Accounting for Postemployment Benefits C hapter 20 COPYRIGHT © 2010 South-Western/Cengage Learning Unit #6

2 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

3 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

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

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

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

7 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

8 The cost of these retroactive benefits is the prior service cost. Prior Service Cost The prior service cost is reported as a liability and as a negative element of other comprehensive income at the date of the plan amendment.

9 The prior service cost is amortized by assigning an equal amount to each future service period of each active employee who, at the date of the amendment, is expected to receive future benefits under the plan. Prior Service Cost Alternatively, straight-line amortization over the average remaining service life of active employees may be used for simplicity.

10 A gain or loss from previous periods from changes in the amount of the projected benefit obligation and the fair value of the pension plan assets resulting from experience different from that assumed, and changes in the assumptions. Gain or Loss

11 Any gain or loss that is not recognized in pension expense in the period it occurs is recognized as an asset or liability and as a component of other comprehensive income. Gain or Loss Accrued/Prepaid Pension Costxxx Other Comprehensive Income: Net Gain/Lossxxx

12 Amortization of Gain or Loss  Amortization of any net gain or loss is included in the pension expense of a given year if, at the beginning of the year, the cumulative net gain or loss from previous periods (included in accumulated other comprehensive income) exceeds a “corridor.”  The “corridor” is defined as 10% of the greater of the actual projected benefit obligation or the fair value of the plan assets.

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

Ending Projected Benefit Obligation: Beginning projected benefit obligation + Prior service cost = Adjusted beginning projected benefit obligation + Service cost for period + Interest cost on beginning projected benefit obligation + Actuarial losses (or – Actuarial gains) – Payments to retirees = Ending projected benefit obligation 14 Projected Benefit Obligation

15 Fair Value of Pension Plan Assets Ending Fair Value of Pension Plan Assets: Beginning fair value of pension plan assets + Actual return on plan assets + Contributions (amounts funded) by the company – Payments to retirees = Ending fair value of pension plan assets

16 1.The company adopts a pension plan on January 1, No retroactive benefits were granted to employees. 2.The service cost each year is: 2010, $400,000; 2011, $420,000; 2012, $432, The projected benefit obligation at the beginning of each year is: 2011, $400,000; and 2012, $840,000. Pension Expense Equal to Pension Funding Assume the following facts for the Carlisle Company: ContinuedContinued

17 4.The discount rate is 10%. 5.The expected long-term rate of return on plan assets is 10%, which is also equal to the actual rate of return. 6.The company adopts a policy of funding an amount equal to the pension expense and makes the payment to the funding agency at the end of each year. 7.Plan assets are based on the amounts contributed each year, plus a return of 10% per year, less an assumed payment of $20,000 to retired employees (beginning in 2011). Pension Expense Equal to Pension Funding

18 Pension Expense Equal to Pension Funding December 31, 2010 Pension Expense400,000 Cash 400,000 December 31, 2011 Pension Expense420,000 Cash 420,000 Service cost$420,000 Interest cost ($400,000 × 10%)40,000 Expected return on plan assets ($400,000 × 10%) (40,000) Pension expense$420,000 Service cost$420,000 Interest cost ($400,000 × 10%)40,000 Expected return on plan assets ($400,000 × 10%) (40,000) Pension expense$420,000

Projected Benefit Obligation Projected Benefit Obligation 400,000 Beginning projected benefit obligation (2010) 420,000 Service cost (2011) 40,000 Interest cost (2011) Payment to retired employees (2011) 20, ,000 Balance 1/1/12

Fair Value of Pension Plan Assets Pension Plan Assets Beginning fair value (2010) 400,000 Actual return on plan assets (2011) 40,000 Contribution (2011) 420,000 20,000 Payment to retired employees (2011) Balance 1/1/12 840,000

21 Note that the interest cost and the return on the plan assets offset each other each year Pension Expense Equal to Pension Funding December 31, 2012 Pension Expense432,000 Cash 432,000 Service cost (assumed)$432,000 Interest cost ($840,000 × 10%)84,000 Expected return on plan assets ($840,000 × 10%) (84,000) Pension expense$432,000 Service cost (assumed)$432,000 Interest cost ($840,000 × 10%)84,000 Expected return on plan assets ($840,000 × 10%) (84,000) Pension expense$432,000

22 The Carlisle Company funds $405,000 in 2010, $425,000 in 2011, and $435,000 in Pension Funding Greater Than Pension Expense December 31, 2010 Pension Expense400,000 Accrued/Prepaid Pension Cost5,000 Cash 405,000 AssetAsset

Accrued/Prepaid Pension Cost Accrued/Prepaid Balance Projected benefit obligation – Fair value of plan assets ($5,000) $400,000 – $405,000 = 23

24 The balance in the asset account is now $10,500 ($5,000 + $5,500). Pension Expense Greater to Pension Funding December 31, 2011 Pension Expense419,500 Accrued/Prepaid Pension Cost5,500 Cash 425,000 Service cost$420,000 Interest cost ($400,000 × 10%)40,000 Expected return on plan assets ($405,000 × 10%) (40,500) Pension expense$419,500 Service cost$420,000 Interest cost ($400,000 × 10%)40,000 Expected return on plan assets ($405,000 × 10%) (40,500) Pension expense$419,500

Projected Benefit Obligation Projected Benefit Obligation 400,000 Beginning projected benefit obligation (2010) 420,000 Service cost (2011) 40,000 Interest cost (2011) Payment to retired employees (2011) 20, ,000 Balance 1/1/12

Fair Value of Pension Plan Assets Pension Plan Assets Beginning fair value (2010) 405,000 Actual return on plan assets (2011) 40,500 Contribution (2011) 425,000 20,000 Payment to retired employees (2011) Balance 1/1/12 850,500

27 The balance in the asset account is now $14,500 ($5,000 + $5,500 + $4,050). Pension Expense Greater to Pension Funding December 31, 2012 Pension Expense430,950 Accrued/Prepaid Pension Cost4,050 Cash 435,000 Service cost$432,000 Interest cost ($840,000 × 10%)84,000 Expected return on plan assets ($850,500 × 10%) (85,050) Pension expense$430,950 Service cost$432,000 Interest cost ($840,000 × 10%)84,000 Expected return on plan assets ($850,500 × 10%) (85,050) Pension expense$430,950

28 The Carlisle Company funds $415,000 in 2010, $425,000 in 2011, and $440,000 in The expected return is 11% each year, and the actual return is 12% each year. Pension Expense Less Than Pension Funding, and Expected Return on Plan Assets Different from Both Actual Return and Discount Rate December 31, 2010 Pension Expense400,000 Accrued/Prepaid Pension Cost15,000 Cash 415,000

29 The balance in the asset account is now $25,650 ($15,000 + $10,650). December 31, 2011 Pension Expense414,350 Accrued/Prepaid Pension Cost10,650 Cash 425,000 Service cost$420,000 Interest cost ($400,000 × 10%)40,000 Expected return on plan assets ($415,000 × 10%) (45,650) Pension expense$414,350 Service cost$420,000 Interest cost ($400,000 × 10%)40,000 Expected return on plan assets ($415,000 × 10%) (45,650) Pension expense$414,350 Pension Expense Less Than Pension Funding, and Expected Return on Plan Assets Different from Both Actual Return and Discount Rate

Projected Benefit Obligation Projected Benefit Obligation 400,000 Beginning projected benefit obligation (2010) 420,000 Service cost (2011) 40,000 Interest cost (2011) Payment to retired employees (2011) 20, ,000 Balance 1/1/12

Fair Value of Pension Plan Assets Pension Plan Assets Beginning fair value (2010) 415,000 Actual return on plan assets (2011) 49,800 Contribution (2011) 425,000 20,000 Payment to retired employees (2011) Balance 1/1/12 869,800

32 Difference Between Expected and Actual Return December 31, 2011 Accrued/Prepaid Pension Cost4,150 Other Comprehensive Income: Net Gain/Loss4,150 Because the 12% actual return is $49,800, which is $4,150 higher than the $45,650 expected return, a journal entry must be made to Accrued/Prepaid Pension Cost and Other Comprehensive Income for the year.

33 The balance in the asset account is now $49,478 ($29,800 + $19,678). December 31, 2012 Pension Expense420,332 Accrued/Prepaid Pension Cost19,678 Cash 440,000 Service cost$432,000 Interest cost ($840,000 × 10%)84,000 Expected return on plan assets ($869,800 × 11%) (95,678) Pension expense$420,332 Service cost$432,000 Interest cost ($840,000 × 10%)84,000 Expected return on plan assets ($869,800 × 11%) (95,678) Pension expense$420,332 Pension Expense Less Than Pension Funding, and Expected Return on Plan Assets Different from Both Actual Return and Discount Rate

34 Difference Between Expected and Actual Return December 31, 2012 Accrued/Prepaid Pension Cost8,698 Other Comprehensive Income: Net Gain/Loss8,698 Because the 12% actual return is $104,376, which is $8,698 higher than the $95,678 expected return, a journal entry must be made to Accrued/Prepaid Pension Cost and Other Comprehensive Income for the year.

35 The Carlisle Company awarded retroactive benefits to employees when it adopted the pension plan on January 1, The prior service cost was estimated to be $2 million, which is to be amortized over 20 years. Carlisle decided to increase its contribution to $705,000 in 2010, $715,000 in 2011, and $730,000 in Pension Expense Including Amortization of Prior Service Cost

36 As required by GAAP, the prior service cost of $2 million must be recorded as a liability and also as a negative element of other comprehensive income for the year. Pension Expense Including Amortization of Prior Service Cost Other Comprehensive Income: Prior Service Cost2,000,000 Accrued/Prepaid Pension Cost2,000,000

37 December 31, 2010 Pension Expense700,000 Accrued/Prepaid Pension Cost5,000 Cash 705,000 Service cost$400,000 Interest cost ($2,000,000 × 10%)200,000 Amortization of prior service cost 100,000 Pension expense$700,000 Service cost$400,000 Interest cost ($2,000,000 × 10%)200,000 Amortization of prior service cost 100,000 Pension expense$700,000 Pension Expense Including Amortization of Prior Service Cost

38 The 2010 pension expense includes $100,000 amortization of prior service cost ($2,000,000 ÷ 20 years). Therefore, the company must record an adjusting entry to increase 2010 other comprehensive income. Pension Expense Including Amortization of Prior Service Cost Accrued/Prepaid Pension Cost100,000 Other Comprehensive Income: Prior Service Cost100,000

Projected Benefit Obligation Projected Benefit Obligation 2,000,000 Beginning projected benefit obligation (2010) 400,000 Service cost (2010) 200,000 Interest cost (2010) 2,600,000 Balance 1/1/11

Fair Value of Pension Plan Assets Pension Plan Assets Beginning fair value (2010) 0 Actual return on plan assets (2010) 0 Contribution (2010) 705,000 Balance 1/1/11 705,000

41 December 31, 2011 Pension Expense702,450 Accrued/Prepaid Pension Cost12,550 Cash 715,000 Service cost$420,000 Interest cost ($2,600,000 × 10%)260,000 Expected return on plan assets ($705,000 × 11%)(77,550) Amortization of prior service cost 100,000 Pension expense$702,450 Service cost$420,000 Interest cost ($2,600,000 × 10%)260,000 Expected return on plan assets ($705,000 × 11%)(77,550) Amortization of prior service cost 100,000 Pension expense$702,450 Pension Expense Including Amortization of Prior Service Cost

42 The 2011 pension expense also includes $100,000 amortization of prior service cost so the company must record an adjusting entry to increase 2011 other comprehensive income. Pension Expense Including Amortization of Prior Service Cost Accrued/Prepaid Pension Cost100,000 Other Comprehensive Income: Prior Service Cost100,000

Projected Benefit Obligation Projected Benefit Obligation 2,000,000 Beginning projected benefit obligation (2010) 420,000 Service cost (2011) 260,000 Interest cost (2011) Payment to retired employees (2011) 20,000 3,260,000 Balance 1/1/12

Fair Value of Pension Plan Assets Pension Plan Assets Beginning fair value (2010) 705,000 Actual return on plan assets (2011) 84,600 Contribution (2011) 715,000 20,000 Payment to retired employees (2011) Balance 1/1/12 1,484,600

The actual return on plan assets was $7,050 higher than the expected return. Therefore, Other Comprehensive Income should be credited. Recognition of Gain on Plan Assets Accrued/Prepaid Pension Cost7,050 Other Comprehensive Income: Net Gain/Loss7,050 45

46 December 31, 2012 Pension Expense694,694 Accrued/Prepaid Pension Cost35,306 Cash 730,000 Service cost$432,000 Interest cost ($3,260,000 × 10%)326,000 Expected return on plan assets ($1,484,600 × 11%)(163,306) Amortization of prior service cost 100,000 Pension expense$694,694 Service cost$432,000 Interest cost ($3,260,000 × 10%)326,000 Expected return on plan assets ($1,484,600 × 11%)(163,306) Amortization of prior service cost 100,000 Pension expense$694,694 Pension Expense Including Amortization of Prior Service Cost

47 The 2012 pension expense also includes the $100,000 amortization of prior service cost, so the company must record an adjusting entry to increase 2012 other comprehensive income. Pension Expense Including Amortization of Prior Service Cost Accrued/Prepaid Pension Cost100,000 Other Comprehensive Income: Prior Service Cost100,000

48 Difference Between Expected and Actual Return December 31, 2012 Accrued/Prepaid Pension Cost14,846 Other Comprehensive Income: Net Gain/Loss14,846 Because the 12% actual return is $178,152, which is $14,846 higher than the $163,306 expected return, a journal entry must be made to Accrued/Prepaid Pension Cost and Other Comprehensive Income for the year.

49 Projected Benefit Obligation Payment to retired employees (2011) 20,0002,000,000Beginning PBO (2010) Payment to retired employees (2012) 20,000420,000 Service cost (2011) 260,000 Interest cost (2011) 432,000 Service cost (2012) 326,000 Interest cost (2012) 3,398,000 Balance 12/31/12 PBO - Plan Assets = Accrued/Prepaid Pension Costs

50 PBO - Plan Assets = Accrued/Prepaid Pension Costs Pension Plan Assets Beginning fair value (2010) 705,00020,000 Payment to retired employees (2011) Actual return on plan assets (2011) 84,60020,000 Payment to retired employees (2012) Contribution (2011)715,000 Actual return on plan assets (2012)178,152 Contribution (2012)730,000 Balance 12/31/122,372,752

51 PBO - Plan Assets = Accrued/Prepaid Pension Costs Accrued/Prepaid Pension Cost Overfunded (2010)5,0002,000,000Prior Service Cost (2010) Amortization of PSC (2010)100,000 Overfunded (2011)12,550 Amortization of PSC (2011)100,000 Actuarial Adjustment (2011)7,050 Overfunded (2012)35,306 Amortization of PSC (2012)100,000 Actuarial Adjustment (2012)14,846 1,625,248 Balance 12/31/12 PBO – Plan Assets Accrued/Prepaid Pension Cost $3,998,000 – $2,372,752 $1,625,248 =

52 The average remaining service life of employees expected to receive benefits is calculated by dividing the expected years of service for all employees by the number of employees. Calculation of Amortization of Prior Service Cost: Straight-Line Amortization Average Remaining Service Life Expected Years of Service Number of Employees =

53 The preferred method assigns an equal amount to each future service period for each active participating employee who is expected to receive future benefits under the plan. Calculation of Amortization of Prior Service Cost: Years-of-Future-Service Method

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

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