Employee Compensation—Payroll, Pensions, and Other Compensation Issues chapter 17 Employee Compensation—Payroll, Pensions, and Other Compensation Issues

Learning Objectives 1. Account for payroll and payroll taxes, and understand the criteria for recognizing a liability associated with compensated absences. 2. Compute performance bonuses and recognize the issues associated with postemployment benefits. Understand the nature and characteristics of employer pension plans, including a detailed discussion of defined benefit plans. 4. Use the components of prepaid/accrued pension costs and changes in the components to compute the periodic expense associated with pensions. Prepare required disclosures associated with pensions, and understand the accounting treatment for pension settlements and curtailments Describe the few remaining differences between U.S. pension accounting standards and the provisions of IAS 19. 7. Explain the differences in accounting for pensions and postretirement benefits other than pensions.

Employee Compensation Event Line Payroll Compensated Absences Time Stock Options and Bonuses Postemployment Benefits Pensions and Postretirement Benefits Other Than Pensions 2

Payroll and Payroll Taxes Social security and income tax legislation impose five taxes based on payrolls: 1. Federal old-age, survivors’, and disability (tax to both the employee and employer) 2. Federal hospital insurance (tax to both employer and employee) Federal unemployment insurance (tax to employer only) State unemployment insurance (tax to employer only) Individual income tax (tax to employee only but withheld and paid by employer)

Payroll and Payroll Taxes FICA The FICA tax rate and the maximum amount taxable continue to change. As of 2002 …the rate is 6.20% on annual wages up to $84,900. This affect both employer and employee. a.k.a. Social Security Federal Hospital Insurance There is no upper limit on this tax. The 2002 rate is1.45% for both employer and employee. a.k.a. Medicare Tax

Payroll and Payroll Taxes Federal Unemployment Insurance The employer pays 6.2% on the first $7,000 earned by each employee. A credit of 5.4% may be applied based on state unemployment tax (see below), therefore making it 0.8% Work for Food State Unemployment Insurance The employer usually pays 5.4% to the state on the first $7,000 earned by each employee.

Payroll and Payroll Taxes Income Tax Employers are required to withhold income tax from wages paid to their employees. Withholding tables provide information about how much to withhold from each employee. These deductions are affected by the number of exemptions claimed.

Salary Expenses and Liabilities The employee’s gross earnings are an expense to the employer. Withholdings are an expense to the employee, not to the employer. Withholdings become a liability to the employer only because the employer keeps money earned by employees and pays obligations on their behalf. 3 4

Accounting for a Payroll Eg. Total salary for 15 employees = $16,000. State unemployment tax = 5.4%. Income tax with-holding = $1,600. Combined FICA = 7.65%. This employer would make the following entry to record salary expense: Salaries Expense 16,000 FICA Taxes Payable 1,224 Employees Income Taxes Payable 1,600 Cash 13,176 To record payment of payroll and related employee withholdings. Continued 5 5

Accounting for a Payroll Employers make this entry to record their portion of FICA and other payroll taxes e.g. SUT & FUT: Payroll Tax Expense 2,216 FICA Taxes Payable 1,224 State Unemployment Taxes Payable 864 Federal Unemployment Taxes Payable 128 To record the payroll tax liability of the employer. 0.0765 x $16,000 0.054 x $16,000 0.008 x $16,000 Payroll taxes are: An expense to the employer. A liability to the employer until they are paid. 8 7

Compensated Absences Compensated absences include payments by employers for vacation, holiday, illness, or other personal activities. FASB Statement No. 43 requires a liability to be recognized for compensated absences that— (1) Have been earned through services already rendered (2) Vest or can be carried forward to subsequent years (3) Are estimable and probable

Compensated Absences S&N Corporation has 20 employees who are paid an average of $700 per week. During 2004, a total of 40 vacation weeks was earned by all employees, but only 30 weeks of vacation were taken. The entry to record the accrued vacation on December 31, 2004, would be: Wages Expense 7,000 Vacation Wages Payable 7,000 To record accrued vacation wages ($700 x 10 weeks). Continued

Compensated Absences In 2005, when the additional vacation weeks are taken, the average rate has increased to $800 per week. Wages Expense 1,000 Vacation Wages Payable 7,000 Cash 8,000 To record payment at current rates of previously earned vacation time ($800 x 10 weeks). Compensated absences are not tax deductible until payment is made, while they are deductible under GAAP, once accrued. This gives right to deferred tax!

Stock-Based Compensation (recall ACC301 - Chapter 11) and Bonuses Photo Graphics, Inc. gives it store managers a 10% bonus based on individual store earnings. The bonus is to based on income after deducting the bonus, but before deduction for income taxes. Store X has income for the year of $100,000. B = 0.10($100,000 – B) B = $10,000 – 0.10B B + 0.10B = $10,000 1.10B = $10,000 B = $9,091 (rounded) Continued

Major Categories of Pension Plans 1. Government plans, primarily social security 2. Individual plans, such as individual retirement accounts (IRAs) 3. Employer plans: Noncontributory – only the employer pays Contributory – the employee also pays Defined Contribution – benefits vary Defined Benefit – contributions vary Vested Benefits - Vesting occurs when an employee has met certain specified requirements and is eligible to receive pension benefits at retirement even if the employee stops working for the employer

Defined Benefit Pension Plans Services Employer Current Employees Pension Fund Contributions Wages and Salaries Retired Employees Defined Benefits

Issues in Accounting for Defined Benefit Plans 1. The amount of net periodic pension expense to be recognized on the income statement. 2. The amount of pension liability or asset to be reported on the balance sheet. 3. Accounting for pension settlements, curtailments, and terminations. 4. Disclosures needed to supplement the amounts reported in the financial statements.

Simple Illustration Lorien Bach is 35 years old and has worked for Thakkar for 10 years. Her salary for 2004 was $40,000. Pension payments begin after the employee turns 65. The annual year-end payment is equal to 2% of the highest salary times the number of years with the company. Thakkar knows for certainty that Bach will live until she is 75. Thakkar uses a discount rate of 10%. As of January 1, 2005, Thakkar had a pension fund of $10,000. During 2005 an additional $1,500 was contributed. The fund earned $350 and the average return is 12%. Continued

Simple Illustration Estimation of Pension Obligation (2% x 10 years) x $40,000 = $8,000 The annual amount that Bach should received on her retirement Continued

Accumulated Benefit Obligation (ABO) Simple Illustration Accumulated Benefit Obligation (ABO) PV of a an annuity of $8,000 per year for ten years deferred for 30 years is $2,817 X X X X X X X X X X 30 years $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 Accumulated benefit obligation (ABO) Continued

Simple Illustration Projected Benefit Obligation (PBO) Assume Thakkar Company expects Bach’s 2004 salary of $40,000 to increase 5% every year until retirement. (2% x 10 years) x $172,877 = $34,575 (rounded) The PBO is the PV of ten equal deferred payments of $34,575 (= $12,176). PV = $40,000, N = 30, I = 5% Continued

Accrued Pension Liability Simple Illustration Accrued Pension Liability PBO, January 1, 2005 $12,176 Pension fund at fair value, January 1, 2005 (10,000) Accrued pension liability* $ 2,176 FASB Statement No. 87 stipulates that these two items be offset against one another and a single amount be shown. * - The reverse direction would give rise to Prepaid pension cost

a.k.a. settlement interest rate Simple Illustration – Other Issues 1. Interest Cost PBO, Beginning Discount Interest of Period x Rate = Cost $12,176 x 0.10 = $1,218 a.k.a. settlement interest rate 2. Service Cost Bach’s work for Thakkar during the year 2005 results in an increase in forecasted annual benefits to Bach because the payments are calculated on 11 years of service. The impact of this one extra year of service is to increase the December 31, 2005 PBO balance by $1,339. Therefore, the service cost element of pension expense for the year is $1,339.

Simple Illustration – Other Issues 3. Return on the Pension Fund Pension expense is reduced by the return on the pension fund for the year. Because Thakkar expects a 12% rate of return, the original $10,000 will have a return of $1,200 in 2005. Continued

Simple Illustration PBO, End of Year – The Liability side Service cost and interest cost PBO, beginning of year Retirement benefits paid Change in actuarial assumptions + – ± Continued

Simple Illustration Fair Value of Pension Fund (FVPF)– The Asset side Fair value of pension fund, beginning of year Employer contribu-tions Retirement benefits paid Actual return on pension fund + – ± Continued

Accrued Pension Liability Simple Illustration Accrued Pension Liability As of December 31, 2005, the PBO for Thakkar is $14,733 and the total FVPF is $12,700 ($10,000 + $1,200 return + $1,500 new contributions). PBO, December 31, 2005 $14,733 Pension fund at fair value, December 31, 2005 (12,700) Accrued pension liability $ 2,033 Continued

New contributions to pension fund Simple Illustration Thakkar would make the following entries for 2005: Pension Expense 1,357 Prepaid/Accrued Pension Cost 1,357 Prepaid/Accrued Pension Cost 1,500 Cash 1,500 New contributions to pension fund Service cost ($1,339) + Interest cost ($1,218) – Expected return ($1,200) Note - A compound entry could have been made

Comprehensive Pension Illustration - The Basic Spreadsheet Approach – see page 1060 Formal Accounts Memorandum Accounts Prepaid/ Periodic Net Accrued Pension Fair Value Unrecognized Prior Service Cost Pension Pension Cost/Expense of Plan Expense Cash Cost Items PBO Assets (FVPF) Beginning Balances (a) Service Cost (b) Interest Cost (c) Actual Return (d) Benefits Paid (e) PSC Amortization (g) Deferred Loss (h) Amort. of Deferred Loss Summary Journal Entries (1) Accrual Pension Expense Accrual (2) Annual Pension Contribution (3) Minimum Liability Adjustment 11

Formal Accounts Left Side of Work Sheet Prepaid/ Accrued Pension Net Cost Net Pension Expense Cash Left Side of Work Sheet

Formal Accounts Records total pension costs accrued. Prepaid/ Accrued Pension Cost Net Pension Expense Cash Records total pension costs accrued. Debited for the sum of all periodic pension cost items. 29

Formal Accounts Prepaid/ Accrued Pension Cost Net Pension Expense Cash Records cash expended for contributions to plan assets. Debited for actual amount of cash contributed to pension fund.

Formal Accounts Reflects changes in net pension asset or liability. Prepaid/ Accrued Pension Cost Net Pension Expense Cash Reflects changes in net pension asset or liability. Debited for cash contributions to pension plan assets. Credited for net pension cost.

Formal Accounts Right Side of Work Sheet Periodic Pension Cost Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Right Side of Work Sheet

Fair Value of Pension Fund Memorandum Accounts Periodic Pension Cost Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Records noncurrent asset arising from recognition of additional pension liability for unfunded pension plans. Account balance should not exceed the sum of unrecognized transition loss plus prior service costs.

Fair Value of Pension Fund Memorandum Accounts Periodic Pension Cost Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Actuarial present value of pension benefits. Uses the benefits per year of service approach. Assumes future compensation levels. PBO EoY = BoY + Service Cost Interest ± Change in Actuarial Assumptions Retirement Benefits Paid –

Fair Value of Pension Fund Memorandum Accounts Periodic Pension Cost Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Amount that could be received from the sale of plan assets in a current sale between a willing buyer and seller. Increased by employer/employee contributions. Decreased by benefits paid. FVPF EoY = BoY + Contributions – Benefits Paid ± Actual Return on Assets

Fair Value of Pension Fund Memorandum Accounts Periodic Pension Cost Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost When a pension plan is initially adopted or amended to provide increased benefits, employees are granted additional benefits for services performed in years prior to the plan’s adoption or amendment. 12

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Prepaid/ Accrued Pension Cost Net Pension Expense Cash Balance, 1/1/05 $ (40,000 ) Left Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Periodic Pension Expense Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Balance $(1,500,000 ) $1,385,000 $75,000 Right Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Prepaid/ Accrued Pension Cost Net Pension Expense Cash Balance, 1/1/05 $ (40,000 ) (a) Service Cost Left Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Periodic Pension Expense Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Balance $(1,500,000 ) $1,385,000 $75,000 (a) $ 75,000 (75,000 ) Right Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Prepaid/ Accrued Pension Cost Net Pension Expense Cash Balance, 1/1/05 $ (40,000 ) Service Cost Interest Cost Left Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Periodic Pension Expense Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Balance $(1,500,000 ) $1,385,000 $75,000 (a) $ 75,000 (75,000 ) (b) 165,000 (165,000) Right Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Actual Return on the Pension Fund Fair value of pension fund, 12/31/05 $1,513,500 Fair value of pension fund, 1/1/05 1,385,000 Increase in fair value $ 128,500 Add benefits paid 125,000 Deduct contributions made (115,000) Actual return on the pension fund $ 138,500

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Prepaid/ Accrued Pension Cost Net Pension Expense Cash Balance, 1/1/05 $ (40,000 ) Service Cost Interest Cost Actual Return Left Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Periodic Pension Expense Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Balance $(1,500,000 ) $1,385,000 $75,000 (a) $ 75,000 (75,000 ) (b) 165,000 (165,000) (c) (138,500) 138,500 Right Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Prepaid/ Accrued Pension Cost Net Pension Expense Cash Balance, 1/1/05 $ (40,000 ) Service Cost Interest Cost Actual Return Benefits Paid Left Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Periodic Pension Expense Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Balance $(1,500,000 ) $1,385,000 $75,000 (a) $ 75,000 (75,000 ) (b) 165,000 (165,000) (c) (138,500) 138,500 (d) 125,000 (125,000) Right Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Amortization of Unrecognized Prior Service Cost Ten percent (15 employees) are expected to retire or quit with vesting privileges. N(N + 1) 2 x D = Total future years of service 10(10 + 1) 2 x 15 = 825 15 employees for 10 years 150 825 x $75,000 = $13,636 Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Prepaid/ Accrued Pension Cost Net Pension Expense Cash Balance, 1/1/05 $ (40,000 ) Service Cost Interest Cost Actual Return Benefits Paid PSC Amortization Left Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Periodic Pension Expense Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Balance $(1,500,000 ) $1,385,000 $75,000 (a) $ 75,000 (75,000 ) (b) 165,000 (165,000) (c) (138,500) 138,500 (d) 125,000 (125,000) (e) 13,636 (13,636) Right Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Prepaid/ Accrued Pension Cost Left Side of Work Sheet Net Pension Expense Cash Balance, 1/1/05 $ (40,000 ) Service Cost Interest Cost Actual Return Benefits Paid PSC Amortization Annual Pension Expense Accrual $115,136 (115,136 ) Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Prepaid/ Accrued Pension Cost Left Side of Work Sheet Net Pension Expense Cash Balance, 1/1/05 $ (40,000 ) Service Cost Interest Cost Actual Return Benefits Paid PSC Amortization Annual Pension Expense Accrual $115,136 (115,136 ) (2) Annual Pension Contribution (115,000) 115,000 Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Periodic Pension Expense Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Balance $(1,500,000 ) $1,385,000 $75,000 (a) $ 75,000 (75,000 ) (b) 165,000 (165,000) (c) (138,500) 138,500 (d) 125,000 (125,000) (e) 13,636 (13,636) (1) (2) 115,000 Right Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Prepaid/ Accrued Pension Cost Left Side of Work Sheet Net Pension Expense Cash Balance, 12/31/05 $ (40,136 ) Only column added on the left side of the work sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Periodic Pension Expense Items Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost 12/31/05 $(1,615,000 ) $1,513,500 $61,364 Right Side of Work Sheet Continued

Thornton Electronics, Inc.—Pension Work Sheet for 2005 Pension Expense 115,136 Prepaid/Accrued Pension Cost 115,136 To record accrual of net pension expense for 2005 Prepaid/Accrued Pension Cost 115,000 Cash 115,000 To record 2005 contribution to the pension plan.

Corridor Amortization of Unrecognised Net Pension Gain/ Loss a. Differences between actual & expected return If actual return of pension fund > estimated return, then the difference = Gain to be deferred The financial statement effect = Increase Pension Expense & Decrease Net Pension Liability The Memorandum entries = Debit Pension expense & Credit Unrecognized Net Pension Gain/Loss If actual return of pension fund < estimated return, then the difference = Loss to be deferred Decrease Pension Expense & Increase Net Pension Liability Credit Pension expense & Debit Unrecognized Net Pension Gain/Loss 18

Corridor Amortization of Unrecognised Net Pension Gain/ Loss b. Differences in Actuarial estimates of BPO If PBO should increase The financial statement effect = nil The Memorandum entries = Credit PBO & Debit Unrecognized Net Pension Gain/Loss 18

Corridor Amortization of Unrecognised Net Pension Gain/ Loss Amortization is required only on portion of unrecognized net gain or loss that exceeds 10% of the greater of: PBO, or market-related value of plan assets at the beginning of the year. May use any amortization method that equals or exceeds straight-line amortization over remaining expected service years of covered employees, and is consistently applied. See Thornton Electronics 2006 & 2007 pages 1063-1067 18

Minimum Pension Liability Net amount of pension liability that must be reported for underfunded plans. Measured as difference between ABO and Fair Value of Plan Assets. Minimum Pension ABO – FV Plan Liability Assets = See pages 1067 – 1068: Quite Interesting! 37

Deferred Pension Cost If an employer is required to record an additional pension liability as a result of applying the minimum liability provisions, FASB Statement No. 87 indicates that the offsetting charge should be to the Deferred Pension Cost account, which is an intangible asset. Clapton Corporation computes the following balances as of December 31, 2005: Accumulated benefit obligation $1,250,000 Fair value of the pension fund 1,140,000 Accrued pension cost 16,000 Unrecognized prior service cost 80,000

Deferred Pension Cost The minimum pension liability is $110,000 ($1,250,000 – $1,140,000). An additional pension liability of $94,000 ($110,000 – $16,000) would be recorded. Deferred Pension Cost 80,000 Excess of Additional Pension Liability over Unrecognized Prior Service Cost* 14,000 Additional Pension Liability 94,000 To recognize additional pension liability. * This is a contra equity account reported as part of “Accumulated other comprehensive income”

Disclosure of Pension Plans Statement No. 132 requires the following major disclosure requirements for most publicly traded companies: A reconciliation between the beginning and ending balances for the projected benefit obligation A reconciliation between the beginning and ending balances in the fair value of the pension fund A disclosure of the accumulated benefit obligation when the ABO exceeds the fair value of the pension fund The funded status of the plans, the amounts not recognized in the balance sheet, and the amount recognized in the balance sheet Continued

Disclosure of Pension Plans The components of pension expense for the period Any effects on the other comprehensive income section as a result of changes in the additional pension liability The assumptions used relating to (a) discount rate, (b) rate of compensation increase, and (c) expected long-term rate of return on the pension fund Certain information about postretirement benefits

Disclosure of Pension Plans Statement No. 132 added that an employer must disclose the amount of pension expense recognized for defined contribution plans separately form the amount of expense recognized for defined benefit plans. In addition, the nature and effect of any significant changes during the period should be disclosed.

Pension Settlements and Curtailments Settlement of a pension plan occurs when an employer takes an irrevocable action that relieves the employer of primary responsibility for all or part of the obligation. E.g. the purchase of an annuity or a lump-sum cash payment to the employee Curtailment of a pension plan arises from an event that significantly reduces the benefits that will be provided for present employees’ future services. E.g. discontinuation of a segment or the suspension of a plan Termination of an employee earlier than expected Termination or suspension of a pension plan

International Pension Accounting Standards IFRS 19 was revised to require that a company’s pension obligation be measured using the same approach as is used under U.S. GAAP. IFRS 19 does not include any provision for the recognition of an additional minimum liability. IFRS 19 does not allow the recognition of a net pension asset unless the amount is less than the discounted present value of any employee refunds to the company plus any anticipated reductions in future pension contributions. UK’s FRS 17 – Pension gains and losses are recognized immediately

chapter 17 The End