Accounting for Postemployment Benefits C hapter 20 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

2 Defined Contribution Plans employer contributes a defined sum to a third party plan trust.  The employer contributes a defined sum to a third party plan trust.  Amounts to be funded are determined by the plan.  The plan invests the contributed assets, which earn income, and makes distributions to retirees.  There is no promise for specific future benefits.  Market risk is borne by the employee.  Accounting for the firm is relatively straightforward.  For profit companies contribute to 401(k) plans and non- profit organizations contribute to 403(b) plans.

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

4 The retirement income, normally paid monthly, usually is determined on the basis of the employees earnings and length of service with the company. Defined Benefit Plans $50,000 average salary X 2.5% per year X 30 years = $37,500 pension per year $50,000 average salary X 2.5% per year X 30 years = $37,500 pension per year

5 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 when paid. 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. Internal Revenue Qualifications

6 promised a certain amount of benefits at retirement  The employee is promised a certain amount of benefits at retirement.  The amount received is based upon variables such as -Years of service -Ending salary or average of best (three) years -Multiplier, such as 2.5% per year of service -Age, if retiring early, a deduction will be made  The employer remains liable for the benefits and bears the market risk.  The employer is the trust-beneficiary.  The accounting by the firm is complex. promised a certain amount of benefits at retirement  The employee is promised a certain amount of benefits at retirement.  The amount received is based upon variables such as -Years of service -Ending salary or average of best (three) years -Multiplier, such as 2.5% per year of service -Age, if retiring early, a deduction will be made  The employer remains liable for the benefits and bears the market risk.  The employer is the trust-beneficiary.  The accounting by the firm is complex. Defined Benefit Plans

7 The projected benefit obligation is the actuary’s estimate of the present value of benefits attributed to date based on future salary levels. Projected Benefit Obligation

8 The accumulated benefit obligation is the actuary’s estimate of the present value of benefits attributed to date based on current salary levels. Accumulated Benefit Obligation

9 Components of Pension Expense 1.+Service cost for the year. Increases pension expense. 2.+Interest on projected benefit obligation (liability). Beginning PBO times the discount or settlement rate. Increases pension expense. 3.-Expected return on plan assets during the year. Fair value of plan assets at beginning of year times expected long-term rate of return on plan assets. Generally decreases pension expense. 4.+Amortization of prior service cost = Present value of additional benefits/modification of the plan amortized over the remaining service lives of active employees. Generally increases pension expense. 5.+Gain or loss = Amortization of the cumulative unrecognized net gain or loss from previous periods in excess of the corridor.

10 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

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

12 The expected return on plan assets, if positive, will decrease pension expense. Expected Return on Assets The expected return on plan assets is the expected increase in plan assets due to investing activities.

13 When a defined benefit plan is either initiated or amended, credit is often given to employees for years of service provided before the date of initiation or amendment. Prior Service Cost

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

15 Prior service cost may be amortized over future service periods of employees active at the time of the plan amendment using either the straight-line or years-of-service method. Methods of Amortization

16 The average remaining service life of employees expected to receive benefits is calculated by dividing the total future service years by the number of employees. Total future service years = average remaining service life Number of employees expected to receive benefits The average remaining service life of employees expected to receive benefits is calculated by dividing the total future service years by the number of employees. Total future service years = average remaining service life Number of employees expected to receive benefits Straight-line Method

17 The Board prefers a years-of-service amortization method where unrecognized prior service cost is divided by the number of future service years to be worked by participating employees, to obtain a cost per service-year. This cost per service-year is multiplied by the number of service years consumed each year. Years-of-Service Method

18 A gain or loss in plan assets arises because of changes in the stock market and because of changes in actuarial assumptions. Gain or Loss

19 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

20 Amortization of Gain or Loss minimum subject to amortization  The minimum amortization required is computed by dividing the total unrecognized gain or loss subject to amortization at the beginning of the year by the average remaining service period of active employees expected to receive benefits.  The amount subject to amortization is the excess of 10% of the larger of the beginning balances of the projected benefit obligation and the market- related asset value. Use absolute values. minimum subject to amortization  The minimum amortization required is computed by dividing the total unrecognized gain or loss subject to amortization at the beginning of the year by the average remaining service period of active employees expected to receive benefits.  The amount subject to amortization is the excess of 10% of the larger of the beginning balances of the projected benefit obligation and the market- related asset value. Use absolute values.

21 1.Amortization of any unrecognized net loss from previous periods is added to compute pension expense, or 2.Amortization of any unrecognized net gain from previous periods is deducted to compute pension expense. 1.Amortization of any unrecognized net loss from previous periods is added to compute pension expense, or 2.Amortization of any unrecognized net gain from previous periods is deducted to compute pension expense. Amortization of Gain or Loss

22 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) 2007$13,000 $110,000$100,000$11,000$2,000$ (2,300)135,000130,00013, , ,000170,00017,0001, ,500230,000215,00023,0004, Assume the average remaining service period is 10 years. Computation of Net Gain or Loss Component of pension expenseComponent expense Divide By 10 years Use January 1 cumulative gain or loss for computation.

23 Facts for the Carlisle Company 1.The company adopts a pension plan on January 1, No retroactive benefits were granted to employees. 2.The service cost each year is: 2007, $400,000; 2008, $420,000; 2009, $432, The projected benefit obligations at the beginning of each year is: 2008, $400,000; and 2009, $840,000. ContinuedContinued Pension Expense Equal to Funding

24 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 2008). Pension Expense Equal to Funding

25 December 31, 2007: Pension Expense400,000 Cash400,000 December 31, 2008: Pension Expense420,000 Cash420,000 Pension Expense Equal to Funding Service cost (from actuary)$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 Service cost (from actuary)$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

26 Balance Plan Assets Cash from ,000 Paid to Return ,000 retirees Cash from , ,000 Bal. 1/1/09 840,000

27 December 31, 2009: Pension Expense432,000 Cash432,000 Note that the interest cost and the return on the plan assets offset each other each year. Pension Expense Equal to Funding Service cost (from actuary)$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 Service cost (from actuary)$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

28 December 31, 2007: Pension Expense400,000 Cash385,000 Prepaid/Accrued Pension Cost15,000 Carlisle Company funds $385,000 in 2007, $400,000 in 2008, and $415,000 in LiabilityLiability Pension Expense Greater Than Funding

29 Service cost (from actuary)$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 Service cost (from actuary)$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 December 31, 2008: Pension Expense421,500 Cash400,000 Prepaid/Accrued Pension Cost21,500 (Liability balance now $15,000 + $21,500) Pension Expense Greater Than Funding

30 December 31, 2009: Pension Expense435,650 Cash415,000 Prepaid/Accrued Pension Cost20,650 The balance in the liability account is $57,150 ($15,000 + $21,500 + $20,650) Pension Expense Greater Than Funding Service cost (from actuary)$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 Service cost (from actuary)$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

31 December 31, 2007: Pension Expense400,000 Prepaid/Accrued Pension Cost15,000 Cash415,000 Carlisle Company funds $415,000 in 2007, $425,000 in 2008, and $440,000 in The expected and actual return is 11%. Pension Fund Less Than Pension Funding and Expected Return Different From Discount Rate

32 December 31, 2008: Pension Expense414,350 Prepaid/Accrued Pension Cost10,650 Cash425,000 The balance in the asset account is $25,650 Pension Fund Less Than Pension Funding and Expected Return Different From Discount Rate 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 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

33 December 31, 2009: Pension Expense420,322 Prepaid/Accrued Pension Cost19,678 Cash440,000 The balance in the asset account is $44,872 Pension Fund Less Than Pension Funding and Expected Return Different From Discount Rate Service cost$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 Service cost$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

34 Carlisle Company funds $385,000 in 2007, $400,000 in 2008, and $415,000 in 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

35 Pension Expense700,000 Cash ($385,000 + $290,000)675,000 Prepaid/Accrued Pension Cost25,000 December 31, 2007: Service cost$400,000 Interest cost ($2,000,000 x 10%)200,000 Amortization of unrecognized prior service cost 100,000 Pension expense$700,000 Service cost$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

36 Pension Expense705,750 Cash 685,000 Prepaid/Accrued Pension Cost20,750 December 31, 2008: 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 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

37 Pension Expense701,690 Cash 700,000 Prepaid/Accrued Pension Cost1,690 December 31, 2009: Service cost$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 Service cost$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 Pension Expense Including Amortization of Unrecognized Prior Service Cost

38 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

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

40 Assume the following facts for the Devon Company at the end of 2007: Projected benefit obligation$2,000,000 Accumulated benefit obligation1,200,000 Plan assets (fair value)1,000,000 Prepaid/accrued pension cost (liability)50,000 Unrecognized prior service cost300,000 Projected benefit obligation$2,000,000 Accumulated benefit obligation1,200,000 Plan assets (fair value)1,000,000 Prepaid/accrued pension cost (liability)50,000 Unrecognized prior service cost300,000 Recognition of Additional Pension Liability

41 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

42 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. Recognition of Additional Pension Liability Accumulated benefit obligation$1,200,000 Plan assets (fair value)(1,000,000) Unfunded accumulated benefit obligation$ 200,000

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

44 Unfunded accumulated benefit obligations$ 200,000 Prepaid/accrued pension cost (liability) (50,000) Additional pension liability$150,000 Unfunded accumulated benefit obligations$ 200,000 Prepaid/accrued pension cost (liability) (50,000) Additional pension liability$150,000 Deferred Pension Cost (intangible asset) 150,000 Additional Pension Liability150,000 December 31, 2007 Recognition of Additional Pension Liability

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

46 Deferred Pension Cost (intangible asset) 120,000 Excess of Additional Pension Liability Over Unrecognized Prior Service Cost (contra equity) 30,000 Additional Pension Liability150,000 ContinuedContinued December 31, 2007 Recognition of Additional Pension Liability

47 Stockholders’ Equity Common stock$600,000 Additional paid-in capital230,000 Retained earnings170,000 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 ContinuedContinued

48 Assume the following facts for the Devon Company at the end of 2008: Accumulated benefit obligation1,300,000 Plan assets (fair value)1,220,000 Prepaid/accrued pension cost (liability)60,000 Unrecognized prior service cost110,000 Accumulated benefit obligation1,300,000 Plan assets (fair value)1,220,000 Prepaid/accrued pension cost (liability)60,000 Unrecognized prior service cost110,000 ContinuedContinued Recognition of Additional Pension Liability

49 60,000 Prepaid/Accrued Additional Liability 150,000 20,000 Unfunded ABO Minimum Liability (not a real account) 80,000 Additional Liability 130,000

50 Additional Pension Liability130,000 Deferred Pension Cost (intangible asset)100,000 Excess of Additional Liability Over Unrecognized Prior Service Cost30,000 December 31, 2008: Accumulated benefit obligation $1,300,000 Plan assets (fair value) 1,220,000 Unfunded accumulated benefit obligations 80,000 Prepaid/accrued pension cost (liability) (60,000) Additional pension liability (balance)$20,000 Accumulated benefit obligation $1,300,000 Plan assets (fair value) 1,220,000 Unfunded accumulated benefit obligations 80,000 Prepaid/accrued pension cost (liability) (60,000) Additional pension liability (balance)$20,000 Recognition of Additional Pension Liability

51 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. Recognition of Additional Pension Liability

52 If the fair value the plan assets is more than the accumulated benefit obligation. No further calculations are needed. Recognition of Additional Pension Liability

53 According to FASB Statement No. 132R, a company must disclose specific information about a defined benefit pension plan. Disclosures

54 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

55 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. Interaction with Deferred Income Taxes

56 C hapter 20 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.