Chapter 18
Employee Benefit Plans
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-2
Postretirement Benefit Plan
Encompass all types of retiree health and
welfare benefits including . . .
Medical coverage,
 Dental coverage,
 Life insurance,
 Group legal services, and
 Other benefits.

McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
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.
McGraw-Hill/Irwin
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.
Slide
18-4
The Net Cost of Benefits
Estimated medical
costs in each
year of retirement
Less:
Equals:
McGraw-Hill/Irwin
Retiree
share of
cost
Medicare
payments
Estimated net
cost of benefits
© 2004 The McGraw-Hill Companies, Inc.
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:
 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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-6
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-8
Measuring the Obligation
EPBO
×
Fraction
attributed to
APBO
=
service to
date
$10,250 ×
6
30
= $2,050
APBO at the beginning of the year.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-9
Measuring the Obligation
To calculate the APBO at the end of the year.
We start by determining the ending EPBO.
EPBO
Beginning
of Year
×
(1 + Discount Rate)
=
EPBO
End
of Year
$10,250 × 1.06 = $10,865
7
$10,865 ×
= $2,535
30
McGraw-Hill/Irwin
APBO End
of Year
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-10
Measuring the Obligation
APBO may also be calculated like this:
APBO beginning of the year
Interest cost ($2,050 × 6%)
Service cost ($10,865 × 1/30)
APBO end of the year
$ 2,050
123
362
$ 2,535
The APBO increases because of interest
and the service fraction (service cost).
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-11
Attribution
The process of assigning the cost of
benefits to the years during which those
benefits are assumed to be earned by
employees.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-12
Postretirement Benefit Expense
Component
Service Cost
Interest Cost
Return on Plan Assets
Prior Service Cost
Losses or Gains
Transition Amount
McGraw-Hill/Irwin
Postretirement Benefit Expense
Portion of the EPBO attributed to
the current period.
Increase in APBO due to the
passage of time.
Earnings on plan investments, if
plan is funded.
Amortization of compensation cost
from amending the plan. Usually a
negative amount.
Amortization of unexpected
changes in either the obligation or
plan assets.
Amortization of difference between
the liability and plan assets at
adoption. Usually a liability.
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-13
Postretirement Benefit Expense
Component
Postretirement Benefit Expense
Portion of the EPBO attributed to
the current period
Increase in APBO due to the
Interest Cost
passage of time
Earnings on plan investments, if
Return
on
Plan
Assets
Interest accrues onplan
theisAPBO
funded as time passes.
Amortization
of year
compensation
cost
APBO at the beginning
of the
times the
Prior
Service discount
Cost
from
the plan.
Usually
a
assumed
rateamending
equals the
interest
cost.
negative amount.
Amortization of unexpected
Losses or Gains
changes in either the obligation or
plan assets
Amortization of difference between
the liability and plan assets at
Transition Amount
adoption. Usually a liability.
Service Cost
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-14
Postretirement Benefit Expense
Component
Postretirement Benefit Expense
Portion of the EPBO attributed to
the current period
Increase in APBO due to the
Interest Cost
passage of time
Earnings on plan investments, if
Return on Plan Assets
plan is funded
Amortization of compensation cost
Unlike
pension
many
postretirement
benefit
Prior Service
Cost plans,
from
amending
the plan. Usually
a
negative amount.
plans are not funded currently.
For funded plans, the
Amortization
of unexpected
earnings on plan assets
reduce
postretirement
Losses or Gains
changes in either the obligation or
benefit
expense.
plan assets
Amortization of difference between
the liability and plan assets at
Transition Amount
adoption. Usually a liability.
Service Cost
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-15
Postretirement Benefit Expense
Component
Postretirement Benefit Expense
Portion of the EPBO attributed to
the current period
Increase in APBO due to the
Interest Cost
passage of time
Earnings on plan investments, if
Return on Plan Assets
plan is funded
Amortization of compensation cost
Prior Service Cost
from amending the plan. Usually a
negative amount.
Amortization of unexpected
Delayed
of prior
service
cost isor
Losses
or Gainsrecognition
changes
in either
the obligation
attributed to the service
of active employees
plan assets
of difference
between
from the date of Amortization
the amendment
to the
full
the liability and plan assets at
Transition
eligibilityAmount
date, not the
expected retirement date.
adoption. Usually a liability.
Service Cost
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-16
Postretirement Benefit Expense
Component
Postretirement Benefit Expense
Portion of the EPBO attributed to
the current period
Increase in APBO due to the
Interest Cost
passage of time
The amount subject to amortization
is the net gain or loss at
Earnings on plan investments, if
Return on Plan
Assets
the beginning
of the
yearplan
in excess
is fundedof 10% of the APBO or
10% of the plan assets. Amortization
The excessof is
amortizedcost
over the
compensation
Prior Service
Cost service
from amending
plan. employees.
Usually a
average
remaining
period ofthe
active
negative amount.
Amortization of unexpected
Losses or Gains
changes in either the obligation or
plan assets
Amortization of difference between
the liability and plan assets at
Transition Amount
adoption. Usually a liability.
Service Cost
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-17
Amortize Net Losses or Gains
APBO
Return on
Plan Assets
Higher Than Expected
Loss
Gain
Lower Than Expected
Gain
Loss
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-18
Postretirement Benefit Expense
Component
Postretirement Benefit Expense
Portion of the EPBO attributed to
the current period
Increase in APBO due to the
Interest Cost
passage of time
Earnings on plan investments, if
Return on Plan Assets
planamount
is funded is part of expense in the
Amortization of the transition
Amortization of compensation cost
current period.
For
financial
reporting, the amortization reduces
Prior Service Cost
from amending the plan. Usually a
current earnings. For income
tax purposes,
income is reduced
negative
amount.
Amortization
of unexpected
when actual payments are
made. This
creates a temporary
Losses or Gains
changes in and
eithertaxable
the obligation
or
difference
between financial
income.
plan assets
Amortization of difference between
the liability and plan assets at
Transition Amount
adoption. Usually a liability.
Service Cost
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-19
Amortization of Transition Amount
An employer may choose to recognize:
 The entire transition obligation immediately,
or
 Amortize the transition obligation on a straightline basis over the plan participants’ future
service periods (or 20 years if that is longer).
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-20
Determining the Expense
Recall our example of your postretirement benefits.
APBO beginning of the year $ 2,050
Interest cost ($2,050 × 6%)
123
Service cost ($10,865 × 1/30)
362
APBO end of the year
$ 2,535
Let’s calculate postretirement benefits expense.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-21
Determining the Expense
Service cost
$
362
Interest cost
123
Because
most
healthNone
plans
Actual return
onpostretirement
plan assets
are
not funded,
there
arecost
no fund assets,
Amortization
of prior
service
None
noAmortization
credit for of
prior
service, and no net
loss.
net loss
None
Amortization of transition liability
85
Postretirement benefit expense
$
570
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).
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-22
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-23
Stock-Based Compensation Plans
Now let’s look at some incentive
compensation plans.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-24
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-25
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
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-26
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
Total
=
Compensation
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-27
Stock Award Plans
The total compensation of $620,000 will be recognized
over the service period of 5 years.
$620,000 ÷
5
=
$124,000 per year
On December 31, 2003, through 2007, we will prepare
the following journal entry:
GENERAL JOURNAL
Date
Description
Debit
Credit
Dec 31 Compensation expense
124,000
Paid-in capital - restricted stock
124,000
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-28
Stock Award Plans
On December 31, 2007, the shares are issued to the
CEO, and the following entry will be made:
GENERAL JOURNAL
Date
Description
Dec 31 Paid-in capital - restricted stock
Common stock (10,000 x $2)
Paid-in capital in excess of par
McGraw-Hill/Irwin
Debit
Credit
620,000
20,000
600,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-29
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-30
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-31
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-32
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-33
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-34
Stock Option Plans
January 1, 2003: Calculate total
compensation expense.
Shares per executive
100,000
Number of executives
4
Total shares
400,000
Compensation per share $
5
Total compensation
$ 2,000,000
$2,000,000 ÷ 5 years (2003 through 2007) = $400,000.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-35
Stock Option Plans
The following entry will be made on December
31, 2003 through 2007, the service period.
GENERAL JOURNAL
Date
Description
Dec 31 Compensation expense
Paid-in capital - stock options
McGraw-Hill/Irwin
Debit
Credit
400,000
400,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-36
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
GENERAL JOURNAL
Date
Description
Debit
Credit
May 2 Cash
11,400,000
Paid-in capital - stock options
1,000,000
Common stock ($1 par)
200,000
Paid in capital in excess of par
12,200,000
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-37
Stock Option Plans
If no options were exercised during the
10-year exercise period, the following entry
would be made when the options expire:
GENERAL JOURNAL
Date
Description
Debit
Credit
Dec 31 Paid-in capital - stock options
2,000,000
Paid-in capital - expired options
2,000,000
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-38
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.
 Tax is paid on the difference between the
market price and exercise price on the
date of subsequent sale.

McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-39
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.
Market price at grant date
$
45.00
Exercise price at grant date
38.50
Compensation per option
$
6.50
Total shares issuable
200,000
Total compensation
$ 1,300,000
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-40
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-41
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.
$$$
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-42
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.

Alternatively, the compensation may be
measured at the end of the accounting period.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-43
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-44
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-45
Stock Appreciation Rights
On December 31, 2003, Matrix common
shares closed at $64.50 per share.
Market value per share
Exercise price per share
Compensation per share
Number of SARs
Total compensation
$ 64.50
60.00
$
4.50
20,000
$ 90,000
Let’s look at the entry to recognize the
compensation expense for 2003.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-46
Stock Appreciation Rights
On December 31, 2003, Matrix common
shares closed at $64.50 per share.
GENERAL JOURNAL
Date
Description
Dec 31 Compensation expense
Cash
Debit
Credit
30,000
30,000
$90,000 ÷ 3 years = $30,000
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-47
Stock Appreciation Rights
On December 31, 2004, the stock closed at
$75 per share.
Market value per share
Exercise price per share
Compensation per share
Number of SARs
Total compensation
$
75.00
60.00
$ 15.00
20,000
$ 300,000
Total compensation
Previously recognized
Compensation
Years expired (2 ÷ 3)
Compensation expense
McGraw-Hill/Irwin
$ 300,000
(30,000)
$ 270,000
2/3
$ 180,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-48
Stock Appreciation Rights
On December 31, 2004, the stock closed at
$75 per share.
GENERAL JOURNAL
Date
Description
Dec 31 Compensation expense
Cash
McGraw-Hill/Irwin
Debit
Credit
180,000
180,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-49
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-50
Type of Plan
Restricted
stock award
Fixed stock
options
Performance
stock options
McGraw-Hill/Irwin
Fair Value Approach
Total
Compensation Balance Sheet
Fair value Fixed Shareholders'
at grant date,
equity: Paid-in
accrued to
capital
service period
Fair value Fixed Shareholders'
at grant date,
equity: Paid-in
accrued to
capital
service period
Fair value Fixed Shareholders'
at grant date,
equity: Paid-in
accrued to
capital
service period
Intrinsic Value Approach
Total
Balance
Compensation
Sheet
Same
Same
Intrinsic value
Same
Fixed at grant
date, accrued to
service period
Intrinsic value
Same
Amount varies
until option
terms are
known,
estmates
expensed until
then.
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-51
Type of Plan
SAR paid in
shares
SAR paid in
cash
Broad-based
plans
McGraw-Hill/Irwin
Fair Value Approach
Total
Compensation Balance Sheet
Fair value Fixed Shareholders'
at grant date,
equity: Paid-in
accrued to
capital
service period
Share price
Liabilities:
appreciation
Liability - SAR
Amount varies
until exercise
None
Shareholders'
equity: Only
when shares are
sold
Intrinsic Value
Total
Compensation
Share price
appreciation
Amount varies
until exercise
Same
Approach
Balance
Sheet
Same
Same
Same
Same
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-52
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
18-53
End of Chapter 18
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.