1. COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Employee Compensation - Payroll, Pensions, and other Issues Chapter 17 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

2. 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. 3.Understand the nature and characteristics of employer pension plans, including a detailed discussion of defined benefit plans.

3. Learning Objectives 4.Use the components of prepaid/accrued pension costs and changes in the components to compute the periodic expense associated with pensions. 5.Prepare required disclosures associated with pensions, and understand the accounting treatment for pension settlements and curtailments. 6.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.

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

5. Payroll and Payroll Taxes 1.Federal old-age, survivors’, and disability (tax to both the employee and employer) 2.Federal hospital insurance (tax to both employer and employee) 3.Federal unemployment insurance (tax to employer only) Social security and income tax legislation impose five taxes based on payrolls: 4.State unemployment insurance (tax to employer only) 5.Individual income tax (tax to employee only but withheld and paid by employer)

6. FICA Federal Insurance Contributions Act (FICA) – both the employers and employees are required to provide funds. Employer is required to withhold FICA taxes from each employee’s wages. In 2005, annual wages up to $90,000 were subject to 6.20% of FICA tax.

7. FICA FICA also includes Medicare tax for federal hospital insurance. This tax is separate from the previously discussed slide. The tax is applied to all wages earned and there is no upper limit. For 2005, the rate was 1.45% for both employer and employee.

8. FUTA Federal Social Security Act and the Federal Unemployment Tax Act (FUTA) established unemployment insurance plans. Employers are taxed quarterly; no tax levied on employees. Tax rate since on the first $7,000 of wages earned is 6.2%. Employer can apply for a credit limited to 5.4% for taxes paid on state unemployment tax.

9. State Unemployment Insurance State unemployment tax laws (SUTA) differ across states. Most states only tax employers, but some both. As a result of the credit applied for federal taxes the amount of tax taking state rates into account does not exceed 0.8%.

10. Accounting for Payroll Taxes 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.

11. Accounting for Payroll Taxes Salaries Expense16,000 FICA Taxes Payable 1,224 Employees Income Taxes Payable 1,600 Cash13,176 Assume salaries for Jan are $16,000. SUTA is 5.4%. Withholdings are $1,600 and FICA is 7.65%. The employer records for payroll and payroll taxes: To record payment of payroll and related employee withholdings.

12. Accounting for Payroll Taxes Payroll taxes are: An expense to the employer. A liability to the employer until they are paid. Payroll taxes are: An expense to the employer. A liability to the employer until they are paid.

13. Accounting for Payroll Taxes Payroll Tax Expense 2,216 FICA Taxes Payable 1,224 State Unemployment Taxes Payable 864 FUTA Payable 128 Assume salaries for Jan are $16,000. SUTA is 5.4%. Withholdings are $1,600 and FICA is 7.65%. Employer’s make this entry to record THEIR portion of FICA and other payroll taxes: To record payroll tax liability to the employer. 0.054 x $16,000 0.008 x $16,000 0.0765 x $16,000

14. Compensated Absences Compensated absences are payments by employers for: Vacations, Holidays, Sick days Other personal days Compensated absences are payments by employers for: Vacations, Holidays, Sick days Other personal days

15. Compensated Absences At the end of the period, the firm has a liability for the earned by unused compensated absences. They must match the estimated amount of liability to current revenue. The tricky part comes when estimating how much should be accrued. FASB 43 provides guidance on this issue.

16. Compensated Absences 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

17. Compensated Absences S&N Corporation has 20 employees who are paid an average of $700 per week. During 2007, a total of 40 vacation weeks was earned by all employees, but only 30 weeks of vacation were taken. They took the remaining 10 weeks of vacation in 2008 when the average rate of pay was $800 per week.

18. Compensated Absences Wages Expense 7,000 Vacation Wages Payable7,000 To record accrued vacation wages ($700 x10 weeks). Wages Expense 1,000 Vacation Wages Payable 7,000 Cash8,000 To record payment at current rates of previously earned vacation time ($800 x 10 weeks). Journal entry for 2007 Journal entry for 2008

19. Stock-Based Compensation 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. Bonus calculation: B = 0.10($100,000 – B) B = $10,000 – 0.10B B + 0.10B = $10,000 1.10B = $10,000 B = $9,091 (rounded)

20. Postemployment Benefits Statement No 112, FASB extends recognition requirements to benefits that accrue to former or inactive employees after employment but before retirement. Examples of the types of benefits: –Severance –Benefits, –Disability related benefits, –Job training and counseling

21. Stop and Think Which ONE of the following is NOT a criterion used in identifying a postemployment benefit obligation?

22. Accounting for Pensions There are three main categories for pensions: 1.Government plans, primarily Social Security 2.Individual plans, such as individual retirement accounts (IRAs) 3.Employer plans

23. Nature and Characteristics of Employer Pension Plans Noncontributory - funded entirely by the employer Contributory - employee also contributes to the cost of the plan Defined Contribution -employer pays a periodic contribution which is administered by an independent third party. Defined Benefit- employee is guaranteed a specified retirement income. Vested Benefits- occurs when an employee has met certain requirements and is eligible to receive pension benefits at retirement.

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

25. Stop and Think Many companies are changing their plans from defined benefit to defined contribution. Why would employers do this?

26. 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.

27. Simple Illustration of Pension Accounting Lorien Bach is 35 years old She has worked for Thakkar for 10 years. Her salary for 2007 was $40,000. Pension payments begin after the employee turns 65. The annual 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, 2008, Thakkar had a pension fund of $10,000. During 2008 an additional $1,500 was contributed. The fund earned $350 and the average return is 12%.

28. Simple Illustration #1 Estimate Pension Obligation (2% x 10 years) x $40,000 = $8,000 The annual amount that Bach should received on her retirement

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

30. Simple Illustration Projected Benefit Obligation (PBO) Assume Thakkar Company expects Bach’s 2007 salary of $40,000 to increase 5% every year until retirement. (2% x 10 years) x $172,877 = $34,575 (rounded) PV = $40,000, N = 30, I = 5% The PBO is the PV of ten equal deferred payments of $34,575 ($12,176).

31. 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.

32. Simple Illustration Interest Cost PBO, Beginning ofDiscountInterest PeriodxRate=Cost $12,176x0.10=$1,218

33. Simple Illustration Service Cost The impact of this extra year of service is to increase the December 31, 2008 PBO by $1,339. Therefore, the service cost element of pension expense for the year is $1,339. 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 2008.

34. Simple Illustration PBO, End of Year Service cost and interest cost PBO, beginning of year +– Retirement benefits paid ± Change in actuarial assumptions Fair Value of Pension Fund Employer contribu- tions Fair value of pension fund, beginning of year +– Retirement benefits paid ± Actual return on pension fund

35. Simple Illustration Accrued Pension Liability As of December 31, 2008, 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, 2008$14,733 Pension fund at fair value, December 31, 2008 (10,000) Accrued pension liability$ 2,176

36. Simple Illustration Thakkar would make the following entries for 2008: Prepaid Expense1,357 Prepaid/Accrued Pension Cost1,357 Service cost ($1,339) + Interest cost ($1,218) – Expected return ($1,200) Prepaid/Accrued Pension Cost1,500 Cash1,500 New contributions to pension fund

37. Comprehensive Illustration A Spreadsheet Approach Net Pension Expense CashPrepaid Accrued Pension PBO

38. The Basic Spreadsheet Formal AccountsMemorandum Accounts Prepaid/Periodic Net AccruedPension Fair Value Pension Cost of Plan ExpenseCashCostItemsPBO Assets 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 Unrecognized Prior Service Cost

39. Formal Accounts Net Pension Expense Cash Prepaid/ Accrued Pension Cost Periodic Pension Cost Items Left Side of Work Sheet

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

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

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

43. Formal Accounts Net Pension Expense Cash Prepaid/ Accrued Pension Cost Periodic Pension Cost Items 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.

44. Memorandum Accounts Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Right Side of Work Sheet

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

46. Memorandum Accounts 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 = FVPA BoY +Contributions– Benefits Paid ± Actual Return on Assets Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost

47. Memorandum Accounts 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. Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost

48. Stop and Think What is the relationship between prior service cost and the measurement of the projected benefit obligation (PBO)?

49. Thompson Electronics, Inc Pension Worksheet Net Pension Expense Cash Prepaid/ Accrued Pension Cost Balance, 1/1/08$ (40,000) Left Side of Work Sheet Periodic Pension Expense Items

50. Thompson Electronics, Inc Pension Worksheet Right Side of Work Sheet Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Bal. $(1,500,000) $1,385,000$75,000

51. Thompson Electronics, Inc Pension Activity Info 2008 Service cost as reported by actuaries….$75,000 Contributions to pension plan………...$115,000 Benefits paid to retirees………………. $125,000 Fair value of pension fund at 12/31/08…………………………$1,513,5000 Settlement interest rate11.0% Long-term expected rate of return10.0%

52. Thompson Electronics, Inc Pension Worksheet Net Pension Expense Cash Prepaid/ Accrued Pension Cost Bal. 1/1/08$ (40,000) (a) Service Cost$ 75,000 Left Side of Work Sheet Periodic Pension Expense Items

53. Thompson Electronics, Inc Pension Worksheet Right Side of Work Sheet Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Bal.$(1,500,000)$1,385,000$75,000 (a)(75,000)

54. Thompson Electronics, Inc Pension Worksheet Net Pension Expense Cash Prepaid/ Accrued Pension Cost Periodic Pension Expense Items Bal. 1/1/08 $ (40,000) (a)Service Cost$ 75,000 (b)Interest Cost 165,000 Left Side of Work Sheet

55. Thompson Electronics, Inc Pension Worksheet Right Side of Work Sheet Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Bal.$(1,500,000)$1,385,000$75,000 (a)(75,000) (b)(165,000)

56. Thompson Electronics, Inc Pension Worksheet Actual Return on the Pension Fund Fair value of pension fund, 12/31/08 $1,513,500 Fair value of pension fund, 1/1/08 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

57. Thompson Electronics, Inc Pension Worksheet Net Pension Expense Cash Prepaid/ Accrued Pension Cost Bal. 1/1/08$ (40,000) (a) Service Cost$ 75,000 (b) Interest Cost165,000 (c) Actual Return(138,500) Left Side of Work Sheet Periodic Pension Expense Items

58. Thompson Electronics, Inc Pension Worksheet Right Side of Work Sheet Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Bal.$(1,500,000)$1,385,000$75,000 (a)(75,000) (b)(165,000) (c)138,500

59. Thompson Electronics, Inc Pension Worksheet Net Pension Expense Cash Prepaid/ Accrued Pension Cost Bal. 1/1/08 $ (40,000) (a)Service Cost$ 75,000 (b)Interest Cost 165,000 (c)Actual Return (138,500) (d)Benefits Paid Left Side of Work Sheet No entry on this side of work sheet Periodic Pension Expense Items

60. Thompson Electronics, Inc Pension Worksheet Right Side of Work Sheet Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Bal. $(1,500,000) $1,385,000$75,000 (a)(75,000) (b)(165,000) (c)138,500 (d)125,000(125,000)

61. Thompson Electronics, Inc Pension Worksheet 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 = 825 150 825 x $75,000 = $13,636 15 employees for 10 years

62. Thompson Electronics, Inc Pension Worksheet Net Pension Expense Cash Prepaid/ Accrued Pension Cost Bal. 1/1/08$ (40,000) (a)Service Cost $ 75,000 (b)Interest Cost 165,000 (c)Actual Return (138,500) (d)Benefits Paid (e)PSC Amortization 13,636 Left Side of Work Sheet Periodic Pension Expense Items

63. Thompson Electronics, Inc Pension Worksheet Right Side of Work Sheet Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Bal.$(1,500,000)$1,385,000$75,000 (a)(75,000) (b)(165,000) (c)138,500 (d)125,000(125,000) (e)(13,636)

64. Thompson Electronics, Inc Pension Worksheet Net Pension Expense Cash Prepaid/ Accrued Pension Cost Bal. 1/1/08 $ (40,000) (a)Service Cost$ 75,000 (b)Interest Cost 165,000 (c)Actual Return (138,500) (d)Benefits Paid (e)PSC Amortization 13,636 (1)Annual Pension Expense Accrual$115,136(115,136) Left Side of Work Sheet Periodic Pension Expense Items

65. Thompson Electronics, Inc Pension Worksheet Net Pension Expense Cash Prepaid/ Accrued Pension Cost Bal. 1/1/08 $ (40,000) (a)Service Cost$ 75,000 (b)Interest Cost 165,000 (c)Actual Return (138,500) (d)Benefits Paid (e)PSC Amortization 13,636 (1)Annual Pension Expense Accrual$115,136(115,136) (2)Annual Pension Contribution(115,000)115,000 Left Side of Work Sheet Periodic Pension Expense Items

66. Thompson Electronics, Inc Pension Worksheet Right Side of Work Sheet Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost Bal. $(1,500,000) $1,385,000 $75,000 (a)(75,000) (b)(165,000) (c)138,500 (d)125,000(125,000) (e)(13,636) (1) (2) 115,000

67. Thompson Electronics, Inc Pension Worksheet Net Pension Expense Cash Prepaid/ Accrued Pension Cost Bal. 12/31/08$ (40,136) Left Side of Work Sheet Periodic Pension Expense Items Only column added on the left side of the work sheet

68. Thompson Electronics, Inc Pension Worksheet Right Side of Work Sheet Projected Benefit Obligation Fair Value of Pension Fund Unrecognized Prior Service Cost 12/31/08 $(1,615,000) $1,513,500 $61,364 Prepaid/Accrued Pension Cost115,000 Cash115,000 To record 2005 contribution to the pension plan. Prepaid/Accrued Pension Cost115,000 Cash115,000 To record 2005 contribution to the pension plan.

69. Thompson Electronics, Inc Pension Activity Info 2009 Service cost as reported by actuaries….$87,000 Contributions to pension plan………....$75,000 Benefits paid to retirees………………. $132,000 Actual return on pension plan……….…$26,350 Actuarial change increasing PBO……...$80,000 Settlement interest rate11.0% Long-term expected rate of return10.0%

70. Thompson Electronics, Inc Pension Worksheet 2009

71. Deferral of Difference between Actual and Expected Return Income Statement Balance Sheet Deferred gain Debit net pension expense Credit net pension liability Deferred loss Credit net pension expense Debit net pension liability Inc pension Inc net pension expenseliability Dec net pension liability expense

72. Thompson Electronics, Inc Pension Activity Info 2010 Service cost as reported by actuaries.$115,000 Contributions to pension plan………....$80,000 Benefits paid to retirees………………. $140,000 Actual return on pension plan………..$175,500 Settlement interest rate11.0% Long-term expected rate of return10.0%

73. Thompson Electronics, Inc Pension Worksheet 2010

74. Corridor Amortization Corridor amount- the accumulated unrecognized pension gain/loss from prior years that is more than an amount defined by the FASB. Amortization is required only on a portion of the 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.

75. Corridor Amortization May use any amortization method that: –equals or exceeds straight-line amortization over remaining expected service years of covered employees, and –is consistently applied.

76. Stop and Think When would a company find itself exceeding the corridor amount?

77. 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. 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 =

78. Deferred Pension Cost An employer may be required to record an additional pension liability if they are 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.

79. Deferred Pension Cost Accumulated benefit obligation$1,250,000 Fair value of the pension fund1,140,000 Accrued pension cost16,000 Unrecognized prior service cost80,000 Clapton Corporation computes the following balances as of December 31, 2008: 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 Liability94,000 To recognize additional pension liability. Deferred Pension Cost 80,000 Excess of Additional Pension Liability over Unrecognized Prior Service Cost 14,000 Additional Pension Liability94,000 To recognize additional pension liability.

80. Disclosure of Pension Plans Statement No. 132 requires the following major disclosure requirements for most publicly traded companies: 1.A reconciliation between the beginning and ending balances for the projected benefit obligation 2.A reconciliation between the beginning and ending balances in the fair value of the pension fund

81. Disclosure of Pension Plans 3.A disclosure of the accumulated benefit obligation when the ABO exceeds the fair value of the pension fund 4.The funded status of the plans, the amounts not recognized in the balance sheet, and the amount recognized in the balance sheet 5.The components of pension expense for the period 6.Any effects on the other comprehensive income section as a result of changes in the additional pension liability

82. Disclosure of Pension Plans 7.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 8.Disclosure of the percentage of the different types of investments held in the pension fund along with a description of the investment strategy 9.For each of the next 5 years, disclose an estimate of the amount of cash to be paid in benefits and the amount of cash to be contributed by the company to the pension fund. 10.Certain information about postretirement benefits

83. Settlements and Curtailments Settlement occurs when an employer takes an irrevocable action that relieves the employer of primary responsibility for all or part of the obligation. Curtailment arises from an event that significantly reduces the benefits that will be provided for present employees’ future services. –Termination of an employee earlier than expected –Termination or suspension of a pension plan

84. 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.

85. Postretirement Benefits other than Pensions For some firms, other postretirement benefits like healthcare for retirees represent a bigger economic obligation than pension obligations. Accounting is similar to the accounting for a defined benefit pension plan. Some differences include: 1.Often not a function of salary level. 2.They may not be funded. 3.There is no minimum liability provision.