1 Pensions & Other Post Employment Benefits – after SFAS No. 158 Includes certain slides provided by authors of Skousen, Stice & Stice and Kieso, Weygandt.

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Pensions & Other Post Employment Benefits – after SFAS No. 158

Includes certain slides provided by authors of Skousen, Stice & Stice and Kieso, Weygandt & Warfield Intermediate Accounting textbooks, as modified and adapted by Teresa Gordon

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Contributory Plan Non-Contributory Plan Defined Contribution Plan Defined Benefit Plan

Types of plans

A Pension Plan is an arrangement whereby an employer provides benefits (payments) to employees after they retire for services they provided while they were working.

Pension PlanAdministratorPension PlanAdministrator

ContributionsEmployerEmployer

Retired Employees Benefit Payments Assets &

Liabilities

LO 1 Distinguish between accounting for the employer’s pension plan and accounting for the pension fund.

Nature of Pension PlansNature of Pension Plans

Some pension plans are:

LO 1 Distinguish between accounting for the employer’s pension plan and accounting for the pension fund.

Contributory: employees voluntarily make payments to increase their benefits.

Noncontributory: employer bears the entire cost.

Qualified pension plans: offer tax benefits.

Pension fund should be a separate legal and accounting entity.

Nature of Pension PlansNature of Pension Plans

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Defined contribution plans

A plan that provides benefits based solely on what has been contributed and the earnings thereon

< 401(k) > Amounts to be funded are determined

by the plan No promise for specific future

benefits. Independent third party holds assets Risk borne by employee Accounting relatively straightforward

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Defined benefit plans

A pension plan that determines the amount of benefit to be provided Contributions based on estimated

amounts needed to meet expected payments

Form versus substance of trust Risk borne by employer Accounting by employer is

complicatedActuaries estimate the employer contribution by considering mortality rates, employee turnover, interest and earning rates, early retirement frequency, future salaries, etc.

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Chart from UK but trend is probably same in US

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Defined Benefit Pension Plan

EmployerCurrent

Employees

Services

Wages and Salaries

Pension Fund

Con

trib

uti

on

s

Retired EmployeesDefined Benefits

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Pension Approaches

Before FASB 87 & 88: “pay as you go” or “noncapitalization”

FASB 87 & 88 Capitalization approach Full obligation reported only in notes

FASB 158 Pension & post-retirement benefit cost is

same as FASB 87 Full obligation is now reported on balance

sheet Additional items now on statement of

comprehensive income

Recognition of the Net Funded Status

Companies must recognize on their balance sheet the full overfunded or underfunded status of their defined-benefit pension plan.

The overfunded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation.

Accounting for PensionsAccounting for Pensions

LO 3 Explain alternative measures for valuing the pension obligation.

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Capitalization approach to pensions:

Employer has full liability for benefits related to service already rendered by employee Expense is recognized as employees work

(service cost) and this increases the liability

Liability balance increases every year since present value of future benefits is larger (less time remains to cash outflow) Liability is reduced through payments to

retirees

Assets of the plan are considered pledged, collateral against a liability Liability less designated assets reported on

balance sheet (net presentation)

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Measures of Pension Liability

VestedBenefit

Obligation

AccumulatedBenefit

Obligation

ProjectedBenefit

Obligation

Benefits forvestedemployeesat currentsalaries

Benefits for vested and non-vested employees at current salaries

Benefits for vested and nonvested employees at future salaries

(GAAP)

PV of ExpectedCash Flows

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Interest/return rates

Discount rate Rates on high-quality fixed-income

investments with maturities consistent with expected payments to retirees Generally equivalent to a portfolio of

zero-coupon bonds with appropriate maturities

Expected rate of return Based on long-term rate of return

anticipated given investment of plan assets

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What happens when

Interest rates increase?

Interest rates decrease?

Service Costs

Interest on the Liability

Actual Return on Plan Assets

Amortization of Prior Service Costs

Gain or Loss

+++-++-

Accounting for PensionsAccounting for Pensions

LO 4 List the components of pension expense.

Components of Pension Expense

1.

2.

3.

4.

5.

Effect on Expense

Companies do not recognize two main items in the accounts and in the financial statements:

Pension Items Not RecognizedPension Items Not Recognized

LO 5 Use a worksheet for employer’s pension plan entries.

Some items are recognized in other comprehensive income; changes in these items are amortized into expense through smoothing techniques.

Prior service costs.

Actuarial gains and losses.

A company must disclose in notes to the financial statements, but not in the body of the financials.

Projected benefit obligation.

Pension plan assets.

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A working paper for pensions

Pension Work SheetGENERAL JOURNAL ENTRIES MEMO RECORD

Prior Pension ProjectedPension Service Asset / Benefit Plan

Items Expense Cash Costs (PSC) Gain/Loss Liability Obligation Assets

Other Comprehensive Income (OCI)

This is very similar to the one in textbookThis is very similar to the one in textbook

LO 5 Use a worksheet for employer’s pension plan entries.

The “General Journal Entries” columns determine the journal entries to be recorded in the formal general ledger.

The “Memo Record” columns maintain balances for the unrecognized pension items.

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Accounts on Employer’s Books

Net Periodic Pension Cost (Expense) Amount recognized by the employer

on the income statement Pension expense includes six basic

elements (more later)Other comprehensive income Up to three amounts reported for

changes in balance of AOCI amounts (see next slide)

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Working Paper – Pension Expense

Pension Worksheet 1 2 3 4 5 6 7 8SFAS NO. 158

Income Stmt BS BS

Pension Expense Cash

Transition (Gain)/Loss

Net actuarial (gain)/loss

Prior Service Cost Funded Status

Projected Benefit

Obligation Plan Assets

BALANCE FORWARD

Service Cost

Interest Cost

Expected return on plan assets

Corridor Amount

AOCI Actuarial (BoY)

Excess

AMORTIZATIONS:

Unrecognized gain/loss

Prior Service Cost

Transition Amount

Contributions to Pension Plan

Retirement Benefits Paid by Plan

Actual Return on Plan Assets

Actuarial Adjustments to PBO

Amounts for journal entry:

AOCI balance forward

BALANCES AT YEAR END

Not on BooksMemorandum AmountsOther comprehensive income stmt

Accounts on Employer's Books

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A working paper for pensions

Interest cost = discount rate * beginning balance in PBO

Expected return = expected return rate * beginning balance in Plan Assets

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Accounts on Employer’s Books

On balance sheet – Net funded position When PBO > Plan Assets, reported as

noncurrent liability (with current liability if there are inadequate plan assets to cover current payments to retirees)

When Plan Assets > PBO, reported as noncurrent asset

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A working paper for pensions

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Accounts on Employer’s Books

Accumulated other comprehensive income (AOCI) Account appears as part of owners’

equity section of balance sheet Three pension related balances

Transition gain or loss Prior service cost Actuarial gains or losses

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A working paper for pensions

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Self-checking featuresEach blue row

must add across to

ZERO

Balance forwards

Balance forwards

Funded status

must equal PBO + Plan

Assets

Plug to balance

JE {row=0

}

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Net Periodic Pension Cost

Net periodic pension cost (the expense) consists of six basic elements: Service cost Interest cost Expected return on plan assets Amortization (if any) of

Transition gain or lossPrior service costUnrecognized gain or loss

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Pension DefinitionsPrior Service Cost (PSC) Cost of benefits granted for service

rendered prior to the inception of the plan Increases PBO at date of amendment but

cost is amortized to expense over future years

Reduces funded status since PBO is higher Recognized as charge to OCI at date of

plan amendment Amortization method recommended:

Years of service method Straight-line or other methods that

amortize PSC faster are also acceptable

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Actuarial Gains and Losses

Actuarial assumptions are subject to inaccuracies as time goes by and circumstances change There is a materiality provision for

determining when gains and losses are sufficiently large to require amortization (charge to expense) 10% Corridor Rule

Question: What is the potential negative impact on Net Income of these unexpected swings?

Volatility

The profession decided to reduce the volatility with smoothing techniques.

Gains and LossesGains and Losses

LO 7 Explain the accounting for unexpected gains and losses.

Corridor Amortization

FASB invented the corridor approach for amortizing the accumulated net gain or loss balance when it gets too large. How large is too large?

10% of the larger of the beginning balances of the projected benefit obligation or the market-related value (which may equal fair value) of the plan assets.

Any accumulated net gain or loss balance above the 10% must be amortized.

Gains and LossesGains and Losses

LO 8 Explain the corridor approach to amortizing gains and losses.

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Kieso, Weygandt & Warfield 11th ed. Illustration 20-14, page 1034

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10% Corridor Amortization

Amortization is required only on the portion of unrecognized net gain or loss that exceeds 10% of the greater of: PBO at beginning of

year, or market-related value

of plan assets at the beginning of the year.

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Settlements & Curtailments

Additional FASB standards govern major changes in pension plans: Settlements

No further obligations to some or all employees

Curtailments Results in significant reduction in expected

years, or No further accrual of benefits

Handling will require further research (primarily FASB 88)

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Pension Disclosures [FAS 132(R)]

Amount and types of assets held Assumptions related to discount rate,

rate of increase in compensation, expected return on plan assets

Alternative amortization policies Past practice or history of regular

benefit increases

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Pension Disclosures [FAS 132(R)]

The details for net periodic pension cost the service cost component. the interest cost component. the expected return on plan assets

[FAS 132] the amortization of PSC, transition

amount and unrecognized gain/loss (separately)

Gain or loss from settlement or curtailment of plan

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Pension Disclosures:Reconciliations

The fair value of plan assets (changes between BOY and EOY)PBO Obligation (changes between BOY and EOY)

Easily obtained from our work paper!

EoY = end of yearBoY = beginning of year

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Pension DisclosuresEmployers with multiple plans Information can be combined but the

computations are made for each individual plan Net position for over-funded plans would

be reported in noncurrent assets Net position for under-funded plans would

be reported in liabilities Part may be reported as a current

liability See next slide

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Current portion of liability

The current portion (determined on a plan-by-plan basis) is the amount by which the actuarial present value of benefits in PBO that are payable in the next 12 months* exceeds the fair value of plan assets* As always, the operating cycle might be

longer than 12 months in which case we’d use the operating cycle

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Other Postretirement Benefits

FASB 106

Appendix Material in KWW textAlso changed by FASB No. 158

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Other Post-retirement Benefits

The accounting is similar to pension accounting EXCEPT that the terminology is slightly

differentEPBOAPBO

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Kieso, Weygandt & Warfield 11th ed. Illustration 20A-3, page 1056

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APBO vs EPBO

Prior to the date on which an employee attains full eligibility for the benefits that employee is expected to earn APBO < EPBO

On and after the full eligibility date, APBO = EPBO

In other words EPBO > APBO until the employee has

earned the right to full benefits EPBO = APBO after the employee has

worked long enough to earn full eligibility

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Kieso, Weygandt & Warfield 11th ed. Illustration 20A-2, page 1056

Cost attributed to period from hire to eligibility (vesting)

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Postretirement Benefit Worksheet

Would be the same as a pension worksheet with modified labels at the top Pension Expense becomes

Postretirement Benefit Expense. PBO becomes APBO.

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Working paper for FAS106

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Net periodic postretirement benefit cost.

The expense basically includes the same elements as pension cost: Service cost -- the actuarial present value

of benefits attributed to services rendered by employees during the period.

Interest cost -- the interest on the beginning balance of the accumulated postretirement benefit obligation

Less expected return on plan assets. Amortizations (transition, prior service cost

and unrecognized gain or loss)

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Comparing FASB 87 & 106 Pension benefits Other postretirement benefits

Name of obligation Projected benefit obligation (PBO)

Accumulated postretirement benefit obligation (APBO)

Components of benefit cost

Service cost Interest cost (Expected return) Amortization of

Prior service cost Transition amount Excess gain/loss

Service cost Interest cost (Expected return) Amortization of

Prior service cost Transition amount Excess gain/loss

Plan Assets Most pension plans have assets set aside in a trust which generate returns that help offset the interest cost component of benefit cost.

These arrangements are rarely funded, that is, there are probably no plan assets and therefore no deduction for expected return on plan assets in the computation of postretirement benefit cost.

Disclosure requirements

Extensive, including reconciliation of change in PBO and plan assets

Same as pension but additional disclosures regarding health care inflation rate assumptions and impact

iGAAP and U.S. GAAP separate pension plans into defined-contribution plans and defined-benefit plans. The accounting for defined-contribution plans is similar.

For defined-benefit plans, both iGAAP and U.S. GAAP recognize the net of the pension assets and liabilities on the balance sheet. Unlike U.S. GAAP, which recognizes prior service cost on the balance sheet (as an element of “Accumulated other comprehensive income”), iGAAP does not recognize prior service costs on the balance sheet. Both GAAPs amortize prior service costs into income over the expected service lives of employees.

Another difference in defined-benefit recognition is that under iGAAP companies have the choice of recognizing actuarial gains and losses in income immediately or amortizing them over the expected remaining working lives of employees. U.S. GAAP does not permit choice.

The IASB has recently issued a discussion paper on pensions proposing: (1) elimination of smoothing via the corridor approach, (2) a different presentation of pension costs in the income statement, and (3) a new category of pensions for accounting purposes—so-called “contribution-based promises.”