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Financial analysts can use select data from a company’s financial statements to derive an economic pension expense in order to better reflect the company’s true economic pension cost. Which of the following formulas will most accurately calculate a company’s economic pension expense?

A) Beginning fair value of plan assets + service cost + interest cost – ending fair value of plan assets.

B) Service cost + interest cost + plan amendments – actual return on plan assets.

C) Service cost + interest cost – actual return on plan assets – benefits paid.

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An economic pension expense is calculated without reflecting the amortization of unrecognized items and other smoothing mechanisms included in reported pension expense, and in addition uses the plan’s actual return on assets, rather than the plan’s expected return.

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An economic pension expense can be calculated to better reflect a firm’s true economic pension cost than the reported pension expense. Which of the following adjustments to reported pension cost should be made?

A) The inclusion of amortization of unrecognized items.

B) The inclusion of actual benefits paid to employees.

C) The use of actual instead of expected return on assets.

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Reported pension cost can be adjusted by the removal of both the amortization of unrecognized items and other smoothing mechanisms, plus the use of actual return on assets rather the expected return. The resulting economic pension expense is a more accurate portrayal of the firm’s true pension cost

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Federal Companies reported the following information in the footnotes to its most recent financial statements:

Beginning Projected Benefit Obligation (PBO)	$65,000,000
Ending PBO	90,000,000
Service Cost	27,000,000
Interest Cost	3,000,000
Benefits Paid	5,000,000
Actual Return on Plan Assets	7,500,000
Expected Return on Plan Assets	8,500,000

Given the information above, calculate Federal’s economic pension expense for the year.

A) $41,000,000.

B) $27,500,000.

C) $22,500,000.

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Economic pension expense = service cost + interest cost – actual return on plan assets + plan ammendments
Therefore, $27,000,000 + 3,000,000 – 7,500,000 = $22,500,000

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Which of the following statements regarding economic pension expense is least accurate?

A) It is equal to the sum of all the changes in projected benefit obligation (PBO) for the period (except for benefits paid) less the actual return on assets.

B) It is equal to the change in the funded status for the period.

C) It is a more volatile measure of pension expense than reported pension expense.

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Economic pension expense is equal to the change in the funded status for the period excluding the firm’s contributions.

Economic pension expense is calculated by eliminating the smoothed amounts from reported pension expense and including the actual return on assets. The result is a more volatile measure of pension expense.

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Which of the following statements about stock-based compensation are correct or incorrect?

Statement #1:	The grant date of a service-based award is the date when the employees’ benefits are fully vested.
Statement #2:	When two or more performance conditions must be satisfied, the requisite service period ends when the first condition is met.

A) Both are incorrect.

B) Only one is correct.

C) Both are correct.

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The grant date is the date an award is approved by the board of directors or compensation committee. When two or more performance conditions must be satisfied, the requisite service period does not end until all conditions are met.

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Jason Moore, CFA, is a credit analyst for Everest Bank in New York in their investment banking division. An existing customer of the bank, Longhorn Partners, which is based in Texas, has approached the bank for a $45 million loan to be used to acquire a smaller competitor. Moore has been appointed head of the credit team that will review Longhorn’s current business with the bank as well as their current operations in order to assess Longhorn’s request.
Overall, Longhorn has achieved consistent profitability over the last decade. The company is appropriately leveraged and appears to be well-run by its senior management team. However, there are a couple of items in the company’s financial statements that Moore believes may warrant further analysis.
For many years, Longhorn has also offered to its fulltime employees a traditional, pension plan. It is a pay-related defined benefit plan, in which upon retirement, eligible employees are promised an annual pension payment of 3% per year of service times their annual salary at retirement. Select information regarding the pension plan from Longhorn’s most recent financial statement is as follows:

Pension Benefit Obligation (PBO)	$85,475,000
Accumulated Benefit Obligation (ABO)	65,250,000
Fair value of plan assets	71,365,000
Net pension liability	5,450,000
Discount rate	6.25%

According to the information above, the funded status of Longhorn’s pension plan is closest to:

A) underfunded by $6,115,000.

B) underfunded by $14,110,000.

C) overfunded by $6,115,000.

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A plan is underfunded when the PBO exceeds the fair market value of the plan assets. In this case, the PBO exceeds the plan assets by $14,110,000 (= $85,475,000 − 71,365,000). (Study Session 6, LOS 24.e)

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Moore reads in the footnotes to Longhorn’s financial statements that the pension plan’s PBO balance increased by $5,000,000 last year. Of this amount, approximately 50% was attributed to benefits earned by its employees that year. The remaining 50% was attributed to a change in the pension plan’s actuarial assumptions. Which one of the following changes to actuarial assumptions would cause an increase in PBO?

A) A decrease in the discount rate.

B) A decrease in the rate of compensation growth.

C) A decrease in the expected rate of return.

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Decreasing the assumed discount rate used to calculate the present value of the pension obligations will increase the PBO. (Study Session 6, LOS 24.d)

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Ignoring taxes, what adjustment is necessary to Longhorn’s net pension liability and other comprehensive income in order to comply with current U.S. accounting standards?

Net pension liability

Other comprehensive income

A) Increase $8,660,000 Decrease $8,660,000

B) Decrease $8,660,000 Increase $8,660,000

C) Increase $14,110,000 Decrease $14,110,000

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According to current U.S. accounting standards, the funded status must be reported on the balance sheet. The plan is underfunded by $14,110,000 ($71,365,000 Plan assets – $85,475,000 PBO). Since Longhorn is reporting a liability of $5,450,000, an additional liability of $8,660,000 ($14,110,000 required liability – $5,450,000 reported liability) must be reported. The increase in net pension liability is offset by a decrease in other comprehensive income. (Study Session 6, LOS 24.e)

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Which of the following is NOT an advantage of share based compensation over cash compensation?

A) Share based compensation does not require a cash outlay.

B) Share based compensation serves to align employee interest with the interests of stockholders.

C) In a share based compensation plan, expense is not recognized, unless the exercise price is set below the market price.

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Share based compensation needs to be recognized at fair value under both U.S. GAAP and IFRS. Intrinsic value does not matter. However, the expense is does not require a cash outlay and serves to align the interests of employees and stockholders.

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Which of the following statements about the methods of valuing employee stock options is least accurate?

A) With the intrinsic value method, once the options are in-the-money, compensation expense is recognized on the income statement.

B) With the fair value method, compensation expense is allocated in the income statement for the period between the grant date and the vesting date.

C) With either method, the offset to compensation expense recognized is an increase in paid-in capital.

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With the intrinsic value method, compensation expense is recognized in the income statement only if the market price of the stock exceeds the exercise price of the option on the date the option was granted (grant date).

Compensation expense is now based on the fair value of the option on the grant date based on the number of options that are expected to vest. The vesting date is the first date the employee can actually exercise the option. The compensation is allocated in the income statement over the service period (which is the time between the grant date and the vesting date).

For any compensation expense recognized, the offset is an expense in paid-in capital, which is a stockholders’ equity account

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Which of the following statements about stock appreciation rights, performance stock, and phantom stock is most accurate?

A) Performance stock cannot be sold by the employee until vesting has occurred.

B) Phantom stock payoffs are based on the performance of the firm’s actual shares.

C) Stock appreciation rights never have any dilution effect on the existing shareholders.

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Stock appreciation rights do not cause dilution to the existing shareholders since no shares are actually issued.

Performance stock is a type of stock grant. It is contingent on meeting performance goals such as accounting earnings or other financial reporting metrics like return on assets or return on equity. Unfortunately, tying performance to accounting earnings and other metrics may result in manipulation by the employee. With restricted stock, the transferred stock cannot be sold by the employee until vesting has occurred.

Phantom stock is similar to stock appreciation rights except the payoff is based on the performance of hypothetical stock instead of the firm’s actual shares.

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In determining the fair value of employee stock options, which of the following statements is most appropriate?

A) Absent a market-based instrument, U.S. GAAP and IFRS prefer firms to use the Black-Scholes option-pricing model.

B) A higher than expected dividend yield will decrease the estimated fair value.

C) A lower risk-free rate will usually increase the estimated fair value.

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Dividends paid out reduce the value of the underlying shares and therefore, reduce the value of the option.

There is no preference of a specific option-pricing model in either IFRS or U.S. GAAP. Acceptable models include the Black-Scholes model or the binomial model.

A lower risk-free rate will usually decrease the estimated fair value of the option (Refer to Study Session 17). The sensitivity factor is “Rho” and for call options, there is a positive relationship between the risk-free rate and the estimated fair value of the option.