CHAPTER 15

VALUATION OF FIRMS WITH PENSION PLANS AND

OTHER POSTEMPLOYMENT BENEFIT PLANS
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
6.
7.
8.

The difference between defined contribution and defined benefit plans.

The meaning and importance of economic ownership.
How defined contribution and defined benefit plans are reported in financial statements and footnotes.
How a valuation incorporates defined contribution and defined benefit plans.
What plan assets are and why they are nonoperating assets in a valuation.
What benefit obligations are and why they are capital claims in a valuation.
How to adjust plan assets and benefit obligations for income tax effects before including them in a valuation.
What service costs are and why they are free cash flow equivalents.

TRUE/FALSE QUESTIONS
1.

When a firm sponsors a defined contribution plan, employees reap the rewards and bear the risks of
investing their assets in the plan.
(easy, L.O. 1, Section 1, true)

2.

Whether a retirement plan defines contributions or benefits determines both the financial reporting rules
and the way an analyst incorporates a plan into the valuation of a firm.
(moderate, L.O. 1, Section 1, true)

3.

In a defined contribution plan employers have no guarantee as to the amounts they will ultimately have to
contribute to fund the plan.
(moderate, L.O. 1, Section 1, false)

4.

Legal ownership belongs to the entity whose welfare is affected by changes in the value of the asset.
(moderate, L.O. 2, Section 1, false)

5.

An analyst treats firm payments into a defined contribution plan in the same manner as salary payments to
employees.
(moderate, L.O. 2, Section 2, true)

6.

The measurement of the legal liability of a defined benefit plan is known as its funded status.
(moderate, L.O. 4, Section 3, false)

7.

The funded status of a defined benefit plan represents either an asset or liability, depending on its sign.
(difficult, L.O. 4, Section 3, true)

8.

The funded status, economic cost, and GAAP assets or liabilities are mutually exclusive in a defined benefit
plan.
(moderate, L.O. 4, Section 3, false)

9.

The economic cost of a defined benefit plan is the change in its funded status not due to contributions.
(moderate, L.O. 4, Section 3, true)

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10.

If defined benefit plan assets exceed the projected benefit obligation, the funded status is negative and the
plan is overfunded.
(moderate, L.O. 5, Section 3, false)

11.

The PBO is the present value of the portion of future retirement benefits employees have earned.
(moderate, L.O. 5, Section 3, true)

12.

The value to the firm of the PBO is its reported value multiplied by one minus the marginal tax rate.
(moderate, L.O. 6, Section 4, true)

13.

When a firm has a defined benefit pension plan, nonoperating assets include service cost, other capital
claims include plan assets, and free cash flow includes the PBO.
(moderate, L.O. 6, Section 4, false)

14.

Free cash flow should include the income tax effect of service cost, but no other amounts related to the
income tax effect of pensions.
(moderate, L.O. 8, Section 4, true)

15.

The APBO, which pertains to other postemployment benefit plans, is similar to the PBO because it is
difficult to value and subject to even greater uncertainty.
(moderate, L.O. 4, Section A1, true)

MULTIPLE CHOICE QUESTIONS

16.

The majority of pension plans today are either defined contribution or defined benefit plans. If a plan is a
defined contribution plan:
a. once the company has contributed required amounts, it has no further obligation to employees
b. the plan dictates the amount of benefits retirees will receive
c. the employer directs the way in which employee funds are invested
d. the plan guarantees the amount of benefits retirees will receive
(easy, L.O. 1, Section 1, a)

17.

Which statement below is correct regarding defined benefit plans?

a. In a defined benefit plan, once the firm has contributed its required amounts, it has no further
obligation to employees.
b. The employees investment returns have no effect on the firms future contributions.
c. Each employee directs the way in which his or her funds are invested in a defined benefit plan.
d. Employees bear no investment risk if the plans investment returns are poor.
(moderate, L.O. 1, Section 1, d)

18.

A plan that provides for health insurance benefits to former employees is known as a(n):
a. defined benefit plan
b. other postemployment benefit plan
c. defined contribution plan
d. employee individual retirement account
(moderate, L.O. 1, Section 1, b)

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19.

Who is the economic owner of a defined contribution plan?

a. all employees of the firm who have been employed the required length of time
b. the firm who sponsors the plan
c. employees who participate in the plan
d. The defined contribution plan is its own economic entity and owner.
(moderate, L.O. 2, Section 1, c)

20.

Generally a firm can fund which plan shown below on a pay-as-you-go basis?
a. an other postemployment benefit plan
b. a defined contribution plan
c. a defined benefit plan
d. a defined contribution or defined benefit plan
(moderate, L.O. 2, Section 1, a)

21.

In a __________ pension plan the plan determines the amount of __________ and the __________ is the
economic owner of plan assets.
a. defined benefit; retiree benefits; employee
b. defined contribution; retiree benefits; employer firm
c. defined benefit; employer contributions; employer firm
d. defined contribution; employer contributions; employee
(moderate, L.O. 2, Section 1, d)

22.

Which statement below is incorrect regarding financial reporting and valuation of defined contribution
plans?
a. A firms defined contribution plan is a balance sheet item found in the long-term assets section of the
statement.
b. Payments to a defined contribution plan are generally tax deductible when made, which reduces the
firms marginal income tax rate.
c. The analyst incorporates a defined contribution plan in a valuation by including periodic contributions
into the forecast, like salary expenses would be included.
d. In some cases the operating expenses of a firm include contributions to defined contribution plans, so it
is unnecessary to consider the contributions explicitly.
(easy, L.O. 3, Section 2, a)

23.

When an analyst is preparing a valuation of a firm, the plan that will require substantial analysis is a(n):
a. defined contribution plan
b. employee individual retirement account
c. defined benefit plan
d. All of the plans will require substantial analysis for valuation purposes.
(moderate, L.O. 4, Section 3, a)

24.

The funded status and economic cost of a defined benefit plan are often volatile from one year to the next.
GAAP has prescribed a mechanism to reduce reported volatility in such plans. This mechanism:
a. is a series of adjustments made to the firms Retained Earnings account which delays income and
expense recognition
b. allows the use of a reserve account to bank any necessary adjustments to smooth the effect of
reported volatility in the plan from period to period
c. a series of smoothing adjustments that delay balance sheet recognition of changes in the plans funded
status, which also delays income and expense recognition
d. Defined benefit plans are separate entities and therefore the firm is not required to account for plans
funded status or investment activities.
(difficult, L.O. 4, Section 3, c)

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25.

Economic amounts change the funded status of a defined benefit plan each reporting period. During a
reporting period, the beginning funded status:
a. is increased by contributions and affected by certain smoothing adjustments to arrive at the ending
funded balance
b. is increased by contributions and decreased by the economic cost of the plan to arrive at the ending
funded balance
c. is increased by contributions and decreased by the expense reported under GAAP to arrive at the
ending funded balance
d. is changed by any smoothing adjustments to arrive at the ending funded balance
(moderate, L.O. 5, Section 3, b)

26.

The difference between defined benefit plan assets and the present value of the future retirement benefits
employees have earned is known as:
a. projected benefit obligation
b. funded status
c. GAAP pension asset or liability
d. plan assets
(moderate, L.O. 5, Section 3, b)

27.

It is determined that a defined benefit plans future contributions must be higher than its current
contribution. This means the plans:
a. assets exceed the PBO
b. assets are less than the PBO and the plan is overfunded
c. funded status is negative since the plans assets exceed the PBO
d. funded status is negative and it is underfunded
(moderate, L.O. 5, Section 3, d)

28.

The return on plan assets affects the market value of a defined benefit plan. An increase in the plans funded
status means:
a. the funded status is positive and the PBO decreases
b. the funded status is positive and the PBO increases
c. the funded status is positive but the PBO is negative
d. the PBO is mutually exclusive of the plans funded status
(moderate, L.O. 5, Section 3, a)

29.

The increase in the PBO that occurs with the passage of time is the plans:
a. overfunded GAAP liability
b. underfunded GAAP liability
c. interest cost
d. service cost
(easy, L.O. 5, Section 3, c)

30.

Actuaries play an important role in estimating the values of PBOs for defined benefit plans. Actuaries use
many assumptions about the future to estimate a plans PBO. When actuarial estimates change, so does the
plans PBO. If it is found that the PBO for a plan increases, there is:
a. an actuarial gain
b. an actuarial loss
c. a service cost increase
d. an interest cost increase
(moderate, L.O. 5, Section 3, b)

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31.

Which item below is not part of the economic cost of a defined benefit plan?
a. changes in the PBO due to changes in how the plan is measured
b. the increase in the PBO that occurs as employees earn additional benefits
c. the increase in the PBO that occurs with the passage of time
d. the amount the firm contributed to the plan during a period
(moderate, L.O. 5, Section 3, d)

32.

Which choice below may be subject to a smoothing adjustment for GAAP amounts on the balance sheet?
a. interest cost
b. employer contributions
c. a sweetener or curtailment
d. service cost
(moderate, L.O. 5, Section 3, c)

33.

Which item below is not subject to a smoothing adjustment for GAAP amounts on the balance sheet?
a. actuarial loss
b. return on plan assets
c. service cost
d. actuarial gain
(moderate, L.O. 5, Section 3, c)

34.

Which statement below is incorrect regarding smoothing adjustments for GAAP amounts on the income
statement?
a. Smoothing adjustments on the income statement follow the same pattern as the economic component of
pensions and GAAP.
b. Income statement smoothing adjustments are equal to the change in balance sheet smoothing
adjustments.
c. Income statement smoothing adjustments may result from either the deferral of current period funded
status changes or the reversal of previously deferred funded status changes.
d. The pension expense reported under GAAP is equal to the change in the reported pension asset or
liability that is due to contributions.
(difficult, L.O. 5, Section 3, d)

35.

The free cash flow forecast should include which of the following amounts related to defined benefit plan
pensions?
a. interest costs, net of any related tax benefits
b. service costs, net of any related tax benefits
c. actuarial gains or losses
d. plan amendments
(moderate, L.O. 6, Section 4, b)

36.

When a firm sponsors a defined benefit plan, the firms economic balance sheet identifies the PBO and/or
ABPO as:
a. debt
b. other capital claims
c. nonoperating net assets
d. free cash flow
(easy, L.O. 6, Section 4, b)

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37.

Which statement below is incorrect regarding the analysis of service costs when valuing a firm?
a. The analyst must perform several steps to convert the GAAP income and cash flow statements to a free
cash flow basis by removing all components of pension expense other than service cost.
b. Historical information about service costs is very useful for forecasting future service costs.
c. The analyst must forecast free cash flow as if it included only the service cost portion of pension
expense.
d. Like contributions, service costs are discretionary.
(moderate, L.O. 7, Section 4, d)

38.

Regarding pension items found on the GAAP financial statements:

a. pension items are often included in selling, general, and administrative expenses, while the pension
asset or liability is often part of other assets or accruals
b. pension items are usually separate line items in the GAAP financial statements
c. the future service cost for a defined benefit plan is usually found as a table in the pension footnote
d. None of the answers above are correct.
(moderate, L.O. 7, Section 4, a)

39.

Which statement below regarding the income tax effects of a defined benefit plan is incorrect?
a. Any difference between reported pension expense and contributions (the expense for tax purposes) is a
temporary difference.
b. Reported income tax expense is the marginal income tax rate times the reported pension expense.
c. The income tax deduction related to pensions is based on service cost.
d. The cash tax saving in any particular year is the marginal tax rate times the amount of contributions
made in that year.
(moderate, L.O. 8, Section 4, c)

40.

Actuaries estimate the values of the PBO and APBO using forecasts for the unknown elements of the
computations. Which statement below is incorrect regarding the present value of the PBO?
a. Before determining the amount of the PBO, the analyst must know the present value of all future
benefit payments, whether earned or not.
b. A reduction in the present value of the PBO would be due to benefit payments, which would commence
at some time in the future.
c. The PBO is not the present value of all future benefit payments, but only the portion of them that has
been earned.
d. All of the statements above are correct regarding the present value of the PBO.
(difficult, L.O. 8, Section A1, b)

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ESSAYS
41.

Explain the basic difference between a defined contribution and defined benefit plan.
Suggested solution:
Defined contribution and defined benefit plans are designed to provide benefits to recipients upon
retirement. A defined contribution plan specifies the amount that a firm must contribute to the plan on
behalf of its employees. A defined benefit plan specifies the benefits retirees will receive from the plan. This
one major difference impacts the way an analyst will incorporate the retirement plan into the valuation of a
firm.
In a defined contribution plan, the firm is only responsible for contributing the required amounts into the
plan. The firm, after it makes its contribution, has no further obligation to its employees. Employees bear
responsibility for the way funds are invested by choosing among various options, which typically bear
different degrees of investment risk. Each employee bears the risks and reaps the rewards of investing.
Investment returns in a defined contribution plan have no impact or effect on the firm or the amount of its
future contributions.
In a defined benefit plan, the firm is responsible for providing benefits to retirees according to a formula.
The firm contributes funds to the plan, which invests the funds until needed to pay benefits to retirees.
Because the plan specifies retiree benefits rather than employer contributions, the amount of benefits to
which an employee is entitled is independent of the return on the plans investments. The firm, not the
employee, bears the risks and rewards of investment in a defined benefit plan.
(moderate, L.O. 1, Section 1)

42.

Discuss economic ownership of retirement plans.

Suggested solution:
Defined contribution and defined benefit plans differ as to when the risks and rewards of investing are
transferred from the firm to its employees. This transfer from firm to employee occurs in part based on the
concepts of economic and legal ownership. The entity (i.e., firm or employee) that holds legal title to an
asset has legal ownership of the asset. In terms of retirement plans, the plan itself (whether it is a defined
contribution or defined benefit) is a separate legal entity distinct from either a firm or its employees. As
such, the plan itself legally owns its own assets. A legal transfer of assets may occur when an employee
retires (as in a defined benefit plan) or possibly sooner if the employee has complied with any vesting
requirement regarding length of employment (as in a defined contribution plan).
The entity whose welfare is affected by changes in the value of the asset has economic ownership of the
asset. The economic owner bears the risks and accepts the rewards of the investment. In the case of defined
contribution plans, the employee is the economic owner of the assets (even if the employee does not hold
legal title to the assets). In a defined benefit plan, the firm is the economic owner of the assets, bearing
investment risk and reward.
(easy, L.O. 2, Section 1)

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43.

What are the concepts of funded status and projected benefit options in a defined benefit plan?
Suggested solution:
A defined benefit plan provides benefits to retirees upon their retirement. Unlike a defined contribution plan,
defined benefit plans specify the benefits a retiree will receive from the plan. Because the defined benefit
plan dictates the amount of benefits retirees receive, the firm has no guarantee as to the amounts that
ultimately must be contributed to the plan to satisfy the plans obligation to retirees. This creates a situation
in which the firm has either an asset or liability connected with a defined benefit plan.
The asset or liability of a defined benefit plan consists of an economic component known as the funded
status. The funded status is the difference between plan assets and the present value of the future retirement
benefits employees have already earned. The present value of future retirement benefits due to employees is
known as the projected benefit obligation (or PBO).
The future value of the PBO depends on several variables, which are difficult to estimate. Actuaries
calculate the PBO based on certain assumptions, such as the life expectancy of retirees (mortality), how
much each employee will be entitled to receive based on current and future earnings, and how long
employees will remain with the firm.
The funded status for a plan may be either positive or negative. When the funded status is positive, the plan
assets exceed the PBO, and the plan is overfunded. A firm with an overfunded plan has an economic asset.
This economic asset permits the firm to contribute less to the plan in future years. Conversely, when the
funded status is negative, the PBO exceeds the plan assets, and the plan is underfunded. A firm with an
underfunded plan has an economic liability. This economic liability means the firm will have to contribute
more to the plan in future years.
(moderate, L.O. 3, Section 3)

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