach. A nonqualified plan requires
earnings to be reduced by compensation expense.

Question 18-12
The fair value of stock options has two essential components: (1) intrinsic value and (2) time value.
“Intrinsic value” is the benefit the holder of an option would realize by exercising the option rather than
buying the underlying stock directly. For example, an option that allows an employee to buy $13 stock
for $8 has an intrinsic value of $5. “Time value” exists so long as time remains before expiration
because the market price of the underlying stock may yet rise and create additional intrinsic value.

Question 18-13
The accounting treatment of SARs depends on whether the award is considered an equity instrument
or a liability. If the employer can choose to settle in shares rather than cash, the award is considered to
be equity. If the employee will receive cash or can choose to receive cash, the award is considered to be
a liability. This is the case with the LTV plan. As a result, the amount of compensation and related
liability is continually adjusted to reflect changes in the market price of stock until the liability is finally
settled. Whenever the market price rises above the reference price (usually the market price on the grant
date), a liability is indicated. A portion of the total liability is attributed to employee service during the
current period and is recorded as compensation expense. The expense each period is the percentage of
the total liability earned to date by recipients of the SARs (based on the elapsed percentage of the
service period), minus any amounts expensed in prior periods. Both compensation expense and the
liability are adjusted each period until the SARs ultimately either are exercised or lapse.

Question 18-14
The accounting treatment of any of the various bonus plans is to accrue compensation expense and a
related liability annually based on the estimated eventual value of compensation. This is similar to
accounting for variable stock-based plans. When material uncertainties exist concerning how much, or
even whether, compensation ultimately will be paid, accrual cannot occur unless it’s both probable that
payment will be made and the amount can be reasonably estimated. This is consistent with the treatment
of contingent liabilities, which many of these plans represent. When stock will be issued rather than
cash (as in performance share plan, for instance) a shareholders’ equity account is created rather than a
liability.

© The McGraw-Hill Companies, Inc., 2004

Solutions Manual, Vol.2, Chapter 18 18-3
Answers to Questions (concluded)
Question 18-15
An employer should accrue an expense and the related liability for employees' compensation for
future absences, like vacation pay, if the obligation meets each of four conditions: (1) the obligation is
attributable to employees' services already performed, (2) the paid absence can be taken in a later year –
the benefit vests (will be compensated even if employment is terminated) or the benefit can be
accumulated over time, (3) the payment is probable, and (4) the amount can be reasonably estimated.
Customary practice should be considered when deciding whether an obligation exists. For instance,
whether the rights to paid absences have been earned by services already rendered sometimes depends
on customary policy for the absence in question. An example is whether compensation for upcoming
sabbatical leave should be accrued. Is it granted only to perform research beneficial to the employer?
Or, is it customary that sabbatical leave is intended to provide unrestrained compensation for past
service.
Similar concerns also influence whether unused rights to the paid absences can be carried forward or
expire. Although holiday time, military leave, maternity leave, and jury time typically do not
accumulate if unused, if it is customary practice that one can be carried forward, a liability is accrued if
it’s probable employees will be compensated in a future year. Similarly, sick pay is specifically
excluded by SFAS 43 from mandatory accrual because future absence depends on future illness, which
usually is not a certainty. But, if company policy or custom is that employees are paid “sick pay” even
when their absence is not due to illness, a liability for unused sick pay should be recorded.

Question 18-16
Sometimes “postemployment” benefits meet the criteria for accrual as compensated absences. If
Benevolent finds that these benefits meet all four conditions of FASB Statement No. 43, Accounting for
Compensated Absences, the company should recognize the obligation to provide these benefits (debit
expense; credit liability).
Otherwise, “postemployment” benefits should be treated as loss contingencies and accrued when it
is probable that a liability has been incurred and the amount can be reasonably estimated in accordance
with FASB Statement No. 5, Accounting for Contingencies. When such obligations are not accrued,
footnote disclosure is required if payment is at least reasonably possible.

Question 18-17
No. When an ESOP borrows cash to buy shares from the employer company the arrangement is
called a leveraged ESOP. The employer (Gillette, in this case) records a liability, offset by a contra-
equity account. As the ESOP repays the debt, both the liability and contra-equity (called “unearned
ESOP compensation” by Gillette) are reduced. This accounting treatment effectively treats the ESOP’s
debt as Gillette’s debt.

© The McGraw-Hill Companies, Inc., 2004

18-4 Intermediate Accounting, 3/e
EXERCISES
Exercise 18-3
Requirement 1 $72,000
EPBO
2003

Requirement 2
$72,000 x 2/[2+28] = $4,800
EPBO fraction APBO
2003 earned 2003

Requirement 3
$72,000 x 1.06 = $76,320
EPBO to accrue EPBO
2003 interest 2004

Requirement 4
$76,320 x 3/30 = $7,632
EPBO fraction APBO
2004 earned 2004

Exercise 18-4

Requirement 1
$50,000 x 3/25 = $6,000
EPBO fraction APBO
earned

Requirement 2

$6,000 (beginning APBO) x 6% = $360

Requirement 3

$53,000 x 1/25 = $2,120

EPBO attributed service
2003 to 2003 cost

Requirement 4

Postretirement benefit expense ($360 + 2,120) ................ 2,480

Accrued postretirement benefit cost .......................... 2,480
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Solutions Manual, Vol.2, Chapter 18 18-5
Exercise 18-5

Requirement 1 22 years

Requirement 2 $44,000

Requirement 3

$44,000 x ?/22 = $20,000

EPBO fraction APBO
earned

$44,000 x 10/22 = $20,000

EPBO fraction APBO
earned

10 years before 2003: beginning of 1994 (or end of 1993)

Requirement 4

$? x 1.10 = $44,000
EPBO interest EPBO
beg. multiple end

$40,000 x 1.10 = $44,000

EPBO interest EPBO
beg. multiple end

or, alternatively:
$? x 9/22 = $16,364
EPBO fraction APBO
earned

$40,000 x 9/22 = $16,364

EPBO fraction APBO
earned

© The McGraw-Hill Companies, Inc., 2004

18-6 Intermediate Accounting, 3/e
Exercise 18-6

Requirement 1

($ in 000s)
Service cost $124
Interest cost (7% x $700) 49
Return on the plan assets (10% x $50) (5)
Amortization of prior service cost 0
Amortization of net gain (1)
Amortization of transition obligation 2

Postretirement benefit expense $169

Requirement 2
($ in 000s)
Postretirement benefit expense (calculated above)..................................... 169
Prepaid (accrued) postretirement benefit cost (difference)......................... 16
Cash (contributions to fund) ................................................................. 185

Exercise 18-12

Requirement 1

$2.50 fair value per share

x 12 million shares granted
= $30 million fair value of award

Requirement 2
no entry

Requirement 3

($ in millions)
Compensation expense ($30 million ÷ 3 years) .......... 10
Paid-in capital – restricted stock............................. 10

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Solutions Manual, Vol.2, Chapter 18 18-7
Requirement 4

Compensation expense ($30 million ÷ 3 years) .......... 10

Paid-in capital – restricted stock............................. 10

Requirement 5

Compensation expense ($30 million ÷ 3 years) .......... 10

Paid-in capital – restricted stock............................. 10

Requirement 6

Paid-in capital – restricted stock ................................. 30

Common stock (12 million shares x $1 par)........... 12
Paid-in capital – excess of par (remainder) ............ 18

Exercise 18-14

Requirement 1

$3 fair value per option

x 4 million options granted
= $12 million total compensation

Requirement 2

no entry

Requirement 3

($ in millions)
Compensation expense ($12 million ÷ 2 years) .......... 6
Paid-in capital – stock options ................................ 6

Requirement 4

Compensation expense ($12 million ÷ 2 years) .......... 6

Paid-in capital – stock options ................................ 6

Requirement 5

By the alternate approach, no compensation is recorded unless the options have “intrinsic value.”
Because the market price does not exceed the exercise price, these options are not recorded. However,
pro forma disclosure is required of both net income and earnings per share calculated as if the elective
approach had been followed. In addition, disclosure notes should include other information to permit
comparability between those companies that elect the FASB’s approach and those that do not.

© The McGraw-Hill Companies, Inc., 2004

18-8 Intermediate Accounting, 3/e
Exercise 18-16

Requirement 1

At January 1, 2003, the estimated value of the award is:

$1 estimated fair value per option
x 40 million options granted
= $40 million fair value of award

Requirement 2

($ in millions)
Compensation expense ($40 million ÷ 2 years) .......... 20
Paid-in capital – stock options ............................... 20

Requirement 3

Compensation expense ($40 million ÷ 2 years) .......... 20

Paid-in capital – stock options ............................... 20

Requirement 4

Cash ($8 exercise price x 30 million shares).............................. 240

Paid-in capital - stock options
(3/4 account balance of $40 million)....................................... 30
Common stock (30 million shares at $1 par per share) ......... 30
Paid-in capital – excess of par (remainder) ........................... 240
Note: The market price at exercise is irrelevant.

Requirement 5

Paid-in capital – stock options ($40 -30 million) ....................... 10

Paid-in capital – expiration of stock options ........................ 10

Exercise 18-19

Requirement 1
No liability or deferred compensation because the intrinsic value of the SARs is zero: [$46 –
$46] x 24 million shares = $0
Requirement 2
December 31, 2003 ($ in millions)
Compensation expense* ................................................. 24
Liability – SAR plan .................................................. 24

* Calculation:

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Solutions Manual, Vol.2, Chapter 18 18-9
 [$50-46] x 24 million x 1/4 – $0 = $24
estimated fraction expensed current
total of service earlier expense
compensation to date

December 31, 2004

Compensation expense* ................................................ 12
Liability – SAR plan ................................................. 12
* Calculation:
[$49-46] x 24 million x 2/4 – $24 = $12
estimated fraction expensed current
total of service earlier expense
compensation to date

December 31, 2005

Compensation expense* ................................................. 36
Liability – SAR plan .................................................. 36

* Calculation:
[$50-46] x 24 million x 3/4 – [$24 + 12] = $36
estimated fraction expensed current
total of service earlier expense
compensation to date

December 31, 2006

Compensation expense* ................................................. 48
Liability – SAR plan ................................................. 48
* Calculation:
[$51-46] x 24 million x 4/4 – [$24 + 12 + 36] = $48
estimated fraction expensed current
total of service earlier expense
compensation to date

Requirement 3
Liability – SAR plan ...................................................... 24
Compensation expense* ........................................... 24

* Calculation:
[$50-46] x 24 million x 4/4 – [$24 + 12 + 36 + 48] = $(24)
estimated fraction expensed current
total of service earlier expense
compensation to date

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18-10 Intermediate Accounting, 3/e
Requirement 4

Compensation expense* ................................................ 72

Liability – SAR plan ................................................. 72

* Calculation:
[$53-46] x 24 million x 4/4 – [$24 + 12 + 36 + 48 - 24] = $72
actual fraction expensed current
total of service earlier expense
compensation to date

Liability – SAR plan (account balance) ........................ 168

Cash............................................................................ 168

Exercise 18-21

Wages expense (increases wages expense to $410,000) ................. 6,000

Liability – compensated future absences .................................. 6,000*

* ($404,000 - 4,000] = $400,000 non-vacation wages

x 1/40 = $10,000 vacation pay earned
(4,000) vacation pay taken
= $ 6,000 vacation pay carried over

Problem 18-5

Requirement 1
($ in millions)
APBO:
Beginning $375
Service cost 23
Interest cost (8% x $375) 30
Loss on APBO 92
Benefit payments (20)
Ending $500

Requirement 2
($ in millions)
Service cost $23
Interest cost 30
Amortization of transition obligation ($375/15) 25
Postretirement benefit expense $78

Requirement 3
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Solutions Manual, Vol.2, Chapter 18 18-11
 ($ in millions)
Postretirement benefit expense (determined above) 78
Accrued postretirement benefit cost (difference) 18
Cash (given) 60

Requirement 4
($ in millions)
APBO $500
Plan assets ($60 - 20) (40)
Funded status $460
Unrecognized net loss (92)
Unrecognized transition obligation ($375 - 25) (350)
Accrued postretirement benefit cost $ 18

Requirement 5

APBO Plan Assets

Balance, Jan. 1 $500 $40
Service cost 32
Interest cost ($500 x 8%) 40
Return on plan assets 5
Contributions 90
Benefit payments (55) (55)
Balance, Dec. 31 $517 $80

Requirement 6
($ in millions)
Net loss (previous losses exceeded previous gains) $92
10% of $500 ($500 is greater than $40) (50)
Excess at the beginning of the year $42
Average remaining service period ÷ 14 years
Amount amortized to 1995 pension expense $3

Requirement 7
($ in millions)
Service cost $32
Interest cost 40
Return on plan assets $(5)
Less: gain (12.5% x $40 – 10% x $40) 1* (4)
Amortization of transition obligation ($375/15) 25
Amortization of net loss (determined above) 3
Postretirement benefit expense $96
* rounded

Requirement 8
($ in millions)
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18-12 Intermediate Accounting, 3/e
 Postretirement benefit expense (determined above) 96
Accrued postretirement benefit cost (difference) 6
Cash (given) 90

Requirement 9
APBO (req. 5) $517
Plan assets (req. 5) (80)
Funded status $437
Unrecognized net loss ($92 - 3 amortization -1 gain) (88)
Unrecognized transition obligation ($375 - 25 - 25) (325)
Accrued postretirement benefit cost $ 24*

* Note: $18 [req.4] + 6 [req. 8] = $24

Problem 18-6

Requirement 1

The measurement date is the date of grant in each case. By the elective fair value approach the
measurement date always is the date of grant. By the traditional alternative approach the
measurement date is the first date we know both: (a) the number of shares obtainable and (b) the
exercise price. Ensor knows both on the grant date.

Requirement 2
Elective fair value approach:
$ 7 estimated fair value per option
x 20 million options granted
= $140 million fair value of award

The total compensation is to be allocated to expense over the 2-year service (vesting) period: 2003 -
2004
$140 million ÷ 2 years = $70 million per year

Alternative intrinsic value approach:

$15 market value per share
(12) exercise price (80% x $15)
$ 3 intrinsic value per option
x 20 million options granted
= $60 million intrinsic value of award

The total compensation is to be allocated to expense over the 2-year service (vesting) period: 2003 -
2004
$60 million ÷ 2 years = $30 million per year

Requirement 3

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Solutions Manual, Vol.2, Chapter 18 18-13
 Elective fair value approach:

The forfeiture rate is 10% (2 million ÷ 20 million). The total compensation is recalculated
when the estimate changes. $140 million - 70 million - 7 million = $63 million allocated to the
remaining service period (one year in this case).

“Paid-in capital – stock options” and “compensation expense” each are reduced by $7 million in
2004 to recapture 10% of the $70 expensed in 2003. Expensing only $63 million in 2004 rather
that $70 lowers the 2004 expense another $7 million. Thus compensation expense will be a
total of $14 million less in 2004, as will be Paid-in capital – stock options from then until
exercise.

Alternative intrinsic value approach:

“Paid-in capital – stock options” and “compensation expense” each are reduced by $3 million in
2004 to recapture 10% of the $30 expensed in 2003. Expensing only $27 million in 2004 rather
that $30 lowers the 2004 expense another $3 million. Thus compensation expense will be a
total of $6 million less in 2004, as will be Paid-in capital – stock options from then until
exercise.

Problem 18-10

Requirement 1

B = .10 ($150,000 - B - T), where B = the bonus

T = income tax
T = .30 ($150,000 - B),

Requirement 2

Since income tax (T) is a component of both equations, we can combine the two and then solve for
the remaining unknown amount (B):
Substitute value of T for T:
B = .10 [ $150,000 - B - .30 ($150,000 - B)]

Reduce the right-hand side of the equation to one known and one unknown value:
B = .10 ( $150,000 - B - $45,000 + .30B)
B = .10 ( $105,000 - .70B)
B = $10,500 - .07B
Add .07B to both sides
1.07B = $10,500
Divide both sides by 1.07
B = $9,813

Requirement 3
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18-14 Intermediate Accounting, 3/e
 Bonus compensation expense.......................................... 9,813
Accrued bonus compensation payable........................ 9,813

Requirement 4

The approach is the same in any case: (1) express the bonus formula as one or more algebraic
equation(s), (2) use algebra to solve for the amount of the bonus. For example, the bonus might specify
that the bonus is 10% of the division’s income before tax, but after the bonus itself:
B = .10 ($150,000 - B)
B = $15,000 - .10B
1.10B = $15,000
B = $13,636

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Solutions Manual, Vol.2, Chapter 18 18-15