Volume 2

ACCOUNTING FOR PENSIONS AND POSTRETIREMENT BENEFITS C H A P T E R 20 ACCOUNTING FOR PENSIONS AND POSTRETIREMENT BENEFITS Intermediate Accounting IFRS Edition Kieso, Weygandt, and Warfield

Learning Objectives Distinguish between accounting for the employer’s pension plan and accounting for the pension fund. Identify types of pension plans and their characteristics. Explain alternative measures for valuing the pension obligation. List the components of pension expense. Use a worksheet for employer’s pension plan entries. Describe the amortization of past service costs. Explain the accounting for unexpected gains and losses. Explain the corridor approach to amortizing gains and losses. Describe the requirements for reporting pension plans in financial statements. Explain special issues related to postretirement benefit plans.

Accounting for Pensions and Postretirement Benefits Nature of Pension Plans Accounting for Pensions Using a Pension Worksheet Reporting Pension Plans in Financial Statements Defined contribution plan Defined-benefit plan Role of actuaries Alternative measures of liability Components of pension expense 2011 entries and worksheet Amortization of past service cost 2012 entries and worksheet Gain or loss 2013 entries and worksheet Recognition of actuarial gains and losses Within the financial statements Within the notes to the financial statements 2013 entries and worksheet—a comprehensive example Special issues

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 employer’s pension plan and accounting for the pension fund.

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 employer’s pension plan and accounting for the pension fund.

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.

Accounting for Pensions Two questions: What is the pension obligation that a company should report in the financial statements? What is the pension expense for the period? LO 3 Explain alternative measures for valuing the pension obligation.

Accounting for Pensions Alternative measures of the Liability Employer’s pension obligation is the deferred compensation obligation it has to its employees for their service under the terms of the pension plan. IASB’s choice Illustration 20-3 LO 3 Explain alternative measures for valuing the pension obligation.

Accounting for Pensions Illustration 20-4 Components of Annual Pension Expense LO 4 List the components of pension expense.

Accounting for Pensions Components of Pension Expense Effect on Expense 1. Service Costs + Actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. LO 4 List the components of pension expense.

Accounting for Pensions Interest on the Liability Components of Pension Expense Effect on Expense 2. Interest on the Liability + Interest for the period on the defined benefit obligation outstanding during the period. Interest rate (discount rate) should be those based on high-quality bonds of currency and term consistent with the liabilities. LO 4 List the components of pension expense.

Accounting for Pensions Actual Return on Plan Assets Components of Pension Expense Effect on Expense 3. Actual Return on Plan Assets +- 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.

Accounting for Pensions Amortization of Prior Service Costs Components of Pension Expense Effect on Expense 4. Amortization of Prior Service Costs + Plan amendments often increase benefits for service provided in prior years. The cost (past service cost) of providing these retroactive benefits is allocated to pension expense depending on whether the benefits vest immediately or not. LO 4 List the components of pension expense.

Accounting for Pensions Components of Pension Expense Effect on Expense 5. Gain or Loss +- Volatility in pension expense can result from sudden and large changes in the fair value of plan assets and by changes in actuarial assumptions that affect the defined benefit obligation. LO 4 List the components of pension expense.

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 employer’s pension plan entries.

Using a Pension Work Sheet BE20-3: At January 1, 2010, Blue Diamond Company had plan assets of $250,000 and a defined benefit obligation of the same amount. During 2010, service cost was $27,500, the discount 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 Blue Diamond for 2010. LO 5 Use a worksheet for employer’s pension plan entries.

Using a Pension Work Sheet BE20-3: Prepare a pension worksheet for Blue Diamond for 2010. $250,000 x 10% ($7,500) net liability LO 5 Use a worksheet for employer’s pension plan entries.

Prior Service Cost Amortization of Prior Service Cost If benefits from the amendment to the plan Vest immediately recognize the expense and related liability at the amendment date. Do not vest immediately recognized as an expense on a straight-line basis over the average remaining period until the benefits become vested. LO 6 Describe the amortization of past service costs.

Prior Service Cost Illustration: Hitchcock plc amends its defined pension plan on January 1, 2011, resulting in £300,000 of past service cost. There are 300 active employees, of which 60 vest immediately (20%) and 240 (80%) vest in four years. The past service cost applicable to the vested employees is £60,000 and vests immediately. Unrecognized past service cost related to the unvested employees is £240,000 and is amortized over four years. Illustration 20-10 LO 6 Describe the amortization of past service costs.

Using a Pension Work Sheet E20-7: The following defined pension data of Doreen Corp. apply to the year 2010. Defined benefit obligation, 1/1/10 (before amendment) $560,000 Plan assets, 1/1/10 546,200 Pension liability 13,800 On January 1, 2010, Doreen Corp., through plan amendment, grants prior service benefits having a present value of 100,000 Discount rate 9% Service cost 58,000 Contributions (funding) 55,000 Actual (expected) return on plan assets 52,280 Benefits paid to retirees 40,000 Past service cost amortization for 2010 17,000 Instructions: For 2010, prepare a pension work sheet for Doreen Corp. that shows the journal entry for pension expense. LO 6 Describe the amortization of past service costs.

Using a Pension Work Sheet ($40,920) liability LO 6

Using a Pension Work Sheet E20-7: Pension Journal Entry for 2010. Dec. 31 Pension Expense 82,120 Pension Liability 27,120 Cash 55,000 LO 6 Describe the amortization of past service costs.

Using a Pension Work Sheet Gain or Loss Unexpected swings in pension expense can result from: Changes in the fair value of plan assets, and Changes in actuarial assumptions that affect the amount of the defined benefit obligation. LO 7 Explain the accounting for unexpected gains and losses.

Gains and Losses Volatility 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.

Gains and Losses Question: What happens to the difference between the expected return and the actual return? 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.

Gains and Losses Question: What happens with unexpected gains or losses from changes in the Defined Benefit Obligation? 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.

Gains and Losses Corridor Amortization IASB uses 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 defined benefit obligation or the 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.

Gains and Losses BE20-7: Hunt Corporation had a defined benefit obligation of $3,100,000 and plan assets of $2,900,000 at January 1, 2010. Hunt’s unrecognized net pension loss was $475,000 at that time. The average remaining service period of Hunt’s employees is 7 years. Instructions: Compute Hunt’s minimum amortization of pension loss. LO 8 Explain the corridor approach to amortizing gains and losses.

Gains and Losses BE20-7: Compute Hunt’s minimum amortization of pension loss. ÷ LO 8 Explain the corridor approach to amortizing gains and losses.

Gains and Losses Immediate Recognition of Gains and Losses IASB indicates: Corridor approach results in the minimum amount recognized as an actuarial gain and loss. Companies may use any systematic method that is faster provided it is used for both gains and losses and is used consistently from period to period. IASB favors the immediate recognition of actuarial gains and losses. Actuarial gain or loss can either adjust net income or other comprehensive income. LO 8

Gains and Losses Illustration: Wentworth Company has the following components of pension expense for 2011. Illustration 20-19 If company decides to report the loss in net income. Illustration 20-20 LO 8

Gains and Losses Illustration: If Wentworth Company decides to report the loss in other comprehensive income. Illustration 20-21 Illustration 20-19 If company decides to report loss in other comprehensive income. LO 8

Using a Pension Work Sheet P20-2: Katie Day Company adopts IAS 19 in accounting for its defined benefit pension plan on January 1, 2000, with the following beginning balances: plan assets $200,000; defined benefit obligation $250,000. Other data are as follows.

Using a Pension Work Sheet

Using a Pension Work Sheet P20-2: Pension Journal Entry for 2010 Dec. 31 Pension Expense 16,000 Cash 16,000

Using a Pension Work Sheet ($49,700) liability

Using a Pension Work Sheet P20-2: Pension Journal Entry for 2011 Dec. 31 Pension Expense 89,700 Pension Liability 49,700 Cash 40,000

Using a Pension Work Sheet ($85,130) liability

Using a Pension Work Sheet P20-2: Pension Journal Entry for 2012 Dec. 31 Pension Expense 83,430 Pension Asset/Liability 35,430 Cash 48,000

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.

Reporting Pension Plans in Financial Statements Within the Notes to the Financial Statements Description of the plan and the accounting policy for recognizing actuarial gains and losses. Schedule showing all the major components of pension expense. Reconciliation showing how the defined benefit obligation and the fair value of the plan assets changed from the beginning to the end of the period. Funded status of the plan and the amounts recognized and not recognized in the financial statements. LO 9 Describe the requirements for reporting pension plans in financial statements.

Reporting Pension Plans in Financial Statements Within the Notes to the Financial Statements Disclosure of the rates used in measuring the benefit amounts (discount rate, expected return on plan assets, rate of compensation). Company’s best estimate of the contributions expected to be made to the plan in the next year. A table indicating the allocation of pension plan assets by category and showing the percentage of or the amount related to the fair value to total plan assets. In addition, the actual return on the plan is disclosed, as well as information on how the expected rate of return is determined. LO 9 Describe the requirements for reporting pension plans in financial statements.

Reporting Pension Plans in Financial Statements Special Issues Other postretirement benefits Curtailments and settlements LO 10 Explain special issues related to postretirement benefit plans.

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

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. U.S. GAAP does not permit choice. For defined benefit plans, U.S. 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. The accounting for pensions and other postretirement benefit plans is the same under IFRS. U.S. GAAP has separate standards for these types of benefits, and significant differences exist in the accounting.

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