Intermediate Accounting II

Chapter 20

Accounting for Pensions

Overview of Employer's Accounting for Pension Plans

• Defined contribution plan - employer agrees to make a defined contribution to a pension plan

• plan participants receive whatever benefits have accumulated

• each year, employer records an expense an a related liability for the contribution

• Defined benefit plan - employer agrees to provide a benefit at retirement that is defines or fixed by formula

• employer accepts risk of meeting the obligation upon employee's retirement

• requires use of complex actuarial estimates

• Involves 2 accounting entities

• employer sponsor - reports pension expense on the income statement, and apension liability which is the sum of two accounts - accrued/prepaid pension cost and additional liability, and an intangible asset -deferred pension cost (if required)

• employee sponsor must also maintain these accounts on a memo basis -unrecognized prior service costs and unrecognized gains and losses

• pension plan - maintains these accounts: projected benefit obligation,accumulated benefit obligation (for reporting purposes only), vested benefits (for reporting purposes only) and plan assets

Terminology

• Accumulated Benefit Obligation (ABO) - actuarial present value of benefits (vested or unvested) attributed by the pension benefit formula to employee services rendered before a specified date, and based on employee service and compensation prior to that date. The ABO differs from the PBO in that it includes no assumptions about future compensation levels.

• Actual return on plan assets - difference between fair value of plan assets at the end of the period and the fair value at the beginning of the period, adjusted for contributions and payments of benefits.

• Expected return on plan assets - amount calculated as a basis for determining the extent of delayed recognition of the effects of changes in the fair value of assets.

• Gain or loss - change in the value of either the PBO or the plan assets resulting from experience different from that assumed or from a change in actuarial assumption. See also "unrecognized net gain or loss".

• Plan amendment - change in the terms of an existing plan or the initiation of a new plan.

• Prior service cost (PSC) - cost of retroactive benefits granted in a plan amendment. See also "unrecognized prior service cost".

• Projected benefit obligation (PBO) - actuarial present value as of a date of all benefits attributed by the pension benefit formula to employee service rendered prior to that date. The PBO is measured using assumptions as to future compensation levels if the pension benefit formula is based on those future compensation levels (pay-related, final-pay, etc. plans)

• Retroactive benefits - benefits granted in a plan amendment that are attributed by the pension benefit formula to employee services rendered in periods prior to the amendment. The cost of retroactive benefits is referred to as prior service cost.

• Service - employment taken into consideration under a pension plan. Years of employment before the inception of a plan constitute an employee's past service; years thereafter are classified in relation to the particular actuarial valuation being made. Years of employment prior to the date of a particular valuation constitute prior service.

• Unrecognized net gain or loss - cumulative net gain(loss) that has not been recognized as a part of net periodic pension expense.

• Unrecognized prior service cost - portion of prior service cost that has not been recognized as a part of the net pension expense

Calculating Pension Expense

• Pension Expense is a net amount calculated by combining the following 5 items

• service cost

• interest on the projected benefit obligation

• actual return on plan assets

• amortization of unrecognized prior service cost

• effects of gains and losses

• Pension expense is included in the income statement, the components are disclosed

Service Cost

• increases pension expense

• df - actuarial present value of benefits attributed to employee service during the current year

• takes future salary levels into consideration (uses the benefits/years of service approach)

• in the worksheet, the amount of service cost is accounted for by debiting Pension expense (income statement account) and crediting PBO (off-balance sheet account -memo)

Interest on Projected Benefit Obligation (PBO)

• increases pension expense

• df - increase in the amount of the PBO due to the passage of time.

• interest rate is called the settlement rate (reflects the rates at which pension benefits are expected to be settled)

• Interest for the year is calculated on the PBO at the beginning of the year (ie use simple interest)

• in the worksheet, interest is accounted for by debiting Pension expense (income statement account) and crediting PBO (off-balance sheet account)

Actual Return on Plan Assets

• decreases pension expense when return is positive, increases pension expense when return is negative (ie, the more the assets increase in value, the less the employer has to contribute to cover pension costs)

• df = (change in the FV of the plan assets from the beginning to the end of the year) + benefits paid to employees - contributions from employer

• NOTE: although the actual return on plan assets is measured and disclosed as one of the components of pension expense

• net pension expense will only include an amount equal to the expected return for plan assets

• difference between actual and expected return on plan assets will be included in thegain or loss calculation discussed below

• in the worksheet, a positive return on assets is accounted for by debiting Plan Assets (off-balance sheet account) and crediting Pension Expense (income statement account)

Prior Service Cost - PSC

• increases or possibly decreases pension expense

• df - retroactive adjustments that are granted to recognize employee services rendered in previous periods

• these costs are caused by an amendment to an existing plan or initiation of a new plan

• if amendment will increase benefits to employees, then PBO will increase

• PSC = increase in the PBO caused by the retroactive adjustment

• PSC should be amortized over the present and future periods affected

• Amortization using the expected future years of service

• calculate total number of employee service years - group according to time until retirement

• calculate cost per service year = PSC (at the beginning of the year) / total employee service years

• amortization = cost per service year * total service years applicable to the current year

• in the worksheet. amortization of PSC is accounted for by debiting Pension expense (income statement account) and crediting unrecognized PSC (off-balance sheet account)

Gain or Losses

• increases or decreases pension expense

• df - change in the amount of the PBO and the change in the value of the plan assets (realized and unrealized) resulting from

• experience being different from that assumed, or

• change in an actuarial assumption

• 3 calculations

• current period differences between actual and expected returns on assets - affect pension expense

• current period differences between actual and expected PBO - does not affect pension expense (completely off-balance sheet)

• amortization of unrecognized gain or loss from previous periods - affects pension expense

• 1st Calculation - Plan Assets

• difference between actual return on assets and expected return on assets = unexpected gain or loss

• unexpected loss means that actual return is less than expected, and unexpected gain means that actual return is more than expected

• in the worksheet, an unexpected loss is accounted for by debiting Unrecognized Net Gain/Loss (off-balance sheet acct) and crediting Pension Expense (income statement acct)

• 2nd Calculation - PBO

• difference between expected and actual amount of PBO

• Liability gain means that the expected amount of PBO is greater than actual, and a liability loss means that the expected amount of the PBO is less than actual

• in the worksheet, the accounting for a liability loss is by debiting Unrecognized Net Gain/Loss (off balance sheet acct) and crediting PBO (off-balance sheet acct)

• NOTE: even though a liability loss/gain does not affect pension expense in the year it occurs, the balance of the unrecognized net gain/loss account is subject to amortization the next year - see next step

• 3rd Calculation - Amortization of previous unrecognized gain/loss

• amortization is similar to amortization of PSC

• don't amortize the full balance in the unrecognized net gain/loss account

• calculate the corridor = 10% * larger of either the PBO or plan assets

• difference between balance in the unrecognized net gain/loss account (at beginning of year) and the corridor is subject to amortization (no amortization if acct balance is < = corridor)

• amortization = difference from part 2 above, divided by average remaining service life

• in the worksheet, amortization is accounted for by debiting Pension Expense (Income Statement acct) and crediting Unrecognized Net Gain/Loss (off balance sheet)

Using the worksheet

• divide into financial statement accounts and memo or off-balance sheet accounts

• record all entries in the worksheet as described previously

• also record contributions to the plan and benefits paid to employees in the worksheet by

• debiting Plan Assets (off-balance sheet acct) and crediting Cash (balance sheet acct)

• debiting PBO (off-balance sheet acct) and crediting Plan Assets (off-balance sheet acct)

• Entry to record pension expense - on the books - debit Pension Expense (total from worksheet), credit Cash (total from worksheet) and debit or credit Prepaid/Accrued Cost (plug figure)

• Reconciliation to prepaid/accrued costs balance - should equal the sum of all entries on the worksheet to off-balance sheet accounts

Minimum Liability

• must be recognized when the accumulated benefit obligation (not the same as the projected benefit obligation or PBO) at year end > fair value of plan assets at year end

• Process

• Compare accumulated benefit obligation (ABO) to plan assets at FV

• if ABO > plan assets, difference = unfunded obligation (minimum liability)

• adjust minimum liability for prepaid/accrued pension cost account (subtract accrued liability, add prepaid cost)

• difference = additional liability required to be booked

• in the worksheet, additional liability is accounted for by debiting Intangible Pension Asset (balance sheet acct) and crediting Additional Pension Liability (balance sheet acct)

• NOTE - the Intangible Pension Asset can't be bigger than the unrecognized PSC acct, if it is,

• debit Intangible Pension asset for an amount that makes the balance equal to PSC

• debit contra equity acct - for the excess

• credit Additional Pension Liability

• NOTE - the additional liability account is combined with the balance in the Accrued/Prepaid Pension cost account to arrive at a single amount reported in the balance sheet as pension liability

Disclosures

• description of the plan including

• benefit formula

• employee groups covered

• funding policy

• types of assets held

• amounts of the components of pension expense for the period

• reconciliation schedule relating the funding status of the plan to the

• FV of plan assets

• projected benefit obligation

• accumulated benefit obligation

• vested benefit obligation

• unrecognized prior service cost

• unrecognized net gain or loss

• additional liability

• end of period prepaid or accrued pension cost balance

• amount of remaining net asset of liability

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