Table of Contents
CFA Level 2 – Financial Reporting and Analysis, Session 6 – Reading 23
(Practice Questions, Sample Questions)
1. 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.
<Explanation> A) 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.
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2. 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.
<Explanation> A) 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
3. 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 rate
Expected rate of return
A)
Increase
No effect
B)
No effect
Decrease
C)
Decrease
No effect
<Explanation> C) 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
4. 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.
<Explanation> C) 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.
5. 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.
<Explanation> B) 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.
7. 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.
<Explanation> B) Deferred benefit obligation is not one of the measures of pension plan liabilities for a defined benefit pension plan.
8. 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.
<Explanation> A) 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.
9. 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).
<Explanation> C)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.
10. In order to decrease the projected benefit obligation (PBO) of a pension plan, which of the following changes in pension assumptions can be made to yield the desired result?
A)Increase the expected rate of return.
B)Decrease the discount rate.
C)Decrease the rate of compensation growth.
<Explanation> C)A decrease in the rate of compensation growth will lower future pension payments and in turn, lower the PBO
11. Wonderful Manufacturing has implemented a change in its pension plan, that will increase the future benefits for all of its current employees. Which of the following is the most likely effect on the company’s financial statements of this change in promised benefits under current U.S. GAAP standards?
A)The net pension liability will increase immediately by the projected increase in pension benefits due to employees.
B)The pension expense for the next reporting period will increase by the projected increase in pension benefits due to employees.
C)The firm’s prior financial statements will be adjusted to reflect the increase in benefits.
<Explanation> A) A plan amendment will result in an immediate increase in the PBO. Under current U.S. accounting standards, an increase in PBO will result in an increase in the net pension liability (decrease in funded status).
12. Wes Livingston is the founder and CEO of Bigwell Corporation. Livingston is interested in Bigwell being acquired by a larger competitor and wants to have his company’s financial statements appear as attractive as possible to a potential suitor. In order to decrease the accumulated benefit obligation (ABO) of the company’s pension plan, which of the following changes in actuarial assumptions could be made?
A)Decrease the rate of compensation growth.
B)Decrease the discount rate.
C)Increase the discount rate
<Explanation> C) Increasing the assumed discount rate of a pension plan will result in lower pension liabilities, thus decreasing both the ABO and the projected benefit obligation (PBO).
13. Peak Productions is a publicly traded company that manufactures consumer electronics products in the U.S. The company has been in operation nearly fifty years, and has a considerable pension plan liability on its financial statements. Peak has a well-deserved reputation among analysts of utilizing aggressive accounting practices with regard to its pension plan. Which of the treatments of the following actuarial assumptions is the best example of aggressive accounting for a pension plan?
A)A high calculated projected benefit obligation (PBO).
B)A high compensation growth rate.
C)A high discount rate.
<Explanation> C) The assumption of a high discount rate will result in a lower pension liability and almost always a lower pension expense. The more aggressive the actuarial assumptions for a pension plan are, the lower the quality of earnings for the firm.
14. Roberto Perez, CFA, is the Chief Financial Officer for Home Stores, Inc., a large home improvement retailer with stores located across the United States. Home Stores is preparing for a secondary stock offering to secure the necessary capital to pursue an aggressive expansion campaign. Perez has received a directive from his boss to make every legitimate effort to present Home Stores’ upcoming financial statements in the best possible light. Perez determines that certain assumptions in the pension plan can be changed to fulfill this request. Which of the following pension plan assumptions can be changed by a firm to manipulate its reported results?
Change
Result
A)
increased expected rate of return
decreased service cost
B)
decreased discount rate
increased expected return
C)
decreased rate of compensation growth
decreased service cost
<Explanation> C) The rate of compensation growth is the expected average annual increase in employee compensation. If the rate of growth is lowered, reported results will be improved due to a decrease in service cost. A decrease in service cost will result in lower pension expense.
15. The Board of Directors of Prime Bank has asked management to make changes in the accounting of its pension plan obligations in order to decrease the reported service cost. Management determines that there are two changes in actuarial assumptions that will result in a lower service cost. Which of the following pairs of changes in actuarial assumptions will best achieve the desired effect? Prime Bank can either:
A)increase the discount rate or decrease the rate of compensation growth.
B)decrease the rate of compensation growth or increase the expected rate of return.
C)decrease the discount rate or increase the expected rate of return.
<Explanation> A) An increase in the discount rate will result in lower service cost. Using a lower rate of compensation growth will yield lower future pension benefits owed, and thus a lower service cost. The expected return has no impact on service cost
16. Tim Gresham, CFO of Alpha Logistics is concerned about changes in the business environment which could lead to Alpha violating some of the covenants of their outstanding debentures. Specifically Gresham is concerned about leverage and profitability ratios. Gresham reviews Alpha’s most recent financial statements and decides that changing the assumptions for the company’s defined benefit pension plan may provide some relief in the short-run. Alpha reports under U.S. GAAP.
Which of the following changes in the pension plan’s assumptions would most likely lead to lower reported leverage and higher reported profitability?
A)Increasing expected return on plan assets.
B)Increasing the discount rate.
C)Increasing the growth rate in compensation expense.
<Explanation> B) Increasing discount rate leads to lower present values and reduces reported pension liability in the balance sheet and also reduces pension expense by reducing the service cost component. Increasing expected return on plan assets does reduce pension expense but does not affect reported assets or liabilities. Increasing the growth rate in compensation expense increases service cost as well as reported pension liability.
17. Under current U.S. GAAP, the assets and liabilities of a defined benefit pension plan are:
A)reported in the appropriate section of the balance sheet, with pension obligations shown under liabilities and plan assets shown under assets.
B)off balance sheet items which are shown only in the footnotes.
C)netted against each other, and only the net asset or liability amount is reported on the company’s balance sheet.
<Explanation> C) Under current U.S. GAAP, companies are required to report only the net asset or liability amount. They cannot show assets and liabilities separately. Although some smoothing details are still disclosed in the footnotes, all major components of pension assets and liabilities are now required to be shown on the balance sheet
18. Which of the following statements regarding pension accounting under U.S. GAAP standards is most accurate?
A)Changes in actuarial assumptions and past service costs fully and immediately affect the income statement.
B)A reconciliation between the funded status and the net pension asset (liability) reported on the balance is required.
C)Changes in the projected benefit obligation (PBO) and plan assets fully and immediately affect the balance sheet.
<Explanation> C) Changes in the projected benefit obligation (PBO) and plan assets immediately affect the funded status (difference in PBO and plan assets) and the full amount of the changes is reflected on the balance sheet when the change occurs.
Changes in actuarial assumptions and past service costs are recognized in the income statement over time thereby smoothing pension expense.
Since the funded status is equal to the net pension asset (liability) reported on the balance sheet under U.S. GAAP, then no reconciliation is required. Note: However, the reconciliation (as illustrated below) is required under current IFRS.
Funded status (Fair value of plan assets – PBO)
Unrecognized deferred (gains) and losses
+ Unrecognized past service cost
Unrecognized transition (asset) or liability
=Net pension asset (liability) reported on the balance sheet
19. Which of the following statements regarding the projected benefit obligation (PBO) and the value of the pension plan assets is most accurate?
A)Plan amendments during the year generally result in a decrease of the PBO at the end of the year.
B)The fair value of plan assets is increased by the amount of the expected return on assets.
C)If the PBO and the plan assets are the same, then nothing needs to be reported on the balance sheet.
<Explanation> C) Neither the PBO nor the plan assets are separately reported on the balance sheet. The funded status is the difference in the PBO and the plan assets. If the PBO exceeds the plan assets, the difference is reported as a liability. If the plan assets exceed the PBO, the difference is reported as an asset. If the amounts are the same, then neither a liability nor asset needs to be reported.
Plan amendments (i.e. additional benefits provided that increase the amount of the employer’s obligation to plan participants) generally result in an increase of the PBO.
The fair value of plan assets at the beginning of the period is increased by the actual return on plan assets as well as any employer contributions. It is reduced by the amount of benefits paid.
20. Which of the following statements regarding pension accounting under current U.S. GAAP standards and International Financial Reporting Standards (IFRS) is most accurate?
A)Under IFRS, the funded status (difference in the PBO and the plan assets) is now reported on the balance sheet.
B)Under U.S. GAAP, firms are required to provide a reconciliation of the funded status and the reported net pension asset or liability.
C)Under IFRS and U.S. GAAP, the calculation of pension expense is the same
<Explanation> C) The calculation of pension expense is not affected by the new standard. Pension expense still includes the smoothing effects of the amortization of deferred gains and losses and the amortization of past (prior) service costs.
Under current U.S. GAAP, the net pension asset or liability reported on the balance sheet is equal to the funded status, without adjustment for unrecognized items. However, under IFRS, the net pension asset or liability reported on the balance sheet represents the funded status adjusted for unrecognized items.
Under current IFRS, firms are required to provide a reconciliation of the funded status and the reported net pension asset or liability. The reconciliation can be used to make an adjustment to the new standard for comparison purposes
21. Straight Elements, Inc. (SE) is a discount manufacturer of parts and supplies for the railroad industry, and uses U.S. GAAP. The following information is from SE’s financial statements and accompanying notes:
(Figures in millions)
PBO
$435
Service Cost
39
ABO
370
Actual Return on Plan Assets
39
Benefits Paid
22
Unamortized Past Service Cost
39
FMV of Plan Assets
295
If SE reported under IFRS instead of US GAAP, the liability reported on the balance sheet would be:
A)
higher.
B)
lower.
C)
the same.
<Explanation> B) Under IFRS the pension liability would be lower because of the $39 million in unamortized past service costs. Under IFRS, the balance sheet entry (funded status) excludes amounts that have not been recognized in the income statement (e.g., deferred gains and losses, and past service cost). Note that the question is asking for the liability vs. the examples in the Notes work with assets. Hence, the logic reverses
22. The following information relates to Nazarali Inc. (Nazarali) and its defined-benefit pension plan for the year:
Contributions $3.0 million
Reported pension expense $2.8 million
Economic pension expense $3.1 million
Based on the information above, which of the following statements is most accurate?
A)There is a reduction in the overall pension obligation of $100,000.
B)There is a reduction in the overall pension obligation of $200,000.
C)There is a source of borrowing of $100,000
<Explanation> C) The economic pension expense represents the true cost of the pension. The reported pension expense is irrelevant in this case.
Since the economic pension expense ($3.1 million) exceeds the contributions ($3.0 million), the $100,000 difference can be viewed as a source of borrowing. Alternatively, if the firm’s contributions exceed the economic pension expense, the difference can be viewed as a reduction in the overall pension obligation, similar to an excess principal payment on a loan.
23. Consider a situation at a firm where the differences in its cash flow and economic pension expense are considered material to the financial statements. The relevant tax rate is 30%. The expected return on plan assets is $120,000, interest cost is $85,000, employer’s contribution is $215,000, service cost is $450,000, and the actual return on plan assets is $50,000. Based on the information provided and for analytical purposes only, which of the following statements is most appropriate?
A)There is a reclassification of $189,000 from operating cash flow to financing cash flow.
B)There is a reclassification of $270,000 from operating cash flow to financing cash flow.
C)There is a reclassification of $140,000 from operating cash flow to financing cash flow.
<Explanation> A) The economic pension expense = service cost + interest cost − actual return on plan assets = $450,000 + $85,000 − $50,000 = $485,000.
Since the differences in cash flow and economic pension expense are considered material, for analysis purposes we should consider reclassifying the difference from operating activities to financing activities in the cash flow statement.
The employer’s contribution was only $215,000. Since the economic pension expense exceeds the cash flow, the difference, net of tax, is treated as a borrowing in the cash flow statement for analytical purposes. Assuming a tax rate of 30%, $189,000 is reclassified from operating cash flow to financing cash flow [($485,000 economic pension expense − $215,000 employer contribution) ((1 − 30% tax rate)]
24. With regard to a firm’s post-retirement healthcare plan, which of the following statements about its cash flows is least accurate?
A)Cash flows occur when the benefits are paid.
B)Cash flows occur when the firm makes contributions to the plan.
C)Cash flows are reported as operating activities.
<Explanation> B) A post-retirement healthcare plan is an example of an unfunded plan. In a funded plan, the cash flows occur when the company makes contributions to the plan. In an unfunded plan, the cash flows occur when the benefits are paid. In either case, the cash flows are reported as operating activities in the cash flow statement.
25. Mountain View Inc.’s latest financial statements show the projected benefit obligation (PBO) of their pension plan to be $250 million, while the fair market value of the plan assets is $210 million. The company’s balance sheet reflects a net pension liability of $25 million. In light of this information, which of the following actions is Mountain View required to take in accordance with current U.S. accounting standards? Ignoring income taxes, the company is required to:
A)record a $15 million “additional pension liability” on its balance sheet.
B)record a $40 million “additional pension liability” on its balance sheet.
C)disclose a $15 million “additional pension liability” in the footnotes to its financial statements.
<Explanation> A) If the PBO exceeds the fair market value of plan assets, GAAP requires that companies disclose the difference on the balance sheet as a liability. The total difference between the PBO and the fair market value of plan assets is $40 million (= $250 million − 210 million). Since $25 million of net pension liability is already reflected in the financial statements, Mountain View needs to book $15 million in additional pension liability
26. When analyzing the disclosures made with regard to pension plan accounting released by a company, which of the following measures most accurately reflects the true economic position of the plan?
A)The accumulated benefit obligation (ABO).
B)The fair value of plan assets.
C)The funded status of the plan
<Explanation> C) The funded status of a pension plan is simply the fair market value of the plan assets minus the PBO
27. Darla Whitney, CFA, is an investment advisor for a small money management firm in New York. She is considering the purchase of shares in Best Corp., a German company. Whitney is aware that there are differences in the accounting treatment of pension benefits for U.S. companies under GAAP and those companies operating under the International Financial Reporting Standards (IFRS). Which of the following statements most accurately describes the most significant difference between the GAAP and the IFRS rules for the accounting for pension plans?
A)GAAP requires that actuarial gains and losses be amortized over the employee’s service life, while IFRS requires that they be amortized over a period not to exceed 15 years.
B)GAAP recognizes the funded status on the balance sheet, while IFRS reflects the funded status adjusted for unrecognized items.
C)GAAP requires that prior service costs for currently vested employees be expensed in the period incurred, while IFRS requires them to be deferred and amortized
<Explanation> B) The major difference between GAAP rules and IFRS rules is the treatment of the funded status. GAAP requires the recognition of the funded status on the balance sheet, while IFRS treatment reflects the funded status adjusted for unrecognized items
28. Which of the following measures is least sensitive to changes in pension plan actuarial assumptions?
A)Reported pension expense.
B)Projected benefit obligation (PBO).
C)Funded status
<Explanation> B) Reported pension expense is a net (smaller) amount and therefore, is generally quite sensitive to relatively minor changes in actuarial assumptions.
Changing an assumption may have a small effect on the projected benefit obligation (PBO) but may have a much larger effect on the funded status (which is a net pension amount)
29. 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.
<Explanation> B) 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
30. 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.
<Explanation> C) 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
31. 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.
<Explanation> C) 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
32. 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
<Explanation> B) 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
33. 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
<Explanation> A) 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
34. 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
<Explanation> C) 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
35. 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.
<Explanation> A) 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
36. 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
<Explanation> C) 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
37. 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
<Explanation> B) 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
38. Jason Johnson, CFA, is a principal of a large private equity firm in New York. One of the associates in his firm has identified a potential investment opportunity for the firm. Gasline, Inc. is a major producer of pipeline used in the production of natural gas in the Southwest United States.
Of particular concern to Johnson is Gasline’s numerous, complicated transactions related to the company’s various stock-based compensation plans.
For example, the CEO of Gasline was awarded a stock option package at the beginning of 2006, which could ultimately have a significant impact on the company’s future earnings. Details of the CEO’s stock option grant are outlined below.
CEO Options (grant date January 1, 2006)
Strike price
$37.00
Current market price
$35.00
Number of options
100,000
Option period
4 years
Vesting period
25% per year
For the valuation of the CEO’s stock options granted on January 1, 2006, Gasline estimated a fair value of $100,000 by using Monte Carlo simulation. In accordance with SFAS No. 123(R), which of the following statements is most accurate? Gasline’s accounting treatment of the options is:
A)in compliance because the firm can elect to use either the intrinsic value model or the fair value model in the valuation of stock option plans.
B)in compliance because a Monte Carlo simulation is an acceptable method of valuing options in the absence of a market-based instrument.
C)not in compliance because the fair value must be established by using the Black-Scholes option pricing model
<Explanation> B) Under SFAS No. 123(R), firms are required to use the fair value method of valuing stock option plans. In the absence of a market-based instrument, firms may select and use an option-pricing model such as the Black-Scholes, the binomial model or Monte Carlo
39. Assume that the CEO of Gasline exercises 25,000 of his options on December 31, 2006, and the market price of the stock on that date is $39.50. Calculate the total compensation expense for the year ending 2006 that Gasline should recognize in association with the CEO option grant
A)$25,000.
B)$62,500.
C)$100,000.
<Explanation> A) Under the fair value method, as required by SFAS No. 123(R), Gasline will recognize compensation expense over the 4 year vesting period. For the year ending 2006, Gasline will recognize $25,000 (= $100,000 / 4 years) in compensation expense. Compensation expense is not affected when options are exercised
