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Pensions and Other Postretirement Benefits

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1 Pensions and Other Postretirement Benefits
17 Pensions and Other Postretirement Benefits Chapter 17: Pensions and Other Postretirement Benefits Employee compensation comes in many forms. Salaries and wages, of course, provide direct and current payment for services provided. However, it’s commonplace for compensation also to include benefits payable after retirement. We discuss pension benefits and other postretirement benefits in this chapter. Accounting for pension benefits recognizes that they represent deferred compensation for current service. Accordingly, the cost of these benefits is recognized on an accrual basis during the years that employees earn the benefits. McGraw-Hill/Irwin 2011, Royal University of Law and Economics

2 Nature of Pension Plans
Pension plans provide income to individuals during their retirement years. This is accomplished by setting aside funds during an employee’s working years so that at retirement, the accumulated funds plus earnings from investing those funds are available to replace wages. Pension plans are designed to provide income to individuals during their retirement years. This is accomplished by setting aside funds during an employee’s working years so that at retirement the accumulated funds plus earnings from investing those funds are available to replace wages. The basic nature of a pension plan is that the company and/or the employees make contributions to a fund manager. The manager invests the funds and makes payments to retired employees. The amount of the contributions to the fund manager is often determined by an actuary. Corporations establish pension plans for a variety of reasons. Sponsorship of pension plans provides employees with a degree of retirement security and fulfills a moral obligation felt by many employers. This security also can induce a degree of job satisfaction and perhaps loyalty that might enhance productivity and reduce turnover. Motivation to sponsor a plan sometimes comes from union demands and often relates to being competitive in the labor market.

3 Nature of Pension Plans
For a pension plan to qualify for special tax treatment it must meet the following requirements: Cover at least 70% of employees. Cannot discriminate in favor of highly compensated employees. Must be funded in advance of retirement through an irrevocable trust fund. Benefits must vest after a specified period of service. Complies with timing and amount of contributions. When established according to tight guidelines, a pension plan gains important tax advantages. Such arrangements are called qualified plans because they qualify for favorable tax treatment. In a qualified plan, the employer is permitted an immediate tax deduction for amounts paid into the pension fund (within specified limits). The employees, on the other hand, are not taxed at the time employer contributions are made—only when retirement benefits are received. Moreover, earnings on the funds set aside by the employer are not taxed while in the pension fund, so the earnings accumulate tax free. If you are familiar with the tax advantages of IRAs, you probably recognize the similarity between those individual plans and corporate pension arrangements. For a pension plan to be qualified for special tax treatment it must meet these general requirements. It must cover at least 70% of employees. It cannot discriminate in favor of highly compensated employees. It must be funded in advance of retirement through contributions to an irrevocable trust fund. Benefits must vest after a specified period of service, commonly five years. (We discuss this in more detail later.) It complies with specific restrictions on the timing and amount of contributions and benefits.

4 Nature of Pension Plans
Defined contribution pension plans promise fixed annual contributions to a pension fund (say, 5% of the employees’ pay). Employees choose (from designated options) where funds are invested—usually stocks or fixed-income securities. Retirement pay depends on the size of the fund at retirement. Defined benefit pension plans promise fixed retirement benefits defined by a designated formula. Typically, the pension formula bases retirement pay on the employees’ (a) years of service, (b) annual compensation (often final pay or an average for the last few years), and sometimes (c) age. Employers are responsible for ensuring that sufficient funds are available to provide promised benefits. Today, more than two-thirds of workers covered by pension plans are covered by defined contribution plans, fewer than one-third by defined benefit plans. This represents a radical shift from previous years when the traditional defined benefit plan was far more common.

5 Defined Contribution Pension Plans
Plan Characteristics Contributions are defined by agreement. Employer deposits an agreed-upon amount into an employee-directed investment fund. Employee bears all risk of pension fund performance. Defined contribution pension plans are becoming increasingly popular vehicles for employers to provide retirement income without the paperwork, cost, and risk generated by the more traditional defined benefit plans. Defined contribution plans promise fixed periodic contributions to a pension fund. Retirement income depends on the size of the fund at retirement. No further commitment is made by the employer regarding benefit amounts at retirement. The employee bears all the risk of pension fund performance. There is no guarantee as to the actual amount of retirement benefits that will be paid to the employee.

6 Defined Contribution Pension Plans
Let’s assume that the annual contribution is to be 3% of an employee’s salary. If an employee earned $110,000 during the year, the company would make the following entry: Pension expense 3,300 Cash ,300 Accounting for these plans is quite simple. We debit pension expense and credit cash for contributions made by employers. In this example, the employer contributed $3,300 to the plan, so we debit pension expense for $3,300 and credit cash for the same amount. The employee’s retirement benefits are totally dependent upon how well investments perform. Who bears the risk (or reward) of that uncertainty? The employee would bear the risk of uncertain investment returns and, potentially, settle for far less at retirement than at first expected. On the other hand, the employer would be free of any further obligation. Because the actual investments are held by an independent investment firm, the employer is free of that recordkeeping responsibility as well. The employee’s retirement benefits are totally dependent upon how well investments perform.

7 Defined Benefit Pension Plans
Plan Characteristics Employer is committed to specified retirement benefits. Employer bears all risk of pension fund performance. Retirement benefits are based on a formula that considers years of service, compensation level, and age. Defined benefit plans promise fixed retirement benefits defined by a designated formula. Uncertainties complicate determining how much to set aside each year to ensure that sufficient funds are available to provide promised benefits. The employer bears all the risks of pension fund performance. Our Social Security system is a defined benefit pension plan.

8 Defined Benefit Pension Plan
A pension formula might define annual retirement benefits as: 1 1/2 % x Years of service x Final year’s salary By this formula, the annual benefits to an employee who retires after 30 years of service, with a final salary of $100,000, would be: 1 1/2 % x 30 years x $100,000 = $45,000 A typical formula might specify that a retiree will receive annual retirement benefits based on the employee’s years of service and annual pay at retirement (say, pay level in the final year, highest pay achieved, or average pay in the last two or more years). For example, a formula might define annual retirement benefits as 1½ percent times the number of years of service times the employee’s annual salary during the last year before retirement. By this formula, the annual benefits to an employee who retires after 30 years of service, with a final salary of $100,000, would be: 1½% x 30 years x $100,000 = $45,000.

9 Defined Benefit Pension Plan
An actuary assesses the various uncertainties (employee turnover, salary levels, mortality, etc.) and estimates the company’s obligation to employees in connection with its pension plan. The key elements of a defined benefit pension plan are: The employer’s obligation to pay retirement benefits in the future. The plan assets set aside by the employer from which to pay the retirement benefits in the future. The periodic expense of having a pension plan. Typically, a firm will hire an actuary, a professional trained in a particular branch of statistics and mathematics, to assess the various uncertainties (employee turnover, salary levels, mortality, etc.) and to estimate the company’s obligation to employees in connection with its pension plan. The key elements of a defined benefit pension plan are: The employer’s obligation to pay retirement benefits in the future. The plan assets set aside by the employer from which to pay the retirement benefits in the future. The periodic expense of having a pension plan. Neither the pension obligation nor the plan assets are reported individually in the balance sheet. This may seem confusing at first because it is inconsistent with the way you’re accustomed to treating assets and liabilities. Even though they are not separately reported, it’s critical that you understand the composition of both the pension obligation and the plan assets because (a) they are reported as a net amount in the balance sheet, and (b) their balances are reported in disclosure notes. And, importantly, the pension expense reported in the income statement is a direct composite of periodic changes that occur in both the pension obligation and the plan assets.

10 Pension Expense—An Overview
The annual pension expense reflects changes in both the pension obligation and the plan assets. The annual pension expense reflects changes in both the pension obligation and the plan assets. The graphic on this slide provides a brief overview of how these changes are included in pension expense. We will explore each of these pension expense components in the context of its being a part of either (a) the pension obligation or (b) the plan assets.

11 The Pension Obligation
Accumulated benefit obligation (ABO) The actuary’s estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels. Vested benefit obligation (VBO) The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment. Projected benefit obligation (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same. There are three different ways to measure the pension obligation that have meaning in pension accounting: Accumulated benefit obligation (ABO) The actuary’s estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels. Vested benefit obligation (VBO) The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment. Projected benefit obligation (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.

12 The Pension Obligation
Vested benefits are those that employees have the right to receive even if their employment were to cease today. Pension plans typically require some minimum period of employment before benefits vest. Beginning in 1989, benefits must vest (a) fully within five years or (b) 20% within three years with another 20% vesting each subsequent year until fully vested after seven years. Five-year vesting is most common. The vested benefit obligation is actually a subset of the ABO, the portion attributable to benefits that have vested. The accumulated benefit obligation (ABO) is an estimate of the discounted present value of the retirement benefits earned so far by employees, applying the plan’s pension formula using existing compensation levels. The accumulated benefit obligation ignores possible pay increases in the future. Since it’s unlikely that there will be no salary increases between now and retirement, a more meaningful measurement should include a projection of what the salary might be at retirement. Measured this way, the liability is referred to as the projected benefit obligation (PBO). The PBO measurement may be less reliable than the ABO but is more relevant and representationally faithful.

13 Projected Benefit Obligation
The PBO is a more meaningful measurement because it includes a projection of what the salary might be at retirement. Jessica Farrow was hired by Global Communications in She is eligible to participate in the company's defined benefit pension plan. The benefit formula is: Annual salary in year of retirement × Number of years of service × 1.5% Annual retirement benefits Farrow is expected to retire in 2039 after 40 years of service. Her retirement period is expected to be 20 years. At the end of 2009, 10 years after being hired, her salary is $100,000. The interest rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement. In the next few slides, we will show you how the actuary calculates the present value of the projected benefit obligation for a single employee. Keep in mind that the in actuality, calculations would be made by the actuary for the entire employee pool rather than on an individual-by-individual basis. Jessica Farrow was hired by Global Communications in She is eligible to participate in the company's defined benefit pension plan. The benefit formula is: Annual salary in year of retirement × Number of years of service × 1.5% Annual retirement benefits Farrow is expected to retire in 2039 after 40 years of service. Her retirement period is expected to be 20 years. At the end of 2009, 10 years after being hired, her salary is $100,000. The interest rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement.

14 Projected Benefit Obligation
Step 1. Use the pension formula to determine the retirement benefits earned to date. $400,000 × × % $ 60,000 per year Step 2. Find the present value of the retirement benefits as of the retirement date. The present value (n=20, i=6%,) of the retirement annuity at the retirement date is $688,195 ($60,000 × ). Step 3. Find the present value of the retirement benefits as of the current date. The present value (n=30, i=6%,) of the retirement benefits at 2009 is $119,822 ($688,195 × ). This is the PBO. Step 1. Use the pension formula to determine the retirement benefits earned to date. $400,000 × × % $ 60,000 per year Step 2. Find the present value of the retirement benefits as of the retirement date. The present value (n=20, i=6%,) of the retirement annuity at the retirement date is $688,195 ($60,000 × ). Step 3. Find the present value of the retirement benefits as of the current date. The present value (n=30, i=6%,) of the retirement benefits at 2009 is $119,822 ($688,195 × ). This is the PBO.

15 Projected Benefit Obligation
If the actuary’s estimate of the final salary hasn’t changed, the PBO a year later at the end of 2010 would be $139,715. Step 1. Use the pension formula to determine the retirement benefits earned to date. $400,000 × × % $ 66,000 per year Step 2. Find the present value of the retirement benefits as of the retirement date. The present value (n=20, i=6%,) of the retirement annuity at the retirement date is $757,015 ($66,000 × ). Step 3. Find the present value of the retirement benefits as of the current date. The present value (n=29, i=6%,) of the retirement benefits at 2010 is $139,715 ($757,015 × ). This is the PBO. If the actuary’s estimate of the final salary hasn’t changed, the PBO a year later at the end of 2010 would be $139,715. We would follow the same steps as seen on the slide before to calculate the 2010 PBO. The PBO increased during 2010 for two reasons: One more service year is included in the pension formula calculation (service cost). The employee is one year closer to retirement, causing the present value of benefits to increase due to the time value of future benefits (interest cost).

16 Projected Benefit Obligation
There are five events that cause changes in the projected benefit obligation from the beginning to the end of an accounting period: (1) service cost, (2) interest cost, (3) prior service cost, (4) gains and losses, and (5) payments to retired employees.

17 Projected Benefit Obligation
The PBO increases each year by the amount of that year’s service cost. This represents the increase in the projected benefit obligation attributable to employee service performed during the period. It also is the primary component of the annual pension expense. Service cost is the increase in the PBO attributable to employee service performed during the period.

18 Projected Benefit Obligation
The second reason the PBO increases is called the interest cost. Even though the projected benefit obligation is not formally recognized as a liability in the company’s balance sheet, it is a liability nevertheless. And, as with other liabilities, interest accrues on its balance as time passes. The amount can be calculated directly as the assumed discount rate multiplied by the projected benefit obligation at the beginning of the year. Interest cost is the interest on the PBO during the period.

19 Projected Benefit Obligation
Another reason the PBO might change is when the pension plan itself is amended to revise the way benefits are determined. When a pension plan is amended, credit often is given for employee service rendered in prior years. The cost of doing so is called prior service cost. Prior service cost is the increase in the PBO due to a plan change that provides credit for employee service rendered in prior years.

20 Projected Benefit Obligation
A number of estimates are necessary to derive the PBO. When one or more of these estimates requires revision, the estimate of the PBO also will require revision. The resulting decrease or increase in the PBO is referred to as a gain or loss, respectively. For example, an increase in the final salary estimate increases the PBO and represents a loss on the PBO because the obligation turned out to be higher than previously expected. However, an increase in the assumed discount rate used in the present value calculations for the PBO would result in a decrease of the estimate of the PBO. This would result in a gain on the PBO because the obligation turned out to be less than previously expected. Loss or gain on PBO results from revising estimates used to determine the PBO.

21 Projected Benefit Obligation
The projected benefit obligation is reduced by benefits paid to retired employees. Retiree benefits paid reduce the PBO.

22 Projected Benefit Obligation
Let’s say now that Global Communications has 2,000 active employees covered by the pension plan and 100 retired employees receiving retirement benefits. The illustration on this slide shows the expanded amounts in the 2011 PBO to represent all covered employees.

23 Pension Plan Assets The pension plan assets are not reported separately in the balance sheet but are netted together with the PBO to report either a net pension asset (debit balance) or a net pension liability (credit balance). The higher the expected return on plan assets, the less the employer must actually contribute. On the other hand, a relatively low expected return means the difference must be made up by higher contributions. The pension plan assets are not reported separately in the balance sheet but are netted together with the PBO to report either a net pension asset (debit balance) or a net pension liability (credit balance). Its separate balance, too, must be reported in the disclosure notes to the financial statements (as does the separate PBO balance), and as explained below, the return on these assets is included in the calculation of the periodic pension expense. The assets of a pension fund must be held by a trustee. A trustee accepts employer contributions, invests the contributions, accumulates the earnings on the investments, and pays benefits from the plan assets to retired employees or their beneficiaries. Plan assets are invested in stocks, bonds, and other income-producing assets. The accumulated balance of the annual employer contributions plus the return on the investments (dividends, interest, market price appreciation) must be sufficient to pay benefits as they come due. When an employer estimates how much it must set aside each year to accumulate sufficient funds to pay retirement benefits as they come due, it’s necessary to estimate the return those investments will produce. This is the expected return on plan assets. The higher the return, the less the employer must actually contribute. On the other hand, a relatively low return means the difference must be made up by higher contributions.

24 Pension Plan Assets Global Communications funds its defined benefit pension plan by contributing the year’s service cost plus a portion of the prior service cost each year. Cash of $48 million was contributed to the pension fund in 2011. Plan assets at the beginning of 2011 were valued at $300 million. The expected rate of return on the investment of those assets was 9%, but the actual return in 2009 was 10%. Retirement benefits of $38 million were paid at the end of 2011 to retired employees. The plan assets at the end of 2011 will be: To calculate the plan assets at the end of the period, we start with the plan assets at the beginning of the period and add the actual return on plan assets and cash contributions made. The actual return is the amount earned by the plan trustee on the beginning balance of plan assets. The cash contributions come from the employer or a combination of the employer and employee. We subtract the benefits paid to retired employees to arrive at the ending balance for plan assets. The plan trustee provides us with information concerning the payments to retired employees. Plan assets at the beginning of 2011 $ ,000,000 Return on plan assets (10% x $300 million) 30,000,000 Cash contributions 48,000,000 Less: Retiree benefits paid (38,000,000) Plan assets at the end of 2011 $ ,000,000

25 Funded Status of the Pension Plan
OVERFUNDED Market value of plan assets exceeds the actuarial present value of all benefits earned by participants. UNDERFUNDED Market value of plan assets is below the actuarial present value of all benefits earned by participants. A plan is said to be overfunded when the fair market value of the plan assets exceed the actuarially determined present value of all benefits earned by plan participants. The plan is undervalued when the fair market value of the plan assets are below the actuarially determined present value of the benefits. It is not unusual for pension plans today to be underfunded. Historically the funded status of pension plans has varied considerably. Prior to the Employee Retirement Income Security Act (ERISA) in 1974, many plans were grossly underfunded. The new law established minimum funding standards among other matters designed to protect plan participants. The new standards brought most plans closer to full funding. Today a majority of plans again are underfunded. The economic crisis has taken its toll. Stock market declines reduced the funded status of pension plans from 108% at the end of 2008 to 79% at the end of In 2009, pension plans of the country's 500 largest companies were underfunded by $200 billion. Many of the underfunded plans are with troubled companies, placing employees at risk. ERISA also established the Pension Benefit Guaranty Corporation (PBGC) to impose liens on corporate assets for unfunded pension liabilities in certain instances and to administer terminated pension plans. The PBGC provides a form of insurance for employees similar to the role of the FDIC for bank accounts and is financed by premiums from employers equal to specified amounts for each covered employee. It makes retirement payments for terminated plans and guarantees basic vested benefits when pension liabilities exceed assets. The PBGC guarantees are limited to about $3,400 per month, often less than promised pension benefits.

26 Reporting the Funded Status of Pension Plan
Projected Benefit Obligation (PBO) - Plan Assets at Fair Value Underfunded / Overfunded Status This amount is reported in the balance sheet as a Pension Liability or Pension Asset. A company’s PBO is not reported separately among liabilities in the balance sheet. Similarly, the plan assets a company sets aside to pay those benefits are not separately reported among assets in the balance sheet. However, firms do report the net difference between those two amounts, referred to as the “funded status” of the plan. The amount of the underfunding or overfunding of the pension plan is reported in the current period balance sheet as either a pension liability in the case of underfunding or a pension asset in the case of overfunding.

27 The Relationship Between Pension Expense and Changes in the PBO and Plan Assets
Like wages, salaries, commissions, and other forms of pay, pension expense is part of a company’s compensation for employee services each year. Accordingly, the accounting objective is to achieve a matching of the costs of providing this form of compensation with the benefits of the services performed. However, the fact that this form of compensation actually is paid to employees many years after the service is performed means that other elements in addition to the annual service cost will affect the ultimate pension cost. These other elements are related to changes that occur over time in both the pension liability and the pension plan assets. The graphic on this slide provides a summary of how some of these changes influence pension expense.

28 Service Cost Actuaries have determined that Global Communications has service cost of $41,000,000 in 2011. For Global Communications, the actuary has determined that the service cost is $41,000,000 for With this information we can begin the process of calculating pension expense.

29 Interest cost is calculated as:
PBOBeg × Discount rate Global had PBO of $400,000,000 on 1/1/11. The actuary uses a discount rate of 6%. The interest element is calculated by taking the beginning projected benefit obligation and multiplying it by the discount rate used by the actuary. For Global Communications, the interest cost for 2011 is $24,000,000, calculated as the PBO at January 1, 2011 of $400,000,000 times 6%. 2011 Interest Cost PBO 1/1/11 $400,000,000 × 6% = $24,000,000

30 Return on Plan Assets The plan trustee reports that plan assets were $300,000,000 on 1/1/11. The trustee uses an expected return of 9% and the actual return is 10%. The actual return on plan assets is equal to the dividends, interest and capital gains generated by the fund during the period. The expected return on plan assets is the trustee’s estimate of the long-term rate of return on invested funds. The fair value of the plan assets at January 1, 2011 is $300,000,000. The trustee used an expected return of 9%, but earned an actual return of 10%. The actual return in 2011 is $30,000,000 ($300,000,000 times 10% actual rate of return). This amount must be adjusted by the $3,000,000 gain to arrive at our expected return of $27,000, We do not include any loss or gain in the pension expense right away.

31 Amortization of Prior Service Cost
In 2010, Global Communications amended the pension plan, increasing the PBO at that time. For all plan participants, the prior service cost was $60 million at 1/1/10. The average remaining service life of the active employee group is 15 years. $60,000,000 PSC ÷ 15 = $4,000,000 per year Prior service cost is the present value of the retroactive benefits from modification of the plan formula or amendment to the plan, and increases the projected benefit obligation. The prior service cost is initially recorded as other comprehensive income and then amortized gradually to pension expense. Prior service costs are usually amortized over the remaining service life of those employees active at the date of amendment of the plan, and who are expected to receive benefits as a result of the amendment. There are two approaches to the amortization of prior service cost. First, we can amortize these costs over the remaining service life on a straight-line basis. This method is sufficient and simple. The preferred method is called the service method. Under this method, we amortize the prior service costs by allocating equal amounts to each employee’s service years remaining. For very large companies, service method amortization can be quite complex. For Global, an amendment occurred in 2010, increasing the PBO at that time. For our illustration, assume that for all plan participants, the prior service cost was $60 million at the beginning of The prior service cost at the beginning of 2011 is $56 million. We assume that the average remaining service life of the active employee group is 15 years. To recognize the $60 million prior service cost in equal annual amounts over this period, the amount amortized as an increase in pension expense each year is $4,000,000.

32 Gains and Losses This table does a very good job of summarizing the recognition of gains and losses. If the projected benefit obligation is higher than expected, a loss will be recognized. On the other hand, if the return on plan assets is higher than expected, a gain will be recognized. Like the prior service cost we just discussed, we don’t include these gains and losses as part of pension expense in the income statement, but instead report them as OCI in the statement of comprehensive income as they occur. We then report the gains and losses on a cumulative basis as a net loss–AOCI or a net gain–AOCI, depending on whether we have greater losses or gains over time. We report this amount in the balance sheet as a part of accumulated other comprehensive income (AOCI), a shareholders’ equity account. There is no conceptual justification for not including losses and gains in earnings. After all, these increases and decreases in either the PBO or plan assets immediately impact the net cost of providing a pension plan and, conceptually, should be included in pension expense as they occur. Nevertheless, The FASB requires that income statement recognition of gains and losses from either source be delayed. Why? The practical justification for delayed recognition is that, over time, gains and losses might cancel one another out. Given this possibility, why create unnecessary fluctuations in reported income by letting temporary gains and losses decrease and increase (respectively) pension expense? Of course, as years pass there may be more gains than losses, or vice versa, preventing their offsetting one another completely. So, if a net gain or a net loss gets “too large,” pension expense must be adjusted. The FASB defines too large rather arbitrarily as being when a net gain or a net loss at the beginning of a year exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher. This threshold amount is referred to as the “corridor.” When the corridor is exceeded, the excess is not charged to pension expense all at once. Instead, as a further concession to income smoothing, only a portion of the excess is included in pension expense. The minimum amount that should be included is the excess divided by the average remaining service period of active employees expected to receive benefits under the plan. Only if a net gain or net loss exceeds the “corridor” is a charge to pension expense allowed.

33 The corridor amount is 10% of the greater of
PBO at the beginning of the period. The corridor amount is 10% of the greater of Or Fair value of plan assets at the beginning of the period. The corridor amount is defined as 10% of the greater of the beginning projected benefit obligation or the beginning fair value of the plan assets. Before a gain or loss would be amortized, it must exceed the corridor amount. The existence of the corridor amount is an effort by the FASB to permit companies to smooth income. Only very large gains or losses exceed the corridor amount and are subject to amortization over an extended period of time.

34 Net unrecognized gain or loss
Gains and Losses If the beginning net unrecognized gain or loss exceeds the corridor amount, amortization is recognized using the following formula . . . Net unrecognized gain or loss at beginning of year Average remaining service period of active employees expected to receive benefits under the plan Corridor amount ־ We amortize the excess of the net unrecognized gain or loss at the beginning of the year over the corridor amount, by the average remaining service life of active employees.

35 Gains and Losses $15,000,000 ÷ 15 years = $1,000,000
For Global Communications, we are assuming a net loss—AOCI of $55 million at the beginning of Also recall that the PBO and plan assets are $400 million and $300 million, respectively, at that time. The amount to amortize to 2011 pension expense is $1 million. This is calculated by taking the net loss of $55 million and subtracting the corridor amount of $40 million ($400 million time 10% is used as the corridor since $400 million is greater than $300 million). This provides the excess at the beginning of the year of $15 million which is divided by the average service life of 15 years to arrive at the amortization of $1 million for 2011. $15,000,000 ÷ 15 years = $1,000,000

36 Determining Pension Expense
We have now completed the calculation of the $43 million pension expense for The expense includes the $41 million service cost and the $24 million interest cost, both of which add to Global’s PBO. Similarly, the expense includes a $27 million expected return on plan assets, which adds to the plan assets. The $4 million amortization of the prior service cost and the $1 million amortization of the net loss are reported in other comprehensive income (OCI) in the statement of comprehensive income. These OCI items accumulate as prior service cost accounts-AOCI and net loss (or gain)-AOCI. So, when we amortize these AOCI accounts, we report the amortization amounts in the statement of comprehensive income as well.

37 Recording Gains and Losses
For 2011, the actual return on plan assets exceeded the expected return by $3 million. In addition, there was a $23 million loss from changes made by the actuary when it revised its estimate of future salary levels causing its PBO estimate to increase. Global would make the following journal entry to record the gain and loss: Loss—OCI 23,000,000 PBO ,000,000 Plan assets 3,000,000 Gain—OCI ,000,000 For 2011, the actual return on plan assets exceeded the expected return by $3 million. In addition, there was a $23 million loss from changes made by the actuary when it revised its estimate of future salary levels causing its PBO estimate to increase. Global would debit loss-OCI and credit PBO for the $23 million loss from the changes that increased the PBO. Global would debit plan assets and credit gain-OCI for $3 million to record the increase in the plan assets above the expected rate of return. OCI = Other comprehensive income

38 RECORD PENSION EXPENSE IN 2009
($ in millions) Pension expense (calculated above) Plan assets ($27 expected return on assets) PBO ($41 service cost + $24 interest cost) Amortization of prior service cost–OCI Amortization of net loss–OCI OCI = Other comprehensive income  Service cost and interest cost add to Global’s PBO.  The return on plan assets adds to the plan assets.  Amortization of OCI items also is OCI. 65 ­ PBO 27 ­ Less: plan assets ­ Net pension liability The entry to record the pension expense for Global is a debit to pension expense of $43 million, a debit to plan assets of $27 million, a credit to PBO of $65 million, a credit to amortization of prior service cost-OCI of $4 million and a credit to amortization of net loss-OCI of $1 million. Service cost $41 Interest cost Expected return on plan assets ($30 actual, less $3 gain) (27) Amortization of prior service cost Amortization of net loss Pension expense $43

39 Recording the Funding of Plan Assets
When Global adds its annual cash investment of $48 million to its plan assets, the value of those plan assets increases by $48 million. Plan assets 48,000,000 Cash ,000,000 When Global adds its annual cash investment of $48 million to its plan assets, the value of those plan assets increases by $48 million. It’s not unusual for the cash contribution to differ from that year’s pension expense. After all, determining the periodic pension expense and the funding of the pension plan are two separate processes. Pension expense is an accounting decision. How much to contribute each year is a financing decision affected by cash flow and tax considerations, as well as minimum funding requirements. The Pension Protection Act of 2006 and the Employee Retirement Income Security Act of 1974 (ERISA) establish the pension funding requirements. Subject to these considerations, cash contributions are actuarially determined with the objective of accumulating (along with investment returns) sufficient funds to provide promised retirement benefits. It’s not unusual for the cash contribution to differ from that year’s pension expense. After all, determining the periodic pension expense and the funding of the pension plan are two separate processes.

40 Recording the Funding of Plan Assets
Global pays $38 million in retirement pension benefits. PBO 38,000,000 Plan assets ,000,000 When pension benefits are paid to retired employees, those payments reduce the plan assets established to pay the benefits and also reduce the obligation to pay the benefits, the PBO. So, if Global paid $38 million in retirement pension benefits, we would debit PBO and credit plan assets for $38 million.

41 U. S. GAAP vs. IFRS Differences in accounting for actuarial gains and losses using U.S. GAAP and IFRS. Permits but does not require that gains and losses be included among OCI items in the statement of comprehensive income. Gains and losses become part of Unrecognized net gain or loss reported as an offset or increase to the net pension liability (or net pension asset) in the liability section of the balance sheet. Requires that gains and losses be included among OCI items in the statement of comprehensive income. Gains and losses become part of AOCI in the shareholders’ equity section of the balance sheet. We’ve seen that U.S. GAAP requires that gains and losses be included among OCI items in the statement of comprehensive income, thus subsequently become part of AOCI. This is permitted under IAS No. 19, but not required. If this choice is made, under IAS No. 19 the gains and losses are not subsequently amortized to expense and recycled or reclassified from other comprehensive income as is required under U.S. GAAP (when the accumulated net gain or net loss exceeds the 10% threshold). A second alternative under IFRS is to expense gains and losses only when the accumulated net gain or net loss exceeds a specified corridor, or threshold, similar to U.S. GAAP. With this alternative we include gains and losses as they occur in the defined benefit obligation (DBO) or plan assets, but then report them as an offset or increase to the net pension liability (or net pension asset) using a valuation account called unrecognized net gain or loss. Using U.S. GAAP, the gain and the loss become part of AOCI in the shareholders’ equity section of the balance sheet. Using IFRS, the gain and the loss become part of Unrecognized net gain or loss reported as an offset or increase to the net pension liability (or net pension asset) in the liability section of the balance sheet. We then amortize a portion of either the AOCI or Unrecognized net gain or loss to expense when the accumulated net gain or net loss exceeds a specified corridor, or threshold, as demonstrated previously.

42 U.S. GAAP and IFRS treat prior service cost (PSC) differently.
U. S. GAAP vs. IFRS U.S. GAAP and IFRS treat prior service cost (PSC) differently. PSC is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized over the average remaining service period. PSC is expensed immediately to the extent it relates to benefits that have vested. The amount not yet expensed (nonvested portion) is reported as an offset or increase to the defined benefit obligation. Under IAS No. 19, prior service cost (called past service cost under IFRS) is expensed immediately to the extent it relates to benefits that have vested. The amount not yet expensed (nonvested portion) is reported as an offset or increase to the defined benefit obligation or DBO (called projected benefit obligation or PBO under U.S. GAAP). Under U.S. GAAP, prior service cost is not expensed immediately, but is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized over the average remaining service period.

43 Comprehensive Income Comprehensive income is a more expansive view of income than traditional net income. Comprehensive income, as you may recall from Chapter 4, is a more expansive view of income than traditional net income. In fact, it encompasses all changes in equity other than from transactions with owners. So, in addition to net income, comprehensive income includes up to four other changes in equity. A statement of comprehensive income is demonstrated on this slide, highlighting the presentation of the components of OCI pertaining to Global’s pension plan.

44 Comprehensive Income Other comprehensive income (OCI) items are reported both (a) as they occur and (b) as an accumulated balance as shown on this slide. In addition to reporting the gains or losses (and other elements of comprehensive income) that occur in the current reporting period, we also report these amounts on a cumulative basis in the balance sheet. Comprehensive income includes (a) net income and (b) OCI. Notice that we report net income that occurs in the current reporting period in the income statement and also report accumulated net income (that hasn’t been distributed as dividends) in the balance sheet as retained earnings. Similarly, we report OCI as it occurs in the current reporting period and also report accumulated other comprehensive income in the balance sheet.

45 U. S. GAAP vs. IFRS As part of a joint project with the FASB, the IASB issued a revised version of IAS No.1, “Presentation of Financial Statements,” that revised the standard to bring international reporting of comprehensive income largely in line with U.S. standards. IFRS does not permit reporting other comprehensive income in the statement of shareholders’ equity. As part of a joint project with the FASB, the International Accounting Standards Board (IASB) in 2007 issued a revised version of IAS No.1, “Presentation of Financial Statements,” that revised the standard to bring international reporting of comprehensive income largely in line with U.S. standards. It provides the option of presenting revenue and expense items and components of other comprehensive income either in (a) a single statement of comprehensive income or (b) in an income statement followed by a statement of comprehensive income. U.S. GAAP also allows reporting other comprehensive income in the statement of shareholders’ equity, which is the way most U.S. companies report it.

46 PENSION SPREADSHEET Reported Recorded in Accounts Only In preceding sections, we’ve discussed (1) the projected benefit obligation (including changes due to periodic service cost, accrued interest, revised estimates, plan amendments, and the payment of benefits); (2) the plan assets (including changes due to investment returns, employer contributions, and the payment of benefits); (3) prior service cost; (4) gains and losses; (5) the periodic pension expense (comprising components of each of these); and (6) the funded status of the plan. These elements of a pension plan are interrelated. It’s helpful to see how each element relates to the others. One way is to bring each part together in a pension spreadsheet like the one illustrated on this slide for Global Communications. You should spend several minutes studying this spreadsheet, focusing on the relationships among the elements that constitute a pension plan. Notice that the first numerical column simply repeats the actuary’s report of how the PBO changed during the yea. Likewise, the second column reproduces the changes in plan assets we discussed earlier. We’ve also previously noted the changes in the prior service cost–AOCI and the net loss–AOCI that are duplicated in the third and fourth columns. The fifth column repeats the calculation of the 2011 pension expense we determined earlier, and the cash contribution to the pension fund is the sole item in the next column. The last column shows the changes in the funded status of the plan. Be sure to notice that the funded status is the difference between the PBO (column 1) and the plan assets (column 2). That means that each of the changes we see in either of the first two columns also is reflected as a change in the funded status in the last column. The net pension liability (or net pension asset) balance is not carried in company records. Instead, we use this label to report the PBO and plan assets in the balance sheet as a single net amount.

47 U. S. GAAP vs. IFRS Under IFRS there is no requirement to present the various components of pension expense as a single net amount. Under IFRS there is no requirement to present the various components of pension expense as a single net amount. As a result, some companies using IFRS report interest cost, expected return on assets, and amortization of gains and losses as financing Income and expense.

48 Postretirement Benefits Other Than Pensions
Many companies also furnish other postretirement benefits to their retired employees. Net Cost of Benefits Estimated medical costs in each year of retirement Retiree share of cost Medicare payments Less: Many companies also furnish other postretirement benefits to their retired employees. These may include medical coverage, dental coverage, life insurance, group legal services, and other benefits. By far the most common is health care benefits. One of every three U.S. workers in medium- and large-size companies participates in health care plans that provide for coverage that continues into retirement. The aggregate impact is considerable; the total obligation for all U.S. corporations is about $500 billion. To determine the postretirement benefit obligation and the postretirement benefit expense, the company’s actuary first must make estimates of what the postretirement benefit costs will be for current employees. Let’s examine how to determine postretirement health benefits. As illustrated on this slide, contributions to those costs by employees are deducted, as well as Medicare’s share of the costs (for retirement years when the retiree will be 65 or older), to determine the estimated net cost of benefits to the employer. Estimated net cost of benefits Equals:

49 Postretirement Benefit Obligation
Expected Postretirement Benefit Obligation (EPBO) – The actuary's estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants. Accumulated Postretirement Benefit Obligation (APBO) – The portion of the EPBO attributed to employee service to date. There are two related obligation amounts. One measures the total obligation and the other refers to a specific portion of the total. Expected Postretirement Benefit Obligation (EPBO) – The actuary's estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants. Accumulated Postretirement Benefit Obligation (APBO) – The portion of the EPBO attributed to employee service to date.

50 POSTRETIREMENT BENEFIT OBLIGATION
 Assume the actuary estimates the net cost of providing health care benefits to a particular employee during her retirement years to have a present value of $10,842 as of the end of This is the EPBO. If the benefits (and therefore the costs) relate to an estimated 35 years of service and 10 of those years have been completed, the APBO would be: 2009 $10,842 x 10/35 = $3, EPBO fraction APBO attributed x 2010 $11,492 x 11/35 = $3,612 EPBO fraction APBO attributed $3,098 represents the portion of the EPBO related to the first 10 years of the 35-year service period. $3,612 represents the portion of the EPBO related to the first 11 years of the 35-year service period. The obligation increases by the 6% accrued interest She now has worked 11 of her estimated 35 years

51 HOW THE APBO CHANGED APBO at the beginning of the year $3,098
Interest cost: $3,098 x 6% Service cost: ($11,492 x 1/35) portion of EPBO attributed to the year APBO at the end of the year $3,612 The APBO increases each year due to (a) interest accrued on the APBO and (b) the portion of the EPBO attributed to that year.

52 Attribution The process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by employees. Attribution is the process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by the employees. We accomplish this by assigning an equal fraction of the EPBO to each year of service from the employee’s date of hire to the employee’s full eligibility date. This is the date the employee has performed all the service necessary to have earned all the retiree benefits estimated to be received by the employee.

53 Accounting for Postretirement Benefit Plans Other Than Pensions
Attribute a portion of the accumulated postretirement benefit obligation to each year as the service cost for that year. Measuring Service Cost It’s necessary to attribute a portion of the accumulated postretirement benefit obligation to each year as the service cost for that year as opposed to measuring the actual benefits employees earn during the year as we did for pension plans. That’s due to the fundamental nature of these other postretirement plans under which employees are ineligible for benefits until specific eligibility criteria are met, at which time they become 100% eligible. This contrasts with pension plans under which employees earn additional benefits each year until they retire. The way we measure service cost is the primary difference between accounting for pensions and for other postretirement benefits. Otherwise, though, accounting for the two is virtually identical.

54 Appendix 17: Service Method of Allocating Prior Service Cost
The allocation approach that reflects the declining service pattern of employees is called the service method. The method requires that the total number of service years for all employees be calculated. This calculation is usually done by the actuary. Assume Global Communications has 2,000 employees and the company’s actuary determined that the total number of service years of these employees is 30,000. We would calculate the following amortization fraction: Appendix 17: Service Method of Allocating Prior Service Cost In the appendix to this chapter, we will look at the service method of allocating prior service cost. Recall that we previously allocated prior service costs on the straight-line basis. The allocation method that reflects that the declining service pattern of employees is called the service method. The method requires that we estimate the total number of service years for all employees. This can be quite a daunting task. We usually request that our actuary make this computation. Global Communications has 2,000 employees and the company’s actuary has determined that the total number of service years of these employees is 30,000. We will use this information to calculate the proper amount of amortization. In the first year, 30,000 total service years will appear in the numerator of the equation, and the 2,000 total employees will appear in the denominator. We will have an average service life in the first year of 15 years. This service life changes from year to year. 30,000 2,000 = 15 average service years

55 End of Chapter 17 End of chapter 17.


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