Accounting for Postemployment Benefits 19 hapter Accounting for Postemployment Benefits An electronic presentation by Douglas Cloud Pepperdine University 1 1 1 1

Objectives 1. Understand the characteristics of pension plans. 2. Explain the historical perspective of accounting for pension plans. 3. Explain the accounting principles for defined benefit plans, including computing pension expense and recognizing pension liabilities and assets. 4. Account for pensions. 5. Understand disclosures of pensions. Continued 2 2 2 4

Objectives 6. Explain the conceptual issues regarding pensions. 7. Understand several additional issue related to pensions. 8. Explain other post-employment benefits. 9. Account for OPEBs. 10. Explain the conceptual issues regarding OPEBs. 11. Understand present value calculations for pensions. (Appendix)

Characteristics of Pension Plans A pension plan requires that a company provide income to its retired employees in return for services they provided during their employment.

Characteristics of Pension Plans The retirement income, normally paid monthly, usually is determined on the basis of the employees earnings and length of service with the company.

Internal Revenue Code Qualifications Most companies design their pension plans to meet the Internal Revenue Code qualifications, which state that: 1. Employer contributions are deductible for income tax purposes. 2. Pension fund earnings are exempt from income taxes. 3. Employer contributions to the pension fund are not taxable to the employees until they receive their pension benefits.

Pension Relationships Employees Payments during retirement Receive rights to pension benefits during retirement Provide service during employment Company Make payments (fund) (affected by ERISA and the Tax Code) Funding Agency (for pension plan)

Pension Relationships Company Funding Agency (for pension plan) Recognize expense (and perhaps asset or liability) Financial Statements Financial Statements FASB Statements No. 87, 88, and 132 FASB Statement No. 35 Prepared according to GAAP

Key Terms Service Cost Service cost is the actuarial present value of the benefits attributed by the pension benefit formula to service rendered by the employees during the current period.

Service Cost Retirement Expected Date of Retirement Expected Date of Death Remaining Expected Period of Employment Current period Payments During Retirement Years of Benefits Earned in Current Period Retirement Service Cost = PV of Payment during Retirement

Interest Cost Interest cost is the increase in the projected benefit obligation due to the passage of time.

Expected Return on Plan Assets The expected return on plan assets is the expected increase in plan assets due to investing activities.

Expected Return on Plan Assets Projected Benefit Obligations at Beginning of Period = Present Value of Benefits Earned to Date Projected Benefit Obligation Grows to Equal Expected Retirement Obligation Assets Used to Pay Retirement Benefits Retirement Interest = Projected Benefit x Discount Cost Obligation Rate Expected Return on Plan Assets During Period Assets Grow to Equal the Amounts Needed to Pay Retirement Benefits Plan assets at Beginning of Period at Fair Value

Amortization of Unrecognized Prior Service Cost Prior service cost is not recorded in the accounts in the period granted. Instead, it is included amortized and included in computation of pension expense. Why is it considered unrecognized? The retroactive benefit to a pension plan is the prior service cost.

Amortization of Unrecognized Prior Service Cost Date of Amendment or Adoption Unrecognized Prior = Present Value of Benefit from the Service Cost Amendment or Adoption to be Received During Retirement Unamortized Prior Service Cost is Amortized Over Average Remaining Service Life of Employees

Gain or Loss A gain or loss arises because actuaries make assumptions about many of the items included in the computation of pension costs and benefits.

Gain or Loss The gain or loss is not recognized in the period in which it occurs, so it is called an unrecognized net gain or loss.

Gain or Loss The gain or loss components of pension expense generally consists of one of the following items: 1. Amortization of any unrecognized net loss from previous periods (added to compute pension expense), or 2. Amortization of any unrecognized net gain from previous periods (deducted to compute pension expense).

Components of Pension Expense Service cost = Present value of benefits earned during the year using the discount rate + Interest expense = Projected benefit obligation at beginning of the year x Discount rate – Expected return on plan assets = Fair value of plan assets at the beginning of the year x Expected long-term rate of return on plan assets + Amortization of prior service cost = Present value of additional benefits/modification of the plan amortized over the remaining service lives of active employees - Gain or loss = Amortization of the cumulative unrecognized net gain or loss from previous periods in excess of the corridor

Additional Pension Liability The accumulated benefit obligation in excess of the fair value of the plan assets is a measure of the obligation of the company based on the legal concept of a liability.

Additional Pension Liability Accumulated benefit obligation – Fair value of plan assets = Unfunded Accumulated Benefit Obligation – Prepaid/accrued pension cost (credit balance) or + Prepaid/accrued pension cost (debit balance) = Additional Pension Liability

Additional Pension Liability The additional pension liability “adjusts” the company’s existing pension liability or asset to the amount of the unfunded accumulated obligation.

Disclosures According to FASB Statement No. 132, a company must disclose specific information about a defined benefit pension plan. These items are shown in Slide 24.

Disclosures 3. The funded status of the plan, the amounts not recognized on the balance sheet, the amounts not recognized on the balance sheet, including the amount of any unamortized prior service cost, the amount of any unrecognized net gain or loss, the amount of any remaining unamortized, unrecognized net obligation or net asset existing at the adoption of FASB Statement No. 87, the net pension prepaid asset or accrued liability; and any intangible asset and the related amount of accumulated other comprehensive income. 5. The amount included within other comprehensive income from a change in the additional pension liability. 1. A reconciliation of the beginning and ending balances of the projected benefit obligation. 2. A reconciliation of the beginning and ending balances of the fair value of the plan assets. 6. The discount rate, the rate of compensation increase, and the expected long-term rate of return on the plan assets. 7. The amounts and types of securities included in the plan assets. 4. The amount of pension expense.

Pension Expense Equal to Funding Facts for the Carlisle Company 1. The company adopts a pension plan on January 1, 2004. No retroactive benefits were granted to employees. 2. The service cost each year is: 2004, $400,000; 2005, $420,000; 2006, $432,000. 3. The projected benefit obligations at the beginning of each year is: 2005, $400,000; and 2006, $840,000. Continued

Pension Expense Equal to Funding 4. The discount rate is 10%. 5. The expected long-term rate of return on plan assets is 10%. 6. The company adopts a policy of funding an amount equal to the pension expense and makes a payment at the end of each year. 7. Plan assets are based on the amounts contributed each year, plus a return of 10%, less $20,000 to retired employees (beginning 2005).

Pension Expense Equal to Funding December 31, 2004: Pension Expense 400,000 Cash 400,000 December 31, 2005: Pension Expense 420,000 Cash 420,000 Service cost (assumed) $420,000 Interest cost ($400,000 x 10%) 40,000 Expected return on plan assets ($400,000 x 10%) (40,000 ) Pension expense $420,000

Pension Expense Equal to Funding December 31, 2006: Pension Expense 432,000 Cash 432,000 Service cost (assumed) $432,000 Interest cost ($840,000 x 10%) 84,000 Expected return on plan assets ($840,000 x 10%) (84,000 ) Pension expense $432,000 Note that the interest cost and the return on the plan assets offset each other each year.

Pension Expense Greater Than Pension Funding Carlisle Company funds $385,000 in 2004, $400,000 in 2005, and $415,000 in 2006. December 31, 2004: Pension Expense 400,000 Cash 385,000 Prepaid/Accrued Pension Cost 15,000 Liability

Pension Expense Greater Than Pension Funding December 31, 2005: Pension Expense 421,500 Cash 400,000 Prepaid/Accrued Pension Cost 21,500 Service cost (assumed) $420,000 Interest cost ($400,000 x 10%) 40,000 Expected return on plan assets ($385,000 x 10%) (38,500 ) Pension expense $421,500

Pension Expense Greater Than Pension Funding December 31, 2006: Pension Expense 435,650 Cash 415,000 Prepaid/Accrued Pension Cost 20,650 Service cost (assumed) $432,000 Interest cost ($840,000 x 10%) 84,000 Expected return on plan assets ($803,500 x 10%) (80,350 ) Pension expense $435,650 The balance in the liability account is $57,150

Pension Fund Less Than Pension Funding and Expected Return Different From Discount Rate Carlisle Company funds $415,000 in 2004, $425,000 in 2005, and $440,000 in 2006. The expected and actual return is is 11%. December 31, 2004: Pension Expense 400,000 Prepaid/Accrued Pension Cost 15,000 Cash 415,000

The balance in the asset account is $25,650 Pension Fund Less Than Pension Funding and Expected Return Different From Discount Rate December 31, 2005: Pension Expense 414,350 Prepaid/Accrued Pension Cost 10,650 Cash 425,000 Service cost (assumed) $420,000 Interest cost ($400,000 x 10%) 40,000 Expected return on plan assets ($415,000 x 11%) (45,650 ) Pension expense $414,350 The balance in the asset account is $25,650

The balance in the asset account is $44,872 Pension Fund Less Than Pension Funding and Expected Return Different From Discount Rate The balance in the asset account is $44,872 December 31, 2006: Pension Expense 420,322 Prepaid/Accrued Pension Cost 19,678 Cash 440,000 Service cost (assumed) $432,000 Interest cost ($840,000 x 10%) 84,000 Expected return on plan assets ($9,800 x 11%) (95,678 ) Pension expense $420,332

Pension Expense Including Amortization of Unrecognized Prior Service Cost Carlisle Company funds $385,000 in 2004, $400,000 in 2005, and $415,000 in 2006. The company awarded retroactive benefits to employees. The unrecognized prior service costs were estimated to be $2 million. Carlisle decided to increase its contribution by $290,000 per year. The $2 million is amortized over 20 years.

Pension Expense Including Amortization of Unrecognized Prior Service Cost December 31, 2004: Pension Expense 700,000 Cash ($385,000 + $290,000) 675,000 Prepaid/Accrued Pension Cost 25,000 Service cost (assumed) $400,000 Interest cost ($2,000,000 x 10%) 200,000 Amortization of unrecognized prior service cost 100,000 Pension expense $700,000

Pension Expense Including Amortization of Unrecognized Prior Service Cost December 31, 2005: Pension Expense 705,750 Cash 685,000 Prepaid/Accrued Pension Cost 20,750 Service cost (assumed) $420,000 Interest cost ($2,600,000 x 10%) 260,000 Expected return on plan assets ($675,000 x 11%) (74,250 ) Amortization of unrecognized prior service cost 100,000 Pension expense $705,750

Pension Expense Including Amortization of Unrecognized Prior Service Cost December 31, 2006: Pension Expense 701,690 Cash 700,000 Prepaid/Accrued Pension Cost 1,690 Service cost (assumed) $432,000 Interest cost ($3,260,000 x 10%) 326,000 Expected return on plan assets ($1,421,000 x 11%) (156,310 ) Amortization of unrecognized prior service cost 100,000 Pension expense $701,690

Computation of Net Gain or Loss Cumulative Projected Fair Excess Unrecognized Benefit Value Unrecognized Recognized Net Loss Obligation of Plan Net Loss Net Loss Year (Gain) Actual Assets Corridor (Gain) (Gain) 2004 $13,000 $110,000 $100,000 $11,000 $2,000 $200 2005 (2,300) 135,000 130,000 13,500 ---- ---- 2006 18,700 168,000 170,000 17,000 1,700 170 2007 27,500 230,000 215,000 23,000 4,500 450

Recognition of Additional Pension Liability Assume the following facts for the Devon Company at the end of 2004: Projected benefit obligation $2,000,000 Accumulated benefit obligation 1,200,000 Plan assets (fair value) 1,000,000 Prepaid/accrued pension cost (liability) 50,000 Unrecognized prior service cost 300,000

Recognition of Additional Pension Liability Remember that the difference between the two benefit obligations is that the PBO includes assumed future pay increase, whereas the ABO is based on current pay levels. Accumulated benefit obligation $1,200,000 Plan assets (fair value) (1,000,000 ) Unfunded accumulated benefit obligation $ 200,000

Recognition of Additional Pension Liability The unfunded accumulated benefit obligation of $200,000 is the minimum liability that the company must recognize. Accumulated benefit obligation $1,200,000 Plan assets (fair value) (1,000,000 ) Unfunded accumulated benefit obligations $ 200,000

Recognition of Additional Pension Liability Unfunded accumulated benefit obligations $200,000 Prepaid/accrued pension cost (liability) (50,000 ) Additional pension liability $150,000 Deferred Pension Cost 150,000 Additional Pension Liability 150,000 December 31, 2004: Continued

Recognition of Additional Pension Liability The intangible asset cannot exceed the unrecognized prior service cost. Assume Devon Company has an unrecognized prior service cost of $120,000. Continued

Recognition of Additional Pension Liability December 31, 2004: Deferred Pension Cost 120,000 Excess of Additional Pension Liability Over Unrecognized Prior Service Cost 30,000 Additional Pension Liability 150,000 Continued

Recognition of Additional Pension Liability Stockholders’ Equity Common stock $600,000 Additional paid-in capital 230,000 Retained earnings 170,000 Accumulated other comprehensive income (loss): Excess of additional pension liability over unrecognized prior service cost (30,000 ) Total stockholders’ equity $970,000

Recognition of Additional Pension Liability Assume the following facts for the Devon Company at the end of 2005: Accumulated benefit obligation 1,300,000 Plan assets (fair value) 1,220,000 Prepaid/accrued pension cost (liability) 60,000 Unrecognized prior service cost 110,000 Continued

Recognition of Additional Pension Liability Unfunded accumulated benefit obligations $80,000 Prepaid/accrued pension cost (liability) (60,000 ) Additional pension liability $20,000 Additional Pension Liability 130,000 Deferred Pension Cost 130,000 December 31, 2005:

Recognition of Additional Pension Liability Since the additional liability is less than the unrecognized prior service cost, the company does not include any reduction in its accumulated other comprehensive income for the year.

Pension Liabilities Five alternatives for meeting the recognition-measurement criteria of a liability that have been identified as follows: 1. Amount attributed to employee service to date. 2. Contributions based on an actuarial funding method. 3. Termination liability. 4. Amount of vested benefits. 5. Amount payable to retirees.

Termination Benefits Paid to Employees FASB Statement No. 88 requires that a company record a loss and a liability for termination benefits when the following two conditions are met: 1. The employee accepts the offer, and 2. The amount can be reasonably estimated.

Other Postemployment Benefits Many companies offer additional benefits to former employees after their retirement—widely referred to as OPEB. What are the major differences between postretirement healthcare benefits and pensions?

Other Postemployment Benefits Item Pensions Healthcare Beneficiary Retired employee (some Retired employee, residual benefit to spouse, and surviving spouse) dependents Benefits Defined, fixed dollar Not limited, paid as amount, paid monthly used, varies geographically Funding Funding legally required Usually not funded and tax deductible because not legally required and not tax deductible

OPEB Expense The net postretirement benefit expense includes the following components: 1. Service cost 2. Interest cost 3. Expected return on plan assets 4. Amortization of unrecognized prior service cost 5. Gain or loss 6. Recognition of the obligation or asset existing at the date of the initial adoption of the statement

Illustration of Accounting for OPEBS Livingston Company adopts a healthcare plan for retired employees on January 1, 2004. At that time the company has two employees and one retired employee. The discount rate is 10%, all employees were hired at age 25 and will become eligible full benefits at age 55. The retired employee was paid $1,500 postretirement healthcare benefits in 2004. The company determines its accumulated postretirement benefit obligations to be $100,000. Continued

Illustration of Accounting for OPEBS Service cost (actuarially determined) $ 1,100 Interest cost ($100,000 x 0.10) 10,000 Expected return on plan assets 0 Amortization of unrecognized prior service cost ($100,000 ÷ 5) 20,000 Gain or loss 0 Amortization of transition obligation 0 Postretirement Benefit Expense $31,100 Continued

Illustration of Accounting for OPEBS December 31, 2004: Postretirement Benefit Expense 31,100 Accrued Postretirement Benefit Cost 31,100 To record the payment of retirement benefits: Accrued Postretirement Benefit Cost 1,500 Cash 1,500

Interaction With Deferred Income Taxes The change in the deferred tax rules from FASB Statement No. 96 to FASB Statement No. 109, which made it easier for a company to recognize deferred tax assets.

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