Chapter 20: Accounting for Pension Benefits

Question 1

Reason to shift from pension plan to IRA

Answer 1

Pension plan (employer risk) –> retirement plan (employee risk)

• to be competitive within their market
• cost
• insurance (premiums paid to pension benefit guarantee corp)
• accounting rules = potential for increased volatility in pension)

Question 2

Pension Plan

Answer 2

Arrangement where an employer provides benefits to retired employees for services provided in working years

Two sides of the accounting

• accounting for the employer
• accounting for the pension fund (benefits paid out from fund, not from employer)

Question 3

Types of pension plans

Answer 3

Contributory: employees bear part of the cost of benefits/ make voluntary payments

non-contributory: employer bears entire cost

Qualified pension plans: offer tax benefits. permit deductability of the employer’s contributions to the pension fund and tax free status of earnings from pension fund assets

Question 4

Pension fund

Answer 4

separate legal and accounting entity from the business entity (own books and own statements)

“Accounting for employee benefits plan”

may be managed by an independent third party

Question 5

Accounting for defined benefit plan

Answer 5

Employer contributes to plan as established by formula - entire pension cost to employer

• liability on balance sheet only if fails to make full contribution
• asset on balance sheet only if contribute more than required

Disclosures: plan description, include employees covered, basis for determination of contributions, nature and effect of significant matters offsetting comparability

Question 6

Defined contribution plan

Answer 6

Employer agrees to contribute to a pension trust a certain sum each period based on some formula defined by the plan
(401k plans)

plan defines only amounts contributed, not amounts eventually collected

Question 7

Defined benefit plan

Answer 7

Plan outlines benefits employees will receive on requirement & company must determine necessary contribution amount based on the time value of money

• benefits trust holds asset
• as long as the plan continues the employer is responsible for the payment of the defined benefits regardless of what happens to the trust

Question 8

Defined benefit plan trust

Answer 8

Employer is beneficiary of defined benefit trust

Employer must make up any shortfall in accumulated assets held by the trust BUT can also recapture any excess accumulated in the trust (via reduced future funding or via reversion of funds)

Question 9

Actuaries

Answer 9

Ensure pension plan is appropriate for employee group covered

assign probabilities to future events and their financial effects

actuaries compute pension measures for financial statements
- pension obligation, cost of serving the plan, cost of amendments to the plan

Question 10

Interest cost on pension obligation

Answer 10

beginning projected benefit obligation x settlement rate

Question 11

Prior service cost on pension worksheet

Answer 11

Add column in general journal entries section for other comprehensive income prior service cost (psc)

• original granting of prior service cost debit to OCI
  (adjust beginning year balance)
• amortization of prior service cost credit to OCI, debit to pension expense

Question 12

Prior service cost

Answer 12

An increase of projected benefit obligation due to recognized benefits offered employees for service years before the initiation of the benefit plan

recorded initially as an adjustment to other comprehensive income and then recognized over remaining service lives of employees expected to benefit

computed by actuary

Question 13

Amortization of prior service cost: straight line method

Answer 13

Straight line amortization over average remaining service live of employees

Service years / employees = average
Total expense / average = amortization

Question 14

Amortization of prior service cost: years-of-service method

Answer 14

• compute total number of service years to be worked by participating employees
• divide prior service cost by total number of years = cost per service year
• multiply number of service years consumed each year by cost per service year = annual amortization charge

Question 15

Vested benefit/ vested benefit

Answer 15

benefits employee is entitled to receive even if they render no further services to the company

obligation calculated with vested benefits at current salary levels

not a favored measure

Question 16

Accumulated benefit obligation

Answer 16

Obligation = deferred compensation amount on an employees total years of service - vested and non-vested using current salary measures

not a favored method

Question 17

Pension obligation

Answer 17

Deferred compensation obligation an employer has to is employees under the terms of the pension plan

can be measured by

• vested benefits
• accumulated benefit obligation
• projected benefit obligation (FAVORED METHOD)

Question 18

Actuarial Present Value

Answer 18

Amount payable adjusted to reflect the time value of money AND the probability of payments between present date and expected date of payment

Question 19

Projected benefit obligation

Answer 19

Measures deferred compensation on both vested and non-vested service, using future salaries (expected to higher)

Preferred method = actuarial present value of vested and non-vested benefits accrued to date based on employees future salary levels

must determine appropriate discount rate at each measurement date

Question 20

Recognition of net funded status of pension plan

Answer 20

Must recognize on balance sheet the full overfunded or underfunded status of defined benefits pension plan

measured as the difference between the fair value of plan assets and projected benefit obligation

underfunded = pension liability
overfunded = pension asset

Question 21

Components of pension expense

Answer 21

1) service cost (increase in pension benefits payable to employees) increases expense
2) interest on liability (liability recorded at discounted value –> accrues interest yearly) increases expense
3) actual return on plan assets (interest + dividends + changes in fair value of of fund) generally decreases expense
4) amortization of prior service cost (allocated to remaining service years of affected employees) increases expense
5) gain or loss may increase or decrease

Question 22

Service Cost

Answer 22

Actuary predicts the additional benefits that an employer must pay under their plan’s benefits formula as a result of the employee’s current years service and then discounts the cost of future benefits back to present value

Companies must consider future compensation levels in thsi measurement if they are parts of the plan benefit formula

Question 23

Settlement rates

Answer 23

Rates at which companies can effectively settle pension benefits

• look at rates of return on high quality fixed-income investments currently available whose cash flows match the timing and amount of assumed benefits payments

Question 24

Interest on the liability

Answer 24

Aka interest expense

• liability payment deferred until maturity = liability recorded on a discounted basis
• interest is accrued over the life of the employee

Interest component is the interest for the period on the projected benefit obligation outstanding for the period

apply settlement rate to the beginning of the year balance of projected liability

Question 25

Actual return on plan assets

Answer 25

Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair value of the plan assets (instruments)

change in fair value of the plan assets adjusted for contributions and benefit payments.

= (plan assets ending balance - plan assets beginning balance) - (contributions - benefits paid)

gain = subtracted from pension expense
loss= added to pension expense

Question 26

Pension worksheet

Answer 26

Columns
General journal entries: Items | Annual pension expense | Cash | Pension Asset/ liability
Memo record: Projected benefit obligation | plan assets

memo record portion maintains balances in the projected benefit obligation and the plan assets

ending balance of pension asset/ liability column = net balance of memo record

Question 27

Pension worksheet journal entry

Answer 27

Dr. Pension Expense
Cr. Cash contributions
Cr. Pension asset/ liability (Cr. liability, Dr. Asset)

Question 28

Pension asset or liability

Answer 28

The difference between the projected benefit obligation and the fair value of the plan assets

Benefit obligation > assets = pension liability (credit)
Benefit obligation < assets = pension asset (debit)

if net amount = credit then cr. liability
if net amount = debit then dr. asset

Question 29

Expected return on plan assets

Answer 29

Expected rate of return (developed by actuary?) x market related asset value at the beginning of the year

recorded on pension worksheet as actual return + or - gain/ loss to bring to expected return

Question 30

Treatment of gains and losses on plan assets

Answer 30

Expected return on plan assets (expected rate of return x market-related asset value)

recorded as an component of pension expense

any unexpected gain or loss recorded as a part of other comprehensive income

Question 31

Unexpected gain or loss on plan assets

Answer 31

Difference between expected return on plan assets and actual return on plan assets
“asset gains and losses”

Actual > expected = asset gain
Actual < expected = asset loss

Recorded in other comprehensive income (OCI)

Question 32

Things that may cause major changes to pension expense

Answer 32

• sudden and large changes in the fair value of plan assets
• changes in actuarial assumptions that affect the amount of the projected benefit obligation
• volatility reduced via “smoothing techniques”

Question 33

Market-related asset value

Answer 33

Either the fair value of plan assets or a calculated value that recognizes changes in fair value in a systematic and rational manner

companies may use different ways of determining market-related value for different classes of assets

Question 34

Liability gains and losses

Answer 34

Unexpected gains or losses from changes to projected benefit obligation

reported in other comprehensive income (G/L)

Accumulate if not amortized into accumulated OCI

Question 35

Corridor amortization approach

Answer 35

To limit growth of accumulated OCI
- if asset/ liability gains and losses do not offset eachother

Amortizing accumulated OCI if too large
Too large = 10% of the larger of the beginning balance of projected benefit obligation or market-related value of plan assets

Minimum amortization is excess of OCI over corridor / average remaining service period of active employees

May use any systematic method as long as amortization is at least the minimum

Question 36

Gains and losses that affect pension expense in period when they occur

Answer 36

Gains and losses that arise from a single occurrence not directly related to operation of the pension plan and not in the ordinary course of the employer’s business

(plant closing, disposal of business component, major layoff event)

Question 37

Amortizing gain or loss using corridor method

Answer 37

(beginning of year accumulated OCI (G/L) less corridor amount) / average remaining service period of active employees expected to receive plan benefits

= current year amortized net gain or loss

Question 38

Recording pension expense with OCI

Answer 38

Dr. Pension expense
Dr. OCI (G/L) [debit if loss, credit if gain]
Cr. Cash
Cr. OCI (PSC)
Cr. Pension asset/liability [debit if asset, credit if liability]

Question 39

Amortization of loss or gain: corridor method

Answer 39

NOT a journal entry

goes on the pension worksheet: pension loss and OCI G/L - moving excess loss or gain to expense account

Amortization of loss: Dr. expense, Cr. OCI
Amortization of gain: Cr. Expense, Dr. OCI

Question 40

Reporting pension assets and liabilities

Answer 40

Net asset or net liability based on the difference between the fair value of plan assets and projected benefit obligation

if multiple pension plans all overfunded plans are recorded together and all underfunded plans are recorded together but they are not netted together

liability may be partially current (benefits to be paid out) and partially non-current. Assets are never current (are a restricted asset)

Question 41

Reporting pension expense in net income

Answer 41

Pension expense split into components

1) service cost: reported as pension expense under income from operations (often part of compensation expense)
2) all other expense reported as a net amount in ‘other expenses and losses’ (below income for operations)

if no income from operations then report in a way that “conveys the underlying nature of the components” (but still keep separated)

Question 42

Reporting pension changes to OCI

Answer 42

• actuarial gains and losses and prior service costs recognized in OCI and then amortized out to penion expense over a service period
  amortization creates a “gain” in OCI

OCI reported a in a separate statement or a combined statement of comprehensive income

Question 43

Comprehensive income statement

Answer 43

Net Income
Other comprehensive loss or gain (loss or gain is based on balance)
        Amortization of PSC
        Unexpected actuarial gain/ loss
       other OCI components

= comprehensive income

Question 44

OCI on balance sheet

Answer 44

Under stockholder’s equity
Common Stock
Retained Earnings
Accumulated other comprehensive loss/ income
Total stockholders’ equity

Question 45

Pension plans in notes to financial statements

Answer 45

In body of statements or in notes

• schedule of major components of pension expense
• reconciliation of change in projected benefit obligation and plan assets from beginning to end of period
• disclosure of rates used in measuring benefit amounts
• table of pension plan assets by category and as a percentage of fair value + narrative of investment policies and strategies
• expected plan benefits paid out each of the next five years + total 5 years after (+ estimate of expected contributions for next year)
• nature and amounts recognized in net income and OCI from plan
• accumulated changes in plan recognized in accumulated OCI

Question 46

Pension Reform act of 1974 (ERISA)

Answer 46

Employee retirement income security act

• employer must fund plan in accordance with an actuarial funding method that will ensure payment of obligation. Failure results in fins/ loss of tax deductions
• required comprehensive description of plan included with annual report
• creation of the pension benefit guaranty corporation - can impose liens of up to 30% of company net worth to guarantee plan

Question 47

Pension benefit Guaranty Corporation

Answer 47

PBGC

Purpose: to administer terminated pension plans and to impose liens on an employers assets for underfunded pension liabilities

guarantees present value of vested benefit

can force a termination of pension plan if the risk of non-payment is too great

employers contribute dollar amount for each employee covered

Question 48

Pension Terminations

Answer 48

ERISA = if companies want to terminate plan they are required to pay participants what is owed first

legal to then terminate the plan and recapture surplus assets (asset reversion - taxed 20-50%)

FASB requires recognition of earnings in gain or loss when employer settles a pension obligation by lump-sum payments or with purchase of annuity contracts

Question 49

Expected post-retirement benefit obligation

Answer 49

EBPO
actuarial present value as of a particular date of all benefits a company expects to pay after requirement to employees and their descendants

not recorded in financial statements - used to measure periodic expenses

Question 50

Accumulated post-retirement benefit obligation

Answer 50

APBO

The actuarial present value of future benefits attributed to employees services rendered to a particular date

= EPBO for retirees and active employees fully eligible for benefits (total EPBO also includes estimated benefits for employees not yet fully eligible)

Question 51

Post-retirement expense

Answer 51

AKA net periodic post-retirement benefit cost
- employer’s annual expense for post retirement benefits
- Components: Service cost
Interest cost (increase in APBO attributable to passage of time: beginning discount rate x beginning APBO adjusted for period payments)
Actual return on plan assets (expected)
Amortization of prior service cost
Gains an losses from changes in / differences from assumptions

Question 52

Post retirement benefits other than pensions

Answer 52

OPEB/ “welfare” benefits

healthcare, legal/tax services, tuition assistance, daycare, housing assistance

GAAP requires accrual basis (must measure future benefits and accrue during employee’s years of service)

contributions are NOT tax deductable though pay outs are

Question 53

Attribution period

Answer 53

Period of service during which the employee earns the benefits under the terms of a plan

begins when the employee is hired and ends on the date when the employee is eligible to receive benefits/ ceases to earn additional benefits

benefits earned before eligibility treated as prior service cost

Question 54

Significant items in post-retirement plan accounting

Answer 54

1) expected post-retirement benefit obligation (EPBO)
- not recognized in financial statments/ notes. recomputed each year for measuring annual service costs
2) accumulated post-retirement benefit obligation (APBO)
3) post-retirement benefit plan assets
4) prior service cost
5) net gain or loss

2-5 in financial statments

Question 55

Gains and losses post-retirement benefits plan

Answer 55

Changes in APBO or value of plan assets

• actual differences
• changes to actuarial assumptions

Similar method to pension gains and losses

• record in other comprehensive income
• corridor approach

Question 56

Post-retirement worksheet

Answer 56

General Journal entries

• annual post-retirement expense
• cash
• post retirement asset/ liability (difference between APBO & plan assets)
• OCI

Memo Record

• APBO
• Plan assets

Question 57

Post- retirement benefits plan corridor approach

Answer 57

Judged from beginning of period accumulated OCI

Corridor - greater of 10% of APBO or 10% of market-related value of plan assets

used to determine if gains/ losses in accumulated OCI should be amortized to post-retirement expense

Minimum amortization amount is any gain or loss in excess of corridor / average remaining service life to expected retirement of active employees
- any amortization amount can be used as long as systematic and at least meets minimum

Question 58

Post-retirement benefit plan disclosures

Answer 58

Similar / as detained as pension disclosures

• impact of plan on financial statements
• info on important assumptions
• components of expense
• amounts in OCI
• reconciliation of liability beginning to end of year
• expected benefit payments going forward

can be combined with pension/ other post-retirement plan disclosures