Financial Accounting and Accounting Standards

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PART II Corporate Accounting Concepts and Issues
Lecture 23
Accounting for Pensions and Postretirement
Benefits
Instructor Adnan Shoaib
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Learning Objectives

1. Distinguish between accounting for the employers
   pension plan and accounting for the pension fund.
2. Identify types of pension plans and their
   characteristics.
3. Explain alternative measures for valuing the
   pension obligation.
4. List the components of pension expense.
5. Use a worksheet for employers pension plan
   entries.
6. Describe the amortization of prior service costs.
7. Explain the accounting procedure for unexpected
   gains and losses.
8. Explain the corridor approach to amortizing gains
   and losses.
9. Describe the requirements for reporting pension
   plans in financial statements.

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Accounting for Pensions and Postretirement
Benefits
Nature of Pension Plans
Accounting for Pensions
Using a Pension Worksheet
Reporting Pension Plans in Financial Statements

• Alternative measures of liability
• Recognition of net funded status
• Components of pension expense

• Defined contribution plan
• Defined-benefit plan
• Role of actuaries

• 2012 entries and worksheet
• Amortization of prior service cost
• 2013 entries and worksheet
• Gain or loss
• 2014 entries and worksheet

• Within the financial statements
• Within the notes to the financial statements
• Pension note disclosure
• 2015 entries and worksheeta comprehensive
  example
• Special issues

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Nature of Pension Plans

• An arrangement whereby an employer provides
  benefits to employees after they retire for
  services they provided while they were working.

Pension Plan Administrator
Contributions
Employer
Retired Employees
Benefit Payments
Assets Liabilities
LO 1 Distinguish between accounting for the
employers pension plan and accounting for the
pension fund.
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Nature of Pension Plans
Pension plans can be

• 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.
LO 1 Distinguish between accounting for the
employers pension plan and accounting for the
pension fund.
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Nature of Pension Plans
Defined-Contribution Plan
Defined-Benefit Plan

• Employer contribution determined by plan (fixed)
• Risk borne by employees
• Benefits based on plan value

• Benefit determined by plan
• Employer contribution varies (determined by
  Actuaries)
• Risk borne by employer

Actuaries estimate the employer contribution by
considering mortality rates, employee turnover,
interest and earning rates, early retirement
frequency, future salaries, etc.
LO 2 Identify types of pension plans and their
characteristics.
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Accounting for Pensions
Two questions

1. What is the pension obligation that a company
   should report in the financial statements?
2. What is the pension expense for the period?

LO 3 Explain alternative measures for valuing
the pension obligation.
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Accounting for Pensions
Alternative measures of the Liability
Employers pension obligation is the deferred
compensation obligation it has to its employees
for their service under the terms of the pension
plan.
FASBs choice
Illustration 20-3
LO 3 Explain alternative measures for valuing
the pension obligation.
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Accounting for Pensions
LO 4 List the components of pension expense.
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Accounting for Pensions
Components of Pension Expense
Effect on Expense
Service Costs

1.
Actuarial present value of new benefits earned by
employees during the period.
LO 4 List the components of pension expense.
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Accounting for Pensions
Components of Pension Expense
Effect on Expense
Interest on the Liability

2.
Interest for the period on the projected benefit
obligation outstanding during the
period. Interest rate (settlement rate) should be
those based rates of return on high-quality
fixed-income investments currently available,
whose cash flows match the timing and amount of
the expected benefit payments.
LO 4 List the components of pension expense.
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Accounting for Pensions
Components of Pension Expense
Effect on Expense
Actual Return on Plan Assets
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3.
Actual return on plan assets is the increase in
pension funds from interest, dividends, and
realized and unrealized changes in the
fair-market value of the plan assets.
Illustration 20-5
LO 4 List the components of pension expense.
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Accounting for Pensions
Components of Pension Expense
Effect on Expense
Amortization of Prior Service Costs

4.
Plan amendments often increase benefits for
service provided in prior years. Company
allocates the cost (prior service cost) of
providing these retroactive benefits to pension
expense in the future, specifically to the
remaining service-years of the affected employees.
LO 4 List the components of pension expense.
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Accounting for Pensions
Components of Pension Expense
Effect on Expense
Gain or Loss
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5.
Volatility in pension expense can result from
sudden and large changes in the fair value of
plan assets and by changes in projected benefit
obligation.
LO 4 List the components of pension expense.
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Using a Pension Work Sheet
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.
LO 5 Use a worksheet for employers pension plan
entries.
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Using a Pension Work Sheet
At January 1, 2012, Beaty Company had plan assets
of 280,000 and a projected benefit obligation of
the same amount. During 2012, service cost was
27,500, the settlement rate was 10, actual and
expected return on plan assets were 25,000,
contributions were 20,000, and benefits paid
were 17,500. Instructions Prepare a pension
worksheet for Beaty for 2012.
LO 5 Use a worksheet for employers pension plan
entries.
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Using a Pension Work Sheet
Prepare a pension worksheet for Beaty for 2012.
(280,000 x 10)
(10,500) net liability
LO 5 Use a worksheet for employers pension plan
entries.
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Using a Pension Work Sheet
Note the following about the Work Sheet

• The balance in the Pension Asset / Liability
  column should equal the net balance in the memo
  record this is the net funded position of the
  pension plan. If a credit balance, Pension
  liability if a debit balance, Pension asset.
• For each transaction or event, the debits must
  equal the credits.

LO 5 Use a worksheet for employers pension plan
entries.
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Prior Service Cost
Amortization of Prior Service Cost
Company should not recognize the retroactive
benefits as pension expense entirely in the year
of amendment. Employer should recognize the
pension expense over the remaining service lives
of the employees who are expected to benefit from
the change in the plan.

• Amortization Method
• Board prefers a years-of-service method.
• SFAS No. 158 allows use of the straight-line
  method.

LO 6 Describe the amortization of prior service
costs.
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Using a Pension Work Sheet
The following defined pension data of Rydell
Corp. apply to the year 2012.
Projected benefit obligation, 1/1/12 (before
amendment) 560,000 Plan assets, 1/1/12
546,200 Pension liability 13,800 On January 1,
2012, Rydell Corp., through plan amendment,
grants prior service benefits having a present
value of 120,000 Settlement rate 9 Service
cost 58,000 Contributions (funding)
65,000 Actual (expected) return on plan assets
52,280 Benefits paid to retirees 40,000 Prior
service cost amortization for 2012 17,000
Instructions For 2012, prepare a pension work
sheet for Rydell Corp. that shows the journal
entry for pension expense.
LO 6 Describe the amortization of prior service
costs.
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Using a Pension Work Sheet
(135,720) liability
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Using a Pension Work Sheet
Pension Journal Entry for 2012.
Dec. 31
Pension Expense 83,920 Other
Comprehensive Income (PSC) 103,000 Pension
Asset/Liability
121,920 Cash 65,000
LO 6 Describe the amortization of prior service
costs.
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Gains and Losses
Gain or Loss

• Unexpected swings in pension expense can result
  from
• Sudden and large changes in the fair value of
  plan assets, and
• Changes in actuarial assumptions that affect the
  amount of the projected benefit obligation.

LO 7 Explain the accounting for unexpected gains
and losses.
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Gains and Losses
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.
LO 7 Explain the accounting for unexpected gains
and losses.
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Gains and Losses
Question What happens to the difference between
the expected return and the actual return?
Answer
Recorded in Net Gain or Loss account. Amortize
amount in excess of corridor to pension expense,
over the average remaining service period of
active employees expected to receive benefits
under the plan.
LO 7 Explain the accounting for unexpected gains
and losses.
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Gains and Losses
Question What happens with unexpected gains or
losses from changes in the Projected Benefit
Obligation (PBO)?
Answer
Recorded in Net Gain or Loss account. Amortize
amount in excess of corridor to pension expense,
over the average remaining service period of
active employees expected to receive benefits
under the plan.
LO 7 Explain the accounting for unexpected gains
and losses.
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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.
LO 8 Explain the corridor approach to amortizing
gains and losses.
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Gains and Losses
Shin Corporation had a projected benefit
obligation of 3,100,000 and plan assets of
3,300,000 at January 1, 2012. Shins also had a
net pension actuarial loss of 465,000 in
accumulated OCI at January 1, 2012. The average
remaining service period of Shins employees is
7.5 years. Instructions Compute Shins minimum
amortization of the actuarial loss.
LO 8 Explain the corridor approach to amortizing
gains and losses.
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Gains and Losses
Compute Shins amortization of the loss.

LO 8 Explain the corridor approach to amortizing
gains and losses.
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Using a Pension Work Sheet
Jackson Company adopts acceptable accounting for
its defined benefit pension plan on January 1,
2011, with the following beginning balances plan
assets 200,000 projected benefit obligation
250,000. Other data are as follows.
LO 8 Explain the corridor approach to amortizing
gains and losses.
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Using a Pension Work Sheet
Pension Work Sheet for 2011

Expected Return on Plan Assets 200,000 x 10
20,000
(57,000)
LO 8 Explain the corridor approach to amortizing
gains and losses.
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Using a Pension Work Sheet
Pension Journal Entry for 2011
Pension Expense 21,000 OCI Gain/Loss
2,000 Pension Asset/Liability
7,000 Cash 16,000
Dec. 31
LO 8 Explain the corridor approach to amortizing
gains and losses.
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Using a Pension Work Sheet
Pension Work Sheet for 2012

Actual return Expected Return
(217,700) liability
LO 8 Explain the corridor approach to amortizing
gains and losses.
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Using a Pension Work Sheet
Pension Journal Entry for 2012
Dec. 31
Pension Expense 95,100 Other
Comprehensive Income (PSC) 105,600 Pension
Asset/Liability
160,700 Cash 40,000
LO 8 Explain the corridor approach to amortizing
gains and losses.
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Using a Pension Work Sheet
Pension Work Sheet for 2013

(203,400) liability
Plug
LO 8 Explain the corridor approach to amortizing
gains and losses.
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Using a Pension Work Sheet
Pension Journal Entry for 2013
Dec. 31
Pension Expense 89,370 Pension
Asset/Liability 14,300 Other Comprehensive
Income (G/L) 14,070 Other Comprehensive
Income (PSC) 41,600 Cash 48,000
LO 8 Explain the corridor approach to amortizing
gains and losses.
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Reporting Pension Plans in Financial Statements
Within the Financial Statements

• Pension expense
• Pension Asset / Liability
• Components of Accumulated Other Comprehensive
  Income

LO 9 Describe the requirements for reporting
pension plans in financial statements.
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Reporting Pension Plans in Financial Statements
Within the Notes to the Financial Statements

1. Major components of pension expense.
2. Reconciliation showing how the projected benefit
   obligation and the fair value of the plan assets
   changed.
3. A disclosure of the rates used in measuring the
   benefit amounts (discount rate, expected return
   on plan assets, rate of compensation).

LO 9 Describe the requirements for reporting
pension plans in financial statements.
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Reporting Pension Plans in Financial Statements
Within the Notes to the Financial Statements

1. A table indicating the allocation of pension plan
   assets by category (equity securities, debt
   securities, real estate, and other assets), and
   showing the percentage of the fair value to total
   plan assets.
2. The expected benefit payments to be paid to
   current plan participants for each of the next
   five fiscal years and in the aggregate for the
   five fiscal years thereafter. Also required is
   disclosure of a companys best estimate of
   expected contributions to be paid to the plan
   during the next year.

LO 9 Describe the requirements for reporting
pension plans in financial statements.
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Reporting Pension Plans in Financial Statements
Within the Notes to the Financial Statements

1. The nature and amount of changes in plan assets
   and benefit obligations recognized in net income
   and in other comprehensive income of each period.
2. The accumulated amount of changes in plan assets
   and benefit obligations that have been recognized
   in other comprehensive income and that will be
   recycled into net income in future periods.
3. The amount of estimated net actuarial gains and
   losses and prior service costs and credits that
   will be amortized from accumulated other
   comprehensive income into net income over the
   next fiscal year.

LO 9 Describe the requirements for reporting
pension plans in financial statements.
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Reporting Pension Plans in Financial Statements
Special Issues

• The Pension Reform Act of 1974
• Pension Terminations

LO 9 Describe the requirements for reporting
pension plans in financial statements.
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ACCOUNTING FOR POSTRETIRMENT BENEFITS
2012 Entries and Worksheet
Illustrative Accounting Entries

• Illustration The use of a worksheet in
  accounting for a postretirement benefits plan,
  assume that on January 1, 2012, Quest Company
  adopts a healthcare benefit plan. The following
  facts apply to the postretirement benefits plan
  for the year 2012.
• Plan assets at fair value on January 1, 2012, are
  zero.
• Actual and expected returns on plan assets are
  zero.
• Accumulated postretirement benefit obligation
  (APBO), January 1, 2012, is zero.
• Service cost is 54,000.
• No prior service cost exists.
• Interest cost on the APBO is zero.
• Funding contributions during the year are
  38,000.
• Benefit payments to employees from plan are
  28,000.

LO 11 Contrast accounting for pensions to
accounting for other postretirement benefits.
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ACCOUNTING FOR POSTRETIRMENT BENEFITS
2012 Entries and Worksheet
Illustrative Accounting Entries
Illustration 20A-4
Journal Entry
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ACCOUNTING FOR POSTRETIRMENT BENEFITS
Illustrative Accounting Entries
Recognition of Gains and Losses

• Gains and losses represent changes in the APBO or
  the value of plan assets. Gains and losses are
  recorded in other comprehensive income.
• The Corridor Approach
• Amortization Methods

LO 11 Contrast accounting for pensions to
accounting for other postretirement benefits.
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ACCOUNTING FOR POSTRETIRMENT BENEFITS
2013 Entries and Worksheet
Illustrative Accounting Entries

• Illustration The following facts apply to the
  postretirement benefits plan for Quest Company
  for the year 2013.
• Actual return on plan assets is 600.
• Expected return on plan assets is 800.
• Discount rate is 8 percent.
• Increase in APBO due to change in actuarial
  assumptions is 60,000.
• Service cost is 26,000.
• Funding contributions during the year are
  18,000.
• Benefit payments to employees during the year are
  5,000.
• Average remaining service to expected retirement
  25 years.

LO 11 Contrast accounting for pensions to
accounting for other postretirement benefits.
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ACCOUNTING FOR POSTRETIRMENT BENEFITS
2013 Entries and Worksheet
Illustrative Accounting Entries
Illustration 20A-6
Journal Entry
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ACCOUNTING FOR POSTRETIRMENT BENEFITS
Illustrative Accounting Entries
Amortization of Gains and Losses in 2014
Illustration 20A-8
LO 11 Contrast accounting for pensions to
accounting for other postretirement benefits.
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RELEVANT FACTS

• IFRS and GAAP separate pension plans into defined
  contribution plans and defined benefit plans. The
  accounting for defined contribution plans is
  similar.
• Both IFRS and GAAP compute unrecognized past
  service costs (PSC) (referred to as prior service
  cost in GAAP) in the same manner. However, IFRS
  recognizes any vested amounts immediately and
  spreads unvested amounts over the average
  remaining period to vesting. GAAP amortizes PSC
  over the remaining service lives of employees.

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RELEVANT FACTS

• Under IFRS, companies have the choice of
  recognizing actuarial gains and losses in income
  immediately (either net income or other
  comprehensive income) or amortizing them over the
  expected remaining working lives of employees.
  GAAP does not permit choice actuarial gains and
  losses are reported in Accumulated other
  comprehensive income and amortized to income
  over remaining service lives.
• For defined benefit plans, GAAP recognizes a
  pension asset or liability as the funded status
  of the plan (i.e., defined benefit obligation
  minus the fair value of plan assets). IFRS
  recognizes the funded status, net of unrecognized
  past service cost and unrecognized net gain or
  loss.

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End of Lecture 23