Exam 3 Flashcards
Plan sponsor
-Employer, makes payments into the fund
Plan participants
-Current or former employees, beneficiaries of the plan, receive retirement benefits from fund as “additional compensation” for work performed prior to retirement
Why do employers establish pension plans?
- Increase employee motivation and productivity
- Reduce current demand for pay increases
- Reduce turnover
- Comply with union contracts
- Remain competitive in the labor market
- Generate tax benefits
Qualified pension plans
Qualified receive beneficial tax treatment
- Employees: not taxed on contributions made to plan, not taxed on earnings, taxed when withdrawing pension amounts (deferred)
- Employers: receive a tax deduction for contributions to the plan, exclude pension fund earnings from taxable income
- Non-qualified receive no tax benefits
Defined Contribution Plan
- Contribution that employer makes is specified based on a formula that considers years of service, salary, etc
- Employee’s retirement depends on how much the contributions earn between now and retirement
- Employee bears the risk
Contributory vs. Non-contributory
Contributory: employee bears part of the cost of contributions or can make additional payments
Non: employer bears the full cost
Defined benefit plan
- Employer bears the risk
- Commits employer to pay specified retirement benefits to employees after retirement
- Benefits are established by a pension benefit formula but periodic contributions not specified
- Most pension plans to arise from collective bargaining are defined benefit
- Annual payments to receive during reitrement are usually (percent)(years of service)(avg highest salary)
ERISA
Employee Retirement Security Act, minimum contribution a company must make to ensure plan heath
PBGC
Government entity, guarantees minimum benefits
Pension Liability
- By initiating a pension plan, company entails a liability (future obligation attributable to current or past benefits received)
- Theoretically, should reflect the PV of retirement payments to be made in the future due to cumulative service performed to date
Pension Asset
-Plans are the sum of all the contributions a company makes to the pension fund plus earnings
PBO
Plan Benefit Obligation
- Actuarial PV of the benefits attributed to employee services rendered to date
- PV of all benefits earned as of right now
- Based on expected final salarY
ABO
Accumulated Benefit Obligation
- Obligation for benefits the employee is expected to receive using current salary levels
- Represents potential obligation faced by tteh firm if the plan is discontinued
Vesting
- Employers often require work for a certain amount of years before they can receive full benefits
- Either 100% vesting after 5 years or vesting schedule
VBO
Vesting Benefit Obligation
- VBO is the present value of all vested benefits employees have earned to date based on current salaries
- PBO>=ABO>=VBO
Plan assets
- Investments (bonds, stocks, etc) and operational assets used in administering pension fund
- Funds are restricted to payment and administration of pension plan benefits
- Assets sit off employers books and can be accessed by employer only upon plan termination
Underfunded
PBO > Plan Assets
Overfunded
PBO < Plan Assets
Change in PBO
Beginning PBO balance \+Service Cost \+Interest Cost \+/-Actuarial gains/losses \+/-Prior Service Cost -Benefits paid =Ending PBO balance
Change in Plan Assets
Beginning Plan Assets Balance \+Employer Contributions \+Return on Assets -Benefits Paid =Ending Plan Assets Balance
Attribution
- Pension expense measured according to attribution
- Allocate PV of future benefit to periods of employee service
Pension expense
Periodic pension expense is the net cost of 6 components:
- Service cost (+)
- interest cost (+)
- expected return on plan assets (+)
- amortization of prior service cost
- recognized portion of cumulative gains or losses
- amortization of transition asset or liability
Service Cost
- Actuarial present value of the pension benefits earned by employees in a given period
- Based on employees estimated future salaries and projected years of service
- PV of benefits employee earned during that year (from one more year of service)
Interest Cost
-Accrues on total outstanding pension liability during a reporting period at discount rate to reflect time value of money
-Updates present value of previously earned benefit payments to new reporting period
-Cost of the obligation being one year closer to having to be paid
=PBO beginning * Discount rate
ERPA
-Expected investment return on plan assets during the period, offsets other periodic pension expenses
-Based on ERR assets will generate
-Instead of using actual return each period, smoothes the volatility of asset returns
=ERR * Plan Assets Beginning
ARPA
-Increase in pension funds from int, dividends, and realized and unrealized changes in FMV of plan assets
-Used in calculating fund balance
Beginning Fund Balance
+ ARPA
+ Employer Contributions
- Benefit Payments
= Ending Balance
Expected vs. Actual
- ERPA used for pension expense calculation only
- ARPA used in calculating new plan asset balance
- Difference becomes a pension G/L which is D/C to OCI and pension expense
PSC
- Credit for work performed before pension plan went into effect
- Total PSC = pension benefit costs associated with time worked before the plan began
PSC Amortization
-Amortized over the remaining service period
1 / Avg. remaining service period
SFAS 158
Requires firms to report funded status on the balance sheet
PBO Gain/Loss
- Increase in PBO is loss
- Decrease in PBO is gain
- Change in assumptions (change in death date, retirement date, salary, growth rate, disc.)
Asset Gains/Losses
- Asset loss is actual return is lower than expected return
- Asset gain is actual return exceeds expected return
- Change in plan itself
Pension Gains and Losses
- Pension expense should ultimately reflect the new assumptions and actual returns
- Not immediately recognized in pension expense, but subject to delayed recognition (amortized gradually)
- Effects of future losses may offset previous gains and vice versa
- Offsetting and amortization help minimize overall impact of gains and losses on pension expense (control volatility)
Changes in rates
- Service cost and interest cost are always computed using the discount rate assumed at the BEGINNING of the year (if rate changes during the year)
- PBO is computed using most RECENT compensation and discount rates
Amortization of Pension G/L
- Not amortized as soon as they occur, accrue in unrecognized gains and losses account which is not amortized until it gets large enough
- Delay allows offsets and minimizes volatility of pension expense
Corridor Amortization
- Minimum g/l amortization that must be recognized in the current year
- Not required unless UGL balance and the BEGINNING of the year exceeds 10% of PBO or PA (whichever is larger)
- Amount above 10% must be amortized over the average remaining service period of the active employees covered by plan
Transition Asset/Liability
- If plan’s funded status is worse than previously reported, transition liability generated
- Amortized on SL basis over average remaining service period
- If avg service is less than 15, then you can amortize over 15 years
- Most firms have completed or are at the end of the amortization
Changes in assumptions (Financial Statements)
- Look for changes in disc rate, estimated compensation increase and ERPA
- Effect of Increase on NI –> Disc rate (+), Decrease service cost (+), Increase int cost (-), ERPA (+). Compensation rate (-)
Issuing stock
- Authorized: how many approved by the state
- Issues: have been sold to shareholders
- Outstanding: still held by shareholders
- Record the value for what you received, credit common stock for par value and APIC for the rest
Treasury Stock
- Shares of stock reacquired by the firm
- Does not have voting rights, dividends, or distributions upon liquidation
- Not considered outstanding
Why repurchase stock?
- Take company private
- Stock for potential takeover
- Manipulate EPS
- Increase market value of stock
- Exercise of employee stock options
Treasury stock journal entries
- Par value method (record treasury stock at par value)
- Cost method (record at purchase price)
- Treasury stock NOT recorded as an asset!!
- APIC amount above purchase price, if lower debit retained earnings for the rest
Retirement of stock
- Company buys the stock and cancels the stock certificate
- # issued decreases
- Stock cannot be resold
- Company must remove the capital account and all accounts related to the stock
Preferred Stock
- Preferences (special rights) from common stock, in exchange may sacrifice voting rights
- Preferences might include: priority with dividends, priority if liquidation, convertability into common stock,a optional redemption
Cumulative preferred stock
- Shareholders have the right to all unpaid dividends
- If dividends are passed over in a year, then the benefits accumulate
- The total accumulated amount (dividends in arrears) must be paid before common shareholders can be paid any dividends
Noncumulative preferred stock
- Shareholders have no claim on passed over dividends
- Firm may pay dividends to common shareholders once it has paid the current year’s preferred dividend
- Few preferred stock issues are noncumulative
Participating Dividends
- Nonparticipating: preferred only entitled to the preferred stock’s stated dividend
- Partially Participating: Participate proportionately with common shareholders in any dividend distribution beyond preferred rate up to specified level
- Fully Participating: preferred participate proportionately with common shareholders in any dividend distribution beyond the preferred rate
Stock dividend
- Dividend distributed by issuing more stock
- Shareholders receive additional shares of stock in proportion to existing holdings
- Really just reclassifying earned capital to contributed capital
- Small stock dividend (less than 25% of total outstanding shares) –> use Market-Value method
- Large stock dividend (more than 25% of total outstanding shares)–> use Par-Value method
Market Value Method
- Record transaction at fair market value of stock
- Stock dividend distributable credit at declaration, debit at issuance
Par Value Method
- Record transaction that par value
- Retained earnings and stock dividend distributable
Stock Split
- Company might declare a stock split in order to reduce the market value of its stock to make it more affordable for investors
- Increases # of shares outstanding and decreases par value of the stock
- No journal entry made, just memo noting the change
- No difference between 2 for 1 split and 100% stock dividend, but dividend has entry and split does not
Dilutive securities
- Contain and option for the holder to obtain a specified # of shares through purchase or conversion
- Convertible bonds
- Convertible preferred stock
- Stock warrants
- Stock options
Accounting for convertible debt
2 options:
- Book value method: issuance price for the stock equals book value of bonds (used most often)
- Market value method: issuance price for stock equals current market price of stock (gain or loss reported)
Convertible preferred stock
-Similar to book value approach (not market value because never recognize income from trading its own equity)
Mandatorily redeemable preferred stock
- Firm promises to pay back the preferred stock at a stated price in the future
- Characteristics of both debt and equity
- SEC said not equity, so companies created the mezzanine (between liabilities and equity)
- Many of these companies no longer use these securities
Convertible bonds
- Recorded like regular bonds, proceeds are recorded in bonds payable
- Recorded as if entire value derives from the bond and no value derives from convertability feature
- Effects: calling it debt could be misleading, misrepresented interest expense
