CHAPTER 21



CHAPTER 21 – Part 1

ACCOUNTING FOR PENSIONS AND POST-RETIREMENT BENEFITS

Read pages 1119 -1128 and answer the following questions and exercises.

1. What is a pension plan? When should the expense related to pensions be recognized?

2. The two most common types of pension plans are defined contribution plans and defined benefit plans.

a. Describe a defined contribution plan.

b. Who assumes the risk of the pension trust performance under a defined contribution plan (i.e., Who benefits if the trust performs well? Who suffers if it does not?)?

c. Describe a defined benefit plan.

d. Who assumes the risk of the pension trust performance under a defined benefit plan (i.e., Who benefits if the trust performs well? Who suffers if it does not?)?

When we deal with pensions, we actually have two separate entities: the employer and the pension trust. The pension trust is responsible for investing assets contributed by the employer and for making payments to retirees. We are not studying the pension trust accounting in this chapter. We are studying the employer’s accounting for pensions.

3. What is an actuary?

4. Assume that you work for a company that has a defined benefit pension plan. The benefits to be received by employees are 2% for every year of employment times their average salary for the last three years of employment. For example, an employee who works for the company for 20 years will receive 40% of their average salary each year after they retire until they die. However, employees must work 5 years in order to vest (be entitled to the benefits). The company has 5,000 employees participating in the pension plan. What actuarial assumptions must be made related to this defined benefit pension plan in order to calculate the pension obligation?

5. One of the biggest controversies surrounding the accounting for pensions is determining the pension obligation (i.e., the liability for pensions). There are three ways to measure this amount: vested benefit obligation, accumulated benefit obligation and the projected benefit obligation. Explain how the obligation is measured under each of these methods.

6. Which of the above methods is required by GAAP?

Prior to SFAS No. 87, companies used the noncapitalization approach to account for defined benefit pension plans. The company recognized an asset (liability) only if the amount of the pension expense was more (less) that the amount funded.

Under a capitalization approach, the company shows a liability for the pension benefits it has promised to employees. The liability is not affected by the amount funded, only by the payment of benefits to employees (decrease) and by the pension expense for the period (increase). Capitalization means measuring and reporting in the financial statements a fair representation of the employers’ pension assets and liabilities.

SFAS No. 87 falls between the noncapitalization and capitalization approaches. This is why the rules are so complicated.

7. What are the five components of pension expense? Describe each and indicate their effect (increase or decrease) on pension expense.

8. Work Brief Exercises 1 and 2 and Exercises 1 and 2.

CHAPTER 21 – part 2

Read pages 1129 -1150. Work Brief Exercises 3-10.

Under SFAS No. 87, the following items are not recognized in the financial statements:

1. Projected benefit obligation

2. Pension plan assets

3. Unrecognized prior service costs

4. Unrecognized net gain or loss

The above items must be disclosed in the footnotes and all are used to compute the annual pension expense. To keep up with these items, memo entries and accounts are maintained outside the formal general ledger accounting system. A pension worksheet is used to determine the general journal entries and the memo entries.

The worksheet consists of two sections:

1. general journal entries – these amounts are actually recorded in the general journal

2. memo records – these represent the pension plan books and are not recorded on the general journal of the employer

The worksheet is explained on a separate page.

There are three complications in recording the pension expense:

1. Amortization of prior service cost

2. Amortization of unexpected gains/losses

3. Recognition of additional minimum pension liability

AMORTIZATION OF UNRECOGNIZED PRIOR SERVICE COST:

Prior service costs arise when a pension plan is adopted or amended and employees are given additional benefits for prior service. This is an increase in the projected benefit obligation. Rather than recognizing the entire amount as expense in the year of the change, we amortize the PSC over the remaining service life of the employees involved. We justify this by saying that the employer is expecting future services from these employees due to these additional benefits granted (the employees will be more loyal and stay with the firm). In truth, this is just a way to smooth the amount of the pension expense.

To enter the incurrence of PSC on the worksheet:

Debit: Unrecognized Prior Service Costs Credit: Projected Benefit Obligation

There are two ways to amortize the prior service costs:

The years-of-service amortization method (preferred by FASB). (See bottom of page 1131 and illustrations 10 and 11).

3 Total number of service-years to be worked by all participating employees is computed.

4 The unrecognized PSC is divided by the total number of service years to obtain a cost per service year.

5 The number of service years consumed each year is multiplied by the cost per service year to obtain the annual amortization charge.

The straight-line method

7 Compute total number of service years as before.

8 Divide by the total number of employees to compute average remaining service life.

9 Divide PSC by average remaining service life to obtain the annual amortization charge.

UNEXPECTED GAIN OR LOSS:

Unexpected gains or losses on the pension plan may be due to

sudden changes in the market value of plan assets or

changes in actuarial assumptions which affect the PBO

The FASB allows these unexpected gains/losses to be smoothed over time. In fact, we only recognize these gains/losses if they become LARGE.

Use a CORRIDOR APPROACH to determine whether the gains/losses are large:

1. Determine the balance in the Unexpected Gains/Losses account at the beginning of the year.

2. Compute the corridor, 10% of the larger of

a. the beginning balance of PBO or

b. the beginning balance of the market related value of plan assets

3. If the balance < corridor, no amortization occurs. If the balance > corridor:

Subtract corridor from balance to determine excess.

Divide excess by average remaining service life of active employees expected to receive benefits under the plan.

FAIR VALUE OF PLAN ASSETS – what the assets are worth at a particular point in time.

MARKET-RELATED VALUE OF PLAN ASSETS – a calculated amount which smooths out changes in fair value of plan assets.

MINIMUM PENSION LIABILITY:

In general, we do not recognize a liability for the PBO or an asset for the value of the plan assets. The only reason is that this would have been a very big change in how companies had been accounting for pensions prior to SFAS No. 87.

We only recognize a liability when the ABO > fair value of plan assets at year-end.

We do not recognize an asset when the ABO < fair value of plan assets at year-end.

Notice that we use the ABO, not the PBO.

Accumulated Benefit Obligation

- Fair value of plan assets

= Minimum pension liability to be reported on balance sheet

Minimum Pension Liability

- Accrued Pension Cost (liability) or

+ Prepaid Pension Cost (asset)

= Additional Minimum Pension Liability

Entry to record the additional minimum pension liability is:

Debit: Intangible Asset – Deferred Pension Liability

Credit: Additional Pension Liability

There is one last complication:

There is a limitation on the amount to be debited to the Intangible Asset. It cannot exceed the amount of the Unrecognized Prior Service Cost. Any excess is debited to an account called Excess of Additional Pension Liability over Unrecognized PSC. The debit is a reduction in Other Comprehensive Income. The account balance (accumulated amount) is a part of accumulated other comprehensive income shown in stockholders’ equity on the balance sheet.

PENSION WORKSHEET

Step 1: Enter the beginning balances in the columns. The net balance of the general

journal columns must equal the net balance of the memo record columns. These are not offsetting amounts (debits and credits); they are the same (both net debits or both net credits).

Step 2: Enter each of the items related to pension expense. Debits = Credits.

1. Service cost – the increase in the PBO caused by this year’s service:

Debit: Pension Expense Credit: Projected Benefit Obligation

2. Interest cost – the increase in PBO caused by the passage of time:

Debit: Pension Expense Credit: Projected Benefit Obligation

3. Return on plan assets – interest earned, dividends earned, increase in fair value:

Debit: Plan Assets Credit: Pension Expense

4. Amortization of Prior Service Cost – this cost is deferred and amortized.

Debit: Pension Expense Credit: Unamortized Prior Service Cost

5. Amortization of Unrecognized Gain/Loss – these amounts are deferred and amortized.

If Loss: If Gain:

Debit: Pension Expense Debit: Unrecognized Gain/Loss

Credit: Unrecognized Gain/Loss Credit: Pension Expense

Step 3: Enter contributions made during the year:

Debit: Plan Assets Credit: Cash

Step 4: Enter any benefits paid by the pension trust during the year:

Debit: Projected Benefit Obligation Credit: Plan Assets

Step 5: Add the entries made in the columns on the general journal side. Do not include

beginning balances. Find the difference between the debits and credits. This is the amount to be added/deducted from the Prepaid/Accrued Cost account.

Step 6: Add the columns for the Memo records including the beginning balances.

Step 7: Perform a reconciliation to prove that the net of the memo record columns equals

the amount in the Prepaid/Accrued Cost column.

Step 8: Prepare the journal entry using the totals from the worksheet general journal

columns.

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