© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 18 Employee Benefit Plans

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-2 Postretirement Benefit Plan Encompass all types of retiree health and welfare benefits including... Medical coverage, Medical coverage, Dental coverage, Dental coverage, Life insurance, Life insurance, Group legal services, and Group legal services, and Other benefits. Other benefits.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-3 Postretirement Health Benefits and Pension Benefits Compared 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-4 The Net Cost of Benefits Estimated medical costs in each year of retirement Estimated medical costs in each year of retirement Estimated net cost of benefits Estimated net cost of benefits Retiree share of costRetiree costMedicarepaymentsMedicarepayments Less: Equals:

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-5 The Net Cost of Benefits Estimating postretirement health care benefits is like estimating pension benefits, but there are some additional assumptions required: 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. Estimating postretirement health care benefits is like estimating pension benefits, but there are some additional assumptions required: 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-6 Postretirement Benefit Obligation Accumulated (APBO) The portion of the EPBO attributed to employee service to date. Accumulated (APBO) The portion of the EPBO attributed to employee service to date. Expected (EPBO) The actuary’s estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants. Expected (EPBO) The actuary’s estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-7 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. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-8 Measuring the Obligation EPBOFraction attributed to service to dateAPBO × = $10, = $2,050 = $2,050× APBO at the beginning of the year.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-9 Measuring the ObligationEPBOBeginning of Year × (1 + Discount Rate) =EPBOEnd of Year To calculate the APBO at the end of the year. We start by determining the ending EPBO. $10,250 × 1.06 = $10,865 APBO End of Year $10,865× 730 = $2,535

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Measuring the Obligation APBO may also be calculated like this: The APBO increases because of interest and the service fraction (service cost).

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Attribution The process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by employees.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Postretirement Benefit Expense

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. assumed discount rate equals the interest cost. Interest accrues on the APBO as time passes. APBO at the beginning of the year times the assumed discount rate equals the interest cost. assumed discount rate equals the interest cost.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Postretirement Benefit Expense Unlike pension plans, many postretirement benefit plans are not funded currently. For funded plans, the earnings on plan assets reduce postretirement benefit expense. Unlike pension plans, many postretirement benefit plans are not funded currently. For funded plans, the earnings on plan assets reduce postretirement benefit expense.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortize Net Losses or Gains

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Transition Amount 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). 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).

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Determining the Expense Recall our example of your postretirement benefits. Let’s calculate postretirement benefits expense.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Determining the Expense 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). Because most postretirement health plans are not funded, there are no fund assets, no credit for prior service, and no net loss. Because most postretirement health plans are not funded, there are no fund assets, no credit for prior service, and no net loss.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.  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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock-Based Compensation Plans Now let’s look at some incentive compensation plans.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. Recognize compensation expense over the service period for which participants receive the shares. 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. Recognize compensation expense over the service period for which participants receive the shares.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Award Plans  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  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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Award Plans No entry is required on January 1, 2003, but total compensation is calculated as follows: Number of Shares issuable Fair value per share TotalCompensation=× 10,000×=$62.00$620,000 Compensation expense is measured on the date of grant. Subsequent changes in the market price of the stock do not impact compensation. Compensation expense is measured on the date of grant. Subsequent changes in the market price of the stock do not impact compensation.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Award Plans 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Award Plans On December 31, 2007, the shares are issued to the CEO, and the following entry will be made:

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Option Plans 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. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Recognizing Fair Value of Options Companies are encouraged, but not required, to estimate the fair value of stock options on the grant date. This encouragement requires the use of an option pricing model that deals with 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. 6. Expected volatility of the stock.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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, 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Option Plans January 1, 2003: Calculate total compensation expense. $2,000,000 ÷ 5 years (2003 through 2007) = $400,000.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Option Plans The following entry will be made on December 31, 2003 through 2007, the service period.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Option Plans On May 2, 2008, two executives exercise their options when the market price of the stock is $92 per 200,000 shares × $57 per share = $11,400,000

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Option Plans If no options were exercised during the 10-year exercise period, the following entry would be made when the options expire: If no options were exercised during the 10-year exercise period, the following entry would be made when the options expire:

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Option Plans and Taxes For incentive plans... The recipient pays no tax at the time of the grant or when the options are exercised. 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. Tax is paid on the difference between the market price and exercise price on the date of subsequent sale. For incentive plans... The recipient pays no tax at the time of the grant or when the options are exercised. 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. Tax is paid on the difference between the market price and exercise price on the date of subsequent sale.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Appreciation Rights The recipient is awarded the share appreciation which is the amount by which the market price on the exercise date exceeds the option price. $ $ $

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Appreciation Rights 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. 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. Alternatively, the compensation may be measured at the end of the accounting period. 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. 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. Alternatively, the compensation may be measured at the end of the accounting period.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Appreciation Rights 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 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Appreciation Rights Let’s see how to account for these SARs. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Appreciation Rights On December 31, 2003, Matrix common shares closed at $64.50 per share. Let’s look at the entry to recognize the compensation expense for 2003.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Appreciation Rights $90,000 ÷ 3 years = $30,000 On December 31, 2003, Matrix common shares closed at $64.50 per share.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Appreciation Rights On December 31, 2004, the stock closed at $75 per share.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Stock Appreciation Rights On December 31, 2004, the stock closed at $75 per share.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Noncompensatory Plans 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. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-50

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 18-51

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Other Employee Compensation Future paid absences should be accrued when:  The obligation is related to employee services already performed,  The benefit vests (is not contingent on future employment) or accumulates (can be carried forward to the next year),  Payment is probable, and  The amount can be reasonably estimated. Future paid absences should be accrued when:  The obligation is related to employee services already performed,  The benefit vests (is not contingent on future employment) or accumulates (can be carried forward to the next year),  Payment is probable, and  The amount can be reasonably estimated. Sick Pay Vacation

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide End of Chapter 18