Intermediate Accounting Kieso ● Weygandt ● Warfield

Intermediate Accounting Kieso ● Weygandt ● Warfield
PREVIEW OF CHAPTER 20 Intermediate Accounting 16th Edition Kieso ● Weygandt ● Warfield

20 Accounting for Pensions and Postretirement Benefits
LEARNING OBJECTIVES After studying this chapter, you should be able to: Understand the fundamentals of pension plan accounting. Use a worksheet for employer’s pension plan entries. Describe the accounting and amortization of prior service costs. Explain the accounting and amortization for unexpected gains and losses. Describe the requirements for reporting pension plans in financial statements. LO 1

PENSION PLAN ACCOUNTING
An arrangement whereby an employer provides benefits (payments) to retired employees for services they provided in their working years. Pension Plan Administrator Contributions Employer Retired Employees Benefit Payments Assets & Liabilities LO 1

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

ILLUSTRATION 20-2 Pension Funds and Pension Expense The two most common types of pension plans are defined contribution plans and defined benefit plans. LO 1

Defined-Contribution Plan
PENSION PLAN ACCOUNTING 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 make predictions (called actuarial assumptions) of mortality rates, employee turnover, interest and earnings rates, early retirement frequency, future salaries, and any other factors necessary to operate a pension plan. LO 1

WHAT DO THE NUMBERS MEAN? WHICH PLAN IS RIGHT FOR YOU?
WHAT’S YOUR PRINCIPLE Defined contribution plans have become much more popular with employers than defined benefit plans, as indicated in the chart below. One reason is that they are cheaper. Defined contribution plans often cost no more than 3 percent of payroll, whereas defined benefit plans can cost 5 to 6 percent of payroll. The total amount of pension assets held by pension plans is $22,117 billion, which is 127 percent of gross domestic product. In 2014, 58 percent of these assets were in defined contribution plans and 42 percent in defined benefit plans. Pension plan assets have grown 6.6 percent per year over the period 2004–2014. Source: Form 5500 filings with U.S. Department of Labor, November 2014, “Private Pension Plan Bulletin.” LO 1

Measures of the Liability
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 1

Alternative Approaches Employer’s pension obligation is the deferred compensation obligation it has to its employees for their service under the terms of the pension plan. FASB’s choice ILLUSTRATION 20-3 Different Measures of the Pension Obligation LO 1

Recognition of the Net Funded Status of the Pension Plan Companies must recognize on their balance sheet the full overfunded or underfunded status of their defined benefit pension plan. The overfunded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation. LO 1

Components of Pension Expense
ILLUSTRATION 20-4 Components of Annual Pension Expense LO 1

+ Components of Pension Expense 1. Service Costs
Effect on Expense 1. Service Costs + Actuarial present value of benefits attributed by the pension benefit formula to employee service during the period LO 1

Interest on the Liability
Components of Pension Expense Effect on Expense 2. Interest on the Liability + Interest for the period on the projected benefit obligation outstanding during the period The interest rate use is referred to as the settlement rate. LO 1

Actual Return on Plan Assets
Components of Pension Expense Effect on Expense 3. Actual Return on Plan Assets +- Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair value of the plan assets. ILLUSTRATION 20-5 Equation for Computing Actual Return LO 1

Amortization of Prior Service Costs
Components of Pension Expense Effect on Expense 4. Amortization of Prior Service Costs + Plan amendments often include provisions to increase benefits for employee service provided in prior years. Company allocates the cost (prior service cost) of providing these retroactive benefits to pension expense in the future, specifically to the remaining service-years of the affected employees. LO 1

+- Components of Pension Expense 5. Gain or Loss
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 projected benefit obligation. LO 1

USING A PENSION WORKSHEET
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 2

Illustration: On January 1, 2017, Zarle Company provides the following information related to its pension plan for the year 2017. Plan assets, January 1, 2017, are $100,000. Projected benefit obligation, January 1, 2017, is $100,000. Annual service cost is $9,000. Settlement rate is 10 percent. Actual return on plan assets is $10,000. Funding contributions are $8,000. Benefits paid to retirees during the year are $7,000. Prepare the pension worksheet for 2017. LO 2

Prepare a pension worksheet for 2017. ILLUSTRATION 20-8 ($100,000 x 10%) ($1,000) net liability LO 2

ILLUSTRATION 20-8 Pension Expense 9,000 Cash 8,000 Pension Asset/Liability 1,000 LO 2

PRIOR SERVICE COST (PSC)
Amortization Company should not recognize the retroactive benefits as pension expense in the year of amendment. Employer should recognize the pension expense over the remaining service lives of the employees who are expected to benefit from the change in the plan. Amortization Method: Board prefers a years-of-service method. Employers may use straight-line amortization over the average remaining service life of the employees. LO 3

Years-of-Service Method
Illustration: Assume that Zarle Company’s defined benefit pension plan covers 170 employees. In its negotiations with the employees, Zarle Company amends its pension plan on January 1, 2018, and grants $80,000 of prior service costs to its employees. The employees are grouped according to expected years of retirement, as follows. LO 3

Illustration shows computation of the service-years per year and the total service-years. ILLUSTRATION 20-10 Computation of Service-Years LO 3

Computed on the basis of a prior service cost of $80,000 and a total of 500 service-years for all years, the cost per service-year is $160 ($80,000 ÷ 500). The annual amount of amortization based on a $160 cost per service-year is computed as follows. ILLUSTRATION 20-11 Computation of Annual Prior Service Cost Amortization LO 3

E20-7: The following defined pension data of Rydell Corp. apply to the year 2017. Projected benefit obligation, 1/1/17 (before amendment) $560,000 Plan assets, 1/1/17 546,200 Pension liability 13,800 On January 1, 2017, Rydell Corp., through plan amendment, grants prior service benefits having a present value of 120,000 Settlement rate 9% Service cost 58,000 Contributions (funding) 65,000 Actual (expected) return on plan assets 52,280 Benefits paid to retirees 40,000 Prior service cost amortization for ,000 Instructions: For 2017, prepare a pension work sheet for Rydell Corp. that shows the journal entry for pension expense. LO 3

($135,720) liability

E20-7: Pension Journal Entry for 2017. Dec. 31 Pension Expense ,920 Other Comprehensive Income (PSC) ,000 Pension Asset/Liability ,920 Cash 65,000 LO 3

GAINS AND LOSSES Unexpected swings in pension expense can result from:
Sudden and large changes in the fair value of plan assets, and Changes in actuarial assumptions that affect the amount of the projected benefit obligation. LO 4

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 4

GAINS AND LOSSES Smoothing Unexpected Gains and Losses on Plan Assets
Companies include the expected return on the plan assets as a component of pension expense, not the actual return in a given year. Companies record asset gains and asset losses in an account, Other Comprehensive Income (G/L), combining them with gains and losses accumulated in prior years. LO 4

WHAT DO THE NUMBERS MEAN? PENSION COSTS UPS AND DOWNS
WHAT’S YOUR PRINCIPLE For some companies, pension plans generate real profits. The plans not only pay for themselves but also increase earnings. This happens when the expected return on pension assets exceed the company’s annual costs. At MeadWestvaco, pension income amounted to approximately 27 percent of operating profit. It tallied 11 percent of operating profit at CenturyTel and 9.5 percent at Sun Trust Banks. The issue is important because in these cases management is not driving the operating income— pension income is. And as a result, income can change quickly. Unfortunately, when the stock market stops booming, pension expense substantially increases for many companies. The reason: expected return on a smaller asset base no longer offsets pension service costs and interest on the projected benefit obligation. As a result, many companies find it difficult to meet their earnings targets, at a time when meeting such targets is crucial to maintaining the stock price. LO 4

GAINS AND LOSSES Smoothing Unexpected Gains and Losses on the Pension Liability Companies report liability gains and liability losses in Other Comprehensive Income (G/L). Companies combine the liability gains and losses in the same Other Comprehensive Income (G/L) account. They accumulate the asset and liability gains and losses in Accumulated Other Comprehensive Income and report on the balance sheet in the stockholders’ equity section. LO 4

GAINS AND LOSSES Corridor Amortization
FASB invented 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 projected benefit obligation or the market-related value of the plan assets. Any Accumulated OCI net gain or loss balance above the 10% must be amortized. LO 4

GAINS AND LOSSES Illustration: Data for Callaway Co.’s projected benefit obligation and plan assets over a period of six years. ILLUSTRATION 20-14 Computation of the Corridor LO 4

GAINS AND LOSSES LO 4 ILLUSTRATION 20-15
Graphic Illustration of the Corridor LO 4

GAINS AND LOSSES BE20-7: Shin Corporation had a projected benefit obligation of $3,100,000 and plan assets of $3,300,000 at January 1, Shin also had a net actuarial loss of $465,000 in accumulated OCI at January 1, The average remaining service period of Shin’s employees is 7.5 years. Instructions: Compute Shin’s minimum amortization of the actuarial loss. LO 4

GAINS AND LOSSES ÷ BE20-7: Compute Shin’s amortization of the loss.

USING A PENSION WORK SHEET
P20-2: Jackson Company adopts acceptable accounting for its defined benefit pension plan on January 1, 2016, with the following beginning balances: plan assets $200,000; projected benefit obligation $250,000. Other data are as follows. LO 4

* Expected Return on Plan Assets $200,000 x 10% = $20,000
USING A PENSION WORK SHEET P20-2: Pension Work Sheet for 2016 * * Expected Return on Plan Assets $200,000 x 10% = $20,000 ($57,000) LO 4

P20-2 Pension Journal Entry for 2016 Dec. 31 Pension Expense 21,000 OCI – Gain/Loss ,000 Pension Asset/Liability ,000 Cash 16,000 LO 4

* Actual return = Expected Return
USING A PENSION WORK SHEET P20-2: Pension Work Sheet for 2017 * * Actual return = Expected Return ($217,700) liability LO 4

P20-2: Pension Journal Entry for 2017 Dec. 31 Pension Expense ,100 Other Comprehensive Income (PSC) ,600 Pension Asset/Liability ,700 Cash 40,000 LO 4

P20-2: Pension Work Sheet for 2018 * * Plug ($203,400) liability LO 4

P20-2: Pension Journal Entry for 2018 Dec. 31 Pension Expense ,370 Pension Asset/Liability 14,300 Other Comprehensive Income (G/L) ,070 Other Comprehensive Income (PSC) 41,600 Cash 48,000 LO 4

REPORTING PENSION PLANS IN FINANCIAL STATEMENTS
Within the Financial Statements Recognition of the Net Funded Status of the Plan Classification of Pension Asset or Pension Liability Aggregation of Pension Plans Actuarial Gains and Losses/Prior Service Cost LO 5

Within the Notes to the Financial Statements Major components of pension expense. Reconciliation showing how the projected benefit obligation and the fair value of the plan assets changed. A disclosure of the rates used in measuring the benefit amounts (discount rate, expected return on plan assets, rate of compensation). LO 5

Within the Notes to the Financial Statements A table indicating the allocation of pension plan assets by category (equity securities, debt securities, real estate, and other assets), and showing the percentage of the fair value to total plan assets. The expected benefit payments to be paid to current plan participants for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter. Also required is disclosure of a company’s best estimate of expected contributions to be paid to the plan during the next year. LO 5

Within the Notes to the Financial Statements The nature and amount of changes in plan assets and benefit obligations recognized in net income and in other comprehensive income of each period. The accumulated amount of changes in plan assets and benefit obligations that have been recognized in other comprehensive income and that will be recycled into net income in future periods. LO 5

Within the Notes to the Financial Statements The amount of estimated net actuarial gains and losses and prior service costs and credits that will be amortized from accumulated other comprehensive income into net income over the next fiscal year. LO 5

Special Issues The Pension Reform Act of 1974 Pension Terminations LO 5

ACCOUNTING GUIDANCE APPENDIX 20A
ACCOUNTING FOR POSTRETIRMENT BENEFITS ACCOUNTING GUIDANCE In December 1990, the FASB issued rules on “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” These rules cover for healthcare and other “welfare benefits” provided to retirees, their spouses, dependents, and beneficiaries. Other welfare benefits include life insurance offered outside a pension plan; medical, dental, and eye care; legal and tax services; tuition assistance; day care; and housing assistance. LO 6 Identify the differences between pensions and postretirement healthcare benefits.

DIFFERENCES BETWEEN PENSION BENEFITS AND HEALTHCARE BENEFITS
APPENDIX 20A ACCOUNTING FOR POSTRETIRMENT BENEFITS DIFFERENCES BETWEEN PENSION BENEFITS AND HEALTHCARE BENEFITS ILLUSTRATION 20A-1 LO 6

DIFFERENCES BETWEEN PENSION BENEFITS AND HEALTHCARE BENEFITS
APPENDIX 20A ACCOUNTING FOR POSTRETIRMENT BENEFITS DIFFERENCES BETWEEN PENSION BENEFITS AND HEALTHCARE BENEFITS Measuring the future payments for healthcare benefit plans is so much more difficult than for pension plans. Many postretirement plans do NOT set a limit on healthcare benefits. The levels of healthcare benefit use and healthcare costs are difficult to predict. Increased longevity, unexpected illnesses (e.g., AIDS, SARS, and avian flu), along with new medical technologies and cures, cause changes in healthcare utilization. LO 6

POSTRETIREMENT BENEFITS ACCOUNTING PROVISIONS
APPENDIX 20A ACCOUNTING FOR POSTRETIRMENT BENEFITS POSTRETIREMENT BENEFITS ACCOUNTING PROVISIONS Attribution Period - period of time over which the postretirement benefit cost accrue. ILLUSTRATION 20A-2 Range of Possible Attribution Periods LO 6

Obligations Under Postretirement Benefits
APPENDIX 20A ACCOUNTING FOR POSTRETIRMENT BENEFITS Obligations Under Postretirement Benefits Expected postretirement benefit obligation (EPBO) is the actuarial present value as of a particular date of all benefits a company expects to pay after retirement to employees and their dependents. Accumulated postretirement benefit obligation (APBO) is the actuarial present value of future benefits attributed to employees’ services rendered to a particular date. LO 6

Postretirement Expense
APPENDIX 20A ACCOUNTING FOR POSTRETIRMENT BENEFITS Postretirement Expense Service Cost Interest Cost Actual Return on Plan Assets Amortization of Prior Service Costs Gains and Losses LO 6

ACCOUNTING ENTRIES APPENDIX 20A ACCOUNTING FOR POSTRETIRMENT BENEFITS
2017 Entries and Worksheet ACCOUNTING ENTRIES Illustration: The use of a worksheet in accounting for a postretirement benefits plan, assume that on January 1, 2017, Quest Company adopts a healthcare benefit plan. The following facts apply to the postretirement benefits plan for the year 2017. Plan assets at fair value on January 1, 2017, are zero. Actual and expected returns on plan assets are zero. Accumulated postretirement benefit obligation (APBO), January 1, 2017, is zero. Service cost is $54,000. No prior service cost exists. Interest cost on the APBO is zero. Funding contributions during the year are $38,000. Benefit payments to employees from plan are $28,000. LO 7 Contrast accounting for pensions to accounting for other postretirement benefits.

ILLUSTRATION 20A-4 Journal Entry

Recognition of Gains and Losses
APPENDIX 20A ACCOUNTING FOR POSTRETIRMENT BENEFITS ACCOUNTING ENTRIES Recognition of Gains and Losses Gains and losses represent changes in the APBO or the value of plan assets. Gains and losses are recorded in other comprehensive income. The Corridor Approach Amortization Methods LO 7

2018 Entries and Worksheet ACCOUNTING ENTRIES Illustration: The following facts apply to the postretirement benefits plan for Quest Company for the year 2018. Actual return on plan assets is $600. Expected return on plan assets is $800. Discount rate is 8 percent. Increase in APBO due to change in actuarial assumptions is $60,000. Service cost is $26,000. Funding contributions during the year are $18,000. Benefit payments to employees during the year are $5,000. Average remaining service to expected retirement: 25 years. LO 7

ILLUSTRATION 20A-6 Journal Entry LO 7

Amortization of Net Gain or Loss in 2019
APPENDIX 20A ACCOUNTING FOR POSTRETIRMENT BENEFITS ACCOUNTING ENTRIES Amortization of Net Gain or Loss in 2019 2016 CORRIDOR TEST 2016 ILLUSTRATION 20A-8 Computation of Amortization Charge (Corridor Test)—2019 LO 7

RELEVANT FACTS - Similarities
IFRS and GAAP separate pension plans into defined contribution plans and defined benefit plans. The accounting for defined contribution plans is similar. IFRS and GAAP recognize a pension asset or liability as the funded status of the plan (i.e., defined benefit obligation minus the fair value of plan assets). (Note that defined benefit obligation is referred to as the projected benefit obligation in GAAP.) IFRS and GAAP compute unrecognized past service cost (PSC) (referred to as prior service cost in GAAP) in the same manner. However, IFRS recognizes past service cost as a component of pension expense in income immediately. GAAP amortizes PSC over the remaining service lives of employees. LO 8 Compare the accounting for pensions under GAAP and IFRS.

RELEVANT FACTS - Differences
IFRS and GAAP include interest expense on the liability in pension expense. Regarding asset returns, IFRS reduces pension expense by the amount of interest revenue (based on the discount rate times the beginning value of pension assets). GAAP includes an asset return component based on the expected return on plan assets. Under IFRS, companies recognize both liability and asset gains and losses (referred to as remeasurements) in other comprehensive income. These gains and losses are not “recycled” into income in subsequent periods. GAAP recognizes liability and asset gains and losses in “Accumulated other comprehensive income” and amortizes these amounts to income over remaining service lives, using the “corridor approach.” LO 8

RELEVANT FACTS - Differences
The accounting for pensions and other postretirement benefit plans is the same under IFRS. GAAP has separate standards for these types of benefits, and significant differences exist in the accounting. LO 8

ON THE HORIZON The IASB and the FASB have been working collaboratively on a postretirement benefit project. The recent amendments issued by the IASB moves IFRS closer to GAAP with respect to recognition of the funded status on the statement of financial position. However, as illustrated in the About the Numbers section above, significant differences remain in the components of pension expense. The FASB is expected to begin work on a project that will reexamine expense measurement of postretirement benefit plans. The FASB likely will consider the recent IASB amendments in this area, which could lead to a converged standard. LO 8

IFRS SELF-TEST QUESTION
At the end of the current period, Oxford Ltd. has a defined benefit obligation of $195,000 and pension plan assets with a fair value of $110,000. The amount of the vested benefits for the plan is $105,000. What amount related to its pension plan will be reported on the company’s statement of financial position? $5,000. $90,000. $85,000. $20,000. LO 8

At the end of the current year, Kennedy Co. has a defined benefit obligation of $335,000 and pension plan assets with a fair value of $245,000. The amount of the vested benefits for the plan is $225,000. Kennedy has unrecognized past service costs of $24,000 and an unrecognized actuarial gain of $8,300. What account and amount(s) related to its pension plan will be reported on the company’s statement of financial position? Pension Liability and $74,300. Pension Liability and $90,000. Pension Asset and $233,300. Pension Asset and $110,000. LO 8

At January 1, 2017, Wembley Company had plan assets of $250,000 and a defined benefit obligation of the same amount. During 2017, 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. Based on this information, what would be the defined benefit obligation for Wembley Company at December 31, 2017? $277,500. c. $27,500. $285,000. d. $302,500. LO 8

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Intermediate Accounting Kieso ● Weygandt ● Warfield

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