April 7_Ch 20 Part I

8/11/2019 April 7_Ch 20 Part I

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Lecture 14

Pensions, Part I

Material to be covered:Kieso/Weygandt/Warfield, Chapter 20

Warren Buffett Says That Pension Accounting Encourages Cheating

Rewriting Pension History


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Why the Pension Gap is Soaring (Source: WSJ Feb. 25, 2013)


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

Pension Plan Administrator

Employer

RetiredEmployees Benefit Payments Assets &

Liabilities

Nature of Pension Plans
http://www.art.com/asp/sp.asp?PD=10036788&T=15040065&RFID=571189


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Pension: An agreement between employer and employees that determines

i. what benefits will be paid to the employees upon retirementii. how these benefits will be earned by the employees

iii. what procedures are required by the employer to provide for the benefits.

Pension fund is administered by a separate legal entity (Trust), who invests funds in capital assets(stocks, bonds, real estate, etc.) to earn additional funds.

Accounting for pension plans is complex because the measurement and recognition of pensionexpense and liability depend upon uncertain future variables.Example: An employer has a group of employees who will be retiring at the age of 62. Under the terms of thepension plan, they will receive 80% of their final salary each year after retirement for the rest of their lives.

What are the uncertainties associated with this pension plan?

a. How long will the employees live beyond age 62?

b. How many employees stay with the company until retirement age?

c. What will be the final salary?

d. What will be the return on the pension fund assets?

e. How much are these future payments worth today?

Numerous factors creating uncertainties as to what the pension liability will be. Need help of aspecialist, Actuary. The actuary gives estimates based on actuarial assumptions.

Overview of Pension Plans


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Two Types of Pension Plans (1)


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.

The employers pensionobligation is the deferredcompensation obligation ithas to its employees fortheir service under theterms of the pension plan.

FASBschoice

Alternative measures of the Liability

Accounting for Pensions

Illustration 20-3


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Pension liability = PV of promised benefits to be provided at retirement.(1) Vested Benefit Obligation:

Vested benefits: The employee is entitled to the benefits even if he/she renders no moreservices to the employer under the plan. Under most plans, a certain minimum number ofyears of service to the employer is required before the benefit is vested. Vested BenefitObligation includes only vested benefits computed using current salary levels, i.e., ignoresyears of non-vested employment and the possibility of future increase in salaries.

(2) Accumulated Benefit Obligation:

Includes all benefits, vested and non-vested, computed using current salary levels.(3) Projected Benefit Obligation:

Includes all benefits, both vested and non-vested, computed using future (projected)salary levels. By definition, VBO < ABO < PBO.

Which measure did the accounting profession adopt?

In general, the profession adopted the PBO (Conservatism!). However, the ABO is usedin certain situations. Information on VBO is also required to be disclosed.

Alternative Measures of Pension Obligation


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Accounting for a Defined Benefit Plan

To understand the accounting for a defined benefit pension plan, it is useful to think of the plan as a single entitymade up of two basic components which comprise the net pension asset or liability reported in the employers

balance sheet:i. the pension plan assets, available to provide benefits to the employees in accordance with the terms of

the plan

ii. the pension plan liability, representing the employers obligation to its employees under the terms of theplan

In addition to these basic balance sheet accounts, there may be other valuation accounts which serve to modifythe reported value of the pension asset and/or liability.

The periodic costs of the plan, representing certain changes in the components of the net pension asset(liability), are reported in the income statement as the net pension cost (expense).Plan Assets

(at Fair Value)EmployerContribution

ROI of planassets

Settlement toretired

employees

Pension Liability (PBO)

Settlement toretiredemployees

Service cost

Interest cost

Pension PlanBalance

Sheet

Net PensionCost/Benefit

Service cost

Interest cost

ROI of planassets

Pension PlanIncome

Statement


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(1) Capitalization Approach: Supports the substance over legal form of a pension plan ( Capitalize, i.e., recognize the assets and liabilities held by the pension plan).

(2) Noncapitalization Approach: Looks at the form of a pension plan (i.e., it is a separatelegal entity). That is, assets and liabilities held by a pension trust are separate from theemployer's assets and liabilities ( Pension assets and liabilities held by a pension trustare not recognized).

3) FASBs position ( SFAS No. 87 & SFAS No. 158 ):

The FASB favored the capitalization approach because it is more sound conceptually.However, the capitalization approach was strongly opposed by many companies (Why?). Itsadoption would have forced them to recognize a huge amount of pension liability that hadnot been reported before.

SFAS No. 87 and the amendment in SFAS No. 158 represent a compromise that combinessome of the features of capitalization with some of the features of noncapitalization. Only thenet pension plan asset or liability is recorded (i.e., net funded status). The plans assetsand liabilities are not reported as being those of the firm.

Conceptual Approaches to Pension Accounting
http://www.fasb.org/pdf/fas87.pdfhttp://www.fasb.org/pdf/fas158.pdfhttp://www.fasb.org/pdf/fas158.pdfhttp://www.fasb.org/pdf/fas87.pdf


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Interest on the pension liability.Since the pension liability is the PV (discounted value) of future compensation, ithas a cost related to the time value of money (i.e., interest).

Interest expense accrues each year.Interest cost = Beginning balance of PBO x interest rate.

Interest rate selected by the actuary is called settlement rate. Example: At 1/1, Iris Co. has a $2,500,000 PBO. The settlement rate given by theactuary is 10%.

[Conceptual Entry] 12/31:

Pension Expense 250,000

PBO 250,000

Components (2): Interest Cost


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Pension plan assets are increased by (i) employer contributions and (ii) actualreturns on the assets.Plan assets are decreased by benefits paid to retired employees.The actual return on the pension plan assets reduces the employers cost ofproviding pension benefits, i.e., the higher the actual return, the less the employerhas to contribute eventually and thus the less pension expense.

Actual return on plan assets reduces pension expense for a given period (as long asthe return is positive).Note that contributions to the plan assets and benefits paid out do not affectpension expense.

Example: The actual return on the pension plan assets for Iris Co. is $300,000.[Conceptual Entry] 12/31:

Plan Assets 300,000

Pension Expense 300,000

Plan Assets is an off -B/S account.

Components (3): Actual Return on Plan Assets


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The Pension Work Sheet

Pension Asset/Liability

Pension Asset/Liability............... .


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Amortization of Prior Service Costs (1)

Example (continued): (i) Years-of-service method


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A. Actuarial assumptions (about mortality, turnover, longevity, salary levels, etc.)

are often modified in light of actual realizations to make the assumptions morereliable.

Changes in actuarial assumptions result in changes in the PBO (i.e., loss =increase in PBO due to changes in actuarial assumptions; gain = decrease inPBO).

Since these gains and losses are associated with a liability (i.e., PBO), they arecalled liability gains and losses. B. Actual return on plan assets reduces pension expense.

Sudden and large changes in the market value of plan assets (return on planassets) can cause pension expense to fluctuate substantially.

Large swings in pension expense and net income due to changes in actuarialassumptions and actual returns on plan assets are viewed by some as harmful tothe employer company.

As a result, some smoothing techniques that dampen the swings in (A) and (B)

were adopted by the FASB.

Components (5): Gain or Loss


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In general, do not include unexpected liability gain or loss in pension expense.These gains and losses are recorded in a Net Gain or Loss account, which belongs toother comprehensive income (OCI).

Liability gains and losses are combined with asset gains and losses in the same account.Example: At 12/31, the actuary of Iris Co. has changed some actuarial assumptions.This results in an increase in the PBO of $350,000.

[Conceptual Entry] 12/31:

Net Gain or Loss OCI 350,000

PBO 350,000

Smoothing Gains & Losses on Pension Liability


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April 7_Ch 20 Part I

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