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Financial Reporting and Analysis【 Reading 23】Sample

The financial statements of Pace Industries issued over the past five years show a progressively increasing net difference between the value of its pension fund and the projected future pension liability on the balance sheet. Pace most likely offers which of the following types of pension plans to its employees?
A)
A defined benefit plan.
B)
A 401(k) plan.
C)
A defined contribution plan.



A company with a defined benefit plan will fund a portfolio structured to fulfill future pension obligations. The difference between the current value of the assets and the projected future liability is shown as a net amount on the balance sheet.

When considering the major differences between a defined contribution and a defined benefit pension plan, which of the following statements is most accurate?
A)
Among the different types of pension plans, accounting for a pay-related defined benefit plan is the most complicated because of the required actuarial assumptions.
B)
Accounting for a defined contribution pension plan is the most complicated because of the many investment options available to the employees.
C)
A company with a defined contribution plan will report on its balance sheet the net difference between the value of the pension fund assets and the value of the pension liability.



Three actuarial assumptions (discount rate, expected increase in employee compensation and the expected return on plan assets) must be estimated to project the value of the corporation’s pension liability today. Subtle changes to any of the three assumptions can drastically change the estimated liability.

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Neptune Corporation (Neptune) is a U.S. company located in Detroit, Michigan. Neptune supplies exhaust emission systems to manufacturers of passenger cars and light duty trucks. In January 2006, Neptune formed a wholly owned subsidiary, Continental Systems GmbH (Continental), to supply automotive manufacturers located throughout Europe. Continental is located in Stuttgart, Germany.
Continental’s most recent financial statements, denominated in euros, are provided in Exhibit 1.
Exhibit 1: Continental Systems GmbH
Income statement
Year ended December 31
(in thousands)2008
Sales revenue€76,000
Cost of goods sold(48,000)
Administrative expense(4,000)
Depreciation expense(6,000)
Interest expense(4,800)
Tax expense(5,760)
Net income€7,440

Balance sheet
As of December 31
(in thousands)
Assets20082007
Cash€8,800€8,000
Accounts receivable44,00042,000
Inventory16,80016,000
Fixed assets, at cost97,20088,000
Accumulated depreciation(42,000)(36,000)
Total assets€124,800€118,000

Neptune has net monetary assets and reports its consolidated financial statements in U.S. dollars. The euro has been consistently appreciating against the dollar.
Continental accounts for its inventory using the first-in, first-out (FIFO) cost flow assumption. Fixed assets consist of machinery, tools, and equipment. All of the fixed assets were acquired at the beginning of 2006.
All of Neptune's U.S. employees are covered by a defined benefit pension plan. The plan is noncontributory and the benefits are based on years of service and employee earnings. Both ABO and PBO currently exceed the fair value of pension plan assets.Which of the following components of the projected benefit obligation is most likely to increase every year as a direct result of the employee working another year for the company?
A)
Current service cost.
B)
Interest cost.
C)
Benefits paid.



The current service cost is the present value of new benefits earned by the employee working another year. Current service cost increases the PBO. Note that the interest cost increases every year regardless of whether the employee works another year or not. (Study Session 6, LOS 24.b)

Which of the following are the most likely impacts on gross profit margin and net profit margin, assuming the temporal method is used to remeasure Continental’s financial statements?
A)
Only net profit margin will be higher.
B)
Both will be higher.
C)
Only gross profit margin will be higher.


Under the temporal method, sales are remeasured at the average rate, and cost of goods sold is remeasured at the historical rate. Since the euro is appreciating relative to the dollar, sales will be higher when stated in dollars. Because cost of goods sold is remeasured at the historical rate, it does not reflect the appreciating euro. Therefore, appreciating sales, without a corresponding increase in cost of goods sold, will result in higher gross profit margin.
Under the temporal method, exposure is defined as the firm’s net monetary asset or net monetary liability position. Continental is holding net monetary assets (monetary assets exceed monetary liabilities), and the position is increasing. Holding net monetary assets when the euro is appreciating will result in the recognition of a gain in the income statement. The gain results in higher net income and, thus, higher net profit margin. (Study Session 6, LOS 25.c)


Which of the following are the most likely impacts on the operating profit margin and the long-term debt-to-equity ratio, assuming the current rate method is used to translate Continental’s financial statements?
A)
Neither ratio will change.
B)
Operating profit margin will be higher.
C)
Long-term debt-to-equity ratio will be higher.


Under the current rate method, all revenues and all expenses are translated at the average rate. Consequently, the subtotals (gross profit, operating profit, and net profit) are translated at the average rate. Translating the numerator (operating profit) and the denominator (sales) at the same rate will have no impact on the ratio.
Under the current rate method, all assets and all liabilities are translated at the current rate. In order for the balance sheet equation to balance, total shareholders’ equity must also be translated at the current rate. Translating the numerator (long-term debt) and the denominator (shareholders’ equity) at the same rate will have no impact on the ratio. (Study Session 6, LOS 25.c)


When stated in U.S. dollars, would Continental most likely report a higher fixed asset turnover ratio and a higher quick ratio under the temporal method, as compared to the current rate method?
A)
Only fixed asset turnover will be higher under the temporal method.
B)
Both ratios will be higher under the temporal method.
C)
Only the quick ratio will be higher under the temporal method.


Continental would report a higher fixed asset turnover ratio (sales/fixed assets) under the temporal method because sales are translated at the same rate under both methods (the average rate), but fixed assets would be translated at the lower historical rate (because the euro is appreciating) under the temporal method. Therefore, the ratio will be higher.
Continental would not report a higher quick ratio under the temporal method. Actually, the quick ratio would be the same under both methods. Continental’s quick assets include cash and accounts receivable. Quick assets and current liabilities are converted at the current rate under both methods. (Study Session 6, LOS 25.c)


Which of the following statements about the temporal method and the current rate method is least accurate?
A)
Subsidiaries whose operations are well integrated with the parent will generally use the current rate method.
B)
Subsidiaries that operate in highly inflationary environments will generally use the temporal method under U.S. GAAP.
C)
Net income is generally more volatile under the temporal method than under the current rate method.



Subsidiaries whose operations are well integrated with the parent will generally use the parent's currency as the functional currency. Remeasurement from the local currency to the functional currency is done with the temporal method. (Study Session 6, LOS 25.c)

If Neptune was to increase the discount rate used in calculating the pension obligations, which of the following would be most correct, concerning its net income and the funded status of the pension plan?
A)
Higher net income, with a lower funded status.
B)
Higher net income, with a higher funded status.
C)
Lower net income, with a higher funded status.


Service cost, a component of pension expense, is a present value calculation. Consequently, an increase in the discount rate will lower the service cost. A lower service cost will result in lower pension expense. Lower pension expense will result in higher net income.
The funded status is equal to the difference in the fair value of the plan assets and PBO. Since service cost is also a component of PBO, an increase in the discount rate will result in a lower PBO. A lower PBO will result in a higher funded status (more funded). (Study Session 6, LOS 24.b)

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An analyst views the assumptions made by a company regarding its pension liabilities as unrealistic, and thinks the discount rate and expected rate of return should both be increased. The most likely effect of increasing the discount rate and expected rate of return on the vested benefit obligation (VBO) is:
Discount rateExpected rate of return
A)
IncreaseNo effect
B)
No effectDecrease
C)
DecreaseNo effect



The VBO will decrease because a higher discount rate will cause the present value of the future obligations to decline. There will be no effect from changing the expected rate of return because expected return relates to the pension funding and expense, not to the size of the obligation.

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The vested benefit obligation is defined as the:
A)
actuarial present value of all future pension benefits earned to date and based on current salary levels, ignoring future increases.
B)
actuarial present value of all future pension benefits earned to date based on expected future salary increases.
C)
amount of the accumulated benefit obligation (ABO) to which the employee is entitled based on the company’s vesting schedule.



The vested benefit obligation is defined as the amount of the accumulated benefit obligation (ABO) to which the employee is entitled based on the company’s vesting schedule.

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The accumulated benefit obligation is defined as the:
A)
actuarial present value of all future pension benefits earned to date based on expected future salary increases.
B)
actuarial present value of all future pension benefits earned to date and based on current salary levels.
C)
increase in the projected benefit obligation (PBO) due to the passage of time.



The accumulated benefit obligation is defined as the actuarial present value of all future pension benefits earned to date and based on current salary levels, ignoring future increases.

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Which of the following is NOT a measure of pension plan liabilities for a defined benefit pension plan?
A)
Vested benefit obligation.
B)
Deferred benefit obligation.
C)
Projected benefit obligation.



Deferred benefit obligation is not one of the measures of pension plan liabilities for a defined benefit pension plan.

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The projected benefit obligation (PBO) is defined as the:
A)
actuarial present value of all future pension benefits earned to date based on expected future salary increases.
B)
actuarial future value of all post-retirement healthcare benefits earned to date.
C)
actuarial present value of all future pension benefits earned to date and based on current salary levels.



The projected benefit obligation (PBO) is defined as the actuarial present value of all future pension benefits earned to date based on expected future salary increases.

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The actuarial present value of all future pension benefits earned to date, based on expected future salary increases, is called the:
A)
vested benefit obligation.
B)
accumulated benefit obligation.
C)
projected benefit obligation (PBO).



The PBO is the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases. It measures the value of the obligation, assuming the firm is a going concern and that the employees will continue to work for the firm until they retire.

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Jon Horton, CFA, is the Chief Financial Officer (CFO) for Springtown Corporation, a manufacturer of windows for residential and commercial applications. As part of an ongoing diversification strategy, Springtown Corp. has recently entered into a preliminary agreement to purchase all of the assets of Prime Doors, a manufacturer and distributor of doors to the same residential and commercial market in which Springtown sells its windows. Horton is head of the due diligence team that will fully evaluate Prime Doors’ financial statements prior to the proposed acquisition.p>
Prime Doors has been in operation for thirty years, and currently has approximately 800 employees at two operating facilities. Horton observes in the notes to the financial statements that Prime Doors has a defined benefit pension plan, for which all employees are eligible. Employees are vested at the rate of 20% per year of employment, and are fully vested upon completion of five years of employment. Springtown does not offer a pension plan to its employees, but encourages employees to contribute to Individual Retirement Accounts (IRAs) and offers a 401(k) program.
Horton wants to fully evaluate the financial implications of Springtown’s assumption of Prime Doors’ pension assets and the associated future liabilities and expenses. Like most companies, the pension plan for Springtown’s employees is not fully funded, but Horton wants to review all assumptions used by Springtown’s accountants in the valuation of the plan’s current liabilities. The most current information regarding the pension plans is as follows:
Select Pension Plan Information for Prime Doors (as of 12/31/05)
Projected benefit obligation (PBO) $15,500,000
Accumulated benefit obligation (ABO) $13,750,000
Market value of plan assets $11,875,000

Horton notices a paragraph in the pension plan footnotes that the original pension plan was amended last year, effectively increasing the level of benefits to be paid to employees with more than ten years of service. However, he is not able to detect what effect, if any, this change in projected benefits has had on Prime Doors’ financial statements or is expected to have in the future.
Horton is aware that a commonly used method can be used to adjust the income statement and provide a better measure of Prime Doors’ economic pension cost than reported pension expense. He is not quite sure which components of the financial statements are utilized to derive an adjusted pension expense, but intends to investigate what analysis he can perform to gain more insight into the company’s position with regards to its pension plan.When accounting for pension liabilities in the U.S., a company must make fundamental assumptions to estimate the future liability and expense for each employee. How are the following assumptions required to be treated in the pension footnotes?
Required disclosureNot required to be disclosed
A)
Discount rateExpected return on plan assets
B)
Rate of compensation growthExpected length of employment
C)
Discount rateRate of compensation growth



A company must disclose the discount rate, the expected return on plan assets, and the rate of compensation growth. The expected length of employment is not a required disclosure. (Study Session 6, LOS 24.d)

What effect will an increased discount rate and increased expected rate of return have on a company’s projected benefit obligation (PBO) and accumulated benefit obligation (ABO) as reflected in the financial statements?
A)
Both will decrease.
B)
Both will increase.
C)
Only one will increase.



The use of a higher discount rate will decrease a company’s PBO and ABO because it will result in a lower present value of future pension liability. The expected rate of return has no impact on pension obligations. (Study Session 6, LOS 24.b)

According to U.S. GAAP, companies must account for pension assets and the associated pension obligation in their financial statements. These could be reported in two ways. Method 1 is to report the values of the pension fund assets and liability separately on the balance sheet. Method 2 is to report a net amount for the difference between the value of the fund assets and the fund liabilities. Which of the following statements most accurately describes the requirements of U.S. GAAP?
A)
Companies may choose to use either method.
B)
Companies are required to use Method 1.
C)
Companies are required to use Method 2.



GAAP requires that companies use the “net” method, which decreases a firm’s total assets and total liability. Netting also affects certain financial ratios, such as return on assets and leverage ratios. (Study Session 6, LOS 24.g)

Prime Doors has recorded a net pension liability of $1.5 million on its balance sheet. According to current U.S. accounting standards, Prime Doors is required to:
A)
immediately recognize $2,125,000 as additional pension expense in its income statement.
B)
record $375,000 as additional pension expense on its balance sheet.
C)
record $2,125,000 as additional pension liability on its balance sheet.



According to current U.S. accounting standards, the funded status must be reported on the balance sheet. The plan is underfunded by $3,625,000 ($11,875,000 Plan assets − $15,500,000 PBO). Since Prime Doors is reporting a liability of $1,500,000, an additional liability of $2,125,000 ($3,625,000 required liability − $1,500,000 reported liability) must be reported. (Study Session 6, LOS 24.b)

Which of the following statements regarding the treatment of pension plan amendments under U.S. GAAP standards is most accurate? A plan amendment results in:
A)
the disclosure in the pension plan footnotes of the nature of the amendment and the projected future financial impact.
B)
an immediate increase in pension expense equal to the amount of the amendment.
C)
an unrecognized prior service cost that is amortized over the expected remaining service life of the affected employees.



The amendment affects the funded status on the balance sheet immediately. In the income statement, the amendment is amortized as a component of pension expense over the remaining service life of the affected employees. (Study Session 6, LOS 24.b)

Pension expense as reported by a firm is routinely adjusted by analysts to derive a more accurate measure of a firm’s true economic pension cost. Economic pension expense is calculated as:
A)
Contribution – ( Ending funded status – beginning funded status)
B)
reported pension expense – service cost + interest cost.
C)
reported pension cost – actual return on plan assets.



Economic pension expense is calculated without reflecting the amortized items normally included in pension expense and using “actual” instead of “expected” return on assets. It can be also computed as Change in funded status excluding contributions (Study Session 6, LOS 24.h)

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