After studying this chapter, you should be able to:
Where Have All The Pensions Gone?
Many companies have benefit plans that promise income and other benefits to retired employees in exchange for services during their working years. However, a shift is on from traditional defined-benefit plans, in which employers bear the risk of meeting the benefit promises, to plans in which employees bear more of the risk. In some cases, employers are dropping retirement plans altogether. Here are some of the reasons for the shift.
Competition. Newer and foreign competitors do not have the same retiree costs that older U.S. companies do. Southwest Airlines does not offer a traditional pension plan, but Northwest and United both have pension deficits exceeding $100,000 per employee.
Cost. Retirees are living longer, and the costs of retirement are higher. Combined with annual retiree healthcare costs, retirement benefits are costing the S&P 500 companies over $25 billion a year and are rising at double-digit rates.
Insurance. Pensions are backed by premiums paid to the Pension Benefit Guarantee Corporation (PBGC). When a company fails, the PBGC takes over the plan. But due to a number of significant company failures, the PBGC is running a deficit, and healthy companies are subsidizing the weak. For example, steel companies pay just 3 percent of PBGC premiums but account for 56 percent of the claims.
Accounting. To bring U.S. standards in line with international rules, accounting rule makers are considering rules that will require companies to "mark their pensions to market" (value them at market rates). Such a move would increase the reported volatility of the retirement plan and of company financial statements. When Britain made this shift, 25 percent of British companies closed their plans to new entrants.
As a result of such factors, it is not hard to believe that experts can think of no major company that has instituted a traditional pension plan in the past decade.
What does this mean for you as you evaluate job offers and benefit packages in the not-too-distant future? To start, you should begin building your own retirement nest egg, rather than relying on your employer to provide postretirement income and healthcare benefits. A look at recent data on retirees' financial position, summarized in the chart to the right, supports a strategy to become more self-reliant.
As indicated, the average person at retirement has about $360,000 in resources to sustain him or her in the retirement years. However, Social Security and traditional pension benefits comprise a substantial share of wealth for typical near-to-retirement households—nearly two-thirds of their $361,000 in total wealth. This wealth snapshot highlights the extraordinary importance of Social Security, traditional pensions, and owner-occupied housing (not very liquid) for typical near-retiree households today. Together, these assets comprise nearly four-fifths of wealth of those on the verge of retirement.
However, these sources of income are in decline and will likely continue to shrink as employers and governments wrestle with financial and other constraints discussed earlier. That means that retirement accounts, including individual retirement accounts and defined-contribution pensions such as 401(k) plans, will need to become a bigger piece of the pie to fill the gap left by smaller government and employer-sponsored benefits. So get started now with a personal savings strategy to ensure an adequate nest egg at your retirement.
Sources: Story adapted from Nanette Byrnes with David Welch, "The Benefits Trap," BusinessWeek (July 19, 2004), pp. 54–72. Source of chart: G. Mermin, "Typical Wealth Held by Those at the Verge of Retirement," Urban Institute, http://www.urban.org/url.cfm?ID=411618 (February 22, 2008).
PREVIEW OF CHAPTER 20
As our opening story indicates, the cost of retirement benefits is getting steep. For example, General Motors' pension and healthcare costs for retirees in a recent year totaled $6.2 billion, or approximately $1,784 per vehicle produced. General Motors and many other companies are facing substantial pension and other postretirement expenses and obligations. In this chapter we discuss the accounting issues related to these benefit plans. The content and organization of the chapter are as follows.
A pension plan is an arrangement whereby an employer provides benefits (payments) to retired employees for services they provided in their working years. Pension accounting may be divided and separately treated as accounting for the employer and accounting for the pension fund. The company or employer is the organization sponsoring the pension plan. It incurs the cost and makes contributions to the pension fund. The fund or plan is the entity that receives the contributions from the employer, administers the pension assets, and makes the benefit payments to the retired employees (pension recipients). Illustration 20-1 shows the three entities involved in a pension plan and indicates the flow of cash among them.
A pension plan is funded when the employer makes payments to a funding agency.[348] That agency accumulates the assets of the pension fund and makes payments to the recipients as the benefits come due.
Some pension plans are contributory. In these, the employees bear part of the cost of the stated benefits or voluntarily make payments to increase their benefits. Other plans are noncontributory. In these plans, the employer bears the entire cost. Companies generally design their pension plans so as to take advantage of federal income tax benefits. Plans that offer tax benefits are called qualified pension plans. They permit deductibility of the employer's contributions to the pension fund and tax-free status of earnings from pension fund assets.
The pension fund should be a separate legal and accounting entity. The pension fund, as a separate entity, maintains a set of books and prepares financial statements. Maintaining records and preparing financial statements for the fund, an activity known as "accounting for employee benefit plans," is not the subject of this chapter.[349] Instead, this chapter explains the pension accounting and reporting problems of the employer as the sponsor of a pension plan.
The need to properly administer and account for pension funds becomes apparent when you understand the size of these funds. Listed in Illustration 20-2 (on page 1051) are the pension fund assets and pension expenses of seven major companies.
As Illustration 20-2 indicates, pension expense is a substantial percentage of total pretax income for many companies.[350] The two most common types of pension plans are defined-contribution plans and defined-benefit plans, and we look at each of them in the following sections.
In a defined-contribution plan, the employer agrees to contribute to a pension trust a certain sum each period, based on a formula. This formula may consider such factors as age, length of employee service, employer's profits, and compensation level. The plan defines only the employer's contribution. It makes no promise regarding the ultimate benefits paid out to the employees. A common form of this plan is a 401(k) plan.
The size of the pension benefits that the employee finally collects under the plan depends on several factors: the amounts originally contributed to the pension trust, the income accumulated in the trust, and the treatment of forfeitures of funds caused by early terminations of other employees. A company usually turns over to an independent third-party trustee the amounts originally contributed. The trustee, acting on behalf of the beneficiaries (the participating employees), assumes ownership of the pension assets and is accountable for their investment and distribution. The trust is separate and distinct from the employer.
The accounting for a defined-contribution plan is straightforward. The employee gets the benefit of gain (or the risk of loss) from the assets contributed to the pension plan. The employer simply contributes each year based on the formula established in the plan. As a result, the employer's annual cost (pension expense) is simply the amount that it is obligated to contribute to the pension trust. The employer reports a liability on its balance sheet only if it does not make the contribution in full. The employer reports an asset only if it contributes more than the required amount.
In addition to pension expense, the employer must disclose the following for a defined-contribution plan: a plan description, including employee groups covered; the basis for determining contributions; and the nature and effect of significant matters affecting comparability from period to period. [2]
A defined-benefit plan outlines the benefits that employees will receive when they retire. These benefits typically are a function of an employee's years of service and of the compensation level in the years approaching retirement.
To meet the defined-benefit commitments that will arise at retirement, a company must determine what the contribution should be today (a time value of money computation). Companies may use many different contribution approaches. However, the funding method should provide enough money at retirement to meet the benefits defined by the plan.
The employees are the beneficiaries of a defined-contribution trust, but the employer is the beneficiary of a defined-benefit trust. Under a defined-benefit plan, the trust's primary purpose is to safeguard and invest assets so that there will be enough to pay the employer's obligation to the employees. In form, the trust is a separate entity. In substance, the trust assets and liabilities belong to the employer. That is, as long as the plan continues, the employer is responsible for the payment of the defined benefits (without regard to what happens in the trust). The employer must make up any shortfall in the accumulated assets held by the trust. On the other hand, the employer can recapture any excess accumulated in the trust, either through reduced future funding or through a reversion of funds.
Outside the U.S., private pension plans are less common because many other nations rely on government-sponsored pension plans. Consequently, accounting for defined-benefit pension plans is typically a less important issue elsewhere in the world.
Because a defined-benefit plan specifies benefits in terms of uncertain future variables, a company must establish an appropriate funding pattern to ensure the availability of funds at retirement in order to provide the benefits promised. This funding level depends on a number of factors such as turnover, mortality, length of employee service, compensation levels, and interest earnings.
Employers are at risk with defined-benefit plans because they must contribute enough to meet the cost of benefits that the plan defines. The expense recognized each period is not necessarily equal to the cash contribution. Similarly, the liability is controversial because its measurement and recognition relate to unknown future variables. Thus, the accounting issues related to this type of plan are complex. Our discussion in the following sections deals primarily with defined-benefit plans.[351]
Defined-contribution plans have become much more popular with employers than defined-benefit plans. One reason is that they are cheaper. Defined-contribution plans often cost no more than 3 percent of payroll, whereas defined-benefit plans can cost 5 to 6 percent of payroll.
In the late 1970s approximately 15 million individuals had defined-contribution plans; today over 62 million do. The following chart reflects this significant change. It shows the percentage of companies using various types of plans, based on a survey of approximately 150 CFOs and managing corporate directors.
Although many companies are changing to defined-contribution plans, over 40 million individuals still are covered under defined-benefit plans.
The problems associated with pension plans involve complicated mathematical considerations. Therefore, companies engage actuaries to ensure that a pension plan is appropriate for the employee group covered.[352] Actuaries are individuals trained through a long and rigorous certification program to assign probabilities to future events and their financial effects. The insurance industry employs actuaries to assess risks and to advise on the setting of premiums and other aspects of insurance policies. Employers rely heavily on actuaries for assistance in developing, implementing, and funding pension funds.
Actuaries make predictions (called actuarial assumptions) of mortality rates, employee turnover, interest and earnings rates, early retirement frequency, future salaries, and any other factors necessary to operate a pension plan. They also compute the various pension measures that affect the financial statements, such as the pension obligation, the annual cost of servicing the plan, and the cost of amendments to the plan. In summary, accounting for defined-benefit pension plans relies heavily upon information and measurements provided by actuaries.
In accounting for a company's pension plan, two questions arise: (1) What is the pension obligation that a company should report in the financial statements? (2) What is the pension expense for the period? Attempting to answer the first question has produced much controversy.
Most agree that an employer's pension obligation is the deferred compensation obligation it has to its employees for their service under the terms of the pension plan. Measuring that obligation is not so simple, though, because there are alternative ways of measuring it.[353]
One measure of the pension obligation is to base it only on the benefits vested to the employees. Vested benefits are those that the employee is entitled to receive even if he or she renders no additional services to the company. Most pension plans require a certain minimum number of years of service to the employer before an employee achieves vested benefits status. Companies compute the vested benefit obligation using only vested benefits, at current salary levels.
Another way to measure the obligation uses both vested and nonvested years of service. On this basis, the company computes the deferred compensation amount on all years of employees' service—both vested and nonvested—using current salary levels. This measurement of the pension obligation is called the accumulated benefit obligation.
Japan is the most rapidly aging nation in the developed world. By the year 2015, 24 percent of its population is expected to be over 65, compared with 17 percent in Europe and 15 percent in the U.S. Aging populations will affect pension liabilities in these countries.
A third measure bases the deferred compensation amount on both vested and non-vested service using future salaries. This measurement of the pension obligation is called the projected benefit obligation. Because future salaries are expected to be higher than current salaries, this approach results in the largest measurement of the pension obligation.
The choice between these measures is critical. The choice affects the amount of a company's pension liability and the annual pension expense reported. The diagram in Illustration 20-3 presents the differences in these three measurements.
Which of these alternative measures of the pension liability does the profession favor? The profession adopted the projected benefit obligation—the present value of vested and nonvested benefits accrued to date, based on employees' future salary levels.[354] Those in favor of the projected benefit obligation contend that a promise by an employer to pay benefits based on a percentage of the employees' future salaries is far greater than a promise to pay a percentage of their current salary, and such a difference should be reflected in the pension liability and pension expense.
Moreover, companies discount to present value the estimated future benefits to be paid. Minor changes in the interest rate used to discount pension benefits can dramatically affect the measurement of the employer's obligation. For example, a 1 percent decrease in the discount rate can increase pension liabilities 15 percent. Accounting rules require that, at each measurement date, a company must determine the appropriate discount rate used to measure the pension liability, based on current interest rates.
Companies must recognize on their balance sheet the full overfunded or under-funded status of their defined-benefit pension plan.[355] [3] The overfunded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation.
To illustrate, assume that Coker Company has a projected benefit obligation of $300,000, and the fair value of its plan assets is $210,000. In this case, Coker Company's pension plan is underfunded, and therefore it reports a pension liability of $90,000 ($300,000 − $210,000) on its balance sheet. If, instead, the fair value of Coker's plan assets were $430,000, it would report a pension asset of $130,000 ($430,000 − $300,000).
As recently as 2004, pension plans for companies in the S&P 500 were underfunded (liabilities exceeded assets) in the aggregate by $158.4 billion. In 2007, by slowing the growth of pension liabilities and increasing contributions to pension funds, the S&P 500 companies reported aggregate overfunding (assets exceeded liabilities) of $61.9 billion.[356]
There is broad agreement that companies should account for pension cost on the accrual basis.[357] The profession recognizes that accounting for pension plans requires measurement of the cost and its identification with the appropriate time periods. The determination of pension cost, however, is extremely complicated because it is a function of the following components.
Service Cost. Service cost is the expense caused by the increase in pension benefits payable (the projected benefit obligation) to employees because of their services rendered during the current year. Actuaries compute service cost as the present value of the new benefits earned by employees during the year.
Interest on the Liability. Because a pension is a deferred compensation arrangement, there is a time value of money factor. As a result, companies record the pension liability on a discounted basis. Interest expense accrues each year on the projected benefit obligation just as it does on any discounted debt. The actuary helps to select the interest rate, referred to as the settlement rate.
Actual Return on Plan Assets. The return earned by the accumulated pension fund assets in a particular year is relevant in measuring the net cost to the employer of sponsoring an employee pension plan. Therefore, a company should adjust annual pension expense for interest and dividends that accumulate within the fund, as well as increases and decreases in the market value of the fund assets.
Amortization of Prior Service Cost. Pension plan amendments (including initiation of a pension plan) often include provisions to increase benefits (or in rare situations, to decrease benefits) for employee service provided in prior years. A company grants plan amendments with the expectation that it will realize economic benefits in future periods. Thus, it allocates the cost (prior service cost) of providing these retroactive benefits to pension expense in the future, specifically to the remaining service-years of the affected employees.
Gain or Loss. Volatility in pension expense can result from sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation (which changes when actuaries modify assumptions or when actual experience differs from expected experience). Two items comprise this gain or loss: (1) the difference between the actual return and the expected return on plan assets, and (2) amortization of the net gain or loss from previous periods. We will discuss this complex computation later in the chapter.
The expense recognition principle and the definition of a liability justify accounting for pension cost on the accrual basis. This requires recording an expense when employees earn the future benefits, and recognizing an existing obligation to pay pensions later based on current services received.
Illustration 20-4 shows the components of pension expense and their effect on total pension expense (increase or decrease).
The service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. That is, the actuary predicts the additional benefits that an employer must pay under the plan's benefit formula as a result of the employees' current year's service, and then discounts the cost of those future benefits back to their present value.
The Board concluded that companies must consider future compensation levels in measuring the present obligation and periodic pension expense if the plan benefit formula incorporates them. In other words, the present obligation resulting from a promise to pay a benefit of 1 percent of an employee's final pay differs from the promise to pay 1 percent of current pay. To overlook this fact is to ignore an important aspect of pension expense. Thus, the FASB adopts the benefits/years-of-service actuarial method, which determines pension expense based on future salary levels.
Some object to this determination, arguing that a company should have more freedom to select an expense recognition pattern. Others believe that incorporating future salary increases into current pension expense is accounting for events that have not yet happened. They argue that if a company terminates the plan today, it pays only liabilities for accumulated benefits. Nevertheless, the FASB indicates that the projected benefit obligation provides a more realistic measure of the employer's obligation under the plan on a going concern basis and, therefore, companies should use it as the basis for determining service cost.
The second component of pension expense is interest on the liability, or interest expense. Because a company defers paying the liability until maturity, the company records it on a discounted basis. The liability then accrues interest over the life of the employee. The interest component is the interest for the period on the projected benefit obligation outstanding during the period. The FASB did not address the question of how often to compound the interest cost. To simplify our illustrations and problem materials, we use a simple-interest computation, applying it to the beginning-of-the-year balance of the projected benefit liability.
How do companies determine the interest rate to apply to the pension liability? The Board states that the assumed discount rate should reflect the rates at which companies can effectively settle pension benefits. In determining these settlement rates, companies should look to rates of return on high-quality fixed-income investments currently available, whose cash flows match the timing and amount of the expected benefit payments. The objective of selecting the assumed discount rates is to measure a single amount that, if invested in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the pension benefits when due.
Pension plan assets are usually investments in stocks, bonds, other securities, and real estate that a company holds to earn a reasonable return, generally at minimum risk. Employer contributions and actual returns on pension plan assets increase pension plan assets. Benefits paid to retired employees decrease them. As we indicated, the actual return earned on these assets increases the fund balance and correspondingly reduces the employer's net cost of providing employees' pension benefits. That is, the higher the actual return on the pension plan assets, the less the employer has to contribute eventually and, therefore, the less pension expense that it needs to report.
The actual return on the plan assets is the increase in pension funds from interest, dividends, and realized and unrealized changes in the fair-market value of the plan assets. Companies compute the actual return by adjusting the change in the plan assets for the effects of contributions during the year and benefits paid out during the year. The equation in Illustration 20-5, or a variation thereof, can be used to compute the actual return.
Stated another way, the actual return on plan assets is the difference between the fair value of the plan assets at the beginning of the period and at the end of the period, adjusted for contributions and benefit payments. Illustration 20-6 uses the equation above to compute the actual return, using some assumed amounts.
If the actual return on the plan assets is positive (a gain) during the period, a company subtracts it when computing pension expense. If the actual return is negative (a loss) during the period, the company adds it when computing pension expense.[358]
We will now illustrate the basic computation of pension expense using the first three components: (1) service cost, (2) interest on the liability, and (3) actual return on plan assets. We discuss the other pension-expense components (amortization of prior service cost, and gains and losses) in later sections.
Companies often use a worksheet to record pension-related information. As its name suggests, the worksheet is a working tool. A worksheet is not a permanent accounting record: it is neither a journal nor part of the general ledger. The work-sheet is merely a device to make it easier to prepare entries and the financial statements.[359] Illustration 20-7 shows the format of the pension worksheet.
The "General Journal Entries" columns of the worksheet (near the left side) determine the entries to record in the formal general ledger accounts. The "Memo Record" columns (on the right side) maintain balances in the projected benefit obligation and the plan assets. The difference between the projected benefit obligation and the fair value of the plan assets is the pension asset/liability, which is shown in the balance sheet. If the projected benefit obligation is greater than the plan assets, a pension liability occurs. If the projected benefit obligation is less than the plan assets, a pension asset occurs.
On the first line of the worksheet, a company records the beginning balances (if any). It then records subsequent transactions and events related to the pension plan using debits and credits, using both sets of columns as if they were one. For each transaction or event, the debits must equal the credits. The ending balance in the Pension Asset/Liability column should equal the net balance in the memo record.
To illustrate the use of a worksheet and how it helps in accounting for a pension plan, assume that on January 1, 2010, Zarle Company provides the following information related to its pension plan for the year 2010.
Plan assets, January 1, 2010, are $100,000.
Projected benefit obligation, January 1, 2010, is $100,000.
Annual service cost is $9,000.
Settlement rate is 10 percent.
Actual return on plan assets is $10,000.
Funding contributions are $8,000.
Benefits paid to retirees during the year are $7,000.
Using the data presented on page 1058, the worksheet in Illustration 20-8 presents the beginning balances and all of the pension entries recorded by Zarle in 2010. Zarle records the beginning balances for the projected benefit obligation and the pension plan assets on the first line of the worksheet in the memo record. Because the projected benefit obligation and the plan assets are the same at January 1, 2010, the Pension Asset/Liability account has a zero balance at January 1, 2010.
Entry (a) in Illustration 20-8 records the service cost component, which increases pension expense by $9,000 and increases the liability (projected benefit obligation) by $9,000. Entry (b) accrues the interest expense component, which increases both the liability and the pension expense by $10,000 (the beginning projected benefit obligation multiplied by the settlement rate of 10 percent). Entry (c) records the actual return on the plan assets, which increases the plan assets and decreases the pension expense. Entry (d) records Zarle's contribution (funding) of assets to the pension fund, thereby decreasing cash by $8,000 and increasing plan assets by $8,000. Entry (e) records the benefit payments made to retirees, which results in equal $7,000 decreases to the plan assets and the projected benefit obligation.
Zarle makes the "formal journal entry" on December 31, which records the pension expense in 2010, as follows.
The credit to Pension Asset/Liability for $1,000 represents the difference between the 2010 pension expense of $9,000 and the amount funded of $8,000. Pension Asset/ Liability (credit) is a liability because Zarle underfunds the plan by $1,000. The Pension Asset/Liability account balance of $1,000 also equals the net of the balances in the memo accounts. Illustration 20-9 shows that the projected benefit obligation exceeds the plan assets by $1,000, which reconciles to the pension liability reported in the balance sheet.
If the net of the memo record balances is a credit, the reconciling amount in the pension asset/liability column will be a credit equal in amount. If the net of the memo record balances is a debit, the pension asset/liability amount will be a debit equal in amount. The worksheet is designed to produce this reconciling feature, which is useful later in the preparation of the financial statements and required note disclosure related to pensions.
In this illustration (for 2010), the debit to Pension Expense exceeds the credit to Cash, resulting in a credit to Pension Asset/Liability—the recognition of a liability. If the credit to Cash exceeded the debit to Pension Expense, Zarle would debit Pension Asset/Liability—the recognition of an asset.
When either initiating (adopting) or amending a defined-benefit plan, a company often provides benefits to employees for years of service before the date of initiation or amendment. As a result of this prior service cost, the projected benefit obligation is increased to recognize this additional liability. In many cases, the increase in the projected benefit obligation is substantial.
Should a company report an expense for these prior service costs (PSC) at the time it initiates or amends a plan? The FASB says no. The Board's rationale is that the employer would not provide credit for past years of service unless it expects to receive benefits in the future. As a result, a company should not recognize the retroactive benefits as pension expense in the year of amendment. Instead, the employer initially records the prior service cost as an adjustment to other comprehensive income. The employer then recognizes the prior service cost as a component of pension expense over the remaining service lives of the employees who are expected to benefit from the change in the plan.
The cost of the retroactive benefits (including any benefits provided to existing retirees) is the increase in the projected benefit obligation at the date of the amendment. An actuary computes the amount of the prior service cost. Amortization of the prior service cost is also an accounting function performed with the assistance of an actuary.
The Board prefers a years-of-service method that is similar to a units-of-production computation. First, the company computes the total number of service-years to be worked by all of the participating employees. Second, it divides the prior service cost by the total number of service-years, to obtain a cost per service-year (the unit cost). Third, the company multiplies the number of service-years consumed each year by the cost per service-year, to obtain the annual amortization charge.
To illustrate the amortization of the prior service cost under the years-of-service method, assume that Zarle Company's defined-benefit pension plan covers 170 employees. In its negotiations with the employees, Zarle Company amends its pension plan on January 1, 2011, and grants $80,000 of prior service costs to its employees. The employees are grouped according to expected years of retirement, as shown below.
Illustration 20-10 shows computation of the service-years per year and the total service-years.
Computed on the basis of a prior service cost of $80,000 and a total of 500 service-years for all years, the cost per service-year is $160 ($80,000 ÷ 500). The annual amount of amortization based on a $160 cost per service-year is computed as follows.
An alternative method of computing amortization of prior service cost is permitted: Employers may use straight-line amortization over the average remaining service life of the employees. In this case, with 500 service-years and 170 employees, the average would be 2.94 years (500 ÷ 170). The annual expense would be $27,211 ($80,000 ÷ 2.94). Using this method, Zarle Company would charge cost to expense in 2011, 2012, and 2013 as follows.
Continuing the Zarle Company illustration into 2011, we note that the company amends the pension plan on January 1, 2011, to grant employees prior service benefits with a present value of $80,000. Zarle uses the annual amortization amounts, as computed in the previous section using the years-of-service approach ($27,200 for 2011). The following additional facts apply to the pension plan for the year 2011.
Annual service cost is $9,500.
Settlement rate is 10 percent.
Actual return on plan assets is $11,100.
Annual funding contributions are $20,000.
Benefits paid to retirees during the year are $8,000.
Amortization of prior service cost (PSC) using the years-of-service method is $27,200. Accumulated other comprehensive income (hereafter referred to as accumulated OCI) on December 31, 2010, is zero.
Illustration 20-12 presents a worksheet of all the pension entries and information recorded by Zarle in 2011. We now add an additional column to the worksheet to record the prior service cost adjustment to other comprehensive income. In addition, as shown in the last two lines of the "Items" column, the other comprehensive income amount related to prior service cost is added to accumulated other comprehensive income ("Accumulated OCI") to arrive at a debit balance of $52,800 at December 31, 2011.
The first line of the worksheet shows the beginning balances of the Pension Asset/Liability account and the memo accounts. Entry (f) records Zarle's granting of prior service cost, by adding $80,000 to the projected benefit obligation and decreasing other comprehensive income—prior service cost by the same amount. Entries (g), (h), (i), (k), and (l) are similar to the corresponding entries in 2010. To compute the interest cost on the projected benefit obligation for entry (h), we use the beginning projected benefit balance of $192,000, which has been adjusted for the prior service cost amendment on January 1, 2011. Entry (j) records the 2011 amortization of prior service cost by debiting Pension Expense for $27,200 and crediting Other Comprehensive Income (PSC) for the same amount.
Zarle makes the following journal entry on December 31 to formally record the 2011 pension expense (the sum of the annual pension expense column), and related pension information.
Because the debits to Pension Expense and to Other Comprehensive Income (PSC) exceed the funding, Zarle credits the Pension Asset/Liability account for the $77,600 difference. That account is a liability. In 2011, as in 2010, the balance of the Pension Asset/Liability account ($78,600) is equal to the net of the balances in the memo accounts, as shown in Illustration 20-13.
The reconciliation is the formula that makes the worksheet work. It relates the components of pension accounting, recorded and unrecorded, to one another.
Of great concern to companies that have pension plans are the uncontrollable and unexpected swings in pension expense that can result from (1) sudden and large changes in the market value of plan assets, and (2) changes in actuarial assumptions that affect the amount of the projected benefit obligation. If these gains or losses impact fully the financial statements in the period of realization or incur-rence, substantial fluctuations in pension expense result.
Therefore, the FASB decided to reduce the volatility associated with pension expense by using smoothing techniques that dampen and in some cases fully eliminate the fluctuations.
One component of pension expense, actual return on plan assets, reduces pension expense (assuming the actual return is positive). A large change in the actual return can substantially affect pension expense for a year. Assume a company has a 40 percent return in the stock market for the year. Should this substantial, and perhaps one-time, event affect current pension expense?
Actuaries ignore current fluctuations when they develop a funding pattern to pay expected benefits in the future. They develop an expected rate of return and multiply it by an asset value weighted over a reasonable period of time to arrive at an expected return on plan assets. They then use this return to determine a company's funding pattern.
The FASB adopted the actuary's approach to dampen wide swings that might occur in the actual return. That is, a company includes the expected return on the plan assets as a component of pension expense, not the actual return in a given year. To achieve this goal, the company multiplies the expected rate of return by the market-related value of the plan assets. The market-related asset value of the plan assets is either the fair value of plan assets or a calculated value that recognizes changes in fair value in a systematic and rational manner. [4][360]
The difference between the expected return and the actual return is referred to as the unexpected gain or loss; the FASB uses the term asset gains and losses. Asset gains occur when actual return exceeds expected return; asset losses occur when actual return is less than expected return.
What happens to unexpected gains or losses in the accounting for pensions? Companies record asset gains and asset losses in an account, Other Comprehensive Income (G/L), combining them with gains and losses accumulated in prior years. This treatment is similar to prior service cost. The Board believes this treatment is consistent with the practice of including in other comprehensive income certain changes in value that have not been recognized in net income (for example, unrealized gains and losses on available-for-sale securities). [5] In addition, the accounting is simple, transparent, and symmetrical.
To illustrate the computation of an unexpected gain or loss and its related accounting, assume that in 2012, Zarle Company has an actual return on plan assets of $12,000 when the expected return is $13,410 (the expected rate of return of 10% on plan assets times the beginning of the year plan assets). The unexpected asset loss of $1,410 ($12,000 − $13,410) is debited to Other Comprehensive Income (G/L) and credited to Pension Expense.
For some companies, pension plans generated real profits in the late 1990s. The plans not only paid for themselves but also increased earnings. This happens when the expected return on pension assets exceed the company's annual costs. At Norfolk Southern, pension income amounted to 12 percent of operating profit. It tallied 11 percent of operating profit at Lucent Technologies, Coastal Corp., and Unisys Corp. The issue is important because in these cases management is not driving the operating income—pension income is. And as a result, income can change quickly.
Unfortunately, when the stock market stops booming, pension expense substantially increases for many companies. The reason: Expected return on a smaller asset base no longer offsets pension service costs and interest on the projected benefit obligation. As a result, many companies find it difficult to meet their earnings targets, and at a time when meeting such targets is crucial to maintaining the stock price.
In estimating the projected benefit obligation (the liability), actuaries make assumptions about such items as mortality rate, retirement rate, turnover rate, disability rate, and salary amounts. Any change in these actuarial assumptions affects the amount of the projected benefit obligation. Seldom does actual experience coincide exactly with actuarial predictions. These unexpected gains or losses from changes in the projected benefit obligation are called liability gains and losses.
Companies report liability gains (resulting from unexpected decreases in the liability balance) and liability losses (resulting from unexpected increases) in Other Comprehensive Income (G/L). Companies combine the liability gains and losses in the same Other Comprehensive Income (G/L) account used for asset gains and losses. They accumulate the asset and liability gains and losses from year to year that are not amortized in Accumulated Other Comprehensive Income. This amount is reported on the balance sheet in the stockholders' equity section.
The asset gains and losses and the liability gains and losses can offset each other. As a result, the Accumulated OCI account related to gains and losses may not grow very large. But, it is possible that no offsetting will occur and that the balance in the Accumulated OCI account related to gains and losses will continue to grow.
To limit the growth of the Accumulated OCI account, the FASB invented the corridor approach for amortizing the account's accumulated balance when it gets too large. How large is too large? The FASB set a limit of 10 percent of the larger of the beginning balances of the projected benefit obligation or the market-related value of the plan assets. Above that size, the Accumulated OCI account related to gains and losses is considered too large and must be amortized.
To illustrate the corridor approach, data for Callaway Co.'s projected benefit obligation and plan assets over a period of six years are shown in Illustration 20-14.
How the corridor works becomes apparent when we portray the data graphically, as in Illustration 20-15.
If the balance in the Accumulated OCI account related to gains and losses stays within the upper and lower limits of the corridor, no amortization is required. In that case, Callaway carries forward unchanged the accumulated OCI related to gains and losses.
If amortization is required, the minimum amortization is the excess divided by the average remaining service period of active employees who are expected to receive benefits under the plan. Callaway may use any systematic method of amortization of gains and losses in lieu of the minimum, provided it is greater than the minimum. It must use the method consistently for both gains and losses, and must disclose the amortization method used.
In applying the corridor, companies should include amortization of the net gain or loss as a component of pension expense only if, at the beginning of the year, the net gain or loss in Accumulated OCI exceeded the corridor. That is, if no net gain or loss exists in Accumulated OCI at the beginning of the period, the company cannot recognize pension expense gains or losses in that period.
To illustrate the amortization of net gains and losses, assume the following information for Soft-White, Inc.
Soft-White recorded in Other Comprehensive Income actuarial losses of $400,000 in 2010 and $300,000 in 2011.
If the average remaining service life of all active employees is 5.5 years, the schedule to amortize the net gain or loss is as shown in Illustration 20-16.
As Illustration 20-16 indicates, the loss recognized in 2011 increased pension expense by $21,818. This amount is small in comparison with the total loss of $400,000. It indicates that the corridor approach dampens the effects (reduces volatility) of these gains and losses on pension expense.
The rationale for the corridor is that gains and losses result from refinements in estimates as well as real changes in economic value; over time, some of these gains and losses will offset one another. It therefore seems reasonable that Soft-White should not fully recognize gains and losses as a component of pension expense in the period in which they arise.
However, Soft-White should immediately recognize in net income certain gains and losses—if they arise from a single occurrence not directly related to the operation of the pension plan and not in the ordinary course of the employer's business. For example, a gain or loss that is directly related to a plant closing, a disposal of a business component, or a similar event that greatly affects the size of the employee work force, should be recognized as a part of the gain or loss associated with that event.
For example, at one time, Bethlehem Steel reported a quartererly loss of $477 million. A great deal of this loss was attributable to future estimated benefits payable to workers who were permanently laid off. In this situation, the loss should be treated as an adjustment to the gain or loss on the plant closing and should not affect pension cost for the current or future periods.
The difference between the actual return on plan assets and the expected return on plan assets is the unexpected asset gain or loss component. This component defers the difference between the actual return and expected return on plan assets in computing current-year pension expense. Thus, after considering this component, it is really the expected return on plan assets (not the actual return) that determines current pension expense.
Companies determine the amortized net gain or loss by amortizing the Accumulated OCI amount related to net gain or loss at the beginning of the year subject to the corridor limitation. In other words, if the accumulated gain or loss is greater than the corridor, these net gains and losses are subject to amortization. Soft-White computed this minimum amortization by dividing the net gains or losses subject to amortization by the average remaining service period. When the current-year unexpected gain or loss is combined with the amortized net gain or loss, we determine the current-year gain or loss. Illustration 20-17 summarizes these gain and loss computations.
In essence, these gains and losses are subject to triple smoothing. That is, companies first smooth the asset gain or loss by using the expected return. Second, they do not amortize the accumulated gain or loss at the beginning of the year unless it is greater than the corridor. Finally, they spread the excess over the remaining service life of existing employees.
Continuing the Zarle Company illustration, the following facts apply to the pension plan for 2012.
Annual service cost is $13,000.
Settlement rate is 10 percent; expected earnings rate is 10 percent.
Actual return on plan assets is $12,000.
Amortization of prior service cost (PSC) is $20,800.
Annual funding contributions are $24,000.
Benefits paid to retirees during the year are $10,500.
Changes in actuarial assumptions resulted in an end-of-year projected benefit obligation of $265,000.
The worksheet in Illustration 20-18 (on page 1068) presents all of Zarle's 2012 pension entries and related information. The first line of the worksheet records the beginning balances that relate to the pension plan. In this case, Zarle's beginning balances are the ending balances from its 2011 pension worksheet in Illustration 20-12 (page 1062).
Entries (m), (n), (o), (q), (r), and (s) are similar to the corresponding entries in 2010 or 2011.
Entries (o) and (p) are related. We explained the recording of the actual return in entry (o) in both 2010 and 2011; it is recorded similarly in 2012. In both 2010 and 2011 Zarle assumed that the actual return on plan assets was equal to the expected return on plan assets. In 2012, the expected return of $13,410 (the expected rate of return of 10 percent times the beginning-of-the-year plan assets balance of $134,100) is higher than the actual return of $12,000. To smooth pension expense, Zarle defers the unexpected loss of $1,410 ($13,410 − $12,000) by debiting the Other Comprehensive Income (G/L) account and crediting Pension Expense. As a result of this adjustment, the expected return on the plan assets is the amount actually used to compute pension expense.
Entry (t) records the change in the projected benefit obligation resulting from the change in the actuarial assumptions. As indicated, the actuary has now computed the ending balance to be $265,000. Given the PBO balance at December 31, 2011, and the related transactions during 2012, the PBO balance to date is computed as shown in Illustration 20-19.
The difference between the ending balance of $265,000 and the balance of $236,470 before the liability increase is $28,530 ($265,000 − $236,470). This $28,530 increase in the employer's liability is an unexpected loss. The journal entry on December 31, 2012, to record the pension information is as follows.
As the 2012 worksheet indicates, the $105,400 balance in the Pension Asset/Liability account at December 31, 2012, is equal to the net of the balances in the memo accounts. Illustration 20-20 shows this computation.
The chart below shows what has happened to the financial health of pension plans over the last few years. It is a real roller coaster.
At the turn of the century, when the stock market was strong, pension plans were overfunded. However the bubble burst, and by 2002 companies in the S&P 500 saw their pension plans funded at just 85 percent of reported liabilities. In recent years, plans have bounced back, and by 2007 pension plans were overfunded again. However, due to recent downturns, plans may be soon under-funded again.
A number of factors cause a fund to change from being overfunded to underfunded: First, low interest rates, such as those experienced in the early part of this decade, decimate returns on pension plan assets. As a result, pension fund assets have not grown; in some cases, they have declined in value. Second, using low interest rates to discount the projected benefit payments leads to a higher pension liability. Finally, more individuals are retiring, which leads to a depletion of the pension plan assets. In short, the years 2002 and 2003 produced the perfect pension storm. Since 2003, companies have increased contributions to their plans and curtailed benefits promised to employees, which have helped the plans bounce back.
Sources: David Zion and Bill Carcache, "The Magical World of Pensions: An Update," CSFB Equity Research: Accounting (September 8, 2004); and J. Ciesielski, "Benefit Plans 2007: Close To The Edge—And Back," The Analyst's Accounting Observer (April 25, 2008).
As you might suspect, a phenomenon as significant and complex as pensions involves extensive reporting and disclosure requirements. We will cover these requirements in two categories: (1) those within the financial statements, and (2) those within the notes to the financial statements.
Companies must recognize on their balance sheet the overfunded (pension asset) or underfunded (pension liability) status of their defined-benefit pension plan. The over-funded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation.
No portion of a pension asset is reported as a current asset. The excess of the fair value of the plan assets over the benefit obligation is classified as a noncurrent asset. The rationale for noncurrent classification is that the pension plan assets are restricted. That is, these assets are used to fund the projected benefit obligation, and therefore noncur-rent classification is appropriate.
The current portion of a net pension liability represents the amount of benefit payments to be paid in the next 12 months (or operating cycle, if longer), if that amount cannot be funded from existing plan assets. Otherwise, the pension liability is classified as a noncurrent liability.[361]
Some companies have two or more pension plans. In such instances, a question arises as to whether these multiple plans should be combined and shown as one amount on the balance sheet. The Board takes the position that all overfunded plans should be combined and shown as a pension asset on the balance sheet. Similarly, if the company has two or more underfunded plans, the underfunded plans are combined and shown as one amount on the balance sheet.
The FASB rejected the alternative of combining all plans and representing the net amount as a single net asset or net liability. The rationale: A company does not have the ability to offset excess assets of one plan against underfunded obligations of another plan. Furthermore, netting all plans is inappropriate because offsetting assets and liabilities is not permitted under GAAP unless a right of offset exists.
To illustrate, assume that Cresci Company has three pension plans as shown in Illustration 20-21.
In this case, Cresci reports a pension plan asset of $100,000 and a pension plan liability of $270,000 ($120,000 + $150,000).
Actuarial gains and losses not recognized as part of pension expense are recognized as increases and decreases in other comprehensive income. The same type of accounting is also used for prior service cost. The Board requires that the prior service cost arising in the year of the amendment (which increases the projected benefit obligation) be recognized by an offsetting debit to other comprehensive income. By recognizing both actuarial gains and losses and prior service cost as part of other comprehensive income, the Board believes that the usefulness of financial statements is enhanced.
To illustrate the presentation of other comprehensive income and related accumulated OCI, assume that Obey Company provides the following information for the year 2010. None of the Accumulated OCI on January 1, 2010, should be amortized in 2010.
Both the actuarial liability loss and the prior service adjustment decrease the funded status of the plan on the balance sheet. This results because the projected benefit obligation increases. However, neither the actuarial liability loss nor the prior service cost adjustment affects pension expense in 2010. In subsequent periods, these items will impact pension expense through amortization.
For Obey Company, the computation of "Other comprehensive loss" for 2010 is as follows.
The computation of "Comprehensive income" for 2010 is as follows.
The components of other comprehensive income must be reported in one of three ways: (1) in a second income statement, (2) in a combined statement of comprehensive income, or (3) as a part of the statement of stockholders' equity. Regardless of the format used, net income must be added to other comprehensive income to arrive at comprehensive income. For homework purposes, use the second income statement approach unless stated otherwise. Earnings per share information related to comprehensive income is not required.
To illustrate the second income statement approach, assume that Obey Company has reported a traditional income statement. The comprehensive income statement is shown in Illustration 20-24.
The computation of "Accumulated other comprehensive income" as reported in stockholders' equity at December 31, 2010, is as follows.
Regardless of the display format for the income statement, the accumulated other comprehensive loss is reported on the stockholders' equity section of the balance sheet of Obey Company as shown in Illustration 20-26. (Illustration 20-26 uses assumed data for the common stock and retained earnings information.)
By providing information on the components of comprehensive income as well as total accumulated other comprehensive income, the company communicates all changes in net assets.
In this illustration, it is assumed that the accumulated other comprehensive income at January 1, 2010, is not adjusted for the amortization of any prior service cost or actuarial gains and losses that would change pension expense. As discussed in the earlier examples, these items will be amortized into pension expense in future periods.
Pension plans are frequently important to understanding a company's financial position, results of operations, and cash flows. Therefore, a company discloses the following information, either in the body of the financial statements or in the notes. [6]
The IASB and FASB are studying whether the various components of pension expense, such as interest cost and investment earnings on plan assets, should be presented separately in the income statement along with other interest expense and investment earnings.
A schedule showing all the major components of pension expense.
Rationale: Information provided about the components of pension expense helps users better understand how a company determines pension expense. It also is useful in forecasting a company's net income.
A reconciliation showing how the projected benefit obligation and the fair value of the plan assets changed from the beginning to the end of the period.
Rationale: Disclosing the projected benefit obligation, the fair value of the plan assets, and changes in them should help users understand the economics underlying the obligations and resources of these plans. Explaining the changes in the projected benefit obligation and fair value of plan assets in the form of a reconciliation provides a more complete disclosure and makes the financial statements more understandable.
A disclosure of the rates used in measuring the benefit amounts (discount rate, expected return on plan assets, rate of compensation).
Rationale: Disclosure of these rates permits users to determine the reasonableness of the assumptions applied in measuring the pension liability and pension expense.
A table indicating the allocation of pension plan assets by category (equity securities, debt securities, real estate, and other assets), and showing the percentage of the fair value to total plan assets. In addition, a company must include a narrative description of investment policies and strategies, including the target allocation percentages (if used by the company).
Rationale: Such information helps financial statement users evaluate the pension plan's exposure to market risk and possible cash flow demands on the company. It also will help users better assess the reasonableness of the company's expected rate of return assumption.
The expected benefit payments to be paid to current plan participants for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter. Also required is disclosure of a company's best estimate of expected contributions to be paid to the plan during the next year.
Rationale: These disclosures provide information related to the cash outflows of the company. With this information, financial statement users can better understand the potential cash outflows related to the pension plan. They can better assess the liquidity and solvency of the company, which helps in assessing the company's overall financial flexibility.
The nature and amount of changes in plan assets and benefit obligations recognized in net income and in other comprehensive income of each period.
Rationale: This disclosure provides information on pension elements affecting the projected benefit obligation and plan assets and on whether those amounts have been recognized in income or deferred to future periods.
The accumulated amount of changes in plan assets and benefit obligations that have been recognized in other comprehensive income and that will be recycled into net income in future periods.
Rationale: This information indicates the pension-related balances recognized in stockholders' equity, which will affect future income.
The amount of estimated net actuarial gains and losses and prior service costs and credits that will be amortized from accumulated other comprehensive income into net income over the next fiscal year.
Rationale: This information helps users predict the impact of deferred pension expense items on next year's income.
In summary, the disclosure requirements are extensive, and purposely so. One factor that has been a challenge for useful pension reporting has been the lack of consistent terminology. Furthermore, a substantial amount of offsetting is inherent in the measurement of pension expense and the pension liability. These disclosures are designed to address these concerns and take some of the mystery out of pension reporting.
In the following sections we provide examples and explain the key pension disclosure elements.
The FASB requires disclosure of the individual pension expense components (derived from the information in the pension expense worksheet column): (1) service cost, (2) interest cost, (3) expected return on assets, (4) other gains or losses component, and (5) prior service cost component. The purpose of such disclosure is to clarify to more sophisticated readers how companies determine pension expense. Providing information on the components should also be useful in predicting future pension expense.
Illustration 20-27 presents an example of this part of the disclosure. It uses the information from the Zarle illustration, specifically the expense component information from the worksheets in Illustrations 20-8 (page 1059), 20-12 (page 1062), and 20-18 (page 1068).
Having a reconciliation of the changes in the assets and liabilities from the beginning of the year to the end of the year, statement readers can better understand the underlying economics of the plan. In essence, this disclosure contains the information in the pension worksheet for the projected benefit obligation and plan asset columns. Using the information for Zarle, the schedule in Illustration 20-28 provides an example of the reconciliation.
This represents another compromise between relevance and reliability. Disclosure attempts to balance these objectives.
The 2010 column reveals that Zarle underfunds the projected benefit obligation by $1,000. The 2011 column reveals that Zarle reports the underfunded liability of $78,600 in the balance sheet. Finally, the 2012 column indicates that Zarle recognizes the underfunded liability of $105,400 in the balance sheet.
Incorporating the corridor computation and the required disclosures, we continue the Zarle Company pension plan accounting based on the following facts for 2013.
Service cost is $16,000.
Settlement rate is 10 percent; expected rate of return is 10 percent.
Actual return on plan assets is $22,000.
Amortization of prior service cost is $17,600.
Annual funding contributions are $27,000.
Benefits paid to retirees during the year are $18,000.
Average service life of all covered employees is 20 years.
Does it make a difference to users of financial statements whether companies recognize pension information in the financial statements or disclose it only in the notes? The FASB was unsure, so in accord with the full disclosure principle, it decided to provide extensive pension plan disclosures.
Zarle prepares a worksheet to facilitate accumulation and recording of the components of pension expense and maintenance of amounts related to the pension plan. Illustration 20-29 shows that worksheet, which uses the basic data presented above. Beginning-of-the-year 2013 account balances are the December 31, 2012, balances from Zarle's revised 2012 pension worksheet in Illustration 20-18 (on page 1068).
Entries (aa) through (gg) are similar to the corresponding entries previously explained in the prior years' worksheets, with the exception of entry (dd). In 2012 the expected return on plan assets exceeded the actual return, producing an unexpected loss. In 2013 the actual return of $22,000 exceeds the expected return of $15,960 ($159,600 × 10%), resulting in an unexpected gain of $6,040, entry (dd). By netting the gain of $6,040 against the actual return of $22,000, pension expense is affected only by the expected return of $15,960.
A new entry (hh) in Zarle's worksheet results from application of the corridor test on the accumulated balance of net gain or loss in accumulated other comprehensive income. Zarle Company begins 2013 with a balance in the net loss account of $29,940. The company applies the corridor criterion in 2013 to determine whether the balance is excessive and should be amortized. In 2013 the corridor is 10 percent of the larger of the beginning-of-the-year projected benefit obligation of $265,000 or the plan asset's $159,600 market-related asset value (assumed to be fair value). The corridor for 2013 is $26,500 ($265,000 × 10%). Because the balance in Accumulated OCI is a net loss of $29,940, the excess (outside the corridor) is $3,440 ($29,940 − $26,500). Zarle amortizes the $3,440 excess over the average remaining service life of all employees. Given an average remaining service life of 20 years, the amortization in 2013 is $172 ($3,440 ÷ 20). In the 2013 pension worksheet, Zarle debits Pension Expense for $172 and credits that amount to Other Comprehensive Income (G/L). Illustration 20-30 shows the computation of the $172 amortization charge.
Zarle formally records pension expense for 2013 as follows.
Illustration 20-31 (next page) shows the note disclosure of Zarle's pension plan for 2013. Note that this example assumes that the pension liability is noncurrent and that the 2014 adjustment for amortization of the net gain or loss and amortization of prior service cost are the same as 2013.
The Employee Retirement Income Security Act of 1974—ERISA—affects virtually every private retirement plan in the United States. It attempts to safeguard employees' pension rights by mandating many pension plan requirements, including minimum funding, participation, and vesting.
These requirements can influence the employers' cash flows significantly. Under this legislation, annual funding is no longer discretionary. An employer now must fund the plan in accordance with an actuarial funding method that over time will be sufficient to pay for all pension obligations. If companies do not fund their plans in a reasonable manner, they may be subject to fines and/or loss of tax deductions.[362]
Many plans are underfunded but still quite viable. For example, at one time Loews Corp. had a $159 million shortfall, but also had earnings of $594 million and a good net worth. Thus, the going concern assumption permits us to ignore pension under-fundings in some cases because in the long run they are not significant.
The law requires plan administrators to publish a comprehensive description and summary of their plans, along with detailed annual reports that include many supplementary schedules and statements.
Another important provision of the Act is the creation of the Pension Benefit Guaranty Corporation (PBGC). The PBGC's purpose is to administer terminated plans and to impose liens on an employer's assets for certain unfunded pension liabilities. If a company terminates its pension plan, the PBGC can effectively impose a lien against the employer's assets for the excess of the present value of guaranteed vested benefits over the pension fund assets. This lien generally has had the status of a tax lien; it takes priority over most other creditorship claims. This section of the Act gives the PBGC the power to force an involuntary termination of a pension plan whenever the risks related to nonpayment of the pension obligation seem too great. Because ERISA restricts to 30 percent of net worth the lien that the PBGC can impose, the PBGC must monitor all plans to ensure that net worth is sufficient to meet the pension benefit obligations.[363]
A large number of terminated plans have caused the PBGC to pay out substantial benefits. Currently the PBGC receives its funding from employers, who contribute a certain dollar amount for each employee covered under the plan.[364]
A congressman at one time noted, "Employers are simply treating their employee pension plans like company piggy banks, to be raided at will." What this congressman was referring to is the practice of paying off the projected benefit obligation and pocketing any excess. ERISA prevents companies from recapturing excess assets unless they pay participants what is owed to them and then terminate the plan. As a result, companies were buying annuities to pay off the pension claimants and then used the excess funds for other corporate purposes.[365]
For example, at one time, pension plan terminations netted $363 million for Occidental Petroleum Corp., $95 million for Stroh's Brewery Co., $58 million for Kellogg Co., and $29 million for Western Airlines. Recently, many large companies have terminated their pension plans and captured billions in surplus assets. The U.S. Treasury also benefits: Federal legislation requires companies to pay an excise tax of anywhere from 20 percent to 50 percent on the gains. All of this is quite legal.[366]
The accounting issue that arises from these terminations is whether a company should recognize a gain when pension plan assets revert back to the company (often called asset reversion transactions). The issue is complex: in some cases, a company starts a new defined-benefit plan after it eliminates the old one. Thus, some contend that there has been no change in substance, but merely a change in form. However, the FASB disagrees. It requires recognition in earnings of a gain or loss when the employer settles a pension obligation either by lump-sum cash payments to participants or by purchasing nonparticipating annuity contracts. [7][367]
The Pension Benefit Guaranty Corp. (PBGC) recently announced that it would take over responsibility for the pilots' pension plan at United Airlines, to the tune of $1.4 billion. This federal agency, which acts as an insurer for corporate pension plans, has spent much of the past few years securing pension plans for "Big Steel" (U.S. steel companies), and it looks as if airlines are next.
For example, the PBGC also became the trustee of US Airways pilots' pensions in 2003, and it may soon announce a takeover of that struggling carrier's other three pension plans. The grand total at US Airways? It's $2.8 billion—mere pocket change next to the $6.4 billion the PBGC will owe if it has to bail out all four of United Airlines' plans. To date, the airline industry, which makes up 2 percent of participants in the program, has made 20 percent of the claims. The chart below shows how a $6.4 billion bailout would compare with the PBGC's biggest payouts to date.
Source: Kate Bonamici, "By the Numbers," Fortune (January 24, 2005), p. 24.
Hardly a day goes by without the financial press analyzing in depth some issue related to pension plans in the United States. This is not surprising, since U.S. pension funds now hold over $14.4 trillion in assets. As you have seen, the accounting issues related to pension plans are complex. Recent changes to GAAP have clarified many of these issues and should help users understand the financial implications of a company's pension plans on its financial position, results of operations, and cash flows.
The accounting for various forms of compensation plans under iGAAP is found in IAS 19 ("Employee Benefits") and IFRS 2 ("Share-Based Payment"). IAS 19 addresses the accounting for a wide range of compensation elements— wages, bonuses, postretirement benefits, and compensated absences. Both of these standards were recently amended, resulting in significant convergence between iGAAP and U.S. GAAP in this area.
iGAAP and U.S. GAAP separate pension plans into defined-contribution plans and defined-benefit plans. The accounting for defined-contribution plans is similar.
For defined-benefit plans, both iGAAP and U.S. GAAP recognize the net of the pension assets and liabilities on the balance sheet. Unlike U.S. GAAP, which recognizes prior service cost on the balance sheet (as an element of "Accumulated other comprehensive income"), iGAAP does not recognize prior service costs on the balance sheet. Both GAAPs amortize prior service costs into income over the expected service lives of employees.
Another difference in defined-benefit recognition is that under iGAAP companies have the choice of recognizing actuarial gains and losses in income immediately or amortizing them over the expected remaining working lives of employees. U.S. GAAP does not permit choice; actuarial gains and losses (and prior service costs) are recognized in "Accumulated other comprehensive income" and amortized to income over remaining service lives.
The IASB has recently issued a discussion paper on pensions proposing: (1) elimination of smoothing via the corridor approach, (2) a different presentation of pension costs in the income statement, and (3) a new category of pensions for accounting purposes—so-called "contribution-based promises."
The FASB and the IASB are working collaboratively on a postretirement benefit project. As discussed in the chapter, the FASB has issued GAAP rules addressing the recognition of benefit plans in financial statements. The FASB has begun work on the second phase of the project, which will reexamine expense measurement of postretirement benefit plans. The IASB also has added a project in this area, but on a different schedule. The IASB is monitoring the FASB's progress and hopes to issue a converged standard in this area by 2010.
In March 1991 IBM's adoption of a new GAAP requirement on postretirement benefits resulted in a $2.3 billion charge and a historical curiosity—IBM's first-ever quarterly loss. General Electric disclosed that its charge for adoption of the same GAAP rules would be $2.7 billion. In the fourth quarter of 1993, AT&T absorbed a $2.1 billion pretax hit for postretirement benefits. What is GAAP in this area, and how could its adoption have so grave an impact on companies' earnings?
After a decade of study, the FASB in December 1990 issued GAAP rules on "Employers' Accounting for Postretirement Benefits Other Than Pensions." [8] It alone was the cause for the large charges to income cited above. These rules cover for healthcare and other "welfare benefits" provided to retirees, their spouses, dependents, and beneficiaries.[368] These other welfare benefits include life insurance offered outside a pension plan; medical, dental, and eye care; legal and tax services; tuition assistance; day care; and housing assistance.[369] Because healthcare benefits are the largest of the other postretirement benefits, we use this item to illustrate accounting for postretirement benefits.
For many employers (about 95 percent) these GAAP rules required a change from the predominant practice of accounting for postretirement benefits on a pay-as-you-go (cash) basis to an accrual basis. Similar to pension accounting, the accrual basis necessitates measuring the employer's obligation to provide future benefits and accrual of the cost during the years that the employee provides service.
One of the reasons companies had not prefunded these benefit plans was that payments to prefund healthcare costs, unlike excess contributions to a pension trust, are not tax-deductible. Another reason was that postretirement healthcare benefits were once perceived to be a low-cost employee benefit that could be changed or eliminated at will and therefore were not a legal liability. Now, the accounting definition of a liability goes beyond the notion of a legally enforceable claim; the definition now encompasses equitable or constructive obligations as well, making it clear that the postretirement benefit promise is a liability.[370]
The FASB used the GAAP rules on pensions as a reference for the accounting prescribed for healthcare and other nonpension postretirement benefits.[371] Why didn't the FASB cover these other types of postretirement benefits in the earlier pension accounting statement? Because the apparent similarities between the two benefits mask some significant differences. Illustration 20A-1 shows these differences.[372]
Two of the differences in Illustration 20A-1 highlight why measuring the future payments for healthcare benefit plans is so much more difficult than for pension plans.
Many postretirement plans do not set a limit on healthcare benefits. No matter how serious the illness or how long it lasts, the benefits continue to flow. (Even if the employer uses an insurance company plan, the premiums will escalate according to the increased benefits provided.)
The levels of healthcare benefit use and healthcare costs are difficult to predict. Increased longevity, unexpected illnesses (e.g., AIDS, SARS, and avian flu), along with new medical technologies and cures, cause changes in healthcare utilization.
Additionally, although the fiduciary and reporting standards for employee benefit funds under government regulations generally cover healthcare benefits, the stringent minimum vesting, participation, and funding standards that apply to pensions do not apply to healthcare benefits. Nevertheless, as you will learn, many of the basic concepts of pensions, and much of the related accounting terminology and measurement methodology, do apply to other postretirement benefits. Therefore, in the following discussion and illustrations, we point out the similarities and differences in the accounting and reporting for these two types of postretirement benefits.
For many companies, other postretirement benefit obligations (OPEBs) are substantial. Generally, OPEBs are not well funded because companies are not permitted a tax deduction for contributions to the plan assets, as is the case with pensions. That is, the company may not claim a tax deduction until it makes a payment to the participant (pay-as-you-go).
Presented below are companies with the largest OPEB obligations, indicating their relationship with other financial items.
So, how big are OPEB obligations? REALLY big.
Source: Company reports.
Healthcare and other postretirement benefits for current and future retirees and their dependents are forms of deferred compensation. They are earned through employee service and are subject to accrual during the years an employee is working.
The period of time over which the postretirement benefit cost accrues is called the attribution period. It is the period of service during which the employee earns the benefits under the terms of the plan. The attribution period, shown in Illustration 20A-2 for a hypothetical employee, generally begins when an employee is hired and ends on the date the employee is eligible to receive the benefits and ceases to earn additional benefits by performing service, the vesting date.[373]
In defining the obligation for postretirement benefits, the FASB maintained many concepts similar to pension accounting. It also designed some new and modified terms specifically for postretirement benefits. Two of the most important of these specialized terms are (a) expected postretirement benefit obligation and (b) accumulated postretirement benefit obligation.
The expected postretirement benefit obligation (EPBO) is the actuarial present value as of a particular date of all benefits a company expects to pay after retirement to employees and their dependents. Companies do not record the EPBO in the financial statements, but they do use it in measuring periodic expense.
The accumulated postretirement benefit obligation (APBO) is the actuarial present value of future benefits attributed to employees' services rendered to a particular date. The APBO is equal to the EPBO for retirees and active employees fully eligible for benefits. Before the date an employee achieves full eligibility, the APBO is only a portion of the EPBO. Or stated another way, the difference between the APBO and the EPBO is the future service costs of active employees who are not yet fully eligible.
Illustration 20A-3 contrasts the EPBO and the APBO.
At the date an employee is fully eligible (the end of the attribution period), the APBO and the EPBO for that employee are equal.
Postretirement expense is the employer's annual expense for postretirement benefits. Also called net periodic postretirement benefit cost, this expense consists of many of the familiar components used to compute annual pension expense. The components of net periodic postretirement benefit cost are as follows. [10][374]
Service Cost: The portion of the EPBO attributed to employee service during the period.
Interest Cost: The increase in the APBO attributable to the passage of time. Companies compute interest cost by applying the beginning-of-the-year discount rate to the beginning-of-the-year APBO, adjusted for benefit payments to be made during the period. The discount rate is based on the rates of return on high-quality, fixed-income investments that are currently available.[375]
Actual Return on Plan Assets: The change in the fair value of the plan's assets adjusted for contributions and benefit payments made during the period. Because companies charge or credit the postretirement expense for the gain or loss on plan assets (the difference between the actual and the expected return), this component is actually the expected return.
Amortization of Prior Service Cost: The amortization of the cost of retroactive benefits resulting from plan amendments. The typical amortization period, beginning at the date of the plan amendment, is the remaining service periods through the full eligibility date.
Gains and Losses: In general, changes in the APBO resulting from changes in assumptions or from experience different from that assumed. For funded plans, this component also includes the difference between actual return and expected return on plan assets.
Like pension accounting, the accounting for postretirement plans must recognize in the accounts and in the financial statements effects of several significant items. These items are:
The EPBO is not recognized in the financial statements or disclosed in the notes. Companies recompute it each year, and the actuary uses it in measuring the annual service cost. Because of the numerous assumptions and actuarial complexity involved in measuring annual service cost, we have omitted these computations of the EPBO.
Similar to pensions, companies must recognize in the financial statements items 2 through 5 listed above. In addition, as in pension accounting, companies must know the exact amount of these items in order to compute postretirement expense. Therefore, companies use the worksheet like that for pension accounting to record both the formal general journal entries and the memo entries.
To illustrate the use of a worksheet in accounting for a postretirement benefits plan, assume that on January 1, 2010, Quest Company adopts a healthcare benefit plan. The following facts apply to the postretirement benefits plan for the year 2010.
Plan assets at fair value on January 1, 2010, are zero.
Actual and expected returns on plan assets are zero.
Accumulated postretirement benefit obligation (APBO), January 1, 2010, is zero.
Service cost is $54,000.
No prior service cost exists.
Interest cost on the APBO is zero.
Funding contributions during the year are $38,000.
Benefit payments to employees from plan are $28,000.
Using that data, the worksheet in Illustration 20A-4 presents the postretirement entries for 2010.
Entry (a) records the service cost component, which increases postretirement expense $54,000 and increases the liability (APBO) $54,000. Entry (b) records Quest's funding of assets to the postretirement fund. The funding decreases cash $38,000 and increases plan assets $38,000. Entry (c) records the benefit payments made to retirees, which results in equal $28,000 decreases to the plan assets and the liability (APBO).
Quest's December 31 adjusting entry formally records the postretirement expense in 2010, as follows.
The credit to Postretirement Asset/Liability for $16,000 represents the difference between the APBO and the plan assets. The $16,000 credit balance is a liability because the plan is underfunded. The Postretirement Asset/Liability account balance of $16,000 also equals the net of the balances in the memo accounts.
Illustration 20A-5 shows the funded status reported in the balance sheet. (Notice its similarity to the pension schedule.)
Gains and losses represent changes in the APBO or the value of plan assets. These changes result either from actual experience different from that expected or from changes in actuarial assumptions. The amortization of these gains and losses follows the approach used for pensions. That is, the gains and losses are recorded in other comprehensive income.
Consistent with pension accounting, companies amortize the gains and losses in accumulated other comprehensive income as a component of postretirement expense if, at the beginning of the period, they exceed a "corridor" limit. The corridor is measured as the greater of 10 percent of the APBO or 10 percent of the market-related value of plan assets.
The intent of the corridor approach is to reduce volatility of postretirement expense by providing a reasonable opportunity for gains and losses to offset over time without affecting net periodic expense.
If the company must amortize gains and losses (beyond the corridor) on postretirement benefit plans, the minimum amortization amount is the excess gain or loss divided by the average remaining service life to expected retirement of all active employees. Companies may use any systematic method of amortization provided that: (1) the amount amortized in any period is equal to or greater than the minimum amount, (2) the company applies the method consistently, and (3) the company applies the method similarly for gains and losses.
The company must recompute the amount of gain or loss in accumulated other comprehensive income each year and amortize the gain or loss over the average remaining service life if the net amount exceeds the "corridor."
Continuing the Quest Company illustration into 2011, the following facts apply to the postretirement benefits plan for the year 2011.
Actual return on plan assets is $600.
Expected return on plan assets is $800.
Discount rate is 8 percent.
Increase in APBO due to change in actuarial assumptions is $60,000.
Service cost is $26,000.
Funding contributions during the year are $18,000.
Benefit payments to employees during the year are $5,000.
Average remaining service to expected retirement: 25 years.
The worksheet in Illustration 20A-6 (on page 1089) presents all of Quest's postretirement benefit entries and information for 2011. The beginning balances on the first line of the worksheet are the ending balances from Quest's 2010 postretirement benefits worksheet in Illustration 20A-4 (on page 1087).
Entries (d), (h), and (i) are similar to the corresponding entries previously explained for 2010. Entry (e) accrues the interest expense component, which increases both the liability and the postretirement expense by $2,080 (the beginning APBO multiplied by the discount rate of 8%). Entries (f) and (g) are related. The expected return of $800 is higher than the actual return of $600. To smooth postretirement expense, Quest defers the unexpected loss of $200 ($800 − $600) by debiting Other Comprehensive Income (G/L) and crediting Postretirement Expense. As a result of this adjustment, the expected return on the plan assets is the amount actually used to compute postretirement expense.
Entry (j) records the change in the APBO resulting from a change in actuarial assumptions. This $60,000 increase in the employer's accumulated liability is an unexpected loss. Quest debits this loss to Other Comprehensive Income (G/L).
On December 31 Quest formally records net periodic expense for 2011 as follows.
The balance of the Postretirement Asset/Liability account at December 31, 2011, is $85,480. This balance is equal to the net of the balances in the memo accounts as shown in the reconciliation schedule in Illustration 20A-7.
Quest has a beginning balance in Accumulated OCI related to losses of $60,200. Therefore, Quest must apply the corridor test for amortization of the balance for 2012. Illustration 20A-8 shows the computation of the amortization charge for the loss.
The disclosures required for other postretirement benefit plans are similar to and just as detailed and extensive as those required for pensions. The note disclosure for Tootsie Roll, Inc. in Illustration 20A-9 provides a good example of the extensive disclosure required for other postretirement benefit plans.
As indicated in Illustration 20A-9, Tootsie Roll shows the impact of the postretirement benefit plan on income, the balance sheet, and the cash flow statement, and it provides information on important assumptions used in the measurement of the postretirement benefit obligation. Also note that given no tax incentives for funding, Tootsie Roll (like many companies) does not have any assets set aside for its other postretirement benefit obligations.
While Tootsie Roll has only an other postretirement benefit plan, many companies sponsor both defined-benefit pension and other postretirement plans. Given the similarities in accounting for these plans, companies can combine pension and other postretirement benefit disclosures.
Measurement of the EPBO, the APBO, and the net periodic postretirement benefit cost is involved and complex. Due to the uncertainties in forecasting healthcare costs, rates of use, changes in government health programs, and the differences employed in non-medical assumptions (e.g., discount rate, employee turnover, rate of pre-65 retirement, spouse-age difference), estimates of postretirement benefit costs may have a large margin of error. Is the information relevant, reliable, or verifiable? The FASB concluded that "the obligation to provide postretirement benefits meets the definition of a liability, is representationally faithful, is relevant to financial statement users, and can be measured with sufficient reliability at a justifiable cost." [11] Failure to accrue an obligation and an expense prior to payment of benefits would result in an unfaithful representation of what financial statements should represent.
The FASB took a momentous step by requiring recognition of a postretirement liability. Many opposed the requirement, warning that the GAAP rules would devastate earnings. Others argued that putting these numbers on the balance sheet was inappropriate. Others noted that the requirement would force companies to curtail postretirement benefits to employees.
The authors believe that the FASB deserves special praise. Because the Board addressed this issue, companies now recognize the magnitude of these costs. This recognition has led to efforts to control escalating healthcare costs. As John Ruffle, a former president of the Financial Accounting Foundation noted, "The Board has done American industry a gigantic favor. Over the long term, industry will look back and say thanks."
The Governmental Accounting Standards Board (GASB) was organized in 1984 as an operating entity of the Financial Accounting Foundation (FAF) to establish standards of financial accounting and reporting for state and local governmental entities. Similar to the FASB, FAF Trustees are responsible for selecting the members of the GASB and its Advisory Council, funding their activities, and exercising general oversight (with the exception of the GASB's resolution of technical issues). The GASB's function is important because high-quality external financial reporting can demonstrate financial accountability of state and local governments to the public and is the basis for investment, credit, and many legislative and regulatory decisions.
Until recently, the GASB went about its work in relative obscurity. How did the GASB get every-one's attention? It recommended that governmental units recognize other postretirement benefits on their balance sheets on an accrual basis, similar to the accounting required for pensions. Some states do not like that recommendation and have proposed legislation that will allow them to ignore GASB standards. However, the GASB, with the support of users of government reports, has pushed for the change. They are concerned that without the new requirements, governments will continue to mis-represent the true cost of their retirement-related promises to public employees. In their view, the new accounting rules are in the best interests of municipal bondholders and the public in general. Thus, it appears that the FASB is not the only standard-setter subject to political pressure.
Source: R. H. Attmore, "Who Do Texas Elected Officials Think They Are Fooling?" The Bond Buyer (June 18, 2007). For more information on the GASB, go to www.gasb.org/.
SUMMARY OF LEARNING OBJECTIVES FOR APPENDIX 20A
FASB Codification References
FASB ASC 960. [Predecessor literature: "Accounting and Reporting by Defined Benefit Pension Plans," Statement of Financial Accounting Standards No. 35 (Stamford, Conn.: FASB, 1979).]
FASB ASC 715-70-50-1. [Predecessor literature: "Employers' Accounting for Pension Plans," Statement of Financial Accounting Standards No. 87 (Stamford, Conn.: FASB, 1985), pars. 63–66.]
FASB ASC 715-30-25-1. [Predecessor literature: "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans: An Amendment to SFAS Nos. 87, 88, 106, and 132(R)," Statement of Financial Accounting Standards No. 158 (Norwalk, CT: FASB, 2006).]
FASB ASC 715-30-35-22. [Predecessor literature: "Employers' Accounting for Pension Plans," Statement of Financial Accounting Standards No. 87 (Stamford, Conn.: FASB, 1985), par. 30.]
FASB ASC 220-10-45-13. [Predecessor literature: "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans: An Amendment of SFAS Nos. 87, 88, 106, and 132(R)," Statement of Financial Accounting Standards No. 158 (Norwalk, CT: FASB, 2006), par. B41.]
FASB ASC 715-20-50-1. [Predecessor literature: "Employers' Disclosure about Pensions and Other Postretirement Benefits," Statement of Financial Accounting Standards No. 132 (Stamford, Conn.: FASB, 1998; revised 2003); and "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans: An Amendment of SFAS Nos. 87, 88, 106, and 132(R)," Statement of Financial Accounting Standards No. 158 (Norwalk, CT: FASB, 2006).]
FASB ASC 715-30-05-9. [Predecessor literature: "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," Statement of Financial Accounting Standards No. 88 (Stamford, Conn.: FASB, 1985).]
FASB ASC 715-60. [Predecessor literature: "Employers' Accounting for Postretirement Benefits Other Than Pensions," Statement of Financial Accounting Standards No. 106 (Norwalk, Conn.: FASB, 1990).]
FASB ASC 712-10-05. [Predecessor literature: "Employers' Accounting for Postemployment Benefits," Statement of Financial Accounting Standards No. 112 (Norwalk, Conn.: FASB, 1992).]
FASB ASC 715-60-35-9. [Predecessor literature: "Employers' Accounting for Postretirement Benefits Other Than Pensions," Statement of Financial Accounting Standards No. 106 (Norwalk, Conn.: FASB, 1990), pars. 46–66.]
FASB ASC 715-60-25. [Predecessor literature: "Employers' Accounting for Postretirement Benefits Other Than Pensions," Statement of Financial Accounting Standards No. 106 (Norwalk, Conn.: FASB, 1990), par. 163.]
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.
What is a private pension plan? How does a contributory pension plan differ from a noncontributory plan?
Differentiate between a defined-contribution pension plan and a defined-benefit pension plan. Explain how the employer's obligation differs between the two types of plans.
Differentiate between "accounting for the employer" and "accounting for the pension fund."
The meaning of the term "fund" depends on the context in which it is used. Explain its meaning when used as a noun. Explain its meaning when it is used as a verb.
What is the role of an actuary relative to pension plans? What are actuarial assumptions?
What factors must be considered by the actuary in measuring the amount of pension benefits under a defined benefit plan?
Name three approaches to measuring benefit obligations from a pension plan and explain how they differ.
Explain how cash-basis accounting for pension plans differs from accrual-basis accounting for pension plans. Why is cash-basis accounting generally considered unacceptable for pension plan accounting?
Identify the five components that comprise pension expense. Briefly explain the nature of each component.
What is service cost, and what is the basis of its measurement?
In computing the interest component of pension expense, what interest rates may be used?
Explain the difference between service cost and prior service cost.
What is meant by "prior service cost"? When is prior service cost recognized as pension expense?
What are "liability gains and losses," and how are they accounted for?
If pension expense recognized in a period exceeds the current amount funded by the employer, what kind of account arises, and how should it be reported in the financial statements? If the reverse occurs—that is, current funding by the employer exceeds the amount recognized as pension expense—what kind of account arises, and how should it be reported?
Given the items and amounts shown on page 1094, compute the actual return on plan assets: fair value of plan assets at the beginning of the period $9,500,000; benefits paid during the period $1,400,000; contributions made during the period $1,000,000; and fair value of the plan assets at the end of the period $10,150,000.
How does an "asset gain or loss" develop in pension accounting? How does a "liability gain or loss" develop in pension accounting?
What is the meaning of "corridor amortization"?
At the end of the current period, Agler Inc. had a projected benefit obligation of $400,000 and pension plan assets (at fair value) of $350,000. What are the accounts and amounts that will be reported on the company's balance sheet as pension assets or pension liabilities?
At the end of the current year, Pociek Co. has prior service cost of $9,150,000. Where should the prior service cost be reported on the balance sheet?
Describe the accounting for actuarial gains and losses.
Boey Company reported net income of $25,000 in 2011. It had the following amounts related to its pension plan in 2011: Actuarial liability gain $10,000; Unexpected asset loss $14,000; Accumulated other comprehensive income (G/L) (beginning balance), zero. Determine for 2011 (a) Boey's other comprehensive income, and (b) comprehensive income.
Describe the reporting of pension plans for a company with multiple plans, some of which are underfunded and some of which are overfunded.
Determine the meaning of the following terms.
Contributory plan.
Vested benefits.
Retroactive benefits.
Years-of-service method.
A headline in the Wall Street Journal stated, "Firms Increasingly Tap Their Pension Funds to Use Excess Assets." What is the accounting issue related to the use of these "excess assets" by companies?
* What are postretirement benefits other than pensions?
* Why didn't the FASB cover both types of postretirement benefits—pensions and healthcare—in the earlier pension accounting rules?
* What are the major differences between postretirement healthcare benefits and pension benefits?
* What is the difference between the APBO and the EPBO? What are the components of postretirement expense?
Service cost
$370
Interest on P.B.O.
672
Return on plan assets
747
Amortization of prior service cost
16
Amortization of net loss
25
Compute AMR Corporation's 2007 pension expense.
Projected benefit obligation
$2,600,000
Plan assets at fair value
2,000,000
Accumulated OCI (PSC)
1,100,000
How should these balances be reported on Hawkins's balance sheet at December 31, 2010?
Actuarial liability loss for 2010
$28,000
Unexpected asset gain for 2010
18,000
Accumulated other comprehensive income (G/L) (beginning balance)
7,000 Cr.
Determine for 2010: (a) Norton's other comprehensive income (loss), and (b) comprehensive income. Net income for 2010 is $26,000; no amortization of gain or loss is necessary in 2010.
How will Lahey report these multiple plans in its financial statements?
Service cost
$40,000
Interest cost
47,400
Actual and expected return on plan assets
26,900
Compute Manno's 2010 postretirement expense.
Actual and expected return on plan assets
$ 15,000
Benefits paid to retirees
40,000
Contributions (funding)
90,000
Interest/discount rate
10%
Prior service cost amortization
8,000
Projected benefit obligation, January 1, 2010
500,000
Service cost
60,000
Instructions
Compute pension expense for the year 2010.
Prepare the journal entry to record pension expense and the employer's contribution to the pension plan in 2010.
Service cost
$ 90,000
Contribution to the plan
105,000
Prior service cost amortization
10,000
Actual and expected return on plan assets
64,000
Benefits paid
40,000
Plan assets at January 1, 2010
640,000
Projected benefit obligation at January 1, 2010
700,000
Accumulated OCI (PSC) at January 1, 2010
150,000
Interest/discount (settlement) rate
10%
Instructions
Compute the pension expense for the year 2010.
Plan assets, January 1, 2010
$490,000
Projected benefit obligation, January 1, 2010
490,000
Settlement rate
8%
Service cost
40,000
Contributions (funding)
25,000
Actual and expected return on plan assets
49,700
Benefits paid to retirees
33,400
Instructions
Using the preceding data, compute pension expense for the year 2010. As part of your solution, prepare a pension worksheet that shows the journal entry for pension expense for 2010 and the year-end balances in the related pension accounts.
Employee
Future Years of Service
Jim
3
Paul
4
Nancy
5
Dave
6
Kathy
6
On January 1, 2010, the company amended its pension plan increasing its projected benefit obligation by $72,000.
Instructions
Compute the amount of prior service cost amortization for the years 2010 through 2015 using the years-of-service method setting up appropriate schedules.
Fair value of pension plan assets, January 1, 2010
$2,400,000
Fair value of pension plan assets, December 31, 2010
2,725,000
Contributions to the plan in 2010
280,000
Benefits paid retirees in 2010
350,000
Instructions
From the data above, compute the actual return on the plan assets for 2010.
Projected benefit obligation, 1/1/10 (before amendment)
$560,000
Plan assets, 1/1/10
546,200
Pension liability
13,800
On January 1, 2010, Rydell Corp., through plan amendment, grants prior service benefits having a present value of
120,000
Settlement rate
9%
Service cost
58,000
Contributions (funding)
65,000
Actual (expected) return on plan assets
52,280
Benefits paid to retirees
40,000
Prior service cost amortization for 2010
17,000
Instructions
For 2010, prepare a pension worksheet for Rydell Corp. that shows the journal entry for pension expense and the year-end balances in the related pension accounts.
Projected Benefit Obligation
Plan Assets Value
2009
$2,000,000
$1,900,000
2010
2,400,000
2,500,000
2011
2,950,000
2,600,000
2012
3,600,000
3,000,000
The average remaining service life per employee in 2009 and 2010 is 10 years and in 2011 and 2012 is 12 years. The net gain or loss that occurred during each year is as follows: 2009, $280,000 loss; 2010, $90,000 loss; 2011, $11,000 loss; and 2012, $25,000 gain. (In working the solution the gains and losses must be aggregated to arrive at year-end balances.)
Instructions
Using the corridor approach, compute the amount of net gain or loss amortized and charged to pension expense in each of the four years, setting up an appropriate schedule.
Instructions
Prepare the note disclosing the components of pension expense for the year 2010.
Determine the amounts of other comprehensive income and comprehensive income for 2010. Net income for 2010 is $35,000.
Compute the amount of accumulated other comprehensive income reported at December 31, 2010.
Plan assets
$480,000
Projected benefit obligation
600,000
Pension asset/liability
120,000
Accumulated OCI (PSC)
100,000
As a result of the operation of the plan during 2010, the following additional data are provided by the actuary.
Service cost for 2010
$90,000
Settlement rate, 9%
Actual return on plan assets in 2010
55,000
Amortization of prior service cost
19,000
Expected return on plan assets
52,000
Unexpected loss from change in projected benefit obligation, due to change in actuarial predictions
76,000
Contributions in 2010
99,000
Benefits paid retirees in 2010
85,000
Instructions
Using the data above, compute pension expense for Webb Corp. for the year 2010 by preparing a pension worksheet.
Prepare the journal entry for pension expense for 2010.
The actuarial present value of future benefits earned by employees for services rendered in 2010 amounted to $56,000.
The company's funding policy requires a contribution to the pension trustee amounting to $145,000 for 2010.
As of January 1, 2010, the company had a projected benefit obligation of $900,000, an accumulated benefit obligation of $800,000, and a balance of $400,000 in accumulated OCI (PSC). The fair value of pension plan assets amounted to $600,000 at the beginning of the year. The actual and expected return on plan assets was $54,000. The settlement rate was 9%. No gains or losses occurred in 2010 and no benefits were paid.
Amortization of prior service cost was $50,000 in 2010. Amortization of net gain or loss was not required in 2010.
Instructions
Determine the amounts of the components of pension expense that should be recognized by the company in 2010.
Prepare the journal entry or entries to record pension expense and the employer's contribution to the pension trustee in 2010.
Indicate the amounts that would be reported on the income statement and the balance sheet for the year 2010.
January 1, 2010
December 31, 2010
Projected benefit obligation
$1,500,000
$1,527,000
Market-related and fair value of plan assets
800,000
1,130,000
Accumulated benefit obligation
1,600,000
1,720,000
Accumulated OCI (G/L)—Net gain
–0–
(200,000)
The service cost component of pension expense for employee services rendered in the current year amounted to $77,000 and the amortization of prior service cost was $120,000. The company's actual funding (contributions) of the plan in 2010 amounted to $250,000. The expected return on plan assets and the actual rate were both 10%; the interest/discount (settlement) rate was 10%. Accumulated other comprehensive income (PSC) had a balance of $1,200,000 on January 1, 2010. Assume no benefits paid in 2010.
Instructions
Determine the amounts of the components of pension expense that should be recognized by the company in 2010.
Prepare the journal entry to record pension expense and the employer's contribution to the pension plan in 2010.
Indicate the pension-related amounts that would be reported on the income statement and the balance sheet for Ferreri Company for the year 2010.
January 1, 2010
December 31, 2010
Vested benefit obligation
$1,500
$1,900
Accumulated benefit obligation
1,900
2,730
Projected benefit obligation
2,500
3,300
Plan assets (fair value)
1,700
2,620
Settlement rate and expected rate of return
10%
Pension asset/liability
800
?
Service cost for the year 2010
400
Contributions (funding in 2010)
700
Benefits paid in 2010
200
Instructions
Compute the actual return on the plan assets in 2010.
Compute the amount of the other comprehensive income (G/L) as of December 31, 2010. (Assume the January 1, 2010, balance was zero.)
Compute the amount of net gain or loss amortization for 2010 (corridor approach).
Compute pension expense for 2010.
Instructions
Compute pension expense and prepare the journal entry to record pension expense and the employer's contribution to the pension plan in 2010. Preparation of a pension worksheet is not required. Benefits paid in 2010 were $35,000.
Indicate the pension-related amounts that would be reported in the company's income statement and balance sheet for 2010.
Incurred during the Year
(Gain) or Loss
2010
$300,000
2011
480,000
2012
(210,000)
2013
(290,000)
Other information about the company's pension obligation and plan assets is as follows.
As of January 1,
Projected Benefit Obligation
Plan Assets (market-related asset value)
2010
$4,000,000
$2,400,000
2011
4,520,000
2,200,000
2012
5,000,000
2,600,000
2013
4,240,000
3,040,000
Gustafson Inc. has a stable labor force of 400 employees who are expected to receive benefits under the plan. The total service-years for all participating employees is 5,600. The beginning balance of accumulated OCI (G/L) is zero on January 1, 2010. The market-related value and the fair value of plan assets are the same for the 4-year period. Use the average remaining service life per employee as the basis for amortization.
Instructions
(Round to the nearest dollar)
Prepare a schedule which reflects the minimum amount of accumulated OCI (G/L) amortized as a component of net periodic pension expense for each of the years 2010, 2011, 2012, and 2013. Apply the "corridor" approach in determining the amount to be amortized each year.
The average remaining service life per employee is 10.5 years. The service cost component of net periodic pension expense for employee services rendered amounted to $400,000 in 2010 and $475,000 in 2011. The accumulated OCI (PSC) on January 1, 2010, was $1,260,000. No benefits have been paid.
Instructions
(Round to the nearest dollar)
Compute the amount of accumulated OCI (PSC) to be amortized as a component of net periodic pension expense for each of the years 2010 and 2011.
Prepare a schedule which reflects the amount of accumulated OCI (G/L) to be amortized as a component of pension expense for 2010 and 2011.
Determine the total amount of pension expense to be recognized by Keeton Company in 2010 and 2011.
Instructions
Determine the missing amounts in the 2010 pension worksheet, indicating whether the amounts are debits or credits.
Prepare the journal entry to record 2010 pension expense for Usher Inc.
The accounting staff has heard of a pension accounting procedure called "corridor amortization." Is Usher required to record any amounts for corridor amortization in (1) 2010? In (2) 2011? Explain.
Service cost
$ 45,000
Contribution to the plan
10,000
Actual and expected return on plan assets
11,000
Benefits paid
20,000
Plan assets at January 1, 2010
110,000
Accumulated postretirement benefit obligation at January 1, 2010
330,000
Discount rate
8%
Instructions
Compute the postretirement benefit expense for 2010.
Accumulated postretirement benefit obligation at January 1, 2010
$710,000
Actual and expected return on plan assets
34,000
Prior service cost amortization
21,000
Discount rate
10%
Service cost
83,000
Instructions
Compute postretirement benefit expense for 2010.
Instructions
Compute the postretirement benefit expense for 2010.
Instructions
Determine the missing amounts in the 2010 postretirement worksheet, indicating whether the amounts are debits or credits.
Prepare the journal entry to record 2010 postretirement expense for Holder Inc.
What discount rate is Holder using in accounting for the interest on its other postretirement benefit plan? Explain.
Projected benefit obligation
$4,500,000
Fair value of plan assets
4,200,000
The interest (settlement) rate applicable to the plan is 10%. On January 1, 2011, the company amends its pension agreement so that prior service costs of $500,000 are created. Other data related to the pension plan are as follows.
2010
2011
Service cost
$150,000
$180,000
Prior service cost amortization
–0–
90,000
Contributions (funding) to the plan
240,000
285,000
Benefits paid
200,000
280,000
Actual return on plan assets
252,000
260,000
Expected rate of return on assets
6%
8%
Instructions
Prepare a pension worksheet for the pension plan for 2010 and 2011.
For 2011, prepare the journal entry to record pension-related amounts.
Instructions
Prepare a pension worksheet presenting all 3 years' pension balances and activities.
Prepare the journal entries (from the worksheet) to reflect all pension plan transactions and events at December 31 of each year.
Indicate the pension-related amounts reported in the financial statements for 2011.
Accumulated other comprehensive loss (PSC)
$150,000
Pension plan assets (fair value and market-related asset value)
200,000
Accumulated benefit obligation
260,000
Projected benefit obligation
380,000
The average remaining service period for the participating employees is 10 years. All employees are expected to receive benefits under the plan. On December 31, 2010, the actuary calculated that the present value of future benefits earned for employee services rendered in the current year amounted to $52,000; the projected benefit obligation was $490,000; fair value of pension assets was $276,000; the accumulated benefit obligation amounted to $365,000. The expected return on plan assets and the discount rate on the projected benefit obligation were both 10%. The actual return on plan assets is $11,000. The company's current year's contribution to the pension plan amounted to $65,000. No benefits were paid during the year.
Instructions
Determine the components of pension expense that the company would recognize in 2010. (With only one year involved, you need not prepare a worksheet.)
Prepare the journal entry to record the pension expense and the company's funding of the pension plan in 2010.
Compute the amount of the 2010 increase/decrease in gains or losses and the amount to be amortized in 2010 and 2011.
Indicate the pension amounts reported in the financial statement as of December 31, 2010.
Instructions
Compute pension expense for 2010 and 2011.
Prepare the journal entries to record the pension expense and the company's funding of the pension plan for both years.
There were no balances as of January 1, 2010, when the plan was initiated. The actual and expected return on plan assets was 10% over the 3-year period but the settlement rate used to discount the company's pension obligation was 13% in 2010, 11% in 2011, and 8% in 2012. The service cost component of net periodic pension expense amounted to the following: 2010, $60,000; 2011, $85,000; and 2012, $119,000. The average remaining service life per employee is 12 years. No benefits were paid in 2010, $30,000 of benefits were paid in 2011, and $18,500 of benefits were paid in 2012 (all benefits paid at end of year).
Instructions
(Round to the nearest dollar.)
Calculate the amount of net periodic pension expense that the company would recognize in 2010, 2011, and 2012.
Prepare the journal entries to record net periodic pension expense, employer's funding contribution, and related pension amounts for the years 2010, 2011, and 2012.
The company has 200 employees. All these employees are expected to receive benefits under the plan. The average remaining service life per employee is 12 years.
The projected benefit obligation amounted to $5,000,000 and the fair value of pension plan assets was $3,000,000. The market-related asset value was also $3,000,000. Unrecognized prior service cost was $2,000,000.
On December 31, 2010, the projected benefit obligation and the accumulated benefit obligation were $4,850,000 and $4,025,000, respectively. The fair value of the pension plan assets amounted to $4,100,000 at the end of the year. A 10% settlement rate and a 10% expected asset return rate were used in the actuarial present value computations in the pension plan. The present value of benefits attributed by the pension benefit formula to employee service in 2010 amounted to $200,000. The employer's contribution to the plan assets amounted to $775,000 in 2010. This problem assumes no payment of pension benefits.
Instructions
(Round all amounts to the nearest dollar.)
Prepare a schedule, based on the average remaining life per employee, showing the prior service cost that would be amortized as a component of pension expense for 2010, 2011, and 2012.
Compute pension expense for the year 2010.
Prepare the journal entries required to report the accounting for the company's pension plan for 2010.
Compute the amount of the 2010 increase/decrease in net gains or losses and the amount to be amortized in 2010 and 2011.
As a result of the operation of the plan during 2010, the actuary provided the following additional data at December 31, 2010.
Service cost for 2010
$108,000
Settlement rate, 9%; expected return rate, 10%
Actual return on plan assets in 2010
48,000
Amortization of prior service cost
25,000
Contributions in 2010
133,000
Benefits paid retirees in 2010
85,000
Average remaining service life of active employees
10 years
Instructions
Using the preceding data, compute pension expense for Hanson Corp. for the year 2010 by preparing a pension worksheet that shows the journal entry for pension expense. Use the market-related asset value to compute the expected return and for corridor amortization.
Instructions
Prepare a pension worksheet presenting both years 2010 and 2011 and accompanying computations and amortization of the loss (2011) using the corridor approach.
Prepare the journal entries (from the worksheet) to reflect all pension plan transactions and events at December 31 of each year.
For 2011, indicate the pension amounts reported in the financial statements.
Projected benefit obligation
$4,600,000
Fair value of plan assets
4,600,000
The interest (settlement) rate applicable to the plan is 10%. On January 1, 2011, the company amends its pension agreement so that prior service costs of $600,000 are created. Other data related to the pension plan are:
2010
2011
Service cost
$150,000
$170,000
Prior service cost amortization
–0–
90,000
Contributions (funding) to the plan
200,000
184,658
Benefits paid
220,000
280,000
Actual return on plan assets
252,000
350,000
Expected rate of return on assets
6%
8%
Instructions
Prepare a pension worksheet for the pension plan in 2010.
Prepare any journal entries related to the pension plan that would be needed at December 31, 2010.
Prepare a pension worksheet for 2011 and any journal entries related to the pension plan as of December 31, 2011.
Indicate the pension-related amounts reported in the 2011 financial statements.
Instructions
Determine the missing amounts in the 2010 pension worksheet, indicating whether the amounts are debits or credits.
Prepare the journal entry to record 2010 pension expense for Kramer Co.
Determine the following for Kramer for 2010: (1) settlement rate used to measure the interest on the liability and (2) expected return on plan assets.
Service cost
$59,000
Actual return on plan assets
32,000
Amortization of prior service cost
28,000
Annual contributions
51,000
Benefits paid retirees
27,000
Average service life of all employees
25 years
For 2011, Kramer will use the same assumptions as 2010 for the expected rate of returns on plan assets. The settlement rate for 2011 is 10%.
Instructions
Prepare a pension worksheet for 2011 and accompanying computations and amortization of the loss, if any, in 2011 using the corridor approach.
Prepare the journal entries (from the worksheet) to reflect all pension plan transactions and events at December 31.
Indicate the pension amounts reported in the financial statements.
As a result of the operation of the plan during 2011, the actuary provided the following additional data at December 31, 2011.
Service cost for 2011
$ 45,000
Actual return on plan assets in 2011
27,000
Amortization of prior service cost
12,000
Contributions in 2011
65,000
Benefits paid retirees in 2011
41,000
Settlement rate
7%
Expected return on plan assets
8%
Average remaining service life of active employees
10 years
Instructions
Compute pension expense for Larson Corp. for the year 2011 by preparing a pension worksheet that shows the journal entry for pension expense.
Indicate the pension amounts reported in the financial statements.
Plan assets
$200,000
Expected postretirement benefit obligation
820,000
Accumulated postretirement benefit obligation
200,000
No prior service costs exist.
As a result of the plan's operation during 2010, the following additional data are provided by the actuary.
Service cost for 2010 is $70,000
Discount rate is 10%
Contributions to plan in 2010 are $65,000
Expected return on plan assets is $10,000
Actual return on plan assets is $15,000
Benefits paid to employees are $44,000
Average remaining service to full eligibility: 20 years
Instructions
Using the preceding data, compute the net periodic postretirement benefit cost for 2010 by preparing a worksheet that shows the journal entry for postretirement expense and the year-end balances in the related postretirement benefit memo accounts. (Assume that contributions and benefits are paid at the end of the year.)
Prepare any journal entries related to the postretirement plan for 2010 and indicate the postretirement amounts reported in the financial statements for 2010.
Accumulated postretirement benefit obligation
$2,250,000
Fair value of plan assets
2,250,000
The interest (settlement) rate applicable to the plan is 10%. On January 1, 2011, the company amends the plan so that prior service costs of $175,000 are created. Other data related to the plan are:
2010
2011
Service costs
$ 75,000
$ 85,000
Prior service costs amortization
–0–
12,000
Contributions (funding) to the plan
45,000
35,000
Benefits paid
40,000
45,000
Actual return on plan assets
140,000
120,000
Expected rate of return on assets
8%
6%
Instructions
Prepare a worksheet for the postretirement plan in 2010.
Prepare any journal entries related to the postretirement plan that would be needed at December 31, 2010.
Prepare a worksheet for 2011 and any journal entries related to the postretirement plan as of December 31, 2011.
Indicate the postretirement-benefit–related amounts reported in the 2011 financial statements.
CA20-1 (Pension Terminology and Theory) Many business organizations have been concerned with providing for the retirement of employees since the late 1800s. During recent decades a marked increase in this concern has resulted in the establishment of private pension plans in most large companies and in many medium- and small-sized ones.
The substantial growth of these plans, both in numbers of employees covered and in amounts of retirement benefits, has increased the significance of pension cost in relation to the financial position, results of operations, and cash flows of many companies. In examining the costs of pension plans, a CPA encounters certain terms. The components of pension costs that the terms represent must be dealt with appropriately if generally accepted accounting principles are to be reflected in the financial statements of entities with pension plans.
Instructions
Define a private pension plan. How does a contributory pension plan differ from a noncontributory plan?
Differentiate between "accounting for the employer" and "accounting for the pension fund."
Explain the terms "funded" and "pension liability" as they relate to:
The pension fund.
The employer.
Discuss the theoretical justification for accrual recognition of pension costs.
Discuss the relative objectivity of the measurement process of accrual versus cash (pay-as-you-go) accounting for annual pension costs.
Distinguish among the following as they relate to pension plans.
Service cost.
Prior service costs.
Vested benefits.
Under the caption Assets:
Pension asset/liability.
Under the caption Liabilities:
Pension asset/liability.
Under the caption Stockholders' Equity:
Prior service cost as a component of Accumulated Other Comprehensive Income.
On the income statement:
Pension expense.
Instructions
Explain the significance of each of the items above on corporate financial statements. (Note: All items set forth above are not necessarily to be found on the statements of a single company.)
CA20-3 (Basic Terminology) In examining the costs of pension plans, Helen Kaufman, CPA, encounters certain terms. The components of pension costs that the terms represent must be dealt with appropriately if generally accepted accounting principles are to be reflected in the financial statements of entities with pension plans.
Instructions
Discuss the theoretical justification for accrual recognition of pension costs.
Discuss the relative objectivity of the measurement process of accrual versus cash (pay-as-you-go) accounting for annual pension costs.
Explain the following terms as they apply to accounting for pension plans.
Market-related asset value.
Projected benefit obligation.
Corridor approach.
What information should be disclosed about a company's pension plans in its financial statements and its notes?
(AICPA adapted)
Note J. The company has a defined-benefit pension plan covering substantially all of its employees. The benefits are based on years of service and the employee's compensation during the last four years of employment. The company's funding policy is to contribute annually the maximum amount allowed under the federal tax code. Contributions are intended to provide for benefits expected to be earned in the future as well as those earned to date.
The net periodic pension expense on Davis Corporation's comparative income statement was $72,000 in 2010 and $57,680 in 2009.
The following are selected figures from the plan's funded status and amounts recognized in the Davis Corporation's Statement of Financial Position at December 31, 2010 ($000 omitted).
Given that Davis Corporation's work force has been stable for the last 6 years, Cole could not understand the increase in the net periodic pension expense. Dilbeck explained that the net periodic pension expense consists of several elements, some of which may increase or decrease the net expense.
Instructions
The determination of the net periodic pension expense is a function of five elements. List and briefly describe each of the elements.
Describe the major difference and the major similarity between the accumulated benefit obligation and the projected benefit obligation.
Explain why pension gains and losses are not recognized on the income statement in the period in which they arise.
Briefly describe how pension gains and losses are recognized.
(CMA adapted)
In an article in Business Week prior to new rules related to pensions, it was reported that the discount rates used by the largest 200 companies for pension reporting ranged from 5% to 11%. How can such a situation exist, and does GAAP alleviate this problem?
An article indicated that when new GAAP rules were issued related to pensions, it caused an increase in the liability for pensions for approximately 20% of companies. Why might this situation occur?
A recent article noted that while "smoothing" is not necessarily an accounting virtue, pension accounting has long been recognized as an exception—an area of accounting in which at least some dampening of market swings is appropriate. This is because pension funds are managed so that their performance is insulated from the extremes of short-term market swings. A pension expense that reflects the volatility of market swings might, for that reason, convey information of little relevance. Are these statements true?
Understanding the impact of the changes required in pension reporting requires detailed information about its pension plan(s) and an analysis of the relationship of many factors, particularly:
the type of plan(s) and any significant amendments.
the plan participants.
the funding status.
the actuarial funding method and assumptions currently used.
What impact does each of these items have on financial statement presentation?
An article noted "You also need to decide whether to amortize gains and losses using the corridor method, or to use some other systematic method. Under the corridor approach, only gains and losses in excess of 10% of the greater of the projected benefit obligation or the plan assets would have to be amortized." What is the corridor method and what is its purpose?
Instructions
What answers do you believe Jill and Pete gave to each of these questions?
Projected Benefit Obligation | Plan Assets Value | |
|---|---|---|
2009 | $2,200,000 | $1,900,000 |
2010 | 2,400,000 | 2,500,000 |
2011 | 2,900,000 | 2,600,000 |
2012 | 3,900,000 | 3,000,000 |
The average remaining service life per employee in 2009 and 2010 is 10 years and in 2011 and 2012 is 12 years. The net gain or loss that occurred during each year is as follows.
2009 | $280,000 loss |
2010 | 85,000 loss |
2011 | 12,000 loss |
2012 | 25,000 gain |
(In working the solution, you must aggregate the unrecognized gains and losses to arrive at year-end balances.)
Instructions
You are the manager in charge of accounting. Write a memo to Vickie Plato, explaining why in some years she must amortize some of the net gains and losses and in other years she does not need to. In order to explain this situation fully, you must compute the amount of net gain or loss that is amortized and charged to pension expense in each of the 4 years listed above. Include an appropriate amortization schedule, referring to it whenever necessary.
The net present value of CE's pension assets was $15.5 million, the vested benefit obligation was $12.9 million, and the projected benefit obligation was $17.4 million. Ott reported this audit finding to Julie Habbe, the newly appointed controller of CE. A few days later Habbe called Ott for his advice on what to do. Habbe started her conversation by asking, "Can't we eliminate the negative income effect of our pension dilemma simply by terminating the employment of nonvested employees before the end of our fiscal year?"
Instructions
How should Ott respond to Habbe's remark about firing nonvested employees?
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso.
Instructions
What kind of pension plan does P&G provide its employees in the United States?
What was P&G's pension expense for 2007, 2006, and 2005 for the United States?
What is the impact of P&G's pension plans for 2007 on its financial statements?
What information does P&G provide on the target allocation of its pension assets? (Compare the asset allocation for "Pensions and Other Retiree Benefits.") How do the allocations relate to the expected returns on these assets?
Instructions
What kind of pension plans do Coca-Cola and PepsiCo provide their employees?
What net periodic pension expense (cost) did Coca-Cola and PepsiCo report in 2007?
What is the year-end 2007 funded status of Coca-Cola's and PepsiCo's U.S. plans?
What relevant rates were used by Coca-Cola and PepsiCo in computing their pension amounts?
Compare the expected benefit payments and contributions for Coca-Cola and PepsiCo.
A Wall Street Journal article discussed a $1.8 billion charge to income made by General Electric for postretirement benefit costs. It was attributed to previously unrecognized healthcare and life insurance cost. As financial vice president and controller for Peake, Inc., you found this article interesting because the president recently expressed interest in adopting a postemployment benefit program for Peake's employees, to complement the company's existing defined-benefit plan. The president, Martha Beyerlein, wants to know how the expense on the new plan will be determined and what impact the accounting for the plan will have on Peake's financial statements.
Instructions
As financial vice president and controller of Peake, Inc., explain the calculation of postemployment benefit expense under GAAP, and indicate how the accounting for the plan will affect Peake's financial statements.
Discuss the similarities and differences in the accounting for the other postemployment benefit plan relative to the accounting for the defined-benefit plan.
Kyowa Hakko Kogyo Co., Ltd., is an R&D–based company with special strengths in biotechnology. The company is dedicated to the creation of new value in the life sciences, especially in its two core business segments of pharmaceuticals and biochemicals, and strives to contribute to the health and well-being of people around the world. The company provided the following disclosures related to its retirement benefits in its 2007 annual report.
Kyowa Hakko Kogyo Co., Ltd.
Note 1. Basis of Presenting Consolidated Financial Statements (partial)
Kyowa Hakko Kogyo Co., Ltd. (the "Company") and its consolidated subsidiaries maintain their accounts and records in accordance with the provisions set forth in the Securities and Exchange Law and in conformity with generally accepted accounting principles and practices prevailing in Japan. ... The Company's fiscal year is from April 1 to March 31. Therefore, "fiscal 2007" begins on April 1, 2006 and ends on March 31, 2007.
Reserve for Retirement Benefits to Employees
A reserve for retirement benefits to employees is provided at an amount equal to the present value of the projected benefit obligation less fair value of the plan assets at the year-end. Unrecognized prior service costs are amortized on a straight-line basis over five years from the year they occur. Unrecognized actuarial differences are amortized on a straight-line basis over ten years from the year after they occur.
Note 9. Reserve for Retirement Benefits to Employees
The Company and its domestic consolidated subsidiaries operate various defined benefit plans, including a corporate pension plan (the so-called cash-balanced plan), a group contributory plan, a tax-qualified pension plan and a severance payment plan.
The reserve for retirement benefits as of March 31, 2007, is analyzed as follows.
The net periodic pension expense related to the retirement benefits for fiscal 2007 is as follows.
Assumptions used in calculation of the above information are as follows.
Instructions
Use the information on Kyowa to respond to the following requirements.
What are the key differences in accounting for pensions under U.S. and Japanese standards?
Briefly explain how differences in U.S. and Japanese standards for pensions would affect the amounts reported in the financial statements.
In light of the differences identified above, would Kyowa's income and equity be higher or lower under U.S. GAAP compared to Japanese standards? Explain.
Monat Company has grown rapidly since its founding in 2002. To instill loyalty in its employees, Monat is contemplating establishment of a defined-benefit plan. Monat knows that lenders and potential investors will pay close attention to the impact of the pension plan on the company's financial statements, particularly any gains or losses that develop in the plan. Monat has asked you to conduct some research on the accounting for gains and losses in a defined-benefit plan.
Instructions
Access the FASB Codification at http://asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses.
Briefly describe how pension gains and losses are accounted for.
Explain the rationale behind the accounting method described in part (a).
What is the related pension asset or liability that will show up on the balance sheet? When will each of these situations occur?
[348] When used as a verb, fund means to pay to a funding agency (as to fund future pension benefits or to fund pension cost). Used as a noun, it refers to assets accumulated in the hands of a funding agency (trustee) for the purpose of meeting pension benefits when they become due.
[349] The FASB issued a separate standard covering the accounting and reporting for employee benefit plans. [1]
[350] One study indicated that during the 1990s, pension funds (private and public) held or owned approximately 25 percent of the market value of corporate stock outstanding and accounted for 32 percent of the daily trading volume on the New York Stock Exchange. The enormous size (and the social significance) of these funds is staggering.
[351] In terms of total assets, recent Federal Reserve (2005) statistics indicate that assets in private defined-benefit and defined-contribution plans were more than $14.4 trillion. In many cases, companies offer a defined-contribution plan in combination with a defined-benefit plan. A recent federal law requires employees to explicitly opt out of an employer-sponsored defined-contribution plan. This should help employees build their own nest eggs (as suggested in the opening story) and will contribute to further growth in defined-contribution plans. See D. Darlin, "On Making Enrollment in a 401(k) Automatic," New York Times (August 19, 2006), p. B1.
[352] An actuary's primary purpose is to ensure that the company has established an appropriate funding pattern to meet its pension obligations. This computation involves developing a set of assumptions and continued monitoring of these assumptions to ensure their realism. That the general public has little understanding of what an actuary does is illustrated by the following excerpt from the Wall Street Journal: "A polling organization once asked the general public what an actuary was, and received among its more coherent responses the opinion that it was a place where you put dead actors."
[353] One measure of the pension obligation is to determine the amount that the Pension Benefit Guaranty Corporation would require the employer to pay if it defaulted. (This amount is limited to 30 percent of the employer's net worth.) The accounting profession rejected this approach for financial reporting because it is too hypothetical and ignores the going concern concept.
[354] When we use the term "present value of benefits" throughout this chapter, we really mean the actuarial present value of benefits. Actuarial present value is the amount payable adjusted to reflect the time value of money and the probability of payment (by means of decrements for events such as death, disability, withdrawals, or retirement) between the present date and the expected date of payment. For simplicity, though, we use the term "present value" instead of "actuarial present value" in our discussion.
[355] Recognize that GAAP applies to pensions as well as other postretirement benefit plans (OPEBs). Appendix 20A addresses the accounting for OPEBs.
[356] J. Ciesielski, "Benefit Plans 2007: Close To The Edge—And Back," The Analyst's Accounting Observer (April 25, 2008).
[357] At one time, companies applied the cash basis of accounting to pension plans by recognizing the amount paid in a particular accounting period as the pension expense for the period. The problem was that the amount paid or funded in a fiscal period depended on financial management and was too often discretionary. For example, funding could depend on the availability of cash, the level of earnings, or other factors unrelated to the requirements of the plan. Application of the cash basis made it possible to manipulate the amount of pension expense appearing in the income statement simply by varying the cash paid to the pension fund.
[358] At this point, we use the actual rate of return. Later, for purposes of computing pension expense, we use the expected rate of return.
[359] The use of a pension entry worksheet is recommended and illustrated by Paul B. W. Miller, "The New Pension Accounting (Part 2)," Journal of Accountancy (February 1987), pp. 86–94.
[360] Companies may use different ways of determining the calculated market-related value for different classes of assets. For example, an employer might use fair value for bonds and a five-year-moving-average for equities. But companies should consistently apply the manner of determining market-related value from year to year for each asset class. Throughout our Zarle illustrations, we assume that market-related values based on a calculated value and the fair value of plan assets are equal. For homework purposes, use the fair value of plan assets as the measure for the market-related value.
[361] Recently, the FASB proposed more extensive disclosures related to pension plan assets. At a minimum, companies would have to disclose the amount of assets allocated to equities, government and corporate bonds, mortgage-backed securities, derivatives, and real estate. Also, information on concentrations of risk must be explained. Finally, fair value disclosures would be required, including classification of amounts into levels of the fair value hierarchy. (See http://www.fasb.org/project/fas132r_disclosures_about_plan_assets.shtml.)
[362] In 2006, Congress passed the Pension Protection Act. This new law has many provisions. One important aspect of the Act is that it will force many companies to expedite their contributions to their pension plans. One group estimates that companies in the S&P 500 would have had to contribute $47 billion to their pension plans if the new rules were fully phased in for 2006. That amount is about 57 percent more than the $30 billion that companies were expecting to contribute to their plans that year. (Source: Credit Suisse, "Pension Protection Act," August 14, 2006, p. 1.)
[363] The major problems in underfunding are occurring in four labor-intensive industries—steel, autos, rubber, and airlines. For example, General Motors' pension plan at one time was 92 percent funded but still had a deficit of over $6 billion.
[364] Pan American Airlines is a good illustration of how difficult it is to assess when to terminate. When Pan Am filed for bankruptcy in 1991, it had a pension liability of $900 million. From 1983 to 1991, the IRS gave it six waivers so it did not have to make contributions. When Pan Am terminated the plan, there was little net worth left upon which to impose a lien. An additional accounting problem relates to the manner of disclosing the possible termination of a plan. For example, should Pan Am have disclosed a contingent liability for its struggling plan? At present this issue is unresolved, and considerable judgment would be needed to analyze a company with these contingent liabilities.
[365] A question exists as to whose money it is. Some argue that the excess funds belong to the employees, not the employer. In addition, given that the funds have been reverting to the employer, critics charge that cost-of-living increases and the possibility of other increased benefits are reduced, because companies will be reluctant to use those remaining funds to pay for such increases.
[366] Another way that companies have reduced their pension obligations is through adoption of cash-balance plans. These are hybrid plans combining features of defined-benefit and defined-contribution plans. Although these plans permit employees to transfer their pension benefits when they change employers (like a defined-contribution plan), they are controversial because the change to a cash-balance plan often reduces benefits to older workers.
The accounting for cash-balance plans is similar to that for defined-benefit plans, because employers bear the investment risk in cash-balance plans. When an employer adopts a cash-balance plan, the measurement of the future benefit obligation to employees generally is lower, compared to a traditional defined-benefit plan. See A. T. Arcady and F. Mellors, "Cash-Balance Conversions," Journal of Accountancy (February 2000), pp. 22–28.
[367] Some companies have established pension poison pills as an anti-takeover measure. These plans require asset reversions from termination of a plan to benefit employees and retirees rather than the acquiring company. For a discussion of pension poison pills, see Eugene E. Comiskey and Charles W. Mulford, "Interpreting Pension Disclosures: A Guide for Lending Officers," Commercial Lending Review (Winter 1993–94), Vol. 9, No. 1.
[368] Accounting Trends and Techniques—2007 reports that of its 600 surveyed companies, 317 reported benefit plans that provide postretirement healthcare benefits. In response to rising healthcare costs and higher premiums on healthcare insurance, companies are working to get their postretirement benefit costs under control. For example, a recent study of employer health-benefit plans indicates that employers are limiting or curtailing postretirement health benefits. See Kelly Greene, "Health Benefits for Retirees Continue to Shrink, Study Says," Wall Street Journal (September 16, 2002), p. A2.
[369] "OPEB" is the acronym frequently used to describe postretirement benefits other than pensions. This term came into being before the scope of guidance was narrowed from "other postemployment benefits" to "other postretirement benefits," thereby excluding postemployment benefits related to severance pay or wage continuation to disabled, terminated, or laid-off employees.
[370] "Elements of Financial Statements," Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: 1985), p. 13, footnote 21.
[371] Other postemployment (but before retirement) benefits include, but are not limited to, salary continuation, disability-related benefits, severance benefits, and continuance of healthcare benefits and life insurance for inactive or former (e.g., terminated, disabled, or deceased) employees or their beneficiaries. These benefits are accounted for similar to accounting for compensated absences (see Chapter 13). [9]
[372] D. Gerald Searfoss and Naomi Erickson, "The Big Unfunded Liability: Postretirement Health-Care Benefits," Journal of Accountancy (November 1988), pp. 28–39.
[373] This is a benefit-years-of-service approach (the projected unit credit actuarial cost method). The FASB found no compelling reason to switch from the traditional pension accounting approach. It rejected the employee's full service period (i.e., to the estimated retirement date) because it was unable to identify any approach that would appropriately attribute benefits beyond the date when an employee attains full eligibility for those benefits. Employees attain full eligibility by meeting specified age, service, or age and service requirements of the plan.
[374] See James R. Wilbert and Kenneth E. Dakdduk, "The New FASB 106: How to Account for Postretirement Benefits," Journal of Accountancy (August 1991), pp. 36–41.
[375] The FASB concluded that the discount rate for measuring the present value of the postretirement benefit obligation and the service cost component should be the same as that applied to pension measurements. It chose not to label it the settlement rate, in order to clarify that the objective of the discount rate is to measure the time value of money.