08878 HM Ch15 - Cengagecollege.cengage.com/accounting/norton/intermediate/2e/... · 2008-06-26 · 15 CHAPTER FIFTEEN LEARNING OBJECTIVES Afterstudyingthischapter, youshouldbeableto:

15CHAPTER FIFTEEN

LEARNING OBJECTIVES

After studying this chapter,you should be able to:

LO1 Understand the natureand types of pension plansthat companies use.

LO2 Determine how toaccount for a defined benefitpension plan.

LO3 Explain the methodused to value a pensionobligation.

LO4 Identify the componentsof pension expense.

LO5 Explain and demon-strate the accounting treat-ment for pension gains andlosses.

LO6 Explain how the fundingstatus of a pension plan ispresented on the financialstatements.

LO7 Identify the accountingtreatment and disclosures forpostretirement obligationsand expenses.

LO8 Analyze financial state-ments and disclosuresrelated to pensions andpostretirement costs.

2

Pensions andPostretirement Plans

F I NA N C I A L R E P O RT I N G C A S E

IBM’s Employee Retirement ObligationsSurpass the Half-Billion-Dollar Mark

Step into the hallways of IBM as a new employee, and you’ll find yourself inan environment in which high performance is expected and rewardedaccordingly.This technology giant believes that offering competitive com-

pensation and benefits packages to attract and retain top-notch employees is criticalto its business strategy. IBM’s compensation program is aimed at offering competi-tive value that will attract the best talent to IBM, motivate employees to perform attheir highest levels, reward outstanding achievement, and retain individuals whohave the leadership abilities and skills necessary for building long-term stockholdervalue.1

Like IBM,many U.S. companies offer their employees pension plans.These plansinvolve contributions by the employee and/or the employer and a promise by theemployer to pay amounts to employees in the future.As the average age of the pop-ulation increases and the “baby boomers” near retirement age, the costs associatedwith pension plans are increasing, especially for companies with a large pool of

With more than 319,000 employees, IBM’s costs for pensions and postretirement benefits are stag-gering. How these plans are designed and managed is critical to the company’s success.

IBMIBM

1 IBM proxy statement, December 31, 2000.

CHAPTER 15 (REVISED) Pensions and Postretirement Plans 3

RETIREMENT-RELATED BENEFITS

IBM offers defined benefit pension plans and defined contribution pension plans, as well asnonpension postretirement plans consisting primarily of retiree medical benefits.These ben-efits form an important part of the company’s total compensation and benefits program,which is designed to attract and retain highly skilled and talented employees.The followingtable shows the impact of the total retirement-related benefit plans on income beforeincome taxes:

(dollars in millions)

U.S. NON-U.S. TOTAL

FORTHEYEAR ENDEDDECEMBER 31: 2003 2002 2001 2003 2002 2001 2003 2002 2001

Total retirement-relatedplans—cost/(income) ) ) ) ) )* )*

Comprise:Defined benefitand contributionpension plans—(income)/cost $(227) $(478) $(632) $254 $(46) $(209) $ 27 $(524) $(841)Nonpensionpostretirementbenefits—cost 294 324 376 41 29 28 335 353 404

*Includes amounts for discontinued operations costs of $77 million and $56 million for 2002 and 2001, respectively.

$(437$(171$362$(181$(17$295$(256$(154$ 67

IBMIBM

retired workers.Accounting for these plans requires accountants to address recogni-tion issues—which pertain to when an expense and the related liability should berecorded—and measurement issues—which pertain to how the expense and therelated liability should be valued.

As of December 2003, IBM had more than 319,000 employees worldwide. De-signing an effective compensation strategy for such a large work force is a huge taskthat must address elements like base salaries, pension plans, health care, and otherpostretirement benefits. The impact on income can be substantial. The note disclo-sure on retirement-related benefits that appears above was taken from IBM’s 2003annual report. As you can see, the company reported costs of $362 million related toretirement benefit plans in 2003.Yet, in the two previous years, it reported income of$171 million and $437 million, respectively.

E X A M I NI NG T HE C A S E

1. What types of recognition andmeasurement issues are related to accounting forretirement plans?

2. What types of retirement benefits does IBM offer its employees, as mentioned inits note disclosure?

3. What income or expense did IBM report for defined benefit and defined contri-bution pension plans in the United States in 2003?

4 PART THREE Financial Instruments and Liabilities

actuaries certified individuals whoare trained to determine future risk,predict the probabilities of futureevents,make price decisions, andformulate investment strategies

Types of Pension Plans

Apension plan is a contract between a company and its employees under whichthe company agrees to pay benefits to the employees after they retire. The exact

nature of the pension agreement varies greatly from company to company. In mostpension plans, the employer and/or the employee contribute to a pension fund. Underthe legal statutes that govern most pension plans, an entity independent of the com-pany must manage the pension fund. The managers who are entrusted with the pen-sion fund's assets are expected to invest them wisely. To do so, they must invest theassets to earn a return (in the form of interest, dividends, and capital appreciation) sothat sufficient amounts are available to pay to the company's retirees at the time ofretirement and for the years after retirement. Illustration 15.1 shows the parties andrelationships involved in a pension plan.

Our focus in this chapter is on how an employer accounts for a pension fund. Wediscuss the accounting entries that should be recorded to develop the employer's finan-cial statements, as well as the additional disclosures that must be presented in the notesthat accompany those statements. Because the pension fund is an independent entity,accounting for it differs from accounting for the employer, and it must be treated sep-arately. Thus, we do not discuss in any detail the accounting presentation that must bemade on the financial statements of the pension fund.

Many estimates, assumptions, and predictions are inherent in accounting for apension plan. For most employees, the time of retirement is many years in the future.The company must estimate how many employees will remain with the company untilretirement, how much their retirement benefits will be at that time, what pension fundassets will be available to pay retirement benefits, and the length of time the employeeswill draw retirement benefits. Most large companies seek the assistance of actuaries todetermine the appropriate estimates and assumptions and to establish the appropriatefunding policies for the pension plan. Actuaries are certified individuals who aretrained to determine future risk, predict the probabilities of future events, make pricedecisions, and formulate investment strategies. The accountants and actuaries mustjointly determine the financial presentation of pension plans. Although there are manytypes of pension plans, they generally fall into one of two categories: defined contribu-tion plans and defined benefit plans.

Defined Contribution PlansA defined contribution plan is a type of employee pension plan in which plan contri-butions are defined, but the amount that will be paid upon retirement is not knownuntil retirement. Typically, an employer is required to contribute a specific amount tothe plan every year; this amount is determined by the agreement between the companyand its employees or by a resolution of the company’s board of directors. In most cases,the employee is also allowed to contribute to the plan. However, while the amount

defined contribution plan a typeof employee pension plan in whichplan contributions are defined,but the amount that will be paidupon retirement is not known untilretirement

LO1 Understand the nature andtypes of pension plans that com-panies use.

pension plan a contract between acompany and its employees underwhich the company agrees to paybenefits to the employees after theyretire

Critical Thinking: How doyou think pension plans affectemployee satisfaction?

Illustration 15.1

Pension Fund Parties andRelationships

Employercontributions

Pension Fund(managed by anindependententity)

Employeecontributions

Pastemployeesand retirees

Payments


2 Ellen Schultz and Theo Francis, “EnronWorkers in 401(k) Suit Can Learn from Precedent,”WallStreet Journal, January 21, 2002.

contributed to the plan is known or defined, the amount that will be paid when anemployee retires is not. There is no guarantee that the employee will get a certainamount upon retirement.

The most prominent examples of defined contribution plans are 401(k) plans andIRAs (individual retirement accounts). During the 1990s, 401(k) plans became enor-mously popular, and many companies eliminated their more traditional defined bene-fit plans. In a 401(k) plan, the employee pays an amount into a pension fund. Often,this amount is matched by a contribution from the employer. Employees are generallygiven a choice of investing strategies, and if the investing strategy is successful, the fundamount will grow and be available to the employee at retirement.

Both employees and employers find 401(k) plans attractive. Employees can tailorthe pension plan to their own needs, investing their plan assets in investments with therisk and return characteristics that they prefer, and they like this degree of control.Employers are fond of this type of pension plan because it shifts the risks involved inretirement planning to the employee.The following excerpt is from a Wall StreetJournal article that discusses the risks that employees of Enron Corporation andMorrison Knudsen Corporation assumed:

Enron Corp. workers whose 401(k) balances have evaporated amid that com-pany’s bankruptcy may find valuable lessons in a continuing lawsuit brought byformer Morrison Knudsen Corp. employees who found themselves in a similarsituation. For one thing, they will learn that when companies fail, there are starkdifferences between [defined benefit] pension plans and [defined contributionplans such as] 401(k)s. [Defined benefit] pensions are protected, because com-panies must set aside money to pay the benefits workers have earned. And if thepension plan doesn’t have enough money, the Pension Benefit Guaranty Corp.,a federal agency, steps up to pay minimum pension benefits.

There is no similar safety net for the 401(k)s, profit-sharing plans, andemployee stock-ownership plans of companies that go bust. If money in theplan is lost because it was invested in employer stock that becomes worthless,that is tough luck.

The only hope employees have of recovering their losses is if they can showthat the company breached its fiduciary duty by not warning them that thestock was a poor investment. However, even if employees have a valid claim,they probably are still out of luck if the company slides into bankruptcy—asMorrison Knudsen did, and Enron has—because the bankruptcy proceedingsultimately could lead a trial court to dismiss the claim.

The bottom line: To the extent possible, employees should diversify theinvestments in their retirement plans. Avoiding a concentrated stock positioncan be difficult when companies contribute their own stock to employee retire-ment plans. But in these situations, workers shouldn’t add to their exposure bybuying more company stock on their own, as many Enron employees did.2

During the stock market boom of the 1990s, employees were pleased with definedcontribution plans because most investments performed well. However, when thestock market declined in 2001 and 2002, many employees found that the amount intheir 401(k) plans plummeted, leaving far less money available for retirement thanthey had anticipated. In some cases, the employer’s contribution to the 401(k) planscame in the form of the company’s own stock. If the company went out of business orwent bankrupt, the employees lost twice—once because they lost their jobs and a sec-ond time because the value of their 401(k) plans suffered drastically.

Many of the problems with defined contribution plans came to light after thedemise of Enron in early 2002, but warning signs had been evident earlier when the


defined benefit plan a type ofemployee pension plan in which theamount of future benefits is defined,but an employer’s contributions varydepending on assumptions abouthowmuch the fund will earn,whenthe money will be paid to retirees,and many other variables

employees of Rite Aid, Columbia HCA, McKesson, and Lucent Technologies suf-fered from the decline of their retirement savings. As a result, there have been manycalls for reform and more legislation to protect employees, as discussed in this excerptfrom a 2002Wall Street Journal article:

The question is whether pension law ought to be modified to include moreprotections for retirement savings plans, which many employees count on tofund retirement. In December, lawmakers introduced bills to make savingsplans safer, and hearings are planned. Last week, President Bush said hisadministration is interested in examining the issue, and Treasury SecretaryPaul O’Neill, Labor Secretary Elaine Chao and Commerce Secretary DonEvans said they were directing their staffs to begin evaluating the adequacy ofretirement-plan rules.

“We will take the necessary steps to ensure appropriate protection for theretirement nest eggs of millions of Americans,” Mr. O’Neill said in a writtenstatement.

But if the past is any guide, change will be difficult. Employers say law-makers are overreacting to views of participants and employers. Says JamesDelaplane, “Our general view is that the 401(k) system has been quite suc-cessful.” Two important issues are whether employers ought to be allowed tocontribute their own stock to employee retirement accounts, and whetheremployers should be allowed to lock employees into it.3

Although 401(k) plans have generated significant debate and potential legislation,the accounting issues related to defined contribution plans are not complex. In mostcases, the employer should recognize an expense for any amount contributed to thepension fund. The employer should not recognize the assets of the pension fund on itsbalance sheet because the assets are in the custody of the pension fund manager andare thus separate from the company. Similarly, the employer should not record a liabil-ity for pensions because it has no further obligation to the employees. For example, if acorporation contributes $80,000 to its defined contribution plan, it records the trans-action as follows:

Defined Benefit PlansThe accounting issues for a defined benefit pension plan are more challenging thanthose for a defined contribution plan. A defined benefit plan is a type of employeepension plan in which the amount of future benefits is defined, but an employer’s con-tributions vary depending on assumptions about how much the fund will earn, whenthe money will be paid to retirees, and a host of other variables. The acounting stan-dards for such a plan were set by “Employers’ Accounting for Pensions,” Statement ofFinancial Accounting Standards No. 87, and were modified by Statement of FinancialAccounting Standards No. 158. Under a defined benefit plan, a formula that may incor-porate several variables—such as the employee’s age, years of service, and salary levelover some time period—defines the amount that will be paid to employees at retire-ment. For example, a pension formula might define an annual retirement benefit as

2%� Years of Service� Final Year’s Salary

Pension Expense 80,000Cash 80,000

3 Ellen Schultz, “Evaporation of Enron 401(K) Accounts Raises Question of Retirement Reform,”Wall Street Journal, January 14, 2002.


underfunded the state of a pen-sion plan when its assets are lessthan the future pension liability

4 “Retiree Benefits Aren’t Ironclad; Bankruptcies Leave Some in the Lurch,”Chicago Tribune,November 27, 2001.

Pension Benefit GuarantyCorporation (PBGC) a federallycreated agency that is responsiblefor insuring pension plans

Using this formula, the annual benefits paid to an employee who retires after 20 yearsof service with a final salary of $120,000 would be $48,000 (2% � 20 years �$120,000).

The retirement amount is “defined” because each employee can use the pensionformula and the applicable variables (e.g., age, years of service, and salary level) todetermine the amount of his or her retirement pay. The amount of retirement pay isnot determined by the amount of the employer’s and employee’s contributions and isnot directly related to the investment performance of the pension fund. Each employerwith a defined benefit pension plan has a duty to contribute sufficient assets to ensurethat the assets accumulate to a level that will allow the payments to retirees that arepromised in the pension plan agreement.

When the assets of a pension plan are less than the liability for future pension pay-ments, the pension plan is referred to as underfunded. Even when a pension plan isunderfunded, the employer is obligated to pay retirement benefits. Thus, the employerassumes a large portion of the risk involved with the pension plan. However, employ-ees also assume a risk because the company could go out of business or go bankrupt,leaving them without any funds or benefits for retirement. Fortunately, this risk hasbeen lessened by federal legislation and by the creation of the Pension BenefitGuaranty Corporation (PBGC), a national insurer of pension plans. When a com-pany becomes bankrupt and cannot meet its pension obligation or when a pensionplan becomes insolvent for other reasons, the PBGC assumes the pension liability andwill pay the retirement benefits (usually at a reduced level). The following excerpt froma Chicago Tribune article offers details on the insolvency of Reliance Insurance Com-pany and the role of the PBGC:

The Pension Benefit Guaranty Corp. assumed control of Reliance InsuranceCo.’s pension plan and said the plan was underfunded by $124 million.

The PBGC said in a news release that it was stepping in because theproperty-casualty insurance company was being liquidated by regulators, andthat the company’s pension plan, without government intervention, wouldhave been unable to make payments to its retired former employees.

Most of the 8,700 employees covered by the plan lost their jobs at somepoint during Reliance’s rapid demise, which was capped by the PennsylvaniaInsurance Department’s order to liquidate the insurer in October. Some for-mer Reliance staffers are working for the department to assist in the liquida-tion process.

A spokeswoman for the Pennsylvania Insurance Department said therewas no indication of wrongdoing related to the handling of Reliance’s pensionassets. Instead, Reliance became unable to continue making payments into theplan as its businesses moved closer to liquidation.

Reliance’s plan had assets of $143 million and benefit liabilities of $267million. The PBGC said it would use the $143 million in assets, along with itsown, to ensure that Reliance retirees will continue to receive monthly pensionchecks.4

The PBGC is funded by premiums that it collects from all defined benefit pensionplans. In a sense, “healthy” pension plans are forced to cover the costs of “unhealthy”plans. In recent years, the PBGC has increased the premiums it collects to cover thepension liability of an increasing number of bankrupt or insolvent pension plans.Companies that maintain healthy pension plans have expressed resentment at theseincreases, and some have eliminated their defined benefit pension plans in favor ofdefined contribution plans.


CHECK YOUR UNDERSTANDING

1. Explain the difference between a defined contribution plan and a defined bene-fit plan.

2. Why would a retirement plan that is underfunded be of concern to employeesand investors?

3. What role does the Pension Benefit Guaranty Corporation (PBGC) play when acompany defaults on its pension obligations?

Accounting for a Defined Benefit Plan

Fundamentals of Pension AccountingAccounting for pensions and postretirement plans has been a difficult and controver-sial topic for the FASB. Fundamental judgments about the nature of the exchangeand the measurement of the liability and expense are involved. Illustration 15.2 summa-rizes the issues and corresponding FASB positions that have established the currentaccounting model. The FASB’s pronouncements in Statement of Financial AccountingStandards No. 87 and Statement of Financial Accounting Standards No. 158 have signif-icantly improved the method of accounting for defined benefit pension plans and thequality of the financial disclosures.

The FASB has adopted the position that a defined benefit pension plan involvesthe incurrence of a liability because of the promise the employer makes to provideemployees with future retirement benefits in exchange for their current services. Theemployer’s liability exists even though a separate legal entity (the pension plan man-ager, or trustee) is usually entrusted with the pension assets and administers the pay-ments to retirees on behalf of the employer.

Regarding recognition of the expense, the FASB has adopted the stance that theemployer incurs the expense at the time it makes the promise and the employee pro-

LO2 Determine how to accountfor a defined benefit pensionplan.

Critical Thinking: How dopension plans affect a company’sexpenses and liabilities?

Issue FASB Position

The incurrence of a liability and A defined benefit pension plan involves thethe nature of the exchange incurrence of a liability because of the

exchange that takes place—that is, theemployer’s promise to pay employees in thefuture for their current services.

Recognition of the expense Pension expense should be recognized usingaccrual accounting procedures.The expenseshould be recorded when employees earnthe pension rather than when it is paid.

Distinction between expensing and The funding decision is an actuarial decision.funding The amount recognized as expense should

be governed by accrual accounting proce-dures.The expense is not represented by theamount of cash put into the fund.

Measurement of the expense Measurement of pension expense should bebased on a series of components.The combi-nation of these components represents theamount of the employer’s expense.

Illustration 15.2

Fundamental Pension Issuesand Positions


pension expense a composite ofperiodic changes that occur in boththe pension obligation and the planassets

LO3 Explain themethod used tovalue a pension obligation.

Critical Thinking: Howshould the promise to fundemployee retirements be valuedas a liability on the financialstatements?

vides the services. Thus, the expense for pensions should be recognized in the period inwhich the benefits are earned rather than in the period in which they are paid. In otherwords, accrual accounting principles should be used to determine the expense. BeforeSFAS No. 87, some companies recognized the expense for pensions at the time theypaid the benefits to employees, which was a form of cash-basis accounting rather thanaccrual accounting.

The FASB also holds that the amount of funding should not be used to determinethe amount expensed. The funding decision concerns how much the employer shouldpay into the pension fund. This is often referred to as an actuarial decision because theactuarial profession has developed highly sophisticated models to help in determiningproper funding levels.When a company pays an amount into a pension fund, the entrywould be as follows:5

The amount expensed is determined by the accounting rules of SFAS No. 87; it isnot determined by the amount of cash contributed to the pension fund.When a com-pany records the expense, the general form of the entry would be as follows:

The FASB uses the term net periodic pension cost when referring to the amount ofthe expense, and many firms also use that term. In this text, we use the term pensionexpense, which refers to a composite of periodic changes that occur in both the pen-sion obligation and the plan assets. Again, the FASB has relied on accrual accountingprinciples and taken the stance that the funding decision is separate from the expens-ing decision.

The Pension ObligationAs noted earlier, the FASB states that a defined benefit pension plan involves the incur-rence of a liability because a promise has been made to employees. Theoretically, theamount measured as the pension liability should represent the fair value of theamounts that will be paid to retirees (including employees who have not yet retired) inall future periods. To determine this present value amount, it is necessary to make sev-eral assumptions about future events, including interest-rate conditions, inflation,employees’ years of service, and the period over which employees will draw retirementbenefits. It is also necessary to develop an assumption about the amount of salaryincreases that employees will receive during their employment. Many pension plansbase an employee’s retirement benefit on the salary level that the employee hasachieved at or near the time of retirement, and when that is the case, it is necessary todevelop an assumption about future salary levels in order to calculate the present valueof the pension obligation.

Before SFAS No. 158, there were several alternative measures of the pension obli-gation. To achieve acceptance of SFAS No. 87, the FASB had to adopt a compromiseapproach that allowed companies to use these alternative measures in some aspects ofaccounting for pensions. While this gave companies some flexibility, using alternativemethods to report the pension obligation was somewhat confusing to statement users.SFAS No. 158 now dictates that the projected benefit obligation be the sole measureused to value the pension obligation: “. . . the Board concluded after extensive debate

Pension Expense xxxxPension Liability xxxx

Pension Assets xxxxCash xxxx

5 When prior service costs or pension gains or losses are involved, additional entries must berecorded.


LO4 Identify the components ofpension expense.

Critical Thinking: Do youbelieve that the costs involved inproviding pension plans toemployees outweigh the benefitsthat the employer derives fromthose plans?

that the projected pension obligation did meet Concept Statement 6’s definition of aliability and was the most relevant measure of the pension obligation.”6

Although an actuary typically calculates the projected benefit obligation, account-ants must understand how the measurement is derived and the measurement issuesinvolved. The projected benefit obligation is the present value as of a specific date ofall benefits earned by an employee before that date.7 If the pension benefit formula isbased on future compensation levels, the projected benefit obligation is measuredusing assumptions about future salary increases. In that case, to calculate the amountof the obligation, the company must make an explicit assumption about the rate ofsalary increases. The assumption should incorporate such factors as the past salary andwage history of each category of employees, future hiring plans, union agreements, andany other factors affecting salaries and wages. The projected benefit obligation shouldbe used not only in measuring the pension liability, but also in calculating the interestcost of the pension expense and in assessing the funding status of the plan.

Many critics of SFAS No. 87 and SFAS No. 158 objected to the projected benefitobligation as a measure of the liability that should be recorded. These objections werebased on both theoretical and practical grounds.

The theoretical objections centered on the definition of a liability and whetheramounts based on future salary increases were consistent with the accepted definitionof a liability. Critics argued that a liability must be based on known events rather thanon unknown future events. In their view, a company does not have a liability for theportion of the pension payments that will be based on future salary levels until theemployee actually earns the salary increases. These critics pointed to other situations inwhich the accountant is not required to anticipate future events in order to measure aliability.

The practical objections centered on the difficulty of estimating future salaryincreases. Salary increases are generally not assured and may take place many years inthe future. A company’s plans for salary increases often change in response to changesin economic conditions or in the company’s profitability. Because of the measurementdifficulties involved, these critics argued that the minimum pension liability provisionshould not incorporate such amounts.

Although the FASB has acknowledged the theoretical and practical concerns, it hasadopted the projected benefit obligation as the appropriate measure of the pension lia-bility. In its view, the merits of the projected benefit obligation far outweigh the objec-tions and concerns. The FASB has, however, indicated its intention of reconsideringthis issue when it conducts a comprehensive review of pension accounting.

Pension ExpenseSFAS No. 87 specifies the components that make up pension expense. Because thecomponents are interrelated, the pronouncement requires that they be combined andrefers to this as the netting of these items. The net amount represents pension expense.SFAS No. 158 has not modified any aspects of the pension expense model in SFAS No.87, so this continues to be the basis for calculating pension expense. Illustration 15.3presents five components of pension expense.We discuss four of these components—service cost, prior service cost, interest cost, and return on plan assets—in the follow-ing sections.We discuss the fifth component, gains and losses, later in the chapter.8

6 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” Statementof Financial Accounting Standards No. 158 (Stamford, Conn.: FASB, 2006), par. 22a.

7 “Employers’ Accounting for Pensions,” Statement of Financial Accounting Standards No. 87(Stamford, Conn.: FASB, 1985), par. 36.

8 SFAS No. 87 also discussed a sixth component, referred to as the adoption amount or the transi-tion amount. This component was required for companies that had a liability amount at the timeSFAS No. 87 was adopted. Because that was many years ago, the adoption amount is no longer aconcern.

projected benefit obligation thepresent value as of a specific date ofall benefits earned by an employeebefore that date


9 SFAS No. 87, par. 264.

10 The term prior service cost refers to benefits granted for periods before the adoption of a pensionplan. Past service cost refers to benefits granted before the amendment of an existing plan.Because the two costs are handled in a similar manner, we do not distinguish between them.

11 SFAS No. 87, par. 27, indicates that the preferred method is to amortize over the years of employ-ees’ service and refers to this method as the benefits-years-of-service approach. Here, we focus onthe straight-line method of amortization.

service cost the actuarial presentvalue of benefits attributed by thepension benefit formula to servicesrendered by employees during aperiod

� Service CostThe service cost is the actuarial present value of benefits attributed by the pensionbenefit formula to services rendered by employees during a period.9 Service cost repre-sents the amount of pension benefits that employees have earned during the currentyear. This is a present value amount because the retirement benefit will be paid manyyears in the future, at the time the employees retire. To determine the present value ofthe future payments, it is necessary to estimate the amount of the future retirementbenefits and to discount that amount.

� Prior Service CostThe prior service cost represents the cost of benefits granted for periods prior to theadoption of the pension plan.10 In most cases, when employers develop a defined ben-efit plan, they try to give some credit to employees who were working for the companybefore the plan was inaugurated. The present value of the credit granted to existingemployees constitutes the prior service costs. SFAS No. 87 holds that prior service costsshould not be treated as a prior period or retroactive adjustment. Rather, the amountof prior service costs should be amortized as part of pension expense over some futureperiod. Thus, prior service costs should initially be treated as unrecognized prior serv-ice costs and amortized as a component of pension expense over a specified period.Unrecognized prior service costs should be amortized over the period during whichthe employees will provide service to the employer. To reduce the complexity and detailof the computations, SFAS No. 87 allows straight-line amortization of the cost over theaverage remaining service period of employees who are expected to receive benefitsunder the plan.11 The provisions of SFA S No. 158 have required companies to treatunrecognized prior service costs as an element of accumulated other comprehensiveincome until they are amortized to pension expense. (Refer to the section on fundingstatus in this chapter for additional discussion of this aspect of prior service costs.)

� Interest CostThe interest cost represents an increase in the pension liability (the projected benefitobligation) that occurs because of the passage of time. A pension liability is like otherliabilities in that if the liability is not paid, there is an interest cost. The amount ofinterest on a pension liability is treated as a component of the employer’s pension

Illustration 15.3

Components of PensionExpense

Gains andlosses

Return onplan assets

Prior servicecost

PensionExpense

Interestcost

Servicecost

prior service cost the cost of bene-fits granted for periods prior to theadoption of the pension plan

interest cost the increase in thepension liability (the projected bene-fit obligation) that occurs because ofthe passage of time


expense. The interest cost that is recognized in a period increases the projected benefitobligation.

Measuring the projected benefit obligation as a present value requires accrual ofthe interest cost at a rate equal to the assumed discount rate. This rate of interest iscalled the settlement rate. The settlement rate is defined as the rate of interest thatwould be incurred if the employer took action to settle (pay off) the pension obliga-tion. The interest cost is measured as follows:

Interest Cost = Projected Benefit Obligation at Beginning of the Period�Discount Rate

� Return on Plan AssetsThe return on plan assets represents the dividends and interest earned and the unre-alized and realized changes in the fair market value of the plan assets. The pensionfund trustee is normally entrusted with investing the plan assets so that they earn inter-est and dividends and thereby increase the funds available. To the extent that there is areturn on the assets, the amount recognized as pension expense is decreased.Therefore,a return on plan assets is deducted when combining the components to calculate pen-sion expense. SFAS No. 87 states that the actual return on plan assets must be deter-mined based on the fair value of plan assets at the beginning and the end of the period,adjusted for contributions and benefit payments.

A reconciliation of the beginning and ending amount of plan assets would be asfollows:

Beginning balance of plan assets $xxxx

Plus: Contributions xxxx

Actual return xxxx

Less: Benefits paid to retirees ( )

Ending balance of plan assets

However, the amount actually used as a component of pension expense is the expectedreturn on plan assets. The difference between actual and expected return represents again or loss on pension assets. (See the section of this chapter on gains and losses for adiscussion of that aspect of the calculations.) SFAS No. 158 requires companies toreport plan assets on their financial statements.

In the next section, we illustrate the calculation of pension expense based on thefour components we have introduced thus far.

Pensions IllustratedThe following example illustrates a basic computation of pension expense.

� Example Assume that ARN Company had the following amounts related to itspension plan at January 1, 2005:

Projected benefit obligation $1,000,000

Pension plan assets 750,000

Unrecognized prior service costs 240,000

ARN and its actuaries have determined the following for 2005:

Service cost $300,000

Actual (and expected) return on plan assets $72,000

Discount (settlement) rate 10%

Average remaining service period of employees 12 years

ARN should determine pension expense for 2005 as follows:

$xxxx

xxxx

settlement rate the rate of interestthat would be incurred if the em-ployer took action to settle (pay off )the pension obligation

return on plan assets dividendsand interest earned and unrealizedand realized changes in the fair mar-ket value of the plan assets



Interest cost 100,000 ($1,000,000� 0.10)

Return on assets (72,000)

Amortization of prior service costs ($240,000� 12 years)

Total pension expense

Pension Gains and LossesThe pension example in the last section was relatively straightforward in that therewere no gains or losses on the pension assets and liabilities.We will now consider casesin which pension gains or losses do occur. Such gains and losses can arise because of

� Changes in the pension assets

� Changes in the projected benefit obligation

� Gains or Losses Resulting from Changes inPension Assets

Asset gains and losses are differences between the actual return on assets during aperiod and the expected return on assets for that period.12 In some cases, the gain orloss occurs because the interest or dividends earned from investing the assets duringthe period were higher or lower than expected. Interest-rate conditions can changequite suddenly and affect the return on a large portfolio of invested assets. But the gainor loss can also be the result of unexpected changes in the assets’market value. Becausethe pension fund assets are measured at market value, any fluctuations in market valueaffect the return on the assets for the period. Any unexpected fluctuations in marketvalue would give rise to a gain or loss on the assets.

� Example Assume the following amounts for BCX Company at January 1, 2005:

Projected benefit obligation $1,000,000

Pension plan assets $750,000

Unrecognized prior service costs $240,000

Expected return on plan assets 10%

BCX has determined the following for 2005:


Discount (settlement) rate 10%


Actual return on plan assets $80,000

In this case, BCX experienced a gain on plan assets of $5,000 because the actual return($80,000) was larger than the expected return ($75,000).

BCX should determine pension expense for 2005 as follows:


Interest cost 100,000 ($1,000,000� 0.10)

Amortization of prior service costs 20,000 ($240,000� 12 years)

Actual return on assets (80,000)

Difference between actual and expected return 5,000 ($80,000� $75,000)

Amortization of gain/loss

Pension expense $ ?

?

$348,000

20,000

LO5 Explain and demonstratethe accounting treatment forpension gains and losses.

Critical Thinking: Does theperformance of a pension fundaffect the net income or loss of thesponsoring employer?

12 SFAS No. 87, par. 32


Note that two amounts have been shown in the calculation: $80,000 as the actualreturn and $5,000 as the difference between the actual and expected return. Whenthese two amounts are netted, the result is equal to the expected return on assets of$75,000. The gain on pension assets of $5,000 should be used to calculate the unrecog-nized gain or loss. The unrecognized gain or loss is the total gain or loss on plan assetsand pension liabilities that has not been treated as pension expense.We have entered aquestion mark in the preceding example because the unrecognized gain or loss isamortized only if it is a very large amount. (This approach is called the corridorapproach and is discussed below.)

� Gains or Losses Resulting from Changes in theProjected Benefit Obligation

Pension gains and losses can also result from fluctuations in the amount measured asthe projected benefit obligation. These gains and losses are sometimes referred to asactuarial gains and losses because they usually result from changes in the assumptionsthat actuaries must make when they estimate and calculate the pension amountsrelated to future periods. For example, if during the year actuaries modify theirassumptions about future interest rates (discount rates), the number of employeeswho will retire from the company, the number of years employees will draw retirementpay, inflation rates, or other economic factors, a gain or loss will occur.

� Example Assume the following amounts for Hopkins Company in 2005:

Projected benefit obligation, January 1, 2005 $ 800,000

Settlement (discount) rate 10%

Service cost for employee service of 2005 $100,000

Benefits paid to retirees $50,000

Projected benefit obligation, December 31, 2005(using updated actuarial assumptions) $1,000,000

If the actuarial assumptions had not changed, we could calculate the endingamount of the projected benefit obligation as follows:

Projected benefit obligation, January 1, 2005 $800,000

Service cost 100,000

Interest 80,000 ($800,000� 0.10)

Benefits paid )

Expected ending projected benefit obligation

The projected benefit obligation at year end of $1,000,000 indicates that there wasa change in the actuarial assumptions used to calculate the pension liability. A lossoccurs when the projected benefit obligation is larger than the expected obligation. Again occurs when the projected benefit obligation is less than the expected obligation.In this case, the loss was $70,000 ($1,000,000� $930,000). This loss is combined withany gain or loss on the pension assets to calculate the amount of the unrecognized gainor loss. However, the loss affects the amount calculated for pension expense only if it isa very large amount that exceeds the guidelines established by the corridor approach.

� Corridor Approach to Gains and LossesIn the deliberations preceding SFAS No. 87, the treatment of gains and losses on pen-sion assets and liabilities generated a great deal of debate. To some extent, the concernswere a consequence of the decision to measure the fair value of pension assets and lia-bilities. Fair value amounts fluctuate in response to market conditions and economicfactors, and those fluctuations can give rise to gains or losses. Major, well-establishedfirms were especially concerned because the dollar amount of assets and liabilities fortheir defined benefit pension plans is often very large. For them, even small changes ininterest rates, stock prices, or actuarial assumptions can cause dramatic gains or losses.

$930,000

(50,000

unrecognized gain or loss thetotal gain or loss on plan assets andpension liabilities that has not beentreated as pension expense


In the initial stages of its deliberations, the FASB indicated its preference forincluding all gains or losses in the calculation of pension expense. Many companieswere alarmed by this approach. They argued that it could cause the amount of recog-nized pension expense to fluctuate wildly from period to period, resulting in increasedvolatility of reported profits. They also argued vigorously that “the market” often asso-ciates increased volatility of profits with increased risk and that inclusion of all gainsand losses in pension expense would affect their stock price adversely.

Consequently, in an attempt to smooth the reporting of gains and losses, the FASBdeveloped a compromise approach. This approach allows a delayed recognition ofgains and losses and was justified by the FASB as follows:

This Statement provides for delayed recognition, in net periodic pension costand in the related liability (accrued unfunded pension cost) or asset (prepaidpension cost), of certain changes in the present value of the obligation and thefair value of plan assets. Those changes (that is, gains and losses and the effectsof plan amendments) are recognized in net periodic pension cost on a system-atic basis over future periods. The Board concluded that it is not practical atthis time to require accelerated recognition of those changes in financial state-ments as they occur, although certain of those changes are recognized in thestatement of financial position through the minimum liability requirement ofthis Statement.

The Board concluded that the difference between the actual return onassets and the expected return on assets could be recognized in net periodicpension cost on a delayed basis. Those effects include the gains and lossesthemselves. That conclusion was based on (a) the probability that at leastsome gains would be offset by subsequent losses and vice versa and (b)respondents’ arguments that immediate recognition would produce unac-ceptable volatility and would be inconsistent with the present accountingmodel.13

This compromise approach is called the corridor approach. With the corridorapproach, gains and losses are included in pension expense only if they exceed estab-lished thresholds.When the amount exceeds the threshold, a portion should be recog-nized as pension expense. Amounts are considered outside the threshold if, as of thebeginning of the year, unrecognized net gain or loss exceeds 10 percent of the greater ofthe projected benefit obligation or the market-related value of plan assets. Illustration 15.4summarizes the definitions and calculations necessary to apply the corridor approach.

Corridor defined 10 percent of the greater of the projected benefitobligation or the market-related value of plan assets.

Market-related value of Either the fair market value of the assets or a calculatedassets defined value (such as an average) that recognizes changes in fair

value in a systematic and rational manner over not morethan five years.

What is compared The cumulative unrecognized gain or loss is compared tothe corridor amount.

If gains/losses are less than Do not include any amount for gains/losses in thethe corridor amount calculation of pension expense.

If gains/losses are greater A portion of the excessmust be included as a componentthan the corridor amount of pension expense.The amount recognized as expense

is the excess divided by the average remaining serviceperiod of active employees.

Illustration 15.4

The Corridor Approach

corridor approach an approach inwhich gains and losses are includedin pension expense only if theyexceed established thresholds

13 SFAS No. 87, par. 102, 121.


Market-related value means either the fair market value of the assets or a calcu-lated value (such as an average) that recognizes changes in fair value in a systematicand rational manner over not more than five years.14 If the unrecognized gain or lossexceeds the corridor amount, a portion of the excess must be included as a componentof pension expense. If the gain or loss exceeds the threshold, the amount recognized asexpense is the excess divided by the average remaining service period of active employ-ees who are expected to receive benefits under the plan. The following example illus-trates the use of the corridor approach.

� Example Assume that Bosio Company had no gains or losses on pension assetsor liabilities before 2005 and that it reported the following for the years 2005, 2006, and2007:

Gain/Loss on Pension Gain/Loss on PensionYear Assets During the Year Liability During the Year Net

2005 $150,000 loss $ 50,000 gain $100,000 loss

2006 50,000 gain 120,000 loss 70,000 loss

2007 70,000 loss 70,000 loss 140,000 loss

Projected Benefit Market Value of Plan Average RemainingYear Obligation, January 1 Assets, January 1 Service Period

2005 $700,000 $ 600,000 10 years

2006 800,000 700,000 10 years

2007 900,000 1,000,000 10 years

The amount of gain or loss that should be amortized in each of the years using thecorridor approach should be determined as follows:

Corridor Unrecognized Gain/Loss AmortizedYear Amount* at January 1 Excess Amount†

2005 $ 70,000 $ 0 $ 0 $ 0

2006 80,000 100,000 loss 20,000 2,000

2007 100,000 168,000 loss‡ 68,000 6,800

*10 percent of the greater of the projected benefit obligation or plan assets.† Excess divided by average remaining service period of employees, 10 years in this example.‡ $100,000 Loss� $70,000 Loss� $2,000 Amortized� $168,000 Unrecognized.

The corridor amount is based on the projected benefit obligation and plan assetsat the beginning of the period and the gain or loss at the beginning of the period.Therefore, the amount that exceeds the threshold for 2005 is zero. In 2006, an amountof $2,000 must be included as a component of pension expense. Because a loss is beingrecognized, the $2,000 amount will increase pension expense. In 2007, it is essential tocalculate the cumulative unrecognized gain or loss. Gains and losses from all periodsmust be combined, but any amounts that have been recognized from the cumulativeamount must be deducted. The result for 2007 is a cumulative unrecognized loss of

14 SFAS No. 87, par. 264. In our examples, to reduce the complexity of the calculations, we assumethat the market-related value of the assets is equal to their fair value.

market-related value either thefair market value of the assets or acalculated value (such as an average)that recognizes changes in fair valuein a systematic and rational mannerover not more than five years


$168,000, or an excess (outside the corridor) of $68,000. This excess of $68,000 is rec-ognized over the average remaining service period for employees—10 years in thiscase—and the result is that $6,800 must be recognized as a component of pensionexpense. Because the amount represents a loss, the $6,800 amount will increase pen-sion expense.

� Evaluation of the Corridor ApproachIn many cases, to achieve acceptance of its pronouncements and to balance the costsand benefits of accounting information, the FASB must make compromises. Its han-dling of SFAS No. 87 is no exception. Here, the board sought to develop a method thatwould allow reporting firms to smooth (spread over time) the reporting of gains orlosses associated with plan assets and liabilities. Although there are arguments againstthe board’s ruling, it is perhaps justified because gains and losses can fluctuate fromperiod to period, so that gains in one period are offset by losses in another period, andvice versa. However, the corridor approach set forth in SFAS No. 87 introduces anextreme form of smoothing.

Essentially, SFAS No. 87 smooths gains and losses in three ways. First, gains andlosses are recognized only if they are large enough to be outside the defined corridor.Second, if the gains and losses are outside the corridor, only the excess amount is con-sidered. Third, even the excess amount is smoothed by recognizing it over the averageservice period of employees.

Critics of the corridor approach argue that the method adopted in SFAS No. 87 isunnecessarily complex and produces pension information that is not useful for deci-sion making. The pension expense recognized on the income statement is a combina-tion of current events (employee service) and past events (delayed recognition of gainsand losses). Critics also maintain that the pension amount recognized on the balancesheet does not accurately represent the employer’s “true” liability for a defined benefitpension plan. Although the critics may be correct, the pension note does provideimportant information about pensions and is a necessary factor in understanding thestatus of any defined benefit pension plan. (See the section on note disclosures later inthis chapter.)

Summary of the Pension ModelIllustration 15.5 summarizes the components of pension expense used in the pensionmodel of both SFAS No. 87 and SFAS No. 158.

1. Service cost

2. � Interest component (interest rate� beginning balance of projected benefitobligation)

3. � Expected return on plan assets

4. � Prior service cost amortized*

Amortization method may be

a. Remaining service life of employees (a declining amount per year)

b. Straight-line over the average remaining service life of employees

5. � Gains recognized or� losses recognized using the corridor approach:

Recognize over the remaining service life of employees a gain or loss that is greaterthan 10 percent of the larger of the projected benefit obligation or the market-related value of plan assets.

Illustration 15.5

Components of PensionExpense

* Occasionally, an amendment to a pension plan reduces employees’ retirement benefits,which reducespension costs. In that case, a negative sign would appear here.


Funding Status of a Pension PlanOne of the most important aspects of analyzing the financial statements of a companywith a defined benefit pension plan is to determine the pension plan’s funding status.Funding status refers to whether there are enough assets in the pension fund to meetthe estimated pension liability (the amount that will be paid out to retirees in thefuture). As we noted earlier, if the amount of pension assets is less than the amount ofthe pension liability, the pension plan is said to be underfunded. If the amount of pen-sion assets is greater than the amount of the pension liability, the pension plan isreferred to as overfunded.

Before the FASB issued SFAS No. 158, it was quite difficult to determine the fund-ing status of a pension plan from the information on the face of the financial state-ments or from the notes to the statements. Under the provisions of SFAS No. 87,companies were not required to recognize the amount of pension assets or the fullamount of the pension liability on the balance sheet. There was an extensive amount ofdisclosure about pensions in the notes to the financial statements, but because the dis-closures were so lengthy, they were difficult to comprehend and analyze. Many finan-cial statement users argued that the disclosures led to a lack of transparency andcreated difficulties in determining the true health of the pension plan. Constituentgroups, including the SEC, members of the Financial Accounting Standards AdvisoryCouncil, and representatives of the PBGC, called for a new set of accounting rules thatwould lead to increased transparency and understandability of the assets and liabilitiesof a pension plan.15

Some may argue that a new accounting standard was not necessary because a greatdeal of information about the health of a pension plan was already available in thenotes. However, the FASB has long held that “footnote disclosure is not an adequatesubstitute for recognition.”16 To improve disclosures and enable statement users to bet-ter assess the funding status of the pension plan, the FASB issued SFAS No. 158. Two ofthe most important aspects of SFAS No. 158 are as follows:

1. A company must recognize the funding status of the pension plan on the balancesheet as an asset or liability, rather than in the notes.

2. A company must recognize as a component of accumulated other comprehensiveincome, net of tax, the prior service costs and pension gains and losses that ariseduring a period but that are not recognized until later periods because of thedelayed recognition provisions of the pension model.

� Pension Assets and LiabilitiesA company must recognize the funding status of its pension plan, measured as the dif-ference between pension assets and liabilities, on the balance sheet. The funding statusof all overfunded pension plans should be shown in the asset category, and the fundingstatus of all underfunded pension plans should be shown as a liability on the balancesheet.

But how should the asset and liability be measured? SFAS No. 158 states that pen-sion assets should be measured and reported at fair value (with minor exceptions) andthat the pension liability should be defined and measured as the projected benefitobligation.

How should the asset and liability be presented on the balance sheet? Classificationdepends on whether the plan is overfunded or underfunded. If a pension plan is over-funded, the amount of pension assets that exceeds the amount of the pension liabilityshould be presented as a noncurrent asset on the balance sheet. If a plan is under-funded, the difference (liability in excess of asset) may be classified as current, long-


Funding status a term referring toa pension fund’s ability to meet theestimated pension liability

Critical Thinking: Howshould a pension plan’s fundingstatus be determined? Why is thefunding status important?

15 SFAS No. 158, par. 12b.

16 Ibid., par. 11b.


term, or both. The amount that should be considered a current liability is “the amountby which the actuarial present value of benefits payable in the next 12 months, or oper-ating cycle if longer, exceeds the fair value of the plan assets.”17 The remaining portionof the liability should be classified as a long-term liability on the balance sheet.

Because SFAS No. 158 requires that pension plan amounts be reported on the faceof the balance sheet rather than being buried in the footnotes, this pronouncementshould increase the transparency of pension disclosures and make it easier for state-ment users to assess the health, or funding status, of the pension plan. However, usersand other analysts must still exercise considerable care and judgment in interpretingthe numbers.

� Pension Elements in Other Comprehensive IncomeIn our discussion of the calculation of pension expense, we indicated that some com-ponents of pension expense are not recognized in the period in which they arise butrather are treated as expense in subsequent periods. We applied this delayed recogni-tion feature to two components: (1) prior service costs and (2) gains or losses resultingfrom unexpected changes in the pension asset or pension liability.

To smooth the pension expense amount and decrease the volatility of a company’searnings, SFAS No. 87 allowed prior service costs to be amortized to pension expenseover time. The treatment of pension gains and losses was somewhat different. In anattempt to smooth the recognition of the gains and losses, the FASB developed the cor-ridor approach As we noted earlier, the corridor approach allows companies to avoidrecognizing pension gains and losses until they exceed a dollar amount threshold. Evenwhen the gain or loss is outside the corridor, additional smoothing occurs because theexcess is recognized as pension expense over time.

SFAS No. 158 has not changed the delayed recognition features of the pensionexpense model. However, before it was issued, the amount of unrecognized prior serv-ice cost and the amount of unrecognized gain or loss did not appear anywhere on theface of the balance sheet. These items were simply off-balance-sheet amounts that werereported in the notes to the financial statements. The requirements of SFAS No. 158have changed the accounting requirements in two important ways:

1. Prior service costs and gains or losses that arise during a period must be recog-nized as components of accumulated other comprehensive income and reportedon the balance sheet.18

2. When prior service costs or gains and losses are recognized as part of pensionexpense, a corresponding adjustment must be made to remove that amount fromaccumulated other comprehensive income.

To illustrate the accounting required to recognize the pension funding status, wepresent two examples. In the first example, we discuss the adjustments a companymust make to adopt the provisions of SFAS No. 158. In the second, we illustrate theaccounting entries necessary to amortize prior service costs and pension gains andlosses.

� Example: Initial Recognition of Amounts in AccumulatedOther Comprehensive Income

Suppose that New Wave Company has a defined benefit pension plan and wants toadopt the provisions of SFAS No. 158 in its year-end financial statements of December

17 Ibid., par. 4b.

18 The amounts in other comprehensive income should be reported net of the related tax effects.The tax effects of accounting transactions are discussed in the chapter on deferred tax.We sim-plify our examples in this chapter by ignoring the tax effects.


31, 2006. The company’s pension plan is underfunded at the time of the adoption andhas the following amounts (in millions) related to its pension plan:

December 31, 2006

Projected benefit obligation $2,400

Plan assets at fair value

Funding status

Delayed recognition items not yet recognized as pension expense are as follows:

Prior service cost $500

Net loss on pension assets and liability

As a result of its accounting for pensions under the rules of SFAS No. 87, the com-pany has an Accrued Pension Liability account of $50. This amount is the differencebetween the amount of pension expense recorded in previous periods and the amountof funding. To simplify our example, we assume that all prior service costs and pensiongains and losses occurred before January 1, 2006.19

To adopt SFAS No. 158 on December 31, 2006, the company should make the fol-lowing journal entry:20

19 We also assume that no additional minimum pension liability exists at December 31, 2006, andthat the company is not required to amortize any of the pension loss amount because theamount is within the corridor threshold.

20 The entries illustrated here differ slightly from the entries in the SFSA No. 158 illustrationbecause in this case, separate asset and liability accounts are established before they are netted onthe balance sheet. The impact on the financial statements is the same with either set of entries.

This entry eliminates the previous balance of the Accrued Pension Liability accountand establishes accounts for the pension fund assets and pension liability. The balanceof the Accumulated Other Comprehensive Income account represents the delayedrecognition items that have occurred and that have not yet been treated as part of pen-sion expense. On the company’s balance sheet at December 31, 2006, the balance of thePension Fund Assets and Pension Liability accounts should be netted. Because the pen-sion fund is underfunded, it will appear as a liability on New Wave’s balance sheet asfollows:

NewWave CompanyBalance Sheet

December 31, 2006

Long-term liabilityPension liability (net) $800($2,400 – $1,600)

Stockholders’ equityAccumulated other comprehensiveincome ($750)

Pension Fund Assets 1,600Accumulated Other Comprehensive Income 750Accrued Pension Liability 50Pension Liability 2,400

1,600

250$750

($ 800)


In classifying the Pension Liability account as a long-term liability, we have assumedthat the pension plan assets exceed the actuarial present value of benefits to be paidover the next fiscal year.

� Example: Recognizing Delayed Recognition Items asPension Expense

In this example, to show how a company accounts for delayed recognition items andrecognizes pension expense, we look at how NewWave Company records its account-ing entries in 2007. Assume that New Wave did not make any amendments to itsdefined benefit pension plan in 2007 and that it has the following amounts related toits plan at December 31, 2007:

December 31, 2006 December 31, 2007

Projected benefit obligation $2,400 $2,550

Plan assets at fair value

Funding status

Delayed recognition items not yet recognized as pension expense are as follows:

Prior service cost $500 $460

Net loss on pension assets and liability

Assume that the change in the net loss on pension assets and liability occurredbecause the expected return on assets was $150 and the actual return was $125. Alsoassume that NewWave did not recognize the loss because it was not outside the thresh-old amount specified by the corridor approach. During the period, the companyfunded the pension plan in the amount of $120, and the fund trustee paid $45 of ben-efits to retirees.

New Wave computed the following components of pension expense for the year2007:

Service cost $100

Interest cost 95

Expected return on plan assets (150)

Amortization of prior service costs 40

Amortization of loss

Pension expense

NewWave Company also made the following entries to recognize pension expense forthe service cost of $100, the interest cost of $95, and the expected return on plan assetsof $150:

To record the service cost:Pension Expense 100Pension Liability 100

To record the interest cost:Pension Expense 95Pension Liability 95

To record the expected return on plan assets:Pension Fund Assets 150Pension Expense 150

1,600 1,755

250

0

275$750 $735

$ 85

($ 800) ($ 795)


NewWave recorded the following entry for the amortization of prior service costs forthe year:

On the company’s balance sheet at December 31, 2007, the balance of the PensionFund Asset and Pension Liability accounts should be netted. The pension plan’s under-funding would appear as a liability on the balance sheet as follows:

Finally, New Wave recorded the additional loss that arose during the year when theactual return was less than the expected return ($150 – $125):

This journal entry would be necessary to record New Wave’s contribution of cash tothe pension fund:

To record the change in pension liability that occurs as amounts are paid to retirees,NewWave would make this entry:

NewWave CompanyBalance Sheet

December 31, 2006

Long-term liabilityPension liability (net) $795($2,550 – $1,755)

Stockholders’ equityAccumulated other comprehensiveincome ($735)


1. How should the projected benefit obligation be defined and measured?

2. What are the five components of the pension expense model?

3. What are two causes of pension gains and losses?

4. In which section of the balance sheet would you look to determine the fundingstatus of a pension plan?

Pension Liability 45Pension Fund Assets 45

Pension Fund Assets 120Cash 120

Accumulated Other Comprehensive Income 25Pension Fund Assets 25

Pension Expense 40Accumulated Other Comprehensive Income 40


LO7 Identify the accountingtreatment and disclosures forpostretirement obligations andexpenses.

Critical Thinking: What arethe implications for retirees if acompany does not properly meas-ure postretirement benefit obliga-tions, such as health-care costs ?

postretirement benefits benefitsother than pensions that employeesreceive after retirement

Postretirement Obligations

During the deliberations that led to SFAS No. 87, the FASB decided to limit thethe discussion to accounting for pensions and to tackle issues related to other

postretirement benefits in another project. Later, it issued Statement of FinancialAccounting Standards No. 106 to provide guidance on accounting for postretirementbenefits. As is evident in its most recent pronouncement—SFAS No. 158—the FASBrecognizes that pensions and postretirement benefits are closely related. SFAS No. 158requires recognition of the funding status of both pensions and postretirement bene-fits and extends the note disclosures relating to both.

Postretirement benefits are benefits other than pensions that employees receiveafter retirement. Examples include an employer’s promise to pay education benefits,legal aid, or relocation costs, but the most significant benefit is payment of health-carecosts. Because health-care costs in the United States have skyrocketed, the obligationfor postretirement costs of many U.S. employers exceeds their obligation for pensionbenefits. Since payment of health-care costs is the most significant postretirement ben-efit, we focus on it in this section.

If an employer agrees to pay some or all of the health-care costs of retired employ-ees, the provisions of SFAS No. 106 and SFAS No. 158 apply. Prior to SFAS No. 106,many companies did not record the expense for postretirement costs before payment.Essentially, they used a pay-as-you-go method. They did not record the obligation forpostretirement costs as a liability on their financial statements and often did not evenprovide note disclosure of the obligation. Because of the large dollar amounts involved,users of the financial statements called for the FASB to require companies to recognizethis liability. The FASB responded by issuing SFAS No. 106. Although financial state-ment users may have been pleased with the new accounting guidelines,many reportingfirms were not. They argued that postretirement obligations do not meet the definitionof a liability and that even if a liability exists, it should not be recognized because thereis no way of reasonably measuring the amounts of the future payments.

SFAS No. 106 uses the pension accounting model of SFAS No. 87 with some mod-ifications. In many ways, it is appropriate to use the same accounting model for pen-sions and postretirement benefits. Both involve an employer’s promise to pay amountsto retirees in the future. Both involve payments far into the future, and thus measuringthe expense and obligation requires significant estimates and accounting judgments.However, there are also differences between pensions and postretirement costs that canaffect accounting for such costs. Among the most important are the following:

� Coverage. Usually a pension covers only the employee, but some employee planspromise to cover the health care of employees and their dependents.

� Ability to predict. Pensions in a defined benefit plan are based on a formula and varywhen the elements of the formula change. In contrast, the amount of health-carecosts incurred by a retiree may fluctuate from month to month. Government pro-grams like Medicare and Medicaid also affect an employer’s costs.

� Funding issues. Employers are required by federal legislation to pay amounts into apension fund to cover pension costs. Employers are not legally required to fundpostretirement obligations. In fact, until recently, many employers did not set asidefunds specifically for postretirement costs.

� Legal issues. In most cases, an employer’s promise to provide pension benefits is alegally binding contract. The legal status of a promise to provide postretirement ben-efits is much less clear. There have been many recent court cases involving companiesthat have terminated or reduced postretirement benefits to retirees or to currentemployees who would become retirees in the future. Whether a legally binding con-tract exists depends on a variety of factors, including the nature of the promise, the


21 “Employers’ Accounting for Postretirement Benefits Other than Pensions,” Statement ofFinancial Accounting Standards No. 106 (Norwalk, Conn.: FASB, 1990), par. 43, 44.

accumulated postretirementbenefit obligation a measureof the present value of the post-retirement benefits attributed toemployee service up to the date ofmeasurement

intent of the employer, and the understanding of the employees. If an employee leavesa company before retirement, the company generally has no obligation to provide ben-efits in the future.

� Tax considerations. Companies are allowed a tax deduction for amounts paid to apension fund, within defined limits. Generally, companies are not allowed a taxdeduction for the funding of postretirement benefits.

Measuring the ObligationAs we noted earlier, SFAS No. 158 mandates that companies use the projected benefitobligation to measure a pension liability. Several alternative measures of the obligationfor postretirement benefits are possible, depending on the assumptions and estimatesthat are made. However, SFAS No. 158 states that the liability for postretirement bene-fits should be measured as the accumulated postretirement benefit obligation. Theaccumulated postretirement benefit obligation is a measure of the present value ofthe postretirement benefits attributed to employee service up to the date of measure-ment. It does not consider any additional benefits that employees may earn in thefuture.

When measuring a postretirement obligation, it is important to consider theperiod over which the postretirement expense should be recorded. This time span,which is referred to as the attribution period, is the period over which the employeeearns the benefits. The FASB has held that the attribution period begins when anemployee enters the employer’s service and ends when the employee is eligible forbenefits:

This Statement requires that an employer’s obligation for postretirement ben-efits expected to be provided to or for an employee be fully accrued by the datethat employee attains full eligibility for all of the benefits expected to bereceived by that employee, any beneficiaries, and covered dependents (the fulleligibility date), even if the employee is expected to render additional servicebeyond that date.21

Some companies argued that the postretirement expense should be spread over alonger period—that is, that the attribution period should end when employees retireor when they reach mandatory retirement age. However, the FASB took the stance thatthe liability is established at the time the employee becomes eligible for the benefitsand that the attribution period should therefore end at that time.

Illustration 15.6 summarizes two key terms that are important in accounting forpostretirement benefit plans.

Components of the PostretirementAccounting ModelIllustration 15.7 provides an overview of the components of postretirement expense.As you can see, the calculation of postretirement expense is similar to the calculationrequired in the pension acounting model. Note, however, that the interest componentof postretirement expense is based on the accumulated postretirement benefit obliga-tion and that it measures the increase that occurs in this component as a result of thepassage of time. Also note that the amortization of prior service costs associated withpostretirement expense may be either a positive (increased) amount or a negative

attribution period the periodover which an employee earnspostretirement benefits


Accumulated postretirement The present value, based on a discount rate, of post-benefit obligation retirement benefits, attributed to employee service to

date.

Attribution period The time period over which the employee earns thepostretirement benefits.The period ends when theemployee becomes eligible for benefits.

Illustration 15.6

Key Postretirement Terms

1. Service cost

2. � Interest component(interest rate� beginning balance of accumulated postretirement benefitobligation)

3. � Return on plan assets (If the postretirement benefit plan is funded, an amountshould be deducted representing the return on assets.)

4. � or� Prior service cost amortized*

Amortization method may be

a. Remaining service life of employees (a declining amount per year)

b. Straight-line over the average time until eligible for benefits (attribution period)

5. � Gains amortized or� losses amortized using the corridor approach

a. Recognize gain or loss that is greater than 10 percent of the larger of:

• Accumulated postretirement benefit obligation

• Market-related value of plan assets

b. If recognized:Amortize the amount over the remaining service period ofemployees

Illustration 15.7

Components ofPostretirement Expense

(decreased) amount. Prior service costs often occur when a postretirement plan isamended. If the plan is amended to give more benefits to retirees, then a loss occurs,and the amount of the loss amortized increases postretirement expense. In recent years,however, many companies have taken action to reduce the amount of postretirementcosts, particularly health-care costs. If the plan is amended to reduce benefits toretirees, then a gain results, and the amount of the gain amortized decreases postretire-ment expense.

The following example illustrates the calculation of postretirement costs.

� Example Suppose that Condon Company had the following amounts associatedwith postretirement benefits at January 1, 2005:

Accumulated postretirement benefit obligation $1,000,000

Postretirement plan assets 50,000


Condon has determined the following for 2005:


Actual (and expected) return on plan assets $5,000

Interest rate (on liability) 10%


* Prior service cost amortized is added if additional benefits are given to employees and is deducted if anamendment reduces benefits to employees.


Condon should determine postretirement expense for 2005 as follows:


Interest cost 100,000 ($1,000,000� 0.10)

Amortization of prior service costs 20,000 ($240,000� 12 years)

Return on assets )

Total postretirement expense

Funding StatusThe requirements of SFAS No. 158 regarding the funding status of defined benefit pen-sion plans also apply to the funding status of postretirement plans:

1. A company must recognize the funding status of the postretirement obligation onthe balance sheet as an asset or liability, rather than in the notes. (Postretirementplans for virtually all companies are a liability rather than an asset.)

2. A company must recognize as a component of accumulated other comprehensiveincome, net of tax, the prior service costs and pension gains and losses that ariseduring a period but that are not recognized until later periods because of thedelayed recognition provisions of the pension model.

� Postretirement Liabilities on the Balance SheetA company must recognize the funding status of its postretirement obligation, meas-ured as the difference between postretirement assets and liabilities, on its balance sheet.For many companies, this is a very large dollar amount that drastically alters theappearance of its financial position. It can affect important financial ratios, such as thedebt-to-equity ratio. Lenders and other creditors often require borrowers to maintaincertain levels of ratios; these requirements are called loan covenants. Some companiesmay find that they are in violation of their loan covenants when they apply the account-ing required by SFAS No. 158. In most cases, lenders will show some flexibility andrevise the loan covenant restrictions. Nonetheless, many companies are worried aboutthe effects of SFAS No. 158 and have indicated that they may cut back or eliminate thebenefits available under their postretirement plans.

The trend to cutting the costs of health-care plans by increasing deductibleamounts or co-payments certainly began before the FSAB issued SFAS No. 158, but theaccounting requirements in this pronouncement are likely to cause companies to con-tinue their efforts to trim costs, and whether that is wise is questionable. Prior to SFASNo. 158, the liability for postretirement costs was evident to anyone who read the notesto the financial statements. It is not evident why companies should alter their benefitplans when the amount of the liability is now recognized on the balance sheet ratherthan disclosed in the notes.

� Postretirement Elements in Other ComprehensiveIncome

The requirements of SFAS No. 158 for postretirement costs that pertain to other com-prehensive income are similar to those for pension costs. They are as follows:

1. Prior service costs and gains or losses that occur during the period must be recog-nized as components of accumulated other comprehensive income and reportedon the balance sheet.22

2. When prior service costs or gains and losses are recognized as part of postretire-ment expense, a corresponding adjustment must be made to remove thoseamounts from accumulated other comprehensive income.

$415,000

(5,000

22 The amounts in other comprehensive income should be reported net of the related tax effects.We simplify our examples in this chapter by ignoring those effects.


23 “Employers’ Disclosures About Pensions and Other Postretirement Benefits,” Statement ofFinancial Accounting Standards No. 132 (Norwalk, Conn.: FASB, 1990), par. 5-11. This statementlists the most important disclosures. It was revised in December 2003 and now requires moredisclosures than the ones discussed here.

LO8 Analyze financial state-ments and disclosures related topensions and postretirementcosts.

Critical Thinking: Whatare the implications for potentialinvestors if a company does notproperly disclose pension andpostretirement benefit plan costsand obligations in its annualreport?

Refer to the section on pensions in this chapter to see how these delayed recognitionitems should be recorded.


1. What are some examples of postretirement benefits?

2. How did most companies account for postretirement costs prior to SFAS No.106?

3. What is the appropriate measure of the obligation for postretirement benefits?

Presentation and Analysis of Pensions andPostretirement Plans

Note DisclosuresIn our earlier discussion of pension and postretirement costs, we emphasized that theamounts recognized in the income statement and balance sheet for defined benefitplans do not present a complete picture of all the important aspects of those costs. It isimportant for any user of financial statements to read and analyze the notes to thestatements, where a wealth of information is provided. In particular, it is important tounderstand (1) the components used to calculate pension and postretirement expenseand (2) the funding status of the plan.

SFAS No. 132 revised and expanded the required disclosures for both pensions andpostretirement costs.23 SFAS No. 158 further expanded the disclosure requirementsregarding funding status and delayed recognition items. Here, we highlight the mostimportant disclosures. The requirements for not-for-profit organizations are some-what different, and we do not address them here. (For a complete listing of all requireddisclosures, refer to SFAS No. 132 and SFAS No. 158.)

Both pension expense and postretirement expense are based on the calculation ofa series of components. SFAS No. 132 outlines the disclosures required for this calcula-tion, as follows:

An employer that sponsors one or more defined benefit pension plans or oneor more defined benefit postretirement plans shall provide the followinginformation:

• The amount of net periodic benefit cost recognized, showing sepa-rately the service cost component, the interest cost component, theexpected return on plan assets for the period, the amortization ofthe unrecognized transition obligation or transition asset, theamount of recognized gains and losses, the amount of prior servicecost recognized, and the amount of gain or loss recognized due to asettlement or curtailment.

• The amount included within other comprehensive income for theperiod arising from a change in the additional minimum pensionliability recognized pursuant to paragraph 37 of Statement No. 87,as amended.

• On a weighted-average basis, . . . assumptions used in the account-ing for the plans: assumed discount rate, rate of compensation


increase (for pay-related plans), and expected long-term rate ofreturn on plan assets.

It is important to analyze the notes to the financial statements to determinewhether the company has used reasonable assumptions in developing its pension andpostretirement estimates and has applied those assumptions consistently from year toyear. It is especially important to determine whether the various rates used in the pro-jections are realistic. Illustration 15.8 summarizes the rates discussed in this chapter.

Statement users and analysts are particularly interested in a pension plan’s fundingstatus. As defined earlier, funding status refers to whether the plan has sufficient assetsto meet future obligations. Critical information is now available on the balance sheet asa result of the requirements of SFAS No. 158. The following requirements regardingnote disclosures also help statement readers assess the funding status of the plan:

An employer that sponsors one or more defined benefit pension plans or oneor more defined benefit postretirement plans shall provide the followinginformation:

a. A reconciliation of beginning and ending balances of the benefitobligation showing separately, if applicable, the effects during theperiod attributable to each of the following: service cost, interestcost, contributions by plan participants, actuarial gains and losses,foreign currency exchange rate changes, benefits paid, plan amend-ments, business combinations, divestitures, curtailments, settle-ments, and special termination benefits

b. A reconciliation of beginning and ending balances of the fair valueof plan assets showing separately, if applicable, the effects duringthe period attributable to each of the following: actual return onplan assets, foreign currency exchange rate changes, contributionsby the employer, contributions by plan participants, benefits paid,business combinations, divestitures, and settlements

c. The funded status of the plans, the amounts not recognized in thestatement of financial position, and the amounts recognized in thestatement of financial position, including:24

Discount rate for pensions The rate used in calculating the interest component.Also referred to as the settlement rate.

Rate of return on pension The rate that represents the expected return on assetsassets invested in the pension plan.

Expected compensation rate The rate that estimates the average amount of salaryincreases for employees in future periods.This rate isused in calculating the projected benefit obligation.

Discount rate for The rate used in calculating the interest component forpostretirement costs postretirement costs. (Similar to the discount rate for

pension expense.) Also referred to as the settlementrate.

Rate of return on The rate that represents the expected return on assetspostretirement assets (if any) invested in the postretirement plan.

Health-care cost trend rate The rate that is an estimate of the average increase inhealth-care costs that will occur in future periods.

Illustration 15.8

Rates for Pension andPostretirement Costs

24 See SFAS No. 158, par. 7c, for a complete listing of disclosure requirements.


25 We excerpted the information about IBM’s U.S. pension plans, which also discloses informationabout its non-U.S. plans.

(1) For each annual statement, the amounts recognized in othercomprehensive income. The amounts shall be separated intoamounts arising during the period and reclassification adjustmentsof other comprehensive income as a result of being recognized ascomponents of pension or postretirement expense.

(2) For each annual statement, the amounts in accumulated othercomprehensive income that have not yet been recognized as com-ponents of pension or postretirement expense, showing separatelythe net gain or loss, past service cost, and net transition obligation.

(3) The amounts in accumulated other comprehensive incomeexpected to be recognized as components of pension or postretire-ment expense over the fiscal year that follows the most recentannual statement showing separately the net gain or loss, past serv-ice cost, and net transition obligation.

Analysts are interested in both overfunded and underfunded pension and post-retirement plans. The overfunding of a plan is a favorable indication of its status andmay provide clues about future actions. In some cases, companies may see an over-funded plan as a source of cash and use a portion of the overfunding to meet otherfinancial needs. Employees and retirees should be quite concerned about such actions.Additionally, companies with an overfunded plan may be potential merger or takeovertargets, as other companies may want to use the overfunding to finance their futureactivities. On the other hand, a plan that is underfunded is often viewed negatively bypotential investors and employees. Employees and retirees have to be quite concernedabout whether assets will be available to meet their retirement needs. It is important toanalyze why the underfunding occurred. Was it because the employer did not con-tribute sufficiently to the plan, because the return on assets was insufficient, or becauseof other factors?

The Financial Reporting Case at the beginning of this chapter introduced some ofthe pension issues facing large companies like IBM that have both defined contribu-tion plans and defined benefit plans. Figure 15.1 shows part of a note disclosureregarding the funding status of IBM’s pension plans at December 31, 2003 and 2002.25

When all of IBM’s pension plans are combined and presented in the aggregate,they appear to be reasonably well funded. For many years, this company’s pensionplans were among the best funded in the United States. However, because of the stockmarket drop of 2001 and 2002, the value of its plan assets declined, and its pensionplans were no longer overfunded. In fact, at December 31, 2003, the fair value of IBM’splan assets was about $425 million less than its benefit obligation.

Although IBM’s pension plans were underfunded, its postretirement plans wereunderfunded to an even greater degree. Figure 15.2 presents part of a note from IBM’sannual report of December 31, 2003, about its postretirement plans. At that time,IBM’s projected obligation for postretirement costs was $6,181 million, and its planassets were $10 million. Therefore, the company’s obligation for postretirement costswas underfunded by more than $6,171 million—an indication that IBM had a verylarge obligation that it would have to pay from funds generated in the future.

Earnings Management and EthicsAccounting for pensions and postretirement costs is based on assumptions and esti-mates about future events. In addition to making assumptions about discount rates,projected salary increases, return on assets, health-care cost trends, and a variety ofother economic events, a company must estimate the associated costs. The assump-tions and estimates that a company makes about these matters must be “reasonable”


Figure 15.2

A Note Disclosure AboutPostretirement Obligation

As of December 31, 2003 2002

(Dollars in Millions)Change in benefit obligation:Benefit obligation at beginning of year $ 5,882 $ 6,148Service cost 36 49Interest cost 382 421Actuarial losses/(gains) 419 (170)Direct benefit payments (538) (566)Benefit obligation at end of year 6,181 5,882

Change in plan assets:Fair value of plan assets at beginning of year 10 8Accrued postretirement benefit liability recognizedin the Consolidated Statement of Financial Position $ (5,526) $ (5,770)

IBMIBM

Figure 15.1

A Note Disclosure AboutFunding Status

As of December 31, 2003 2002

(Dollars in Millions)Change in benefit obligation:Benefit obligation at beginning of year $ 38,357 $ 37,762Service cost 576 650Interest cost 2,518 2,591Plan participants contributions — —Acquisitions/divestitures, net — 32Amendments — 18Actuarial losses 3,472 47Benefits paid from trust (2,819) (2,743)Direct benefit payments — —Foreign exchange impact — —Plan curtailments/settlements/termination benefits — —Benefit obligation at end of year 42,104 38,357Change in plan assets:Fair value of plan assets at beginning of year 36,984 39,565Actual return on plan assets 7,514 (3,801)Employer contribution — 3,963Acquisitions/divestitures, net — —Plan participants contributions — —Benefits paid from trust (2,819) (2,743)Foreign exchange impact — —Fair value of plan assets at end of year 41,679 36,984Fair value of plan assets in excess of benefit obligation (425) (1,373)

IBMIBM

and reflect the environment and experience of the company. Thus, companies have agreat deal of latitude in accounting for pensions and postretirement benefits. The eth-ical climate of a company can play an important role in the range of reasonableassumptions and estimates that it makes.

When the dollar amounts involved with pensions and postretirement costs arelarge, a small change in an assumption can cause a large difference in the outcome. Forexample, as indicated in Figure 15.1, IBM’s projected benefit obligation for pensionswas more than $42 billion as of December 31, 2003. This number was based on anassumed discount rate used to calculate the present value amount. If the company sim-ply altered the discount rate by a small percentage, it would have caused a large differ-


ence in the amount of pension expense for the company. The following excerpt, takenfrom a Financial Executive article, discusses assumed pension discount rates:

When Fortune magazine editor Carol Loomis sat down for an interview withWarren Buffett late last year, the conversation could have led in many direc-tions: the economy, the stock market or the tenets of value investing. Instead,it mostly led in just one: U.S. pension fund accounting and the current pen-sion return assumptions underlying it. Buffett espoused in that interview (andhas continued to espouse since) that pension accounting is likely to blossominto yet another scandal besmirching America’s corporate boardrooms—andis a problem potentially far larger than the accounting shenanigans caused bycompanies such as Enron Corp. or Adelphia Communications. “I invite you toask the CFO of a company having a large defined-benefit pension fund whatadjustment would need to be made to the company’s earnings if its pensionassumptions were lowered to 6.5 percent,” Buffett stated. “And then, if youwant to be mean, ask what the company’s assumptions were back in 1973when both stocks and bonds had far higher prospective returns than they donow.”

Many corporations set this return assumption using a five-year movingaverage of recent annual returns, but the Financial Accounting StandardsBoard makes no explicit requirement to reveal what methodology is used—asking only that the approach be consistent over time.

The “smoothed” accrual typically shows up either within the GrossIncome line of the income statement or as a part of Sales and GeneralAdministration expense. Many Wall Street analysts bemoan this practice as apotential obfuscation of true operating earnings, but the accounting commu-nity has long since signed off on either treatment. But Buffett believes a 9.25percent annual return assumption in today’s world is just dead wrong, and tonot admit that keeps corporate earnings artificially higher for a longer periodof time—something potentially deceiving and dangerous. “Companies withreturn on asset assumptions above 6.5 percent are not facing reality, and any-one choosing not to lower assumptions—CEOs, auditors, actuaries—is risk-ing litigation for misleading investors,” Buffett argues. “And directors whodon’t question [this] optimism simply won’t be doing their job.”26

Many analysts and accounting researchers have come to realize that a company can“manage” its earnings by adjusting the important estimates higher or lower. The termearnings management refers to a company’s use of accounting information, princi-ples, or standards to smooth out the ups and downs in the earnings process. A com-pany can also alter the apparent funding status of its pension and postretirement plansby adjusting the assumptions to make its plans appear better funded.

A variety of academic studies have been conducted to determine whether compa-nies do in fact manage their earnings by adjusting pension and postretirementassumptions.27 Although the results of these studies are inconclusive, there is evidencethat some companies use pension estimates to alter their reported earnings and thatthe assumptions used by companies with well-funded plans differ from those used bycompanies with plans that are not as well funded.

The ability of companies to “manage” their earnings via the assumptions used indeveloping their pension accounting amounts has diminished somewhat as a result ofSFAS No. 158. First, companies are required to determine the funding status of theirpension and postretirement plans at year end. Previously, the estimates of funding

earnings management the pur-poseful use of accounting informa-tion, principles, or standards tosmooth out ups and downs in theearnings process

26 Barclay T. Leib, “Questioning the Basic Assumptions,” Financial Executive, September 2002,pp. 35–38.

27 See, for example, G. Newell, J. Kreuze, and D. Hurtt, “Corporate Pension Plans: How ConsistentAre the Assumptions in Determining Pension Funding Status?”Mid-American Journal ofBusiness, Fall 2002, pp. 23–29.

status could be done at a different time of the year and often did not match the num-bers in the year-end financial statements. Second, SFAS No. 158 gives additional guid-ance about the selection of discount rates and requires companies to more accuratelydetermine the appropriate rate for their pension or postretirement plans. Nonetheless,analysts must be aware that companies may attempt to manage their earnings throughtheir accounting for pensions and postretirement costs and should carefully review thedisclosures in the notes to the financial statements regarding the assumptions that thecompany uses.

International IssuesPension and postretirement accounting is an area in which there are significant differ-ences between the accounting guidance in U.S. generally accepted accounting princi-ples and the guidance in international accounting pronouncements. “PostemploymentBenefits Including Pensions,” IAS No. 19, and subsequent amendments and interpreta-tions address pension and postretirement issues.28 Illustration 15.9 summarizes theportions of IAS No. 19 pertaining to defined benefit pension and postretirement plans.

A comparison of IAS No. 19 and the FASB standards reveals many differencesbetween the two. Most importantly, IAS No. 19 covers both pensions and postretire-ment costs, whereas the FASB has issued separate pronouncements on pensions (SFASNo. 87 and SFAS No. 158) and postretirement costs (SFAS No. 106 and SFAS No. 158).Also, there are many differences in the way the components of the expense are calcu-lated. For example, the interest cost component under IAS No. 19 is calculated usingthe interest rate on high-quality corporate bonds, whereas the interest cost component


28 “Postemployment Benefits Including Pensions,” International Accounting Standard No. 19,became effective in 1999, but amendments were made in 2000 and 2001. An amendment con-cerning the “asset ceiling” provision of IAS No. 19 is under consideration.

• Current service cost should be recognized as an expense.

• All companies use the projected unit credit method (an accrued benefit method) tomeasure their pension expense and pension obligation.

• Projected benefit methods may not be used.

• The discount rate is the interest rate on high-quality corporate bonds with a maturitycomparable to plan obligations.

• Plan assets and reimbursement rights are measured at fair value.

• Defined benefit obligations are presented net of plan assets.

• Reimbursement rights are presented as a separate asset.

• A net pension asset on the balance sheet may not exceed the present value of avail-able refunds plus the available reduction in future contribution as a result of a plansurplus.

• If the net cumulative unrecognized actuarial gains and losses exceed the greater of(a) 10 percent of the present value of the plan obligation and (b) 10 percent of the fairvalue of plan assets, that excess must be amortized over a period no longer than theestimated average remaining working lives of employees participating in the plan.

• Faster amortization, including immediate income recognition for all actuarial gains andlosses, is permitted if an enterprise follows a consistent and systematic policy.

• Prior service cost should be recognized over the average period until the amendedbenefits become vested.

• The effect of termination, curtailment, or settlement should be recognized when theevent occurs.

Illustration 15.9

Summary of IAS No. 19—Defined Benefit Plans


in U.S. standards is based on the settlement rate. For a full discussion of the other dif-ferences between U.S. and international standards on pension and postretirementaccounting, refer to the IASB website.


1. What are the potential implications of an overfunded pension plan?

2. The note disclosures required by SFAS No. 132 and SFAS No. 158 include a rec-onciliation of the beginning and ending balances of the benefit obligation. Listthe components that might be applicable to this application.

3. Under IAS No. 19, how should pension plan assets and reimbursement rights bemeasured?

Revisiting the CaseIBM’S EMPLOYEE RETIREMENT OBLIGATIONS SURPASS THE HALF-BILLION-DOLLAR MARK

1. When to record an expense and the related liability is a recognition issue in account-ing for retirement plans. How to value the expense and related liability is a meas-urement issue.

2. IBM offers defined benefit pension plans and defined contribution pension plans,as well as nonpension postretirement plans consisting primarily of retiree medicalbenefits.

3. In 2003, IBM reported $227 million for defined benefit and defined contributionpension plans in the United States.

SUMMARY BY LEARNING OBJECT IVE

A pension plan is a promise by an employer to pay benefits to employees when theyretire. Normally, the employer must pay a designated amount into a pension fund. Thepension fund’s trustee invests the funds so that they accumulate and sufficient fundsare available to pay the promised benefits to retirees. There are two primary categoriesof pension plans. A defined contribution plan is a pension plan in which the amountthat is paid into the pension fund is known (or defined), but the amount that will bepaid upon retirement is not known until retirement. The most prominent examples ofdefined contribution plans are 401(k) plans and IRAs (individual retirementaccounts). A defined benefit plan is a plan in which the amount that will be paid toemployees at retirement is defined. Usually, the amount of the employees’ retirementpay is based on a formula that incorporates several variables, such as the employee’sage, years of service, and salary level over some time period. The retirement amount is“defined” because each employee can use the pension formula and the applicable vari-ables to determine the amount of his or her retirement pay.

SFAS No. 87 and subsequent pronouncements provide guidance on accounting fordefined benefit pension plans. The FASB states that a defined benefit pension planinvolves the incurrence of a liability because a promise has been made to employees.Pension expense for the plan should be recognized using accrual accounting proce-dures. The expense should be recorded when it is earned by the employees rather thanwhen it is paid. The FASB also holds that the determination of the funding of the

LO2 Determine how to accountfor a defined benefit pensionplan.

LO1 Understand the nature andtypes of pension plans that com-panies use.


The projected benefit obligation is the sole measure used to value a pension obligation.It is defined as the present value as of a specific date of all benefits attributed by thepension benefit formula to employee service rendered prior to that date. If the pensionbenefit formula is based on future compensation levels, the projected benefit obliga-tion is measured using assumptions about future salary increases.

The components of pension expense are service cost (the amount of benefits thatemployees have earned through their work during the current period), prior servicecost (the cost of benefits granted to employees for periods before the pension plan wasadopted), interest cost (the increase in the obligation that occurs because of the pas-sage of time), return on plan assets (the return on amounts invested in the pensionfund), and any gains or losses on pension assets or liabilities if the amounts exceed athreshold referred to as the corridor amount. Each component must be calculated, andthe total represents the amount of pension expense for the period.

Gains and losses can occur on both the pension assets and the pension liability. Gainsand losses on pension assets arise when the actual return on assets differs from theexpected return. Gains and losses on pension liabilities are a result of changes in theactuarial assumptions used to estimate the liability. If the amounts of the gains andlosses exceed the specified corridor amount, they are amortized as a component ofpension expense.

A company must recognize the funding status of its pension plan, measured as the dif-ference between pension assets and liabilities, on the balance sheet. The funding statusof all overfunded pension plans should be shown in the asset category, and the fundingstatus of all underfunded pension plans should be shown as a liability on the balancesheet. Classification depends on whether the plan is overfunded or underfunded. If apension plan is overfunded, the amount of pension assets that exceeds the amount ofthe liability should be presented as a noncurrent asset on the balance sheet. If a plan isunderfunded, the difference (liability in excess of asset) may be classified as current,long-term, or both. The amount that should be considered a current liability is theexcess of the fair value of the plan assets over the actuarial present value of benefitspayable in the next 12 months, or the operating cycle if that is longer. The remainingportion of the liability should be classified as a long-term liability on the balance sheet.

Postretirement benefits are benefits other than pensions that employees receive afterretirement. Examples include an employer’s promise to pay education benefits, legalaid, or relocation costs, but health-care benefits are usually the most significant item.Postretirement expense is calculated using a series of components in a manner similarto the calculation of pension expense.

It is important for any user of financial statements to understand and analyze the notedisclosures for pensions and postretirement obligations. It is particularly important todetermine the components that were used to calculate pension and postretirementexpense and the funding status of the plan. Overfunding, which occurs when the valueof the pension assets is larger than the pension or postretirement obligation, is a favor-able indication of the plan’s health. Underfunding, which occurs when the pension orpostretirement obligation is larger than the assets available, is a negative indication ofthe health of the plan because it indicates some doubt about the employer’s ability toprovide the benefits that have been promised.

LO8 Analyze financial state-ments and disclosures related topensions and postretirementcosts.

LO7 Identify the accountingtreatment and disclosures forpostretirement obligations andexpenses.

LO4 Identify the components ofpension expense.

LO3 Explain the method used tovalue a pension obligation.

LO5 Explain and demonstratethe accounting treatment forpension gains and losses.


pension plan is an actuarial decision, whereas the amount recognized as expenseshould be governed by accrual accounting procedures. The expense is not representedby the amount of cash put into the fund. Instead, the pension expense should be meas-ured based on a series of components. The combination of these components repre-sents the amount of the expense to the employer.

KEY TERMS

accumulated postretirement benefitobligation (p. 24)

actuaries (p. 4)attribution period (p. 24)corridor approach (p. 15)defined benefit plan (p. 6)defined contribution plan (p. 4)earnings management (p. 31)

funding status (p. 18)interest cost (p. 11)market-related value (p. 16)Pension Benefit GuarantyCorporation (p. 7)

pension expense (p. 9)pension plan (p. 4)postretirement benefits (p. 23)

prior service cost (p. 11)projected benefit obligation (p. 10)return on plan assets (p. 12)service cost (p. 11)settlement rate (p. 12)underfunded (p. 7)unrecognized gain or loss (p. 14)

CHAPTER 15 Pensions and Postretirement Plans 35

EXERC ISES

LO1, 2 EXERCISE 15-1 Defined Contribution and Defined Benefit PlansAssume that you have recently started a new job and have been told that your employeroffers a variety of benefit plans to its employees. The company provides a defined benefitpension plan and a defined contribution plan that can be used to supplement your retire-ment income.

Required:

1. Explain the differences between a defined benefit pension plan and a defined contri-bution plan.What factors would be important to you in choosing one of these plans?

2. Assume that you choose the defined contribution plan, but you want to calculate thepresent value of the retirement benefits that you will be paid upon retirement fromyour employer. Since you are still young, retirement is many years in the future. List themost important estimates and assumptions you must make in order to calculate theamount of your future retirement pay.

LO2, 3, 4, 6 EXERCISE 15-2 Pension ExpenseThe following information relates to the 2006 activity of the defined benefit pension planof Linsey Corp., a company whose stock is publicly traded:


Expected and actual return on plan assets 40,000

Interest cost on pension benefit obligation 82,000

Amortization of actuarial loss 15,000

Fair value of plan assets at year end 800,000

Projected benefit obligation at year end 750,000

Employer contribution to plan during 2006 250,000

Assume that the company adopted SFAS No. 158 for the year 2006 and that it recog-nized the appropriate amounts prior to recording the current year’s pension expense.Also assume that no prior service costs or pension gains or losses occurred during theyear.

Required:

1. Determine the components of pension expense for 2006

2. Prepare the appropriate entries to record pension expense and to amortize any delayedrecognition items.

3. Indicate what amounts related to the pension plan would be shown in Linsey’s 2006income statement.

4. What is the funding status of the pension plan? Indicate how the funding status wouldbe shown in Linsey’s balance sheet as of December 31, 2006. In what category of thebalance sheet would the items be presented?


LO2, 3, 4, 6 EXERCISE 15-3 Pension ExpenseThe following amounts are related to the defined benefit plan of Kane Company for 2006:


Interest cost 38,000

Expected and actual return on plan assets 22,000

Amortization of unrecognized prior service cost 52,000

Employer contributions 50,000

At December 31, 2006, the fair value of plan assets exceeds the projected benefit obligationby $100,000.

Assume that the company adopted SFAS No. 158 for the year 2006 and recognizedthe appropriate amounts prior to recording the current year’s pension expense. Alsoassume that no prior service costs or pension gains or losses occurred during the cur-rent year.

Required:

1. Determine the components of pension expense for 2006.

2. Prepare the appropriate entries to record pension expense and to amortize any delayedrecognition items.

3. Indicate what amounts related to the pension plan would be shown in Kane’s 2006income statement.

4. What is the funding status of the pension plan? Indicate how the funding status wouldbe shown in Kane’s balance sheet as of December 31, 2006. In what category of the bal-ance sheet would the items be presented?

LO2, 3, 4 EXERCISE 15-4 Projected Pension Benefit ObligationThe following information pertains to Seda Co.’s pension plan:

Actuarial estimate of projected benefit obligation at 1/1/06 $72,000

Assumed discount rate 10%

Service costs for 2006 $18,000

Pension benefits paid during 2006 $15,000

Required:

1. Develop a memo that explains the meaning of the term projected benefit obligation.

2. Assuming that there were no changes in actuarial estimates during 2006, calculateSeda’s projected benefit obligation at December 31, 2006.

3. Give an example of a change in actuarial estimate. How would such a change affect theprojected benefit obligation?

LO4, 5 EXERCISE 15-5 Corridor Approach for Gains and LossesThe actuary for the pension plan for Fab Five calculated the following net gains and losses:

Unrecognized Net Gain or Loss

Year ended 2003 $1,200,000 gain

Year ended 2004 500,000 loss

Year ended 2005 800,000 gain

Other information about Fab Five’s plan is as follows:

As of January 1 Projected Benefit Obligation Plan Assets

2003 $6,000,000 $5,000,000

2004 6,600,000 5,600,000

2005 7,200,000 6,200,000

Fab Five has a stable work force of 200 employees. The total service years for all employeesis 3,000.


Required:Determine the amount of gain or loss that should be amortized as a componentof pension expense for each year 2003 to 2005.

LO4, 7 EXERCISE 15-6 Postretirement CostsFoster Co.must determine the proper amounts related to its defined benefit postretirementplan. The following information pertains to Foster Co.’s postretirement plan for the year2006:


Benefit payment 55,000

Interest on the accumulated postretirement benefit obligation 20,000

Funding payment by Foster to trustee 0

Assume that the company adopted SFAS No. 158 for the year 2006 and recognized theappropriate amounts prior to recording the current year’s postretirement expense.Also assume that no prior service costs or postretirement gains or losses occurred dur-ing the current year. Further, assume that the accumulated postretirement benefit obli-gation at December 31, 2006, was $500,000 and that the company did not fund theplan in any previous periods.

Required:

1. Develop a memo that indicates the most important differences between pensions andother postretirement costs.

2. Determine the components of postretirement expense for 2006 and develop theaccounting entries to record the postretirement expense.

3. Indicate what amounts related to the postretirement costs should be shown in Foster’s2006 income statement.

4. What is the funding status of the plan? How should the funding status be shown inFoster’s balance sheet as of December 31, 2006? In what category of the balance sheetwould the items be presented?

LO2, 4, 6 EXERCISE 15-7 Pension Expense,AccrualRocha Company has a defined benefit pension plan with the following account balances atJanuary 1, 2007:

Projected Benefit Obligation $2,300,000

Unrecognized Prior Service Costs 350,000

Pension Plan Assets 1,900,000

Rocha Company’s actuaries have determined that the service cost for the year endedDecember 31, 2007, is $420,000. The company uses a settlement rate of 8 percent, and theactual and expected return on plan assets was determined to be $84,000. The averageremaining service period of Rocha’s employees is 14 years. Rocha made a pension paymentof $460,000 into the pension fund during 2007. During the year, the company paid$500,000 of benefits to retirees.

Assume the company adopted SFAS No. 158 at December 31, 2006, and properlyrecognized the appropriate amounts in accumulated other comprehensive income forthe delayed recognition items. Also assume that no prior service costs or pension gainsor losses occurred during 2007.

Required:

1. Calculate pension expense for 2007.

2. Record the transactions to recognize pension expense for 2007.

3. Determine the funding status of the plan at December 31, 2007. How will the fundingstatus be reflected on the balance sheet?

LO2, 4, 6 EXERCISE 15-8 Pension AccrualSorrenta, Inc. has a defined benefit pension plan with the following account balances atJanuary 1, 2007:


Projected Benefit Obligation $1,650,000

Unrecognized Prior Service Costs 255,000

Pension Plan Assets 1,150,000

Sorrenta’s actuaries have determined that the service cost for the year ended December 31,2007, is $287,000. The actual and expected return on plan assets is $92,000. The averageremaining service period of Sorrenta’s employees is 15 years, and the expected settlementrate is 9 percent. During 2007, Sorrenta paid $456,000 into the pension fund and $120,000of benefits to retirees. Assume that the company adopted SFAS No. 158 at December 31,2006, and recognized the appropriate amounts in accumulated other comprehensiveincome for the delayed recognition items. Also assume that no prior service costs orpension gains or losses occurred during 2007.

Required:

1. Determine the pension expense for 2007 and prepare the journal entries necessary torecognize pension expense and amortize the delayed recognition items.

2. Is the pension plan underfunded? Explain.

3. How will the funding status be reflected on the balance sheet?

LO5 EXERCISE 15-9 Pension Gains and LossesHerbert Company offers a defined benefit pension plan and has determined the followingamounts for the year ended December 31, 2005:

Expected settlement rate 7%Service cost $130,000Benefits paid to retirees $54,000

The projected benefit obligation at January 1, 2005, was $2,300,000.

Required:

1. Suppose an update in actuarial assumptions calculated the projected benefit obliga-tion at December 31, 2005, to be $2,800,000. Determine whether an actuarial gain orloss exists and its amount, if any.

2. Identify the nature of any other gains or losses that may result in accounting for pen-sions. Explain how they might arise.

LO5 EXERCISE 15-10 Gains and Losses,Corridor ApproachB12 Company offers a defined benefit pension plan and has determined the followingamounts for the year ended December 31, 2005:

Expected settlement rate 8%


Benefits paid to retirees $140,000

Average remaining service period 16 years

The projected benefit obligation and plan assets at January 1, 2005, were $1,840,000 and$1,630,000, respectively. An update in actuarial assumptions calculated the projected bene-fit obligation at December 31, 2005, to be $1,800,000. The unrecognized gain on pensionassets as of January 1, 2005, was $80,000.

Required:

1. Determine the amount of the actuarial gain or loss.

2. Apply the corridor approach to the actuarial gain or loss.What effect does this amorti-zation have on pension expense?

3. How does the corridor approach give rise to smoothing of pension gains and losses?

LO7 EXERCISE 15-11 Postretirement ExpenseIgnito, Inc., has a defined benefit postretirement plan. The following information wasdetermined for the postretirement plan for 2007:



Interest rate on obligation 8%

Actual and expected return on plan assets $21,000

Fund contribution $75,000


The following amounts existed at January 1, 2007:

Accumulated postretirement benefit obligation $800,000

Plan assets 450,000


Assume that the company adopted SFAS No. 158 for the year 2006 and that it recog-nized the appropriate amounts in other comprehensive income at the time of theadoption. Also assume that no prior service costs or postretirement gains or lossesoccurred during 2007 and that the company paid $90,000 of benefits to retirees duringthe year.

Required:

1. Calculate postretirement expense for 2007.

2. Prepare the journal entries to record the postretirement expense and to amortize anydelayed recognition items.

3. Determine the amount of accumulated postretirement benefit obligation and theamount of plan assets at December 31, 2007. How will the funding status be reflectedon the balance sheet?

PROBLEMS

LO2, 3, 4, 5, 6 PROBLEM 15-1 Comprehensive Pension ProblemThe Louisville Duke Company sponsors a defined benefit pension plan for its 200 employ-ees. The company’s actuary provided the following information about the plan:

January 1, 2007 December 31, 2007

Projected benefit obligation $3,000,000 $3,710,000

Plan assets (fair value) 1,800,000 2,200,000

Cumulative unrecognized net loss 0 360,000

Unrecognized prior service cost 400,000 ?

Discount rate (current settlement rate) 10%

The service cost component for employee services rendered for 2007 was computed as$400,000. The expected and actual return on assets for 2007 was $200,000. The companyexpects the average remaining years of service for employees to be 10 years. Louisville Dukemade a funding contribution to the pension plan of $550,000 on December 31, 2007(which is reflected in the amounts given) and paid $350,000 in benefits to retirees duringthe year.

Assume that the company adopted SFAS No. 158 in 2006 and recorded all appro-priate amounts at that time. Also assume that no amendments to the plan occurred in2007.

Required:

1. Indicate the components of pension expense for 2007. Indicate whether the amountsincrease or decrease the pension expense, and indicate the total pension expense for2007.

2. Prepare all necessary journal entries for 2007.

3. Indicate the amounts for the pension plan disclosed in the 2007 income statement.


4. Indicate the amounts related to the pension plan that are presented in the balancesheet as of December 31, 2007. In what category of the balance sheet would the itemsbe presented?

LO3, 4, 5, 6 PROBLEM 15-2 Pension Expense and Pension ObligationThe following information pertains to Flock Company’s defined benefit pension plan:

Year 2006 Year 2005

(in thousands)

Interest cost $210 $175

Service cost 190 170

Expected return on plan assets 180

Actual return on plan assets 160 170

Amortization of prior service cost 20 20

Employer contributions 300 250

Pension expense 205 175

Benefits paid 190 174

Discount rate 7% 7%

Pension plan assets were $2,000 on 1/1/05. The prior service cost is amortized over 15 years,starting on 1/1/03.

Required:

1. Calculate the balance of the projected benefit obligation on 1/1/06.

2. Calculate the expected rate of return expressed in percent. Assume that the same ratewas utilized for both years.

3. Calculate the balance of the unamortized prior service cost on 12/31/06 before theamortization entry is made on 1/1/07.

4. Calculate the balance of the pension plan assets on 12/31/05.

5. Calculate the amortization of gains and losses for the year 2005.

Analyze: Calculate the expected return on plan assets for the year 2006 in dollars (round tothe nearest thousand dollars).

LO2, 3, 4, 6 PROBLEM 15-3 Comprehensive Pension ProblemConsider the following information regarding Smith Company’s defined benefit pensionplan:

2008 2007

(in thousands)

Projected benefit obligation, 12/31 $10,500 $9,500

Plan assets, 12/31 9,000 8,100

Employer contribution to pension plan 1,600 1,600

Unrecognized prior service cost, 1/1 1,900 2,000

Benefits paid 900 800

Pension expense for each year was calculated as follows:

Service cost $1,500 $1,300

Interest 400 400

Actual and expected return 200 200

Amortization of prior service costs 100 100

Assume that the company adopted SFAS No. 158 at December 31, 2006 and recognizedall required amounts at that time. No pension-related gains or losses occurred during2007 or 2008. No prior service costs originated in either year.


Required:

1. For each of the two years, show all journal entries that Smith Company made for itspension plan. Assume that the company contributed cash to its pension plan when therelated expense was recognized.

2. Show the balance sheet presentation at December 31, 2007, and December 31, 2008,the end of the accounting periods.

LO2, 3, 4, 5, 6 PROBLEM 15-4 Comprehensive Pension Problem (CPA adapted)The following information pertains to Sparta Company’s defined benefit pension plan:

Discount rate 8%

Expected rate of return 10%

Average service life 12 years

At January 1, 2005:


Fair value of pension plan assets 720,000

Unrecognized prior service cost 240,000

Unamortized prior pension gain 96,000

At December 31, 2005:


Fair value of pension plan assets 825,000

Service cost for 2005 was $90,000. There were no contributions made or benefits paidduring the year. The company uses the straight-line method of amortization over the max-imum period permitted.

Required: Calculate the following amounts at December 31, 2005:

1. Interest cost

2. Expected return on plan assets

3. Actual return on plan assets

4. Amortization of prior service costs

5. Amortization of unrecognized pension gain

LO7 PROBLEM 15-5 Postretirement Obligation—TwoYearsFoster Company must determine the proper amounts related to its defined benefit post-retirement plan. The following information pertains to Foster’s postretirement plan for theyears 2007 and 2008:

2007 2008

Service cost $120,000 $150,000

Accumulated benefit obligation, January 1 $700,000 $900,000

Unrecognized prior service cost $200,000 ?

Discount rate 10% 10%

Actual and expected return on assets 8% 8%

Unrecognized gains and losses 0 0

Funding payment made December 31 $100,000 $100,000

Average attribution period for employees (in years) 12 12

Prior to 2007, Foster Company had not funded any amount for postretirement costs. Thecompany paid no benefits to retirees in 2007 or 2008. It adopted SFAS No. 158 in 2006 andrecorded all appropriate amounts at that time.

Required:

1. Determine the components of postretirement expense for 2007 and 2008.


2. Indicate what amounts related to the postretirement costs should be shown in Foster’s2007 and 2008 income statements.

3. Indicate what amounts related to the postretirement costs would be shown in Foster’sbalance sheet as of December 31, 2007 and 2008. In what category of the balance sheetwould the items be presented?

Analyze: If the postretirement plan is amended in 2008 to give retirees more benefits, whateffect will this action have on net income in that year? Explain your answer.

LO2, 4, 5, 6 PROBLEM 15-6 Comprehensive Pension ProblemThe following information relates to Milton Company’s defined benefit pension plan forthe year 2007:

Projected benefit obligation, 1/1 $1,800,000

Unrecognized prior service cost, amortized over 10 years 1,200,000

Service cost for the year 900,000

Unrecognized gains or losses 0

Pension plan assets, 1/1 1,000,000

Pension benefits paid during the year 400,000

Employer contributions to the pension plan during the year 1,100,000

Actual return on plan assets 40,000

Discount rate 8%

Expected rate of return on plan assets 10%

The company adopted SFAS No. 158 in 2006 and recorded all required amounts at thattime.

Required:

1. Compute the balance of the pension plan assets on 12/31/07.

2. Compute pension expense for the year.

3. Give the journal entry(ies) relating to the pension plan for the year 2007.

5. Compute the balance of the projected benefit obligation on 12/31/07.

Analyze: If Milton Company wished to decrease its pension liability, which estimates orassumptions might be altered? Explain your answer.

LO2, 3, 4, 5, 6, 8 PROBLEM 15-7 Comprehensive Pension ProblemSmith Corporation sponsors a defined benefit pension plan covering substantially all of itsemployees. The following information is available from the company’s accounting system,the actuary, and the pension fund trustee for the year 2007:

Projected benefit obligation, 1/1 $100,000

Pension plan assets, 1/1 83,000


Unrecognized prior service costs, 1/1 30,000

Unamortized gain 20,000

Actual return on pension plan assets for the year 6,000

Employer contributions to pension plan 15,000

Benefits paid to employees 9,000


Smith discloses the following assumptions:

Discount rate 7%

Expected long-term rate of return 8%

Expected compensation rate increase 3%


Required:

1. Calculate pension expense.

2. Calculate the balance of pension plan assets on 12/31/07.

3. Calculate the balance of the projected benefit obligation on 12/31/07.

4. Calculate the amount of the unamortized gain on 12/31/07 (after recording the cur-rent year’s expense).

LO7 PROBLEM 15-8 Comprehensive Postretirement ProblemWeiss Company had the following data relating to its postretirement benefit plan in 2007:

Accumulated postretirement benefit obligation, 1/1 $1,000,000

Unrecognized prior service cost 300,000


Unrecognized losses, 1/1 50,000

Plan assets, 1/1 800,000

Postretirement benefits paid to retirees during thecurrent year 120,000

Employer contributions to the postretirement planduring the current year 110,000

Actual return on plan assets (50,000)


Assumptions:

Discount rate 7%

Expected rate of return on plan assets 9%

Health-care trend rate 4%

The company adopted SFAS No. 158 in 2006 and recorded all required amounts at thattime.

Required:

1. Compute the postretirement expense for the year.

2. Compute the ending balance in postretirement plan assets on 12/31/07.

3. Show the journal entry(ies) that the company made relating to its postretirement ben-efit plan.

CASES

LO1, 2, 4 FINANCIAL REPORTING CASE 15-1 Pension Components (CPA adapted)Essex Company has a single-employer defined benefit pension plan and a compensationplan for future vacations for its employees.

Required:

1. Define the interest cost component of pension expense for a period. How should Essexdetermine its interest cost component of pension expense for a period?

2. Define prior service cost.How should Essex account for prior service cost? Why?

LO2, 3, 4, 5, 6 FINANCIAL REPORTING CASE 15-2 Pension Components (CPA adapted)At December 31, 2007, as a result of its single-employer defined benefit pension plan,Bighorn Co. had an unrecognized net loss and a debit amount in accumulated other com-prehensive income related to its pension plan. Bighorn’s pension plan and its actuarialassumptions did not change during 2007. Bighorn has made annual contributions to theplan.


Required:

1. Identify the components of net pension cost that Bighorn should recognize in its 2007financial statements.

2. What circumstances caused Bighorn’sa. unrecognized net loss?b. debit amount in accumulated other comprehensive income?

3. How should Bighorn determine its funding status? How should the funding status bepresented on the balance sheet?

LO1, 2, 7 CRITICAL THINKING CASE 15-3 Postretirement Costs at PolaroidThe following is an excerpt from a letter that Polaroid Corporation sent to its employeeson October 12, 2001:

Today, Polaroid Corporation took the painful but necessary step of voluntarily fil-ing for reorganization under Chapter 11 of the U.S. Bankruptcy Code. This actionbecame inevitable, particularly in recent weeks, as our revenues continued theirsharp decline and our liquidity situation further deteriorated.

As part of our need to reduce costs substantially, it is with great regret that wehave terminated the retiree health and life insurance plans, as well as severancepayments for former U.S. employees. It is important to note at this point that youhave an option to continue your medical coverage in the Polaroid health plansunder the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA). Ifyou choose this option you will pay the full unsubsidized premium plus a 2%administrative fee. For additional information about this option please call theFidelity Benefits Connection at 1 800 210 4015.We are also notifying the PensionBenefit Guaranty Corporation (PBGC), a federal agency, about our Chapter 11 fil-ing. We will cooperate with the PBGC as it assesses our pension status and out-look and continue to operate our plan in the normal manner. Retirees will bereceiving a detailed information packet in the mail shortly.

The notes to Polaroid’s financial statements of December 31, 2000, contained the followingdisclosures (in millions):

Net periodic postretirement benefit cost $ 11.5

Net periodic pension cost/(benefit) (18.0)

Projected benefit pension obligation 1,196.8

Fair value of pension plan assets at year end 1,388.5

Accumulated postretirement benefit obligation at year end 218.2

Fair value of postretirement plan assets at year end 0

Required:

1. Discuss the nature of the obligation for pensions and postretirement obligations. Dothe obligations constitute legal obligations?

2. Why was the fair value of the postretirement plan assets at December 31, 2000, equalto zero?

3. Polaroid took the rather drastic action of eliminating health insurance and life insur-ance coverage for its employees and retirees.What amount of liability did the companyeliminate as a result of that action?

4. Most companies have sought methods to limit their liability for postretirement obliga-tions, especially health-care costs. Instead of eliminating coverage for employees, whatother actions have companies taken to reduce their liability? Cite some examples.

LO4, 5, 7 CRITICAL THINKING CASE 15-4 Pension EstimatesIn accounting for pensions and postretirement benefit plans, companies must make manyestimates and projections about such matters as employee turnover and longevity. Theymust also make several rate estimates. In addition to estimating a discount rate and an


expected rate of return on plan assets, they must estimate a compensation trend rate forpension plans and a health-care cost trend rate for postretirement benefit plans. Actuarieshired by the company typically assist with this estimation process. However, it is the com-pany that ultimately decides what rates it will use. The rates chosen can significantly influ-ence accounting accruals. In fact, for some companies with large plans, even a fractionalchange in these rates can significantly affect the company’s expenses and obligations.Recent empirical studies suggest that companies may use the rate assumptions involved inaccounting for pensions and postretirement benefits to manage their earnings. Earningsmanagement generally represents an undesirable consequence of flexibility in the account-ing rules.

Required:

1. Briefly describe how each rate assumption can affect pension and postretirement ben-efit accruals and/or obligations.

2. Give an example of how a company can manage its earnings by choosing a higher orlower rate.

3. What factors facilitate earnings management with respect to defined benefit pensionplans? Focus on (a) inherent characteristics of pension and other postretirement ben-efit plans and (b) accounting for pensions and other postretirement benefit plans.

LO4, 5 ETHICS CASE 15-5 Flexibility in Accounting for PensionsOn December 9, 2003, the chief financial officer of Schoen Company enters the office ofMaggie Flowers to share with her the news that the Dow Jones Industrial Average has justreached 10,000 points for the first time in 18 months. Maggie is the chief accountant forSchoen Company, a manufacturer of high-technology electronics components. Since 1958,Schoen Company has sponsored a defined benefit pension plan that covers substantially allof its full-time employees. Many of the company’s current employees are nearing retire-ment. Thus, the company’s projected pension benefit obligation is very significant.

The CFO, Jerry Green, is very pleased about the positive stock market news. He asksMaggie to show him the company’s pension plan numbers and disclosures for the nextreporting period. After reviewing the information, he tells Maggie that recent market andeconomic changes warrant some changes in the pension rate assumptions. He asks Maggieto increase the expected rate of return on plan assets from 8 percent to 8.75 percent, and thediscount rate from 5.5 percent to 6 percent.

For the past few years, the actual returns on pension plan assets have been either nega-tive or significantly below the 8 percent expected rate. Maggie asks why these changes arenecessary. Jerry tells her that the increase in the expected rate of return is justified by therecent stock market gains and that the increase in the discount rate is justified because ofrising interest rates and also because it preserves conservatism. He assures Maggie that hehas already discussed the changes with the company’s actuary and points out that the newrates will be well within the rate ranges set forth in the current edition of the AICPA’sAccounting Trends and Techniques. He asks Maggie to recalculate the pension numbersusing the new assumptions and to take care of all necessary filings.

Maggie’s calculations show that the increase in the rates will reduce pension expenseslightly and that the increase in the discount rate will significantly reduce the reported pen-sion obligations and funding requirement and eliminate the necessity for an additionalminimum liability accrual. Maggie is aware that the additional funding required under thecurrent rates would cause cash flow problems for the company. Maggie, who worked in theDepartment of Labor’s pension benefits division before joining the company, is concernedthat the changes may not be justified.

Required:

1. Is Maggie faced with an ethical dilemma? If so, describe the issues.

2. Who will be affected by the decision that Maggie makes?

3. What values and principles are likely to influence Maggie’s decision?

4. What alternative actions might Maggie consider?


5. a. Whose interest is most important?b. Which values and principles are most important?c. Which of the possible consequences will do the most good or cause the least harm?d. Which consideration is most important?

6. What would you do if you were Maggie?

LO8 ETHICS CASE 15-6 The Income-Generating Power of IBM’s Pension PlanOn January 28, 2003, the new CEO of IBM, Samuel J. Palmisano, astounded his boardmembers by announcing that he would cut his own bonus by 50 percent and share thesefunds with 20 of his top executives.29 Bonus plans are a popular method of motivating andrewarding employees. However, they are not typically available to the majority of a com-pany’s employees. Employee-sponsored pension plans, on the other hand, typically areavailable to most full-time employees.

There are two common types of pension plans: defined benefit and defined contribu-tion pension plans. Accounting for defined contribution plans presents few accountingissues. However, accounting for defined benefit plans gives rise to complex accounting andbusiness issues. Accounting issues include choosing appropriate pension rates (the dis-count rate, expected rate of return on pension plan assets, and rates of compensationincrease), and business issues include selecting the amount of pension plan funding. Thedecisions that companies make regarding these issues can significantly affect their operat-ing income and net income.

Pension plans typically give rise to pension expense. When stock market returns arehigh, pension expense may be low; in fact, the pension plan may even generate income. Butduring extended periods of stock market declines, pension expense tends to increase.However, that is not always the case. In recent years, IBM has consistently recognizedincome from its defined benefit pension plans. For example, IBM derived pretax income of$917 million, $1,025 million, $896 million, and $638 million from its U.S. plans during theyears 2002, 2001, 2000, and 1999, respectively.30 In fact, approximately 10 percent of thecompany’s income for the year 2001 was generated by pension plan income.

How can IBM consistently recognize positive income from its pension plan, especiallyduring years when actual returns are negative? There are two primary reasons: (1) Thecompany calculates pension cost using expected returns rather than actual returns, and (2)it used return rates between 8.5 and 10 percent during those years. Thus, while the actualreturn on IBM’s pension plan assets during 2001 was negative $2.405 billion, the com-pany’s pension cost calculation included a positive return of $4.202 billion.

Negative market (and pension plan) returns persisted. In its 10-K filing with the SEC,IBM announced that effective January 1, 2003, it had reduced its expected rate of return to8 percent, which was expected to decrease income for the year 2003.31 However, anotherpension-related action by IBM mitigated this effect. In December 2002, IBM announcedthat it would contribute $3.95 billion in cash and stock to its pension plan. In contrast, inseveral prior years, IBM had contributed little or no funds to its plan. These additionalfunds created a significantly higher asset base to which the new lower expected return ratewas applied, thus mitigating the effect of the decreased rate. So IBM still expects to derivepositive income from its pension plan, continuing to boost its bottom line.

Required:

1. What are the ethical implications of relying on pension income to increase operatingand net income?

2. Can accounting for defined benefit pension plans provide opportunities for earningsmanagement?

3. Can the income-increasing effect of a positive expected rate of return continue todepress pension cost or generate income from pension plans? What provision of SFASNo. 87may prevent this from occurring?

29 Spencer E. Ante, “The New Blue,”BusinessWeek, March 17, 2003, pp. 80–88.

30 IBM, 2001 Annual Report and 2002 10-K filing.

31 IBM, 2002 10-K filing.


4. Were pension plans intended to generate income for the sponsoring employer?

5. During the year 2000, IBM increased its expected rate of return from 9.5 to 10 percentand also decreased its discount rate from 7.75 to 7.25 percent.What effect do these tworate changes have?

LO1 COMMUNICATION CASE 15-7 Pension Plan ChoicesAs the chief financial officer for a company that is now profitable and stable, you areresponsible for submitting a report to the board of directors concerning the effects of pro-viding retirement benefits to employees. The board is choosing between a defined benefitplan and a defined contribution plan and would like to know how each of the plans willaffect the company’s financial statements.

Required: Prepare a written report comparing the financial statement effects of definedcontribution and defined benefit plans.

LO7 ANALYSIS CASE 15-8 Impact of Pension AssumptionsOne of the most difficult issues in pension accounting is understanding how changes in theunderlying events and assumptions can affect the projected benefit obligation. The tablebelow lists numerous events and changes in pension assumptions.

Required: Complete the table by determining the impact on pension expense and pro-jected benefit obligation (PBO) for each change in assumption. The first row is completedas an example.

Impact ChangeWould HaveChange in Pension Assumption on PBO

1. Increase in settlement (discount) rate Decrease PBO

2. Increase in expected return on plan assets

3. Decrease in expected future compensationlevels

4. Increase in expected lifespan of retirees

5. Increase in average remaining service lifeof employees

6. Decrease in settlement (discount) rate

7. Payment of benefits

8. Increase in benefits because of planamendment

9. Increase in expected future compensationlevels

LO4, 7 COMMUNICATION CASE 15-9 Determining Pension ExpenseAs the controller for your company, you are asked to provide information to managementconcerning the company’s pension plan.

Required: Prepare written responses to the following questions:

1. If your company decides to initiate a defined benefit pension plan and the companywill recognize pension expense each period, what factors will determine each period’spension expense?

2. How will each element of pension expense affect total pension expense for the period(increase, decrease, or uncertain)?

LO2 ANALYSIS CASE 15-10 Defined Benefit Pension PlansAs the controller for Rose Corp., you are required to account for the company’s definedbenefit pension plan. You are presented with the following information about the plan: OnJanuary 1, 2007, Rose Corp.’s projected benefit obligation was $4,300,000. On that date, thefair value of plan assets was also $4,300,000. During 2007, the company paid retirees bene-fits of $285,000 and contributed an additional $326,000 to the pension plan. The servicecost associated with the plan during 2007 was $210,000. Rose Corp. assumes a 6 percent


settlement rate and expects a return of 8 percent on the plan assets. The actual return onplan assets during 2007 was $273,000.

Required:

1. Determine the projected benefit obligation at December 31, 2007.

2. Determine the fair value of plan assets at December 31, 2007.

3. Calculate pension expense for 2007.

ON THE WEB

The following exercises, activities, and problems are available on the IntermediateAccounting website. Use these resources to reinforce your understanding of the topicspresented in this chapter.

• CPA-Adapted Simulations • Annual Report Project• Interpreting the Accounting Standards • ACE Practice Tests• Extending the Global Focus • Flashcards• Extending the Ethics Discussion • Glossary• Mastering the Spreadsheet • Check Figures for Text Problems• Career Snapshots • PowerPoint Presentations

SOLUT IONS: CHECK YOUR UNDERSTANDING

Types of Pension Plans (p. 8)

1. A defined contribution plan is a type of employee pensionplan in which contributions are defined, but the amountthat will be paid upon retirement is not known untilretirement. A defined benefit plan is a type of employeepension plan in which the amount of future benefits isfixed, but an employer’s contributions vary dependingon assumptions about how much the fund will earn,when the money will be paid to retirees, and many othervariables.

2. When the assets of a pension plan are less than the futurepension liability, the pension plan is underfunded. Anunderfunded plan may cause employees concernbecause it could indicate that the employer will not beable to meet the obligations of the plan. It may causeinvestors concern because it could indicate that the com-pany has not planned well enough to meet its obligationsto its employees.

3. The Pension Benefit Guaranty Corporation (PBGC) is anational insurer of pension plans. When a companybecomes bankrupt and cannot meet its pension obliga-tion or when a pension plan becomes insolvent for otherreasons, the PBGC assumes the pension liability and willpay the retirement benefits (usually at a reduced level).

Accounting for a Defined Benefit Plan (p. 22)

1. The projected benefit obligation is defined as the presentvalue as of a specific date of all benefits earned by anemployee before that date. If the pension benefit formula

is based on future compensation levels, the projectedbenefit obligation is measured using assumptions aboutfuture salary increases.

2. The components of the pension expense model are serv-ice cost, prior service cost, interest cost, return on assets,and pension gains and losses.

3. Pension gains and losses can arise because of changes inthe pension assets or in the projected benefit obligation.

4. The funding status of overfunded pension plans shouldbe shown in the asset category of the balance sheet, andthe funding status of underfunded pension plans shouldbe shown as a liability on the balance sheet.

Postretirement Obligations (p. 27)

1. Education benefits, legal aid, relocation costs, and health-care benefits are examples of postretirement benefits.

2. Prior to SFAS No. 106, many companies did not recordthe expense for postretirement costs prior to payment.Essentially, they used a pay-as-you-go method, did notrecord the obligation for postretirement costs as a lia-bility on their financial statements, and often did noteven provide note disclosure of the obligation.

3. The appropriate measure of the liability for postretire-ment benefits is the accumulated postretirement benefitobligation, which is a measure of the present value ofthe postretirement benefits attributed to employee serv-ice up to the date of measurement. It does not considerany additional benefits that employees may earn in thefuture.


Presentation and Analysis of Pensions andPostretirement Plans (p. 33)

1. Companies may see an overfunded plan as a source ofcash and use a portion of the overfunding to meet otherfinancial needs. Companies with an overfunded planmay be potential merger or takeover targets, as othercompanies may want to use the overfunding to financetheir future activities.

2. Components that might be applicable to a reconciliationof the beginning and ending balances of a benefit obliga-

tion are as follows: service cost, interest cost, contribu-tions by plan participants, actuarial gains and losses,changes in foreign currency exchange rates, benefitspaid, plan amendments, business combinations, divesti-tures, curtailments, settlements, and special terminationbenefits.

3. Under IAS No. 19, pension plan assets and reimburse-ment rights should be measured at fair value.

08878 HM Ch15 - Cengagecollege.cengage.com/accounting/norton/intermediate/2e/... · 2008-06-26 · 15 CHAPTER FIFTEEN LEARNING OBJECTIVES Afterstudyingthischapter, youshouldbeableto:

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