companies have benefit plans

WHERE HAVE ALL THE PENSIONS GONE?Many companies have benefit plans that promise income and other benefits to retired employees in exchangefor services during their working years. However, a shift is on from traditional defined benefit plans, in whichemployers bear the risk of meeting the benefit promises, to plans in which employees bear more of the risk. Insome cases, employers are dropping retirement plans altogether. Here are some of the reasons for the shift.• Competition. Newer and foreign competitors do not have the same retiree costs that older U.S. companiesdo. Southwest Airlines does not offer a traditional pension plan, but United has a pension deficit exceeding $100,000 per employee.• Cost. Retirees are living longer, and the costs of retirement are higher. Combined with annual retireehealthcare costs, retirement benefits are costing the S&P 500 companies over $25 billion a year and arerising at double-digit rates.• Insurance. Pensions are backed by premiums paid to the Pension Benefit Guarantee Corporation(PBGC). When a company fails, the PBGC takes over the plan. But due to a number of significant companyfailures, the PBGC is running a deficit, and healthy companies are subsidizing the weak.• Accounting. To bring U.S. standards in line with international rules, accounting rule-makers are considering rules that will require companies to “mark their pensions to market” (value them at market rates). Sucha move would increase the reported volatility of the retirement plan and of company financial statements.When Great Britain made this shift, 25 percent of British companies closed their plans to new entrants.As a result of such factors, it is understandable that experts can think of no major company that has instituted atraditional pension plan in the past decade. What does this mean for you as you evaluate job offers and benefitpackages? To start, you should begin building your own retirement nest egg, rather than relying on your employerto provide postretirement income and healthcare benefits. Recently, a sample of Americans was asked the following question: When you retire, do you think you will have enough money to live comfortably, or not? Thegraph on the next page shows a change in responses from nonretired adults from 2002 to 2014.Prior to 2008, a majority of nonretired Americans consistently thought they would be able to live comfortably in retirement. But this dropped to 46 percent early during the U.S. recession in 2008 and stayed below50 percent until 2014. In 2012, fewer than four in 10 nonretirees thought they would have enough money to livecomfortably in retirement.General economic conditions affect how Americans look at retirement. Americans are generally more positive about retirement when the economy is growing. However, the continuing political discussion about thefragility of the country’s Social Security and Medicare programs may reduce nonretired Americans’ comfort with
20
123
Accounting for Pensions and Postretirement BenefitsUnderstand the fundamentals of pensionplan accounting.Use a worksheet for employer’s pensionplan entries.Describe the accounting and amortizationof prior service costs.4 Explain the accounting and amortizationfor unexpected gains and losses.5 Describe the requirements for reportingpension plans in financial statements.LEARNING OBJECTIVESAfter studying this chapter, you should be able to:1117projections of their monetary resources in their retirement. In addition, many are beginning to realize thatretirement at the age of 65 may no longer be possible given the possible extension of social benefits to later ages.This means that retirement accounts, including individual retirement accounts and defined contributionpensions such as 401(k) plans, will need to become a bigger piece of the pie to fill the gap left by smaller government and employer-sponsored benefits. So get started now with a personal savings strategy to ensure an adequate nest egg at your retirement.Sources: Story adapted from Nanette Byrnes with David Welch, “The Benefits Trap,”BusinessWeek (July 19, 2004), pp. 54–72;and T. Riffkin, “More Americans Think They Will Retire Comfortably,” http://www.gallup.com/poll/168959/americans-thinkretire-comfortably.aspx.REVIEW AND PRACTICEGo to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary reviewand practice problem with solution. Multiple-choice questions with annotated solutions as well asadditional exercises and practice problem with solutions are also available online.PREVIEW OF CHAPTER 20 As our opening story indicates, the cost of retirementbenefits is steep. For example, British Airways’ pension and healthcare costs for retirees in arecent year totaled $195 million, or approximately $6 per passenger carried. Many other companies are also facing substantial pension and other postretirement expenses and obligations.In this chapter, we discuss the accounting issues related to these benefit plans. The content andorganization of the chapter are as follows.ACCOUNTING FOR PENSIONS AND POSTRETIREMENT BENEFITS
FUNDAMENTALSOF PENSION PLANACCOUNTING• Definedcontribution plan• Defined benefitplan• Role of actuaries• Measures of theliability• Components ofpension expense
USING A PENSIONWORKSHEET• 2017 entries andworksheet• Funded status
GAINS AND LOSSES• Unexpectedgains and losses(assets)• Unexpectedgains and losses(liabilities)• Corridoramortization• 2019 entries andworksheet
REPORTINGPENSION PLANSIN FINANCIALSTATEMENTS• Within the financialstatements• Within the notesto the financialstatements• Pension notedisclosure• 2020 entries andworksheet—acomprehensiveexample• Special issues
PRIOR SERVICECOST (PSC)• Amortization• 2018 entries andworksheet
This chapter also includesnumerous conceptual andinternational discussionsthat are integral to the topicspresented here.2002304560%2003 2004 2005 2006 2007 2008 2009 2010 2011% Yes % No2012 2013 2014Live Comfortably During Retirement or Not?1118 Chapter 20 Accounting for Pensions and Postretirement Benefi tsFUNDAMENTALS OF PENSION PLAN ACCOUNTING
A pension plan
LEARNING OBJECTIVE 1Understand thefundamentals of pensionplan accounting.
is an arrangement whereby an employer provides benefits (payments)to retired employees for services they provided in their working years. Pension accounting may be divided and separately treated as accounting for the employer and accounting for the pension fund. The company or employer is the organization sponsoring thepension plan. It incurs the cost and makes contributions to the pension fund. The fundor plan is the entity that receives the contributions from the employer, administers thepension assets, and makes the benefit payments to the retired employees (pension recipients). Illustration 20-1 shows the three entities involved in a pension plan and indicatesthe flow of cash among them.1When used as a verb, fund means to pay to a funding agency (as to fund future pension benefits or to fundpension cost). Used as a noun, it refers to assets accumulated in the hands of a funding agency (trustee) forthe purpose of meeting pension benefits when they become due.2The FASB issued separate guidance covering the accounting and reporting for employee benefit plans. [1]
Employer(company)
Contributions
$
Pension FundFund Assets
Benefts
$
Investments Earnings$ $PensionRecipients(employees)ILLUSTRATION 20-1Flow of Cash amongPension Plan ParticipantsA pension plan is funded when the employer makes payments to a funding agency.1That agency accumulates the assets of the pension fund and makes payments to therecipients as the benefits come due.Some pension plans are contributory. In these, the employees bear part of the costof the stated benefits or voluntarily make payments to increase their benefits. Otherplans are noncontributory. In these plans, the employer bears the entire cost. Companies generally design their pension plans so as to take advantage of federal income taxbenefits. Plans that offer tax benefits are called qualified pension plans. They permitdeductibility of the employer’s contributions to the pension fund and tax-free statusof earnings from pension fund assets.The pension fund should be a separate legal and accounting entity. The pensionfund, as a separate entity, maintains a set of books and prepares financial statements.Maintaining records and preparing financial statements for the fund, an activity knownas “accounting for employee benefit plans,” is not the subject of this chapter.2 Instead,this chapter explains the pension accounting and reporting problems of the employeras the sponsor of a pension plan.The need to properly administer and account for pension funds becomes apparentwhen you understand the size of these funds. Listed in Illustration 20-2 are the pensionfund assets and pension expenses of six major companies.Size of 2014 Pension Pension ExpenseCompany Pension Expense as % of Pretax($ in millions) Fund (Income) Income
General MotorsHewlett-PackardDeere & Company
$79,15210,86611,447
$151(225)164
3.56%–3.433.42
Merck
3,247
12
0.07
The Coca-Cola Company
6,343
34
0.36
Molson Coors Brewing
2,883
21
2.71
ILLUSTRATION 20-2Pension Funds andPension ExpenseSee the FASBCodifcationReferences(pages 1179–1180).Fundamentals of Pension Plan Accounting 1119As Illustration 20-2 indicates, pension expense is a substantial percentage of totalpretax income for many companies.3 The two most common types of pension plans aredefined contribution plans and defined benefit plans, and we look at each of them inthe following sections.Defi ned Contribution PlanIn a defined contribution plan, the employer agrees to contribute to a pension trust acertain sum each period, based on a formula. This formula may consider such factors asage, length of employee service, employer’s profits, and compensation level. The plandefines only the employer’s contribution. It makes no promise regarding the ultimatebenefits paid out to the employees. A common form of this plan is a 401(k) plan.The size of the pension benefits that the employee finally collects under the plandepends on several factors: the amounts originally contributed to the pension trust, theincome accumulated in the trust, and the treatment of forfeitures of funds caused byearly terminations of other employees. A company usually turns over to an independent third-party trustee the amounts originally contributed. The trustee, acting onbehalf of the beneficiaries (the participating employees), assumes ownership of the pension assets and is accountable for their investment and distribution. The trust is separateand distinct from the employer.The accounting for a defined contribution plan is straightforward. The employeegets the benefit of gain (or the risk of loss) from the assets contributed to the pensionplan. The employer simply contributes each year based on the formula established inthe plan. As a result, the employer’s annual cost (pension expense) is simply the amountthat it is obligated to contribute to the pension trust. The employer reports a liability onits balance sheet only if it does not make the contribution in full. The employer reportsan asset only if it contributes more than the required amount.In addition to pension expense, the employer must disclose the following for adefined contribution plan: a plan description, including employee groups covered; thebasis for determining contributions; and the nature and effect of significant mattersaffecting comparability from period to period. [2]Defined Benefi t PlanA defined benefit plan outlines the benefits that employees will receive when theyretire. These benefits typically are a function of an employee’s years of service and of thecompensation level in the years approaching retirement.To meet the defined benefit commitments that will arise at retirement, a companymust determine what the contribution should be today (a time value of money computation). Companies may use many different contribution approaches. However, thefunding method should provide enough money at retirement to meet the benefitsdefined by the plan.The employees are the beneficiaries of a defined contribution trust, but theemployer is the beneficiary of a defined benefit trust. Under a defined benefit plan, thetrust’s primary purpose is to safeguard and invest assets so that there will be enough topay the employer’s obligation to the employees. In form, the trust is a separate entity.In substance, the trust assets and liabilities belong to the employer. That is, as long asthe plan continues, the employer is responsible for the payment of the defined benefits (without regard to what happens in the trust). The employer must make up any3At the end of 2014, pension assets for the 16 major pension markets were estimated at $36.1 trillion,representing a 6.1 percent rise compared to the 2013 year-end value. Pension assets relative to gross domesticproduct (GDP) reached 84.4 percent in 2014, which represents a 2.3 percent increase from the 2013 ratio of82.1 percent. The largest pension markets are the United States, United Kingdom, and Japan with 61.2 percent,9.2 percent, and 7.9 percent of total pension assets in the study, respectively. In U.S. dollar terms, the pensionassets’ growth rate of these three largest markets in 2014 was 9.0 percent, 5.7 percent, and –1.2 percent,respectively. See “Global Pension Asset Study—2015,” www.towerswatson.com.1120 Chapter 20 Accounting for Pensions and Postretirement Benefi tsshortfall in the accumulated assets held by the trust. On the other hand, the employercan recapture any excess accumulated in the trust, either through reduced future funding or through a reversion of funds.Because a defined benefit plan specifies benefits in terms of uncertain future variables, a company must establish an appropriate funding pattern to ensure the availability of funds at retirement in order to provide the benefits promised. This funding leveldepends on a number of factors such as turnover, mortality, length of employee service,compensation levels, and interest earnings.Employers are at risk with defined benefit plans because they must contributeenough to meet the cost of benefits that the plan defines. The expense recognized eachperiod is not necessarily equal to the cash contribution. Similarly, the liability is controversial because its measurement and recognition relate to unknown future variables.Thus, the accounting issues related to this type of plan are complex. Our discussion inthe following sections deals primarily with defined benefit plans.4INTERNATIONALPERSPECTIVEOutside the UnitedStates, private pensionplans are less commonbecause many othernations rely on government-sponsoredpension plans. Consequently, accounting fordefi ned benefi t pensionplans is typically a lessimportant issue elsewhere in the world.4A recent federal law requires employees to explicitly opt out of an employer-sponsored defined contributionplan. This should help employees build their own nest eggs (as suggested in the opening story) and willcontribute to further growth in defined contribution plans. However, note the following three warnings:(1) low-income workers will still not be able to stash enough away, (2) it leaves each participant alone tomanage risk, and (3) companies establish a minimum contribution, which too many participants chooseto use, instead of a larger contribution.WHAT DO THE NUMBERS MEAN? WHICH PLAN IS RIGHT FOR YOU?Source: Form 5500 filings with U.S. Department of Labor, November 2014, “Private Pension Plan Bulletin.”Defi ned contribution plans have become much more popularwith employers than defi ned benefi t plans, as indicated in thechart below. One reason is that they are cheaper. Defi nedThe 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 defi nedcontribution plans often cost no more than 3 percent of payroll,whereas defi ned benefi t plans can cost 5 to 6 percent ofpayroll.contribution plans and 42 percent in defi ned benefi t plans.Pension plan assets have grown 6.6 percent per year over theperiod 2004–2014.Active Participants (in millions)Calendar Year01975 1980 1985 1990 1995 2000 2005 2010 201520406080100120140Defned Beneft Plan Defned Contribution Plan TotalNumber of Active Participants in Employer-Sponsored Retirement Plans (in thousands) by Type of PlanFundamentals of Pension Plan Accounting 1121The Role of Actuaries in Pension AccountingThe problems associated with pension plans involve complicated mathematical considerations. Therefore, companies engage actuaries to ensure that a pension plan is appropriate for the employee group covered.5 Actuaries are individuals trained through a longand rigorous certification program to assign probabilities to future events and theirfinancial effects. The insurance industry employs actuaries to assess risks and to adviseon the setting of premiums and other aspects of insurance policies. Employers rely heavily on actuaries for assistance in developing, implementing, and funding pension funds.Actuaries make predictions (called actuarial assumptions) of mortality rates, employeeturnover, interest and earnings rates, early retirement frequency, future salaries, andany other factors necessary to operate a pension plan. They also compute the variouspension measures that affect the financial statements, such as the pension obligation, theannual cost of servicing the plan, and the cost of amendments to the plan. In summary,accounting for defined benefit pension plans relies heavily upon information and measurements provided by actuaries.Measures of the LiabilityIn accounting for a company’s pension plan, two questions arise. (1) What is the pensionobligation that a company should report in the financial statements? (2) What is the pension expense for the period? Attempting to answer the first question has producedmuch controversy.Alternative ApproachesMost agree that an employer’s pension obligation is the deferred compensation obligation it has to its employees for their service under the terms of the pension plan. Measuring that obligation is not so simple, though, because there are alternative ways of measuring it.6One measure of the pension obligation is to base it only on the benefits vested to theemployees. Vested benefits are those that the employee is entitled to receive even if heor she renders no additional services to the company. Most pension plans require a certain minimum number of years of service to the employer before an employee achievesvested benefits status. Companies compute the vested benefit obligation using onlyvested benefits, at current salary levels.Another way to measure the obligation uses both vested and nonvested years of service. On this basis, the company computes the deferred compensation amount on all yearsof employees’ service—both vested and nonvested—using current salary levels. Thismeasurement of the pension obligation is called the accumulated benefit obligation.A third measure bases the deferred compensation amount on both vested and nonvested service using future salaries. This measurement of the pension obligation iscalled the projected benefit obligation. Because future salaries are expected to be higherthan current salaries, this approach results in the largest measurement of the pensionobligation.The choice between these measures is critical. The choice affects the amount of acompany’s pension liability and the annual pension expense reported. Illustration 20-3(on page 1122) presents the differences in these three measurements.5An actuary’s primary purpose is to ensure that the company has established an appropriate fundingpattern to meet its pension obligations. This computation involves developing a set of assumptions andcontinued monitoring of these assumptions to ensure their realism. That the general public has littleunderstanding of what an actuary does is illustrated by the following excerpt from the Wall Street Journal:“A polling organization once asked the general public what an actuary was, and received among its morecoherent responses the opinion that it was a place where you put dead actors.”6One measure of the pension obligation is to determine the amount that the Pension Benefit GuarantyCorporation would require the employer to pay if it defaulted. (This amount is limited to 30 percent of theemployer’s net worth.) The accounting profession rejected this approach for financial reporting because it istoo hypothetical and ignores the going concern concept.1122 Chapter 20 Accounting for Pensions and Postretirement Benefi tsWhich of these alternative measures of the pension liability does the professionfavor? The profession adopted the projected benefit obligation—the present value ofvested and nonvested benefits accrued to date, based on employees’ future salarylevels.7 Those in favor of the projected benefit obligation contend that a promise by anemployer to pay benefits based on a percentage of the employees’ future salaries is fargreater than a promise to pay a percentage of their current salary, and such a differenceshould be reflected in the pension liability and pension expense.Moreover, companies discount to present value the estimated future benefits to bepaid. Minor changes in the interest rate used to discount pension benefits can dramatically affect the measurement of the employer’s obligation. For example, a 1 percent decrease in the discount rate can increase pension liabilities 15 percent. Accounting rules require that at each measurement date, a company must determine theappropriate discount rate used to measure the pension liability, based on currentinterest rates.Recognition of the Net Funded Status of the Pension PlanCompanies must recognize on their balance sheet the full overfunded or underfundedstatus of their defined benefit pension plan.8 [3] The overfunded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation.To illustrate, assume that Coker Company has a projected benefit obligation of$300,000, and the fair value of its plan assets is $210,000. In this case, Coker Company’spension plan is underfunded, and therefore it reports a pension liability of $90,000($300,000 – $210,000) on its balance sheet. If instead the fair value of Coker’s plan assetswere $430,000, it would report a pension asset of $130,000 ($430,000 – $300,000).Benefts forvested employeesonly atcurrent salaries.Benefts fornonvestedemployees atcurrent salaries.ProjectedbeneftobligationBenefts for vestedand nonvestedemployees atfuture salaries.Accumulatedbeneftobligation(FASB’s choice)VestedbeneftobligationPresent value ofexpected cash flowscomputed by actuariesILLUSTRATION 20-3Different Measures of thePension Obligation7When we use the term “present value of benefits” throughout this chapter, we really mean the actuarialpresent value of benefits. Actuarial present value is the amount payable adjusted to reflect the time valueof money and the probability of payment (by means of decrements for events such as death, disability,withdrawals, or retirement) between the present date and the expected date of payment. For simplicity,though, we use the term “present value” instead of “actuarial present value” in our discussion.8Recognize that GAAP applies to pensions as well as other postretirement benefit plans (OPEBs). Appendix20A addresses the accounting for OPEBs.Fundamentals of Pension Plan Accounting 1123In 2010, by slowing the growth of pension liabilities and increasing contributions topension funds, the S&P 500 companies reported aggregate overfunding (assets exceededliabilities) of $42.9 billion. However, by 2014, these same pension plans were underfunded by $394.9 billion.99J. Ciesielski, “S&P 500 Defined Benefit Plans: State of the Pension Plan Promise, 2014,” The Analyst’sAccounting Observer (May 28, 2015).10At one time, companies applied the cash basis of accounting to pension plans by recognizing theamount paid in a particular accounting period as the pension expense for the period. The problem wasthat the amount paid or funded in a fiscal period depended on financial management and was too oftendiscretionary. For example, funding could depend on the availability of cash, the level of earnings, orother factors unrelated to the requirements of the plan. Application of the cash basis made it possible tomanipulate the amount of pension expense appearing in the income statement simply by varying the cashpaid to the pension fund.WHAT DO THE NUMBERS MEAN? ROLLER COASTERThe chart below shows what has happened to the fi nancial healthof pension plans over the last few years. It is a real roller coaster.At the turn of the century, when the stock market wasstrong, pension plans were overfunded. However, the bubbleburst, and by 2002 companies in the S&P 1500 saw their pension plans funded at less than reported liabilities. Then, plansbounced back, and by 2007 pension plans were overfundedagain. However, due to recent downturns in the wake of thefi nancial crisis, plans are now underfunded again and the futureis highly uncertain.A number of factors cause a fund to change from beingoverfunded to underfunded. First, low interest rates decimatereturns on pension plan assets. Second, using low interestrates to discount the projected benefi t payments leads to ahigher pension liability. Similarly, as was observed recently,actuaries may revise estimates related to mortality rates orexpected salary levels, which could lead to an increase in theprojected benefi t obligation and more underfunded plans.Finally, more individuals are retiring and living longer, whichleads to a depletion of the pension plan assets.2007 2008 2009 2010 2011 2012 2013 2014Funded Status of Defined Benefit Pension Plans for the S&P 1500105%10095908580757065Source: http://www.mercer.com/newsroom/SP-1500-pension-funded-status-declines-in-2014-as-low-interest-rates-andnew-mortality-tables-overpower-positive-asset-returns.htmlSource: V. Monga, “Longer Lives Cut Premium to Offload Pensions,” Wall Street Journal (February 3, 2015).Components of Pension ExpenseThere is broad agreement that companies should account for pension cost on the accrualbasis.10 The profession recognizes that accounting for pension plans requires measurement of the cost and its identification with the appropriate time periods. The determination of pension expense, however, is extremely complicated because it is a function ofthe following components.1. Service cost. Service cost is the expense caused by the increase in pension beneftspayable (the projected beneft obligation) to employees because of their services1124 Chapter 20 Accounting for Pensions and Postretirement Benefi tsrendered during the current year. Actuaries compute service cost as the presentvalue of the new benef ts earned by employees during the year.2. Interest on the liability. Because a pension is a deferred compensation arrangement, there is a time value of money factor. As a result, companies record the pension liability on a discounted basis. Interest expense accrues each year on the projected benef t obligation just as it does on any discounted debt. The actuary helpsto select the interest rate, referred to as the settlement rate.3. Actual return on plan assets. The return earned by the accumulated pensionfund assets in a particular year is relevant in measuring the net cost to theemployer of sponsoring an employee pension plan. Therefore, a company shouldadjust annual pension expense for interest and dividends that accumulatewithin the fund, as well as increases and decreases in the fair value of the fundassets.4. Amortization of prior service cost. Pension plan amendments (including initiationof a pension plan) often include provisions to increase benef ts (or in rare situations,to decrease benefts) for employee service provided in prior years. A companygrants plan amendments with the expectation that it will realize economic beneftsin future periods. Thus, it allocates the cost (prior service cost) of providing theseretroactive benef ts to pension expense in the future, specif cally to the remainingservice-years of the affected employees.5. Gain or loss. Volatility in pension expense can result from sudden and large changesin the fair value of plan assets (resulting in differences between the actual return andthe expected return on plan assets) and by changes in the projected beneft obligation(which changes when actuaries modify assumptions or when actual experience differs from expected experience). We will discuss this complex computation later in thechapter.Illustration 20-4 shows the components of pension expense and their effect on totalpension expense (increase or decrease).PensionExpense
Interest onliability(increases pensionexpense)
Actual return onplan assets(generally decreasespension expense)Service costfor the year(increases pensionexpense)Gain or loss(decreases orincreasespension expense)Amortization ofprior service cost(generally increasespension expense)ILLUSTRATION 20-4Components of AnnualPension ExpenseUNDERLYINGCONCEPTSThe expense recognition principle and thedefi nition of a liabilityjustify accounting forpension cost on theaccrual basis. Thisrequires recording anexpense when employees earn the future benefi ts, and recognizingan existing obligationto pay pensions laterbased on current services received.Service CostThe service cost is the actuarial present value of benefits attributed by the pensionbenefit formula to employee service during the period. That is, the actuary predictsFundamentals of Pension Plan Accounting 1125the additional benefits that an employer must pay under the plan’s benefit formula as aresult of the employees’ current year’s service, and then discounts the cost of thosefuture benefits back to their present value.The Board concluded that companies must consider future compensation levels inmeasuring the present obligation and periodic pension expense if the plan benefitformula incorporates them. In other words, the present obligation resulting from apromise to pay a benefit of 1 percent of an employee’s final pay differs from the promiseto pay 1 percent of current pay. To overlook this fact is to ignore an important aspect ofpension expense. Thus, the FASB adopts the benefits/years-of-service actuarialmethod, which determines pension expense based on future salary levels.Some object to this determination, arguing that a company should have more freedom to select an expense recognition pattern. Others believe that incorporating futuresalary increases into current pension expense is accounting for events that have not yethappened. They argue that if a company terminates the plan today, it pays only liabilities for accumulated benefits. Nevertheless, the FASB indicates that the projected benefit obligation provides a more realistic measure of the employer’s obligation underthe plan on a going concern basis and, therefore, companies should use it as the basisfor determining service cost.Interest on the LiabilityThe second component of pension expense is interest on the liability, or interestexpense. Because a company defers paying the liability until maturity, the companyrecords it on a discounted basis. The liability then accrues interest over the life of theemployee. The interest component is the interest for the period on the projected benefit obligation outstanding during the period. The FASB did not address the questionof how often to compound the interest cost. To simplify our illustrations and problemmaterials, we use a simple interest computation, applying it to the beginning-of-theyear balance of the projected benefit liability.How do companies determine the interest rate to apply to the pension liability? TheBoard states that the assumed discount rate should reflect the rates at which companies can effectively settle pension benefits. In determining these settlement rates,companies should look to rates of return on high-quality fixed-income investments currently available, whose cash flows match the timing and amount of the expected benefitpayments. The objective of selecting the assumed discount rates is to measure a singleamount that, if invested in a portfolio of high-quality debt instruments, would providethe necessary future cash flows to pay the pension benefits when due.Actual Return on Plan AssetsPension plan assets are usually investments in stocks, bonds, other securities, and realestate that a company holds to earn a reasonable return, generally at minimum risk.Employer contributions and actual returns on pension plan assets increase pension planassets. Benefits paid to retired employees decrease them. As indicated, the actual returnearned on these assets increases the fund balance and correspondingly reduces theemployer’s net cost of providing employees’ pension benefits. That is, the higher theactual return on the pension plan assets, the less the employer has to contribute eventually and, therefore, the less pension expense that it needs to report.The actual return on the plan assets is the increase in pension funds from interest,dividends, and realized and unrealized changes in the fair value of the plan assets.Companies compute the actual return by adjusting the change in the plan assets for theeffects of contributions during the year and benefits paid out during the year. The equation in Illustration 20-5, or a variation thereof, can be used to compute the actual return.
ActualReturn =(
– (Contributions – Benefits Paid)(
–
Plan
Plan
AssetsAssets
Ending
Beginning
Balance
Balance
ILLUSTRATION 20-5 Equation for Computing Actual Return1126 Chapter 20 Accounting for Pensions and Postretirement Benefi tsStated another way, the actual return on plan assets is the difference between thefair value of the plan assets at the beginning of the period and at the end of the period,adjusted for contributions and benefit payments. Illustration 20-6 uses the equationabove to compute the actual return, using some assumed amounts.
Insert Page Layout Formulas Data Review ViewHome
A
B
C
D
E
F
P18 fx
Pension Worksheet.xls
1
General Journal Entries
Memo Record
2
3
PensionAsset/Liability
Items
AnnualPensionExpense
Cash
PlanAssets
ProjectedBeneftObligation
4
5
6
7
8
9
ILLUSTRATION 20-7Basic Format of PensionWorksheetIf the actual return on the plan assets is positive (a gain) during the period, a company subtracts it when computing pension expense. If the actual return is negative (aloss) during the period, the company adds it when computing pension expense.11USING A PENSION WORKSHEETWe will now illustrate the basic computation of pension expense using the first threecomponents: (1) service cost, (2) interest on the liability, and (3) actual return on planassets. We discuss the other pension expense components (amortization of prior servicecost, and gains and losses) in later sections.Companies often use a worksheet to record pension-related information. As itsname suggests, the worksheet is a working tool. A worksheet is not a permanentaccounting record. It is neither a journal nor part of the general ledger. The worksheet ismerely a device to make it easier to prepare entries and the financial statements.12 Illustration 20-7 shows the format of the pension worksheet.
LEARNING OBJECTIVE 2Use a worksheet foremployer’s pensionplan entries.
Fair value of plan assets at end of periodDeduct: Fair value of plan assets at beginning of period
$5,000,0004,200,000
Increase in fair value of plan assets 800,000Deduct: Contributions to plan during period $500,000Less benefits paid during period 300,000 200,000Actual return on plan assets $ 600,000ILLUSTRATION 20-6Computation of ActualReturn on Plan Assets11At this point, we use the actual rate of return. Later, for purposes of computing pension expense, we usethe expected rate of return.12The use of a pension entry worksheet is recommended and illustrated by Paul B. W. Miller, “The New PensionAccounting (Part 2),” Journal of Accountancy (February 1987), pp. 86–94.The “General Journal Entries” columns of the worksheet (near the center) determine the entries to record in the formal general ledger accounts. The “Memo Record”columns (on the right side) maintain balances in the projected benefit obligation and theplan assets. The difference between the projected benefit obligation and the fair value ofthe plan assets is the pension asset/liability, which is reported in the balance sheet. Ifthe projected benefit obligation is greater than the plan assets, a pension liability occurs.If the projected benefit obligation is less than the plan assets, a pension asset occurs.Using a Pension Worksheet 1127
Insert Page Layout Formulas Data Review ViewHome
A
B
C
D
E
F
P18 fx
Pension Worksheet—2017.xls
1
Memo Record
General Journal Entries
2
3
PensionAsset/Liability
ProjectedBeneftObligation
PlanAssets
Items
AnnualPensionExpense
Cash
4
5
6
Balance, Jan. 1, 2017
100,000 Cr.
100,000 Dr.
—
7
9,000 Dr.
(a) Service cost
9,000 Cr.
8
10,000 Dr.
(b) Interest cost
10,000 Cr.
9
10,000 Cr.
(c) Actual return
10,000 Dr.
10
(d) Contributions
8,000 Dr.
8,000 Cr.
11
(e) Benefts
7,000 Dr.
7,000 Cr.
12
13
14
9,000 Dr.
Journal entry for 2017
8,000 Cr.
1,000 Cr.*
15
Balance, Dec. 31, 2017
112,000 Cr.
111,000 Dr.
1,000 Cr.**
16
17
*$9,000 – $8,000 = $1,000
18
**$112,000 – $111,000 = $1,000
ILLUSTRATION 20-8PensionWorksheet—2017Entry (a) in Illustration 20-8 records the service cost component, which increasespension expense by $9,000 and increases the liability (projected benefit obligation) by$9,000. Entry (b) accrues the interest expense component, which increases both the liability and the pension expense by $10,000 (the beginning projected benefit obligationmultiplied by the settlement rate of 10 percent). Entry (c) records the actual return on theOn the first line of the worksheet, a company records the beginning balances (ifany). It then records subsequent transactions and events related to the pension planusing debits and credits, using both sets of columns as if they were one. For each transaction or event, the debits must equal the credits. The ending balance in the PensionAsset/Liability column should equal the net balance in the memo record.2017 Entries and WorksheetTo illustrate the use of a worksheet and how it helps in accounting for a pension plan,assume that on January 1, 2017, Zarle Company provides the following informationrelated 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.Using this data, the worksheet in Illustration 20-8 presents the beginning balancesand all of the pension entries recorded by Zarle in 2017. Zarle records the beginning balances for the projected benefit obligation and the pension plan assets on the first line ofthe worksheet in the memo record. Because the projected benefit obligation and the planassets are the same at January 1, 2017, the Pension Asset/Liability account has a zerobalance at January 1, 2017.1128 Chapter 20 Accounting for Pensions and Postretirement Benefi tsplan assets, which increases the plan assets and decreases the pension expense. Entry(d) records Zarle’s contribution (funding) of assets to the pension fund, thereby decreasing cash by $8,000 and increasing plan assets by $8,000. Entry (e) records the benefitpayments made to retirees, which results in equal $7,000 decreases to the plan assetsand the projected benefit obligation.Zarle makes the “formal journal entry” on December 31, which records the pensionexpense in 2017, as follows.2017
Pension Expense
9,000
Cash
8,000
Pension Asset/Liability
1,000
Funded StatusThe credit to Pension Asset/Liability for $1,000 represents the difference between the2017 pension expense of $9,000 and the amount funded of $8,000. Pension Asset/Liability (credit) is a liability because Zarle underfunds the plan by $1,000. The Pension Asset/Liability account balance of $1,000 also equals the net of the balances in the memoaccounts. Illustration 20-9 shows that the projected benefit obligation exceeds the planassets by $1,000, which reconciles to the pension liability reported in the balance sheet.
Projected benefit obligation (Credit)Plan assets at fair value (Debit)
$(112,000)111,000
Pension asset/liability (Credit) $ (1,000)ILLUSTRATION 20-9Pension ReconciliationSchedule—December 31,2017If the net of the memo record balances is a credit, the reconciling amount in the pension asset/liability column will be a credit equal in amount. If the net of the memorecord balances is a debit, the pension asset/liability amount will be a debit equal inamount. The worksheet is designed to produce this reconciling feature, which is usefullater in the preparation of the financial statements and required note disclosure relatedto pensions.In this illustration (for 2017), the debit to Pension Expense exceeds the credit toCash, resulting in a credit to Pension Asset/Liability—the recognition of a liability. If thecredit to Cash exceeded the debit to Pension Expense, Zarle would debit Pension Asset/Liability—the recognition of an asset.PRIOR SERVICE COST (PSC)When either initiating (adopting) or amending a defined benefit plan, a company oftenprovides benefits to employees for years of service before the date of initiation or amendment. As a result of this prior service cost, the projected benefit obligation is increasedto recognize this additional liability. In many cases, the increase in the projected benefitobligation is substantial.AmortizationShould a company report an expense for these prior service costs (PSC) at the time itinitiates or amends a plan? The FASB says no. The Board’s rationale is that the employerwould not provide credit for past years of service unless it expects to receive benefits inthe future. As a result, a company should not recognize the retroactive benefits as pension expense in the year of amendment. Instead, the employer initially records theprior service cost as an adjustment to other comprehensive income. The employerthen recognizes the prior service cost as a component of pension expense over the
LEARNING OBJECTIVE 3Describe the accountingand amortization of priorservice costs.
Prior Service Cost (PSC) 1129ExpectedGroup Number of Employees Retirement on Dec. 31A 40 2018B 20 2019C 40 2020D 50 2021E 20 2022170remaining service lives of the employees who are expected to benefit from the changein the plan.The cost of the retroactive benefits (including any benefits provided to existingretirees) is the increase in the projected benefit obligation at the date of the amendment. An actuary computes the amount of the prior service cost. Amortization of the priorservice cost is also an accounting function performed with the assistance of an actuary.The Board prefers a years-of-service method that is similar to a units-of-productioncomputation. First, the company computes the total number of service-years to beworked by all of the participating employees. Second, it divides the prior service cost bythe total number of service-years, to obtain a cost per service-year (the unit cost). Third,the company multiplies the number of service-years consumed each year by the cost perservice-year, to obtain the annual amortization charge.To illustrate the amortization of the prior service cost under the years-of-servicemethod, assume that Zarle Company’s defined benefit pension plan covers 170 employees. In its negotiations with the employees, Zarle Company amends its pension plan onJanuary 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.Service-YearsYear A B C D E Total2018 40 20 40 50 20 1702019 20 40 50 20 1302020 40 50 20 1102021 50 20 702022 20 2040 40 120 200 100 500ILLUSTRATION 20-10Computation of ServiceYears
Total
Cost per
Annual
Year
Service-Years
Service-Year
Amortization
×=2018 170 $160 $27,2002019 130 160 20,8002020 110 160 17,6002021 70 160 11,2002022 20 160 3,200500 $80,000ILLUSTRATION 20-11Computation of AnnualPrior Service CostAmortizationComputed on the basis of a prior service cost of $80,000 and a total of 500 serviceyears for all years, the cost per service-year is $160 ($80,000 ÷ 500). The annual amountof amortization based on a $160 cost per service-year is computed as follows.Illustration 20-10 shows computation of the service-years per year and the totalservice-years.An alternative method of computing amortization of prior service cost is permitted.Employers may use straight-line amortization over the average remaining service life ofthe employees. In this case, with 500 service-years and 170 employees, the average would1130 Chapter 20 Accounting for Pensions and Postretirement Benefi tsbe 2.94 years (500 ÷ 170). The annual expense would be $27,211 ($80,000 ÷ 2.94). Using thismethod, Zarle Company would record expense in 2018, 2019, and 2020 as follows.
Year Expense2018 $27,2112019 27,2112020 25,578*$80,000
*.94 × $27,211
2018 Entries and WorksheetContinuing the Zarle Company illustration into 2018, we note that the company amendsthe pension plan on January 1, 2018, to grant employees prior service benefits with apresent value of $80,000. Zarle uses the annual amortization amounts, as computed inthe previous section using the years-of-service approach ($27,200 for 2018). The following additional facts apply to the pension plan for the year 2018.• Annual service cost is $9,500.• Settlement rate is 10 percent.• Actual return on plan assets is $11,100.• Annual funding contributions are $20,000.• Benefits paid to retirees during the year are $8,000.• Amortization of prior service cost (PSC) using the years-of-service method is $27,200.• Accumulated other comprehensive income (hereafter referred to as accumulatedOCI) on December 31, 2017, is zero.Illustration 20-12 presents a worksheet of all the pension entries and informationrecorded by Zarle in 2018. We now add an additional column to the worksheet to record
Insert Page Layout Formulas Data Review ViewHome
A
B
C
D
E
F
G
P18 fx
Pension Worksheet—2018.xls
1
General Journal Entries
Memo Record
2
3
OtherComprehensiveIncome
ProjectedBeneftObligation
PensionAsset/Liability
Items
Plan Assets
AnnualPensionExpense
Cash
4
5
6 7
Prior ServiceCost
8
Balance, Dec. 31, 2017
112,000 Cr.
1,000 Cr.
111,000 Dr.
9
(f) Prior service cost
80,000 Cr.
0
80,000 Dr.
10
11
Balance, Jan. 1, 2018
192,000 Cr.
111,000 Dr.
12
9,500 Dr.
(g) Service cost
9,500 Cr.
13
19,200 Dr.
(h) Interest cost
19,200 Cr.
14
11,100 Cr.
(i) Actual return
11,100 Dr.
15
27,200 Dr.
(j) Amortization of PSC
27,200 Cr.
16
(k) Contributions
20,000 Dr.
20,000 Cr.
17
(l) Benefts
8,000 Dr.
8,000 Cr.
18
19
44,800 Dr.
Journal entry for 2018
77,600 Cr.
20,000 Cr.
52,800 Dr.
2021
Accumulated OCI, Dec. 31, 2017
0
22
Balance, Dec. 31, 2018
212,700 Cr.
78,600 Cr.
134,100 Dr.
52,800 Dr.
23
ILLUSTRATION 20-12Pension Worksheet—2018Gains and Losses 1131the prior service cost adjustment to other comprehensive income. In addition, as shownin rows 19, 21, and 22, the other comprehensive income amount related to prior servicecost is added to accumulated other comprehensive income (“Accumulated OCI”) toarrive at a debit balance of $52,800 at December 31, 2018.The first line of the worksheet shows the beginning balances of the Pension Asset/Liability account and the memo accounts. Entry (f) records Zarle’s granting of prior servicecost, by adding $80,000 to the projected benefit obligation and decreasing other comprehensive income—prior service cost by the same amount. Entries (g), (h), (i), (k), and (l) are similar to the corresponding entries in 2017. To compute the interest cost on the projected benefit obligation for entry (h), we use the beginning projected benefit balance of $192,000,which has been adjusted for the prior service cost amendment on January 1, 2018. Entry(j) records the 2018 amortization of prior service cost by debiting Pension Expense for$27,200 and crediting Other Comprehensive Income (PSC) for the same amount.Zarle makes the following journal entry on December 31 to formally record the 2018pension expense (the sum of the annual pension expense column), and related pensioninformation.2018
Pension Expense
44,800
Other Comprehensive Income (PSC)Cash
52,800
20,000
Pension Asset/Liability
77,600
Because the debits to Pension Expense and to Other Comprehensive Income (PSC)exceed the funding, Zarle credits the Pension Asset/Liability account for the $77,600difference. That account is a liability. In 2018, as in 2017, the balance of the PensionAsset/Liability account ($78,600) is equal to the net of the balances in the memo accounts,as shown in Illustration 20-13.
Projected benefit obligation (Credit)Plan assets at fair value (Debit)
$(212,700)134,100
Pension asset/liability (Credit) $ (78,600)ILLUSTRATION 20-13Pension ReconciliationSchedule—December 31,2018The reconciliation is the formula that makes the worksheet work. It relates the components of pension accounting, recorded and unrecorded, to one another.GAINS AND LOSSESOf great concern to companies that have pension plans are the uncontrollable and unexpected swings in pension expense that can result from (1) sudden and large changes inthe fair value of plan assets, and (2) changes in actuarial assumptions that affect theamount of the projected benefit obligation. If these gains or losses impact fully the financial statements in the period of realization or incurrence, substantial fluctuations in pension expense result.Therefore, the FASB decided to reduce the volatility associated with pension expenseby using smoothing techniques that dampen and in some cases fully eliminate thefluctuations.Smoothing Unexpected Gains and Losses on Plan AssetsOne component of pension expense, actual return on plan assets, reduces pensionexpense (assuming the actual return is positive). A large change in the actual return cansubstantially affect pension expense for a year. Assume a company has a 40 percentreturn in the stock market for the year. Should this substantial, and perhaps one-time,event affect current pension expense?Actuaries ignore current fluctuations when they develop a funding pattern to payexpected benefits in the future. They develop an expected rate of return and multiply it by
LEARNING OBJECTIVE 4Explain the accountingand amortization forunexpected gains and
losses.1132 Chapter 20 Accounting for Pensions and Postretirement Benefi tsan asset value weighted over a reasonable period of time to arrive at an expected return onplan assets. They then use this return to determine a company’s funding pattern.The FASB adopted the actuary’s approach to dampen wide swings that might occurin the actual return. That is, a company includes the expected return on the plan assetsas a component of pension expense, not the actual return in a given year. To achieve thisgoal, the company multiplies the expected rate of return by the market-related value ofthe plan assets. The market-related asset value of the plan assets is either the fair valueof plan assets or a calculated value that recognizes changes in fair value in a systematicand rational manner. [4]13The difference between the expected return and the actual return is referred to asthe unexpected gain or loss; the FASB uses the term asset gains and losses. Asset gainsoccur when actual return exceeds expected return; asset losses occur when actual returnis less than expected return.What happens to unexpected gains or losses in the accounting for pensions? 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. This treatment is similar to prior service cost. The Board believes this treatment is consistent with the practice ofincluding in other comprehensive income certain changes in value that have not beenrecognized in net income (for example, unrealized gains and losses on available-for-salesecurities). [5] In addition, the accounting is simple, transparent, and symmetrical.To illustrate the computation of an unexpected gain or loss and its related accounting,assume that in 2019, Zarle Company has an actual return on plan assets of $12,000 whenthe expected return is $13,410 (the expected rate of return of 10% on plan assets times thebeginning-of-the-year plan assets). The unexpected asset loss of $1,410 ($12,000 – $13,410)is debited to Other Comprehensive Income (G/L) and credited to Pension Expense. Weshow treatment of this loss in the worksheet in Illustration 20-18 (page 1137).WHAT DO THE NUMBERS MEAN? PENSION COSTS UPS AND DOWNSFor some companies, pension plans generate real profi ts. Theplans not only pay for themselves but also increase earnings. Thishappens when the expected return on pension assets exceedthe company’s annual costs. At MeadWestvaco, pensionincome amounted to approximately 27 percent of operatingprofi t. It tallied 11 percent of operating profi t at CenturyTel and9.5 percent at Sun Trust Banks. The issue is important becausein 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 baseno longer offsets pension service costs and interest on theprojected benefi t obligation. As a result, many companiesfi nd it diffi cult to meet their earnings targets, at a time whenmeeting such targets is crucial to maintaining the stockprice.13Companies may use different ways of determining the calculated market-related value for different classesof assets. For example, an employer might use fair value for bonds and a five-year moving-average forequities. But companies should consistently apply the manner of determining market-related value fromyear to year for each asset class. Throughout our Zarle illustrations, we assume that market-related valuesbased on a calculated value and the fair value of plan assets are equal. For homework purposes, use the fairvalue of plan assets as the measure for the market-related value.Smoothing Unexpected Gains andLosses on the Pension LiabilityIn estimating the projected benefit obligation (the liability), actuaries make assumptionsabout such items as mortality rate, retirement rate, turnover rate, disability rate, andsalary amounts. Any change in these actuarial assumptions affects the amount of theprojected benefit obligation. Seldom does actual experience coincide exactly with actuarial predictions. These unexpected gains or losses from changes in the projected benefitobligation are called liability gains and losses.Gains and Losses 1133Companies report liability gains (resulting from unexpected decreases in the liability balance) and liability losses (resulting from unexpected increases) in Other Comprehensive Income (G/L). Companies combine the liability gains and losses in the sameOther Comprehensive Income (G/L) account used for asset gains and losses. They accumulate the asset and liability gains and losses from year to year that are not amortizedin Accumulated Other Comprehensive Income. This amount is reported on the balancesheet in the stockholders’ equity section.Corridor AmortizationThe asset gains and losses and the liability gains and losses can offset each other. As aresult, the Accumulated OCI account related to gains and losses may not grow verylarge. But, it is possible that no offsetting will occur and that the balance in the Accumulated OCI account related to gains and losses will continue to grow.To limit the growth of the Accumulated OCI account, the FASB invented the corridor approach for amortizing the account’s accumulated balance when it gets too large.How large is too large? The FASB set a limit of 10 percent of the larger of the beginningbalances of the projected benefit obligation or the market-related value of the planassets. Above that size, the Accumulated OCI account related to gains and losses isconsidered too large and must be amortized.To illustrate the corridor approach, data for Callaway Co.’s projected benefit obligation and plan assets over a period of six years are shown in Illustration 20-14.ILLUSTRATION 20-14Computation of theCorridor
Projected Market-RelatedAsset Corridor*Value +/– 10%2016 $1,000,000 $ 900,000 $100,0002017 1,200,000 1,100,000 120,0002018 1,300,000 1,700,000 170,0002019 1,500,000 2,250,000 225,0002020 1,700,000 1,750,000 175,0002021 1,800,000 1,700,000 180,000
*The corridor becomes 10% of the larger (in red type) of the projected benefitobligation or the market-related plan asset value.
Beginning-of-the- Benefit Year Balances Obligation 250200150100500(in thousands)2016501001502002502017 2018 2019 2020 2021
10
0 1
0
2
25
17
5
180
10
0 12
0
1
0
180
The
Corridor
170225175ILLUSTRATION 20-15Graphic Illustrationof the CorridorHow the corridor works becomes apparent when we portray the data graphically,as in Illustration 20-15.1134 Chapter 20 Accounting for Pensions and Postretirement Benefi tsIf the balance in the Accumulated OCI account related to gains and losses stayswithin the upper and lower limits of the corridor, no amortization is required. In thatcase, Callaway carries forward unchanged the accumulated OCI related to gains andlosses.If amortization is required, the minimum amortization is the excess divided by theaverage remaining service period of active employees who are expected to receive benefits under the plan. Callaway may use any systematic method of amortization of gainsand losses in lieu of the minimum, provided it is greater than the minimum. It must usethe method consistently for both gains and losses, and must disclose the amortizationmethod used.Example of Gains/LossesIn applying the corridor, companies should include amortization of the net gain or lossas a component of pension expense only if, at the beginning of the year, the net gain orloss in Accumulated OCI exceeded the corridor. That is, if no net gain or loss exists inAccumulated OCI at the beginning of the period, the company cannot recognize pension expense gains or losses in that period.To illustrate the amortization of net gains and losses, assume the following informationfor Soft-White, Inc.ILLUSTRATION 20-16Corridor Test andGain/Loss AmortizationSchedule
MinimumProjected Amortizationof Loss(For Current Year)2017 $2,100,000 $2,600,000 $260,000 $ –0– $ –0–2018 2,600,000 2,800,000 280,000 400,000 21,818c2019 2,900,000 2,700,000 290,000 678,182d 70,579d
aAll as of the beginning of the period.b10% of the greater of projected benefit obligation or plan assets’ market-related value.c$400,000 – $280,000 = $120,000; $120,000 ÷ 5.5 = $21,818.d$400,000 – $21,818 + $300,000 = $678,182; $678,182 – $290,000 = $388,182; $388,182 ÷ 5.5 = $70,579.
Benefit Plan Accumulated Year Obligationa Assetsa Corridorb OCI (G/L)a Soft-White recorded in Other Comprehensive Income actuarial losses of $400,000 in2017 and $300,000 in 2018.If the average remaining service life of all active employees is 5.5 years, the scheduleto amortize the net gain or loss is as shown in Illustration 20-16.Beginning of the Year2017 2018 2019Projected benefit obligation $2,100,000 $2,600,000 $2,900,000Market-related asset value 2,600,000 2,800,000 2,700,000As Illustration 20-16 indicates, the loss recognized in 2018 increased pension expenseby $21,818. This amount is small in comparison with the total loss of $400,000. It indicates that the corridor approach dampens the effects (reduces volatility) of these gainsand losses on pension expense.The rationale for the corridor is that gains and losses result from refinements inestimates as well as real changes in economic value. Over time, some of these gains andlosses will offset one another. It therefore seems reasonable that Soft-White should notfully recognize gains and losses as a component of pension expense in the period inwhich they arise.Gains and Losses 1135However, Soft-White should immediately recognize in net income certaingains and losses—if they arise from a single occurrence not directly related to theoperation of the pension plan and not in the ordinary course of the employer’sbusiness. For example, a gain or loss that is directly related to a plant closing, a disposal of a business component, or a similar event that greatly affects the size of theemployee work force should be recognized as a part of the gain or loss associatedwith that event.For example, at one time, Bethlehem Steel reported a quarterly loss of $477 million.A great deal of this loss was attributable to future estimated benefits payable to workerswho were permanently laid off. In this situation, the loss should be treated as an adjustment to the gain or loss on the plant closing and should not affect pension cost for thecurrent or future periods.Summary of Calculations for Asset Gain or LossThe difference between the actual return on plan assets and the expected return on planassets is the unexpected asset gain or loss component. This component defers the difference between the actual return and expected return on plan assets in computingcurrent-year pension expense. Thus, after considering this component, it is really theexpected return on plan assets (not the actual return) that determines current pension expense.Companies determine the amortized net gain or loss by amortizing the Accumulated OCI amount related to net gain or loss at the beginning of the year subject to thecorridor limitation. In other words, if the accumulated gain or loss is greater thanthe corridor, these net gains and losses are subject to amortization. Soft-White computed this minimum amortization by dividing the net gains or losses subject to amortization by the average remaining service period. When the current-year unexpectedgain or loss is combined with the amortized net gain or loss, we determine thecurrent-year gain or loss. Illustration 20-17 summarizes these gain and losscomputations.ILLUSTRATION 20-17Graphic Summary of Gainor Loss Computation
Current Year
Actual Return
=
Current Year
Unexpected GainorLoss
+
=
Current Year
AmortizedNet Gainor Loss
Current Year
Expected Return
CorridorAverageRemainingService LifeBeginning-ofYearAccumulatedOCI (G/L)Current-Year Gain or Loss=In essence, these gains and losses are subject to triple smoothing. That is, companiesfirst smooth the asset gain or loss by using the expected return. Second, they do notamortize the accumulated gain or loss at the beginning of the year unless it is greaterthan the corridor. Finally, they spread the excess over the remaining service life of existing employees.1136 Chapter 20 Accounting for Pensions and Postretirement Benefi ts2019 Entries and WorksheetContinuing the Zarle Company illustration, the following facts apply to the pensionplan for 2019.• Annual service cost is $13,000.• Settlement rate is 10 percent; expected earnings rate is 10 percent.• Actual return on plan assets is $12,000.• Amortization of prior service cost (PSC) is $20,800.• Annual funding contributions are $24,000.• Benefits paid to retirees during the year are $10,500.• Changes in actuarial assumptions resulted in an end-of-year projected benefitobligation of $265,000.The worksheet in Illustration 20-18 presents all of Zarle’s 2019 pensionentries and related information. The first line of the worksheet records the beginningbalances that relate to the pension plan. In this case, Zarle’s beginning balances arethe ending balances from its 2018 pension worksheet in Illustration 20-12 (page1130).Entries (m), (n), (o), (q), (r), and (s) are similar to the corresponding entries in 2017or 2018.EVOLVING ISSUE BYE BYE CORRIDORMany companies have signifi cant actuarial losses in their pension plans, which are presently deferred through use of the corridor approach. However, companies do have a choice—theymay select any method of accounting for these deferred lossesas long as it is systematic, rational, and consistently applied,and meets a minimum for recognition in the income statement.Some companies are now shifting away from the corridorapproach and recognizing actuarial losses immediately. Forexample, AT&T, Verizon Communications, and HoneywellInternational have changed accounting principles fromsmoothing these losses to recognizing them in the year incurred.Companies argue this approach provides more transparency for these losses that will directly affect pension expense inthe current period (and this accounting is also more similar toIFRS). However, there is a silver lining for these companies—they can charge many of these deferred losses to past years.For example, the table at the top of the right-hand column indicates deferred losses as of 2009 for three major companies.When AT&T changed to immediate recognition in 2010,it restated its previous years. In 2008, for example, AT&Tincreased its pension cost by $24.9 billion, which led to a netloss in 2008 of $2.6 billion instead of a profi t of $12.9 billion. Asa result, in 2010 it recognized a much smaller pension cost of$3 billion. Skeptics suggest that AT&T made this change tocharge these losses to prior periods. In other words, does anyone in 2011 care that the profi t in 2008 was changed to a loss?In addition, once these losses are charged to prior periods,they no longer affect current and future earnings.Although earnings in the future will probably be more volatile due to fl uctuations in pension expense, more companiesare willing to move in the direction of immediate expensing toeliminate large deferred losses which would be a drag on futureincome.Deferred Losses as Losses as % ofof 2009 (in billions) Pension Assets
$23.04
49%43
$12.20
$7.57
55
AT&TVerizonHoneywellSources: Michael Rapoport, “Rewriting Pension History,” Wall Street Journal (March 9, 2011); and SEI, “Why Are Pension Plan Sponsors Switchingto Mark-to-Market Accounting?” (October 2013).Gains and Losses 1137
Insert Page Layout Formulas Data Review ViewHome
A
B
C
D
E
F
G
H
P18 fx
Pension Worksheet—2019.xls
1
General Journal Entries
Memo Record
2
3
OtherComprehensive Income
ProjectedBeneftObligation
PensionAsset/Liability
Items
Plan Assets
AnnualPensionExpense
Cash
4
5
6 7
Prior ServiceCost
Gains/Losses
8
Balance, Jan. 1, 2019
212,700 Cr.
78,600 Cr.
134,100 Dr.
9
13,000 Dr.
(m) Service cost
13,000 Cr.
10
21,270 Dr.
(n) Interest cost
21,270 Cr.
11
12,000 Cr.
(o) Actual return
12,000 Dr.
12
1,410 Cr.
1,410 Dr.
(p) Unexpected loss
13
20,800 Dr.
(q) Amortization of PSC
20,800 Cr.
14
(r) Contributions
24,000 Dr.
24,000 Cr.
15
(s) Benefts
10,500 Dr.
10,500 Cr.
16
28,530 Dr.
(t) Liability increase
28,530 Cr.
17
18
41,660 Dr.
29,940 Dr.
Journal entry for 2019
26,800 Cr.
24,000 Cr.
20,800 Cr.
19
20
0
Accumulated OCI, Dec. 31, 2018
52,800 Dr.
21
29,940 Dr.
Balance, Dec. 31, 2019*
265,000 Cr.
105,400 Cr.
159,600 Dr.
32,000 Dr.
22
23
$32,000 Dr.
*Accumulated OCI (PSC)
24
29,940 Dr.
Accumulated OCI (G/L)
25
$61,940 Dr.
Accumulated OCI, Dec. 31, 2019
26
ILLUSTRATION 20-18Pension Worksheet—2019ILLUSTRATION 20-19Projected Benefi t ObligationBalance (Unadjusted)
December 31, 2018, PBO balanceService cost [entry (m)]
$212,70013,000
Interest cost [entry (n)]Benefits paid [entry (s)]
21,270(10,500)
December 31, 2019, PBO balance (before liability increases) $236,470Entries (o) and (p) are related. We explained the recording of the actual return inentry (o) in both 2017 and 2018; it is recorded similarly in 2019. In both 2017 and 2018,Zarle assumed that the actual return on plan assets was equal to the expected returnon plan assets. In 2019, the expected return of $13,410 (the expected rate of return of10 percent times the beginning-of-the-year plan assets’ balance of $134,100) is higherthan the actual return of $12,000. To smooth pension expense, Zarle defers the unexpected loss of $1,410 ($13,410 – $12,000) by debiting the Other Comprehensive Income(G/L) account and crediting Pension Expense. As a result of this adjustment, theexpected return on the plan assets is the amount actually used to compute pensionexpense.Entry (t) records the change in the projected benefit obligation resulting from thechange in the actuarial assumptions. As indicated, the actuary has now computedthe ending balance to be $265,000. Given the PBO balance at December 31, 2018, andthe related transactions during 2019, the PBO balance to date is computed as shown inIllustration 20-19.The difference between the ending balance of $265,000 and the balance of $236,470before the liability increase is $28,530 ($265,000 – $236,470). This $28,530 increase in the1138 Chapter 20 Accounting for Pensions and Postretirement Benefi tsemployer’s liability is an unexpected loss. The journal entry on December 31, 2019, torecord the pension information is as follows.
Pension Expense
41,660
Other Comprehensive Income (G/L)Cash
29,940
24,000
Other Comprehensive Income (PSC)
20,800
Pension Asset/Liability
26,800
As the 2019 worksheet indicates, the $105,400 balance in the Pension Asset/Liabilityaccount at December 31, 2019, is equal to the net of the balances in the memo accounts.Illustration 20-20 shows this computation.14At a minimum, companies must disclose the amount of assets allocated to equities, government andcorporate bonds, mortgage-backed securities, derivatives, and real estate. Also, information on concentrationsof risk must be explained. Finally, fair value disclosures would be required, including classification ofamounts into levels of the fair value hierarchy. [6]ILLUSTRATION 20-20Pension ReconciliationSchedule—December 31,2019
Projected benefit obligation (Credit)Plan assets at fair value (Debit)
$(265,000)159,600
Pension asset/liability $(105,400)REPORTING PENSION PLANS INFINANCIAL STATEMENTSAs you might suspect, a phenomenon as significant and complex as pensions involvesextensive reporting and disclosure requirements. We will cover these requirements intwo categories: (1) those within the financial statements, and (2) those within the notesto the financial statements.Within the Financial StatementsRecognition of the Net Funded Status of the Pension PlanCompanies must recognize on their balance sheet the overfunded (pension asset) orunderfunded (pension liability) status of their defined benefit pension plan. The overfunded or underfunded status is measured as the difference between the fair value ofthe plan assets and the projected benefit obligation.Classifi cation of Pension Asset or Pension LiabilityNo portion of a pension asset is reported as a current asset. The excess of the fair valueof the plan assets over the benefit obligation is classified as a noncurrent asset. The rationale for noncurrent classification is that the pension plan assets are restricted. That is,these assets are used to fund the projected benefit obligation, and therefore noncurrentclassification is appropriate.The current portion of a net pension liability represents the amount of benefit payments to be paid in the next 12 months (or operating cycle, if longer), if that amountcannot be funded from existing plan assets. Otherwise, the pension liability is classifiedas a noncurrent liability.14Aggregation of Pension PlansSome companies have two or more pension plans. In such instances, a question arises asto whether these multiple plans should be combined and shown as one amount on thebalance sheet. The Board takes the position that all overfunded plans should be combined and shown as a pension asset on the balance sheet. Similarly, if the company hastwo or more underfunded plans, the underfunded plans are combined and shown asone amount on the balance sheet.
LEARNING OBJECTIVE 5Describe the requirementsfor reporting pension plansin financial statements.
Reporting Pension Plans in Financial Statements 1139The FASB rejected the alternative of combining all plans and representing the netamount as a single net asset or net liability. The rationale: A company does not have theability to offset excess assets of one plan against underfunded obligations of anotherplan. Furthermore, netting all plans is inappropriate because offsetting assets and liabilities is not permitted under GAAP unless a right of offset exists.To illustrate, assume that Cresci Company has three pension plans as shown inIllustration 20-21.ILLUSTRATION 20-21Multiple Pension Plans’Funded StatusPension Assets Projected Benefit Pension(at Fair Value) Obligation Asset/LiabilityPlan A $400,000 $300,000 $100,000 AssetPlan B 600,000 720,000 120,000 LiabilityPlan C 550,000 700,000 150,000 LiabilityIn this case, Cresci reports a pension plan asset of $100,000 and a pension plan liability of$270,000 ($120,000 + $150,000).Actuarial Gains and Losses/Prior Service CostActuarial gains and losses not recognized as part of pension expense are recognized asincreases and decreases in other comprehensive income. The same type of accounting isalso used for prior service cost. The Board requires that the prior service cost arising inthe year of the amendment (which increases the projected benefit obligation) be recognized by an offsetting debit to other comprehensive income. By recognizing both actuarial gains and losses and prior service cost as part of other comprehensive income, theBoard believes that the usefulness of financial statements is enhanced.To illustrate the presentation of other comprehensive income and related accumulated OCI, assume that Obey Company provides the following information for the year2017. None of the Accumulated OCI on January 1, 2017, should be amortized in 2017.Net income for 2017 $100,000Actuarial liability loss for 2017 60,000Prior service cost adjustment to provide additionalbenefits in December 2017 15,000Accumulated OCI, January 1, 2017 40,000Both the actuarial liability loss and the prior service cost adjustment decrease thefunded status of the plan on the balance sheet. This results because the projected benefitobligation increases. However, neither the actuarial liability loss nor the prior servicecost adjustment affects pension expense in 2017. In subsequent periods, these items willimpact pension expense through amortization.For Obey Company, the computation of “Other comprehensive loss” for 2017 is asfollows.
Actuarial liability lossPrior service cost benefit adjustmentOther comprehensive loss
$60,00015,000$75,000
ILLUSTRATION 20-22Computation of OtherComprehensive IncomeILLUSTRATION 20-23Computation ofComprehensive Income
Net incomeOther comprehensive lossComprehensive income
$100,00075,000$ 25,000
The computation of “Comprehensive income” for 2017 is as follows.As discussed in Chapter 4, the components of other comprehensive income must bereported in one of two ways: (1) in a second income statement, or (2) in a combinedstatement of comprehensive income. Regardless of the format used, net income must be1140 Chapter 20 Accounting for Pensions and Postretirement Benefi tsadded to other comprehensive income to arrive at comprehensive income. For homeworkpurposes, use the second income statement approach unless stated otherwise. Earnings pershare information related to comprehensive income is not required.To illustrate the second income statement approach, assume that Obey Companyhas reported a traditional income statement. The comprehensive income statement isshown in Illustration 20-24.ILLUSTRATION 20-24Comprehensive IncomeReportingOBEY COMPANYCOMPREHENSIVE INCOME STATEMENTFOR THE YEAR ENDED DECEMBER 31, 2017Net income $100,000Other comprehensive lossActuarial liability loss $60,000Prior service cost 15,000 75,000Comprehensive income $ 25,000The computation of “Accumulated other comprehensive income” as reported in stockholders’ equity at December 31, 2017, is as follows.ILLUSTRATION 20-25Computation ofAccumulated OtherComprehensive Income
Accumulated other comprehensive income, January 1, 2017Other comprehensive lossAccumulated other comprehensive loss, December 31, 2017
$40,00075,000$35,000
Regardless of the display format for the income statement, the accumulated othercomprehensive loss is reported in the stockholders’ equity section of the balance sheetof Obey Company as shown in Illustration 20-26. (Illustration 20-26 uses assumed datafor the common stock and retained earnings information.)ILLUSTRATION 20-26Reporting ofAccumulated OCIOBEY COMPANYBALANCE SHEETAS OF DECEMBER 31, 2017(STOCKHOLDERS’ EQUITY SECTION)Stockholders’ equityCommon stock $100,000Retained earnings 60,000Accumulated other comprehensive loss 35,000Total stockholders’ equity $125,000By providing information on the components of comprehensive income as well as total accumulated other comprehensive income, the company communicates all changes in net assets.In this illustration, it is assumed that the accumulated other comprehensive incomeat January 1, 2017, is not adjusted for the amortization of any prior service cost or actuarial gains and losses that would change pension expense. As discussed in the earlierexamples, these items will be amortized into pension expense in future periods.Within the Notes to the Financial StatementsPension plans are frequently important to understanding a company’s financial position, results of operations, and cash flows. Therefore, a company discloses the followinginformation, either in the body of the financial statements or in the notes. [7]1. A schedule showing all the major components of pension expense. Rationale: Information provided about the components of pension expense helps users betterunderstand how a company determines pension expense. It also is useful in forecasting a company’s net income.Reporting Pension Plans in Financial Statements 11412. A reconciliation showing how the projected benef t obligation and the fair value ofthe plan assets changed from the beginning to the end of the period. Rationale:Disclosing the projected benef t obligation, the fair value of the plan assets, andchanges in them should help users understand the economics underlying the obligations and resources of these plans. Explaining the changes in the projected beneftobligation and fair value of plan assets in the form of a reconciliation provides amore complete disclosure and makes the f nancial statements more understandable.3. A disclosure of the rates used in measuring the benef t amounts (discount rate,expected return on plan assets, rate of compensation). Rationale: Disclosure ofthese rates permits users to determine the reasonableness of the assumptionsapplied in measuring the pension liability and pension expense.4. 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 thefair value to total plan assets. In addition, a company must include a narrativedescription of investment policies and strategies, including the target allocationpercentages (if used by the company). Rationale: Such information helps fnancialstatement users evaluate the pension plan’s exposure to market risk and possiblecash flow demands on the company. It also will help users better assess the reasonableness of the company’s expected rate of return assumption.5. The expected beneft payments to be paid to current plan participants for each ofthe next fve fscal years and in the aggregate for the fve fscal years thereafter. Alsorequired is disclosure of a company’s best estimate of expected contributions to bepaid to the plan during the next year. Rationale: These disclosures provide information related to the cash outfl ows of the company. With this information, fnancialstatement users can better understand the potential cash outflows related to thepension plan. They can better assess the liquidity and solvency of the company,which helps in assessing the company’s overall fnancial flexibility.6. The nature and amount of changes in plan assets and beneft obligations recognizedin net income and in other comprehensive income of each period. Rationale: Thisdisclosure provides information on pension elements affecting the projected beneftobligation and plan assets and on whether those amounts have been recognized inincome or deferred to future periods.7. The accumulated amount of changes in plan assets and beneft obligations that havebeen recognized in other comprehensive income and that will be recycled into netincome in future periods. Rationale: This information indicates the pension-relatedbalances recognized in stockholders’ equity, which will affect future income.8. The amount of estimated net actuarial gains and losses and prior service costs andcredits that will be amortized from accumulated other comprehensive income intonet income over the next fscal year. Rationale: This information helps users predictthe impact of deferred pension expense items on next year’s income.In summary, the disclosure requirements are extensive, and purposely so. One factorthat has been a challenge for useful pension reporting has been the lack of consistent terminology. Furthermore, a substantial amount of offsetting is inherent in the measurementof pension expense and the pension liability. These disclosure requirements are designedto address these concerns and take some of the mystery out of pension reporting.15INTERNATIONALPERSPECTIVEThe FASB’s proposedAccounting StandardsUpdate on presentationof pension expense,if adopted, will alignGAAP with IFRS.UNDERLYINGCONCEPTSDoes it make a differenceto users of fi nancialstatements whethercompanies recognizepension information inthe fi nancial statementsor disclose it only in thenotes? The FASB wasunsure, so in accordwith the full disclosureprinciple, it decided toprovide extensive pension plan disclosures.15As part of its Disclosure Framework project, the FASB has issued two proposed Accounting Standards Updates(ASUs) intended to improve financial reporting of pensions and other postretirement benefits (discussed inAppendix 20A). The first ASU would make defined benefit plan disclosures more useful by adding disclosurerequirements (e.g., descriptions of plan benefits and the reasons for significant gains and losses) as requested byusers. The ASU also eliminates less-useful disclosures as indicated by users (e.g., the amount of the accumulatedbenefit obligation). The second proposed ASU requires that the servie cost component of pension expense bereported with other compensation costs. This change in classification will result in only the service cost componentto be eligible for capitalization, for example, as a cost of internally manufactured inventory or a self-constructedasset. Other components of net pension expense (e.g., interest cost, prior servie cost amortization) will be presentedin the income statement as part of “Other expenses and losses.” The FASB concluded that this change will result inmore useful information, based on input from users indicating that the service cost component of pension expenseis analyzed differently and has different predictive value from the other pension expense components.1142 Chapter 20 Accounting for Pensions and Postretirement Benefi tsExample of Pension Note DisclosureIn the following sections, we provide examples and explain the key pension disclosureelements.Components of Pension ExpenseThe FASB requires disclosure of the individual pension expense components (derivedfrom the information in the pension expense worksheet column): (1) service cost,(2) interest cost, (3) expected return on assets, (4) other gains or losses component, and(5) prior service cost component. The purpose of such disclosure is to clarify to moresophisticated readers how companies determine pension expense. Providing information on the components should also be useful in predicting future pension expense.Illustration 20-27 presents an example of this part of the disclosure. It uses the information from the Zarle illustration, specifically the expense component information fromthe worksheets in Illustrations 20-8 (page 1127), 20-12 (page 1130), and 20-18 (page 1137).ILLUSTRATION 20-27Summary of ExpenseComponents—2017,2018, 2019
ZARLE COMPANY2017 2018 2019Components of pension expenseService cost $ 9,000 $ 9,500 $13,000Interest cost 10,000 19,200 21,270Expected return on plan assets (10,000) (11,100) (13,410)*Amortization of prior service cost –0– 27,200 20,800Pension expense $ 9,000 $44,800 $41,660
*Note that the expected return must be disclosed, not the actual return. In 2019, the expectedreturn is $13,410, which is the actual gain ($12,000) adjusted by the unrecognized loss ($1,410).
Funded Status of PlanHaving a reconciliation of the changes in the assets and liabilities from the beginningof the year to the end of the year, statement readers can better understand the underlying economics of the plan. In essence, this disclosure contains the information in thepension worksheet for the projected benefit obligation and plan asset columns. Usingthe information for Zarle, the schedule in Illustration 20-28 provides an example of thereconciliation.UNDERLYINGCONCEPTSThis represents anothercompromise betweenrelevance and faithfulrepresentation. Disclosureattempts to balancethese objectives.ILLUSTRATION 20-28Pension Disclosure forZarle Company—2017,2018, 2019ZARLE COMPANY2017 2018 2019Change in benefit obligationBenefit obligation at beginning of year $100,000 $112,000 $ 212,700Service cost 9,000 9,500 13,000Interest cost 10,000 19,200 21,270Amendments (Prior service cost) –0– 80,000 –0–Actuarial loss –0– –0– 28,530Benefits paid (7,000) (8,000) (10,500)
Benefit obligation at end of yearChange in plan assetsFair value of plan assets at beginning of yearActual return on plan assets
112,000
100,00010,000
ContributionsBenefits paid
8,000(7,000)
20,000 24,000Fair value of plan assets at end of year 111,000 134,100 159,600Funded status (Pension asset/liability) $ (1,000) $ (78,600) $(105,400)PENSION DISCLOSUREReporting Pension Plans in Financial Statements 1143The 2017 column reveals that Zarle underfunds the projected benefit obligation by$1,000. The 2018 column reveals that Zarle reports the underfunded liability of $78,600in the balance sheet. Finally, the 2019 column indicates that Zarle recognizes the underfunded liability of $105,400 in the balance sheet.2020 Entries and Worksheet—A Comprehensive ExampleIncorporating the corridor computation and the required disclosures, we continue theZarle Company pension plan accounting based on the following facts for 2020.• Service cost is $16,000.• Settlement rate is 10 percent; expected rate of return is 10 percent.• Actual return on plan assets is $22,000.• Amortization of prior service cost is $17,600.• Annual funding contributions are $27,000.• Benefits paid to retirees during the year are $18,000.• Average service life of all covered employees is 20 years.Zarle prepares a worksheet to facilitate accumulation and recording of the components of pension expense and maintenance of amounts related to the pension plan. Illustration 20-29 shows that worksheet, which uses the basic data presented above. Beginningof-the-year 2020 account balances are the December 31, 2019, balances from Zarle’s 2019pension worksheet in Illustration 20-18 (on page 1137). ILLUSTRATION 20-29Comprehensive PensionWorksheet—2020
Insert Page Layout Formulas Data Review ViewHome
A
B
C
D
E
F
G
H
P18 fx
Comprehensive Pension Worksheet—2020.xls
1
General Journal Entries
Memo Record
2
3
OtherComprehensive Income
ProjectedBeneftObligation
PensionAsset/Liability
Items
Plan Assets
AnnualPensionExpense
Cash
4
5
6 7
Prior ServiceCost
Gains/Losses
8
Balance, Dec. 31, 2019
265,000 Cr.
105,400 Cr.
159,600 Dr.
9
16,000 Dr.
(aa) Service cost
16,000 Cr.
10
26,500 Dr.
(bb) Interest cost
26,500 Cr.
11
22,000 Cr.
(cc) Actual return
22,000 Dr.
12
6,040 Dr.
6,040 Cr.
(dd) Unexpected gain
13
17,600 Dr.
(ee) Amortization of PSC
17,600 Cr.
14
(ff) Contributions
27,000 Dr.
27,000 Cr.
15
(gg) Benefts
18,000 Dr.
18,000 Cr.
16
172 Dr.
172 Cr.
(hh) Amortization of loss
17
18
44,312 Dr.
6,212 Cr.
Journal entry for 2020
6,500 Dr.
27,000 Cr.
17,600 Cr.
19
20
29,940 Dr.
Accumulated OCI, Dec. 31, 2019
32,000 Dr.
21
23,728 Dr.
Balance, Dec. 31, 2020*
289,500 Cr.
98,900 Cr.
190,600 Dr.
14,400 Dr.
22
23
$14,400 Dr.
*Accumulated OCI (PSC)
24
23,728 Dr.
Accumulated OCI (G/L)
25
$38,128 Dr.
Accumulated OCI, Dec. 31, 2020
26
1144 Chapter 20 Accounting for Pensions and Postretirement Benefi tsWorksheet Explanations and EntriesEntries (aa) through (gg) are similar to the corresponding entries previously explainedin the prior years’ worksheets, with the exception of entry (dd). In 2019, the expectedreturn on plan assets exceeded the actual return, producing an unexpected loss. In 2020,the actual return of $22,000 exceeds the expected return of $15,960 ($159,600 × 10%),resulting in an unexpected gain of $6,040, entry (dd). By netting the gain of $6,040against the actual return of $22,000, pension expense is affected only by the expectedreturn of $15,960.A new entry (hh) in Zarle’s worksheet results from application of the corridor teston the accumulated balance of net gain or loss in accumulated other comprehensiveincome. Zarle Company begins 2020 with a balance in the net loss account of $29,940.The company applies the corridor criterion in 2020 to determine whether the balance isexcessive and should be amortized. In 2020, the corridor is 10 percent of the larger of thebeginning-of-the-year projected benefit obligation of $265,000 or the plan asset’s$159,600 market-related asset value (assumed to be fair value). The corridor for 2020 is$26,500 ($265,000 × 10%). Because the balance in Accumulated OCI is a net loss of$29,940, the excess (outside the corridor) is $3,440 ($29,940 – $26,500). Zarle amortizesthe $3,440 excess over the average remaining service life of all employees. Given anaverage remaining service life of 20 years, the amortization in 2020 is $172 ($3,440 ÷ 20).In the 2020 pension worksheet, Zarle debits Pension Expense for $172 and credits thatamount to Other Comprehensive Income (G/L). Illustration 20-30 shows the computation of the $172 amortization charge.ILLUSTRATION 20-30Computation of 2020Amortization Charge(Corridor Test)2020 Corridor TestNet (gain) or loss at beginning of year in accumulated OCI $29,94010% of larger of PBO or market-related asset value of plan assets (26,500)
Amortizable amountAverage service life of all employees2020 amortization ($3,440 ÷ 20 years)
$ 3,44020 years$172
Zarle formally records pension expense for 2020 as follows.2020
Pension Expense
44,312
Pension Asset/LiabilityCash
6,500
27,000
Other Comprehensive Income (G/L)
6,212
Other Comprehensive Income (PSC)
17,600
Note DisclosureIllustration 20-31 shows the note disclosure of Zarle’s pension plan for 2020. Note thatthis example assumes that the pension liability is noncurrent and that the 2021 adjustment for amortization of the net gain or loss and amortization of prior service cost arethe same as 2020.Special IssuesThe Pension Reform Act of 1974A classic example of the unfortunate consequences of an underfunded pension planis the 1963 shutdown of the Studebaker Automobile operations in South Bend,Indiana, in which 4,500 workers lost 85 percent of their vested benefits. As a resultof such situations, the Employee Retirement Income Security Act of 1974—ERISA—was passed. The legislation affects virtually every private retirement plan in theReporting Pension Plans in Financial Statements 1145United States. It attempts to safeguard employees’ pension rights by mandatingmany pension plan requirements, including minimum funding, participation, andvesting.These requirements can influence the employers’ cash flows significantly. Underthis legislation, annual funding is no longer discretionary. An employer now must fundthe plan in accordance with an actuarial funding method that over time will be
ZARLE COMPANYNOTES TO THE FINANCIAL STATEMENTS
Note D. The company has a pension plan covering substantially all of its employees. The plan is noncontributory and provides pension benefits that are based on the employee’s compensation during the threeyears immediately preceding retirement. The pension plan’s assets consist of cash, stocks, and bonds.The company’s funding policy is consistent with the relevant government (ERISA) and tax regulations.Pension expense for 2020 is comprised of the following components of pension cost.Total recognized in pension expense and other comprehensive income $20,500The estimated net actuarial loss and prior service cost for the defined benefit pension plan that will beamortized from accumulated other comprehensive into pension expense over the next year are estimatedto be the same as this year.The amount recognized as a long-term liability in the balance sheet is as follows:Noncurrent liabilityTotal $38,128Change in benefit obligationBenefit obligation at beginning of year $265,000Service cost 16,000Interest cost 26,500Amendments (Prior service cost) –0–Actuarial gain –0–Benefits paid (18,000)Fair value of plan assets at end of year 190,600Funded status (liability) $ 98,900The weighted-average discount rate used in determining the 2020 projected benefit obligationwas 10 percent. The rate of increase in future compensation levels used in computing the 2020 projectedbenefit obligation was 4.5 percent. The weighted-average expected long-term rate of return on theplan’s assets was 10 percent.
Service cost $16,000Interest on projected benefit obligation 26,500Expected return on plan assets (15,960)Amortization of prior service cost 17,600Amortization of net loss 172Pension expense $44,312Other changes in plan assets and benefit obligationsrecognized in other comprehensive incomeNet actuarial gain $ 6,212Amortization of prior service cost 17,600Total recognized in other comprehensive income (23,812)Pension liability $98,900The amounts recognized in accumulated other comprehensive income related to pensions consist of:Net actuarial loss $23,728Prior service cost 14,400Benefit obligation at end of year 289,500Change in plan assetsFair value of plan assets at beginning of year 159,600Actual return on plan assets 22,000Contributions 27,000Benefits paid (18,000)Components of pensionexpenseAmounts recognized in othercomprehensive incomeAmounts recognized in thebalance sheetReconciliations of pensionliability and plan assetsFunded status of planRates used to estimateplan elementsILLUSTRATION 20-31Minimum Note Disclosureof Pension Plan, ZarleCompany, 20201146 Chapter 20 Accounting for Pensions and Postretirement Benefi tssufficient to pay for all pension obligations. If companies do not fund their plans in areasonable manner, they may be subject to fines and/or loss of tax deductions.16The law requires plan administrators to publish a comprehensive description andsummary of their plans, along with detailed annual reports that include many supplementary schedules and statements.Another important provision of the act is the creation of the Pension BenefitGuaranty Corporation (PBGC). The PBGC’s purpose is to administer terminatedplans and to impose liens on an employer’s assets for certain unfunded pension liabilities. If a company terminates its pension plan, the PBGC can effectively impose alien against the employer’s assets for the excess of the present value of guaranteedvested benefits over the pension fund assets. This lien generally has had the status ofa tax lien; it takes priority over most other creditorship claims. This section of the actgives the PBGC the power to force an involuntary termination of a pension plan whenever the risks related to nonpayment of the pension obligation seem too great. BecauseERISA restricts to 30 percent of net worth the lien that the PBGC can impose, the PBGCmust monitor all plans to ensure that net worth is sufficient to meet the pension benefit obligations.A large number of terminated plans have caused the PBGC to pay out substantialbenefits. Currently the PBGC receives its funding from employers, who contribute acertain dollar amount for each employee covered under the plan.1716In 2006, Congress passed the Pension Protection Act. This law has many provisions. One importantaspect of the act is that it forced many companies to expedite their contributions to their pension plans.One group estimates that companies in the S&P 500 would have had to contribute $47 billion to theirpension plans if the new rules were fully phased in for 2006. That amount is about 57 percent more thanthe $30 billion that companies were expecting to contribute to their plans that year. Subsequently,Congress continues to provide pension funding relief. For example, in the “Moving Ahead for Progressin the 21st Century” Act (enacted July 6, 2012), companies can use a higher discount rate based onhigh-grade bond yields averaged over 25 years, which helps reduce the pension liability and requiredcontributions.17Pan American Airlines is a good illustration of how difficult it is to assess when to terminate. When PanAm filed for bankruptcy in 1991, it had a pension liability of $900 million. From 1983 to 1991, the IRS gave itsix waivers so it did not have to make contributions. When Pan Am terminated the plan, there was little networth left upon which to impose a lien. An additional accounting problem relates to the manner ofdisclosing the possible termination of a plan. For example, should Pan Am have disclosed a contingentliability for its struggling plan? At present this issue is unresolved, and considerable judgment is needed toanalyze a company with these contingent liabilities.UNDERLYINGCONCEPTSMany plans are underfunded but still quiteviable. For example, atone time Loews Corp.had a $159 millionshortfall, but also hadearnings of $594 millionand a good net worth.Thus, the going concernassumption permitsus to ignore pensionunderfundings in somecases because in thelong run they are notsignifi cant.WHAT DO THE NUMBERS MEAN? WHO GUARANTEES THE GUARANTOR?The Pension Benefi t Guaranty Corporation (PBGC) in arecent annual report indicates that its primary mission is toencourage the continuation and maintenance of voluntary private pension plans. It‘s an obligation which the PBGC takesseriously. However, the trends are ominous:• Americans today are spending more years in retirement.They’re healthier and more active, which is great news.Unfortunately, pensions haven’t kept up.• Many businesses, for competitive and other reasons, continue to reduce their support for retirement plans. Somehave switched from a defi ned benefi t plan to a defi nedcontribution plan which costs less and comes with fewerobligations. Others offer lump-sum cash payments to employees or retirees to settle the employer’s obligations.• Left on their own, many people save less, as well as investand plan less well. They also pay higher fees and they getlower returns.• Many people defer retirement but still don’t have enoughmoney for retirement—and they’re worried. One poll citedby the Senate Health, Education, Labor, and PensionsCommittee says that 92 percent of people think there’s aretirement crisis. They’re right to be concerned.Add to these concerns that obligations in pension plans todaygreatly exceed pension assets. Finally, the PBGC has a problem as well—a large defi cit in its accounts. The following chartindicates that downward spiral in the net worth of the PBGCover the last 12 years as pension payments have exceededpremiums received.Reporting Pension Plans in Financial Statements 1147Pension TerminationsA congressman at one time noted, “Employers are simply treating their employee pension plans like company piggy banks, to be raided at will.” What this congressman wasreferring to is the practice of paying off the projected benefit obligation and pocketingany excess. ERISA prevents companies from recapturing excess assets unless they payparticipants what is owed to them and then terminate the plan. As a result, companieswere buying annuities to pay off the pension claimants and then used the excess fundsfor other corporate purposes.18For example, at one time, pension plan terminations netted $363 million for Occidental Petroleum Corp., $95 million for Stroh’s Brewery Co., $58 million for KelloggCo., and $29 million for Western Airlines. Recently, many large companies have terminated their pension plans and captured billions in surplus assets. The U.S. Treasury alsobenefits: Federal legislation requires companies to pay an excise tax of anywhere from20 percent to 50 percent on the gains. All of this is quite legal.19The accounting issue that arises from these terminations is whether a companyshould recognize a gain when pension plan assets revert back to the company (oftencalled asset reversion transactions). The issue is complex. In some cases, a companystarts a new defined benefit plan after it eliminates the old one. Thus, some contend thatthere has been no change in substance but merely a change in form. However, the FASB18A question exists as to whose money it is. Some argue that the excess funds belong to the employees, notthe employer. In addition, given that the funds have been reverting to the employer, critics charge thatcost-of-living increases and the possibility of other increased benefits are reduced because companies will bereluctant to use those remaining funds to pay for such increases.19Another way that companies have reduced their pension obligations is through adoption of cash-balanceplans. These are hybrid plans combining features of defined benefit and defined contribution plans.Although these plans permit employees to transfer their pension benefits when they change employers (likea defined contribution plan), they are controversial because the change to a cash-balance plan often reducesbenefits to older workers.The accounting for cash-balance plans is similar to that for defined benefit plans, because employers bear theinvestment risk in cash-balance plans. However, when an employer adopts a cash-balance plan, the measurementof the future benefit obligation to employees generally is lower, compared to a traditional defined benefit plan.See A. T. Arcady and F. Mellors, “Cash-Balance Conversions,” Journal of Accountancy (February 2000), pp. 22–28.PBGC’s Defcit Continues to Rise(In billions)20145$10(5)(10)(15)(20)(25)(30)(35)(60)(65)2000 2001 2002 2003 2004 2005Surplus Defcit2006 2007 2008 2009 2010 2011 20120Source: http://www.pbgc.gov/about/reports/ar2014.html.1148 Chapter 20 Accounting for Pensions and Postretirement Benefi tsdisagrees. It requires recognition in earnings of a gain or loss when the employer settlesa pension obligation either by lump-sum cash payments to participants or by purchasing nonparticipating annuity contracts. [8]20Concluding ObservationsHardly a day goes by without the financial press analyzing in depth some issue relatedto pension plans in the United States. This is not surprising, since pension funds exceedover $22 trillion in assets globally. As you have seen, the accounting issues related topension plans are complex. The FASB has clarified many of these issues which shouldhelp users understand the financial implications of a company’s pension plans on itsfinancial position, results of operations, and cash flows.20Some companies have established pension poison pills as an anti-takeover measure. These plans require assetreversions from termination of a plan to benefit employees and retirees rather than the acquiring company. Fora discussion of pension poison pills, see Eugene E. Comiskey and Charles W. Mulford, “Interpreting PensionDisclosures: A Guide for Lending Officers,” Commercial Lending Review (Winter 1993–94), Vol. 9, No. 1.21Accounting Trends and Techniques indicates that of its 500 surveyed companies, 317 reported benefit plansthat provide postretirement healthcare benefits. In response to rising healthcare costs and higher premiumson healthcare insurance, companies are working to get their postretirement benefit costs under control.22“OPEB” is the acronym frequently used to describe postretirement benefits other than pensions. This termcame into being before the scope of guidance was narrowed from “other postemployment benefits” to“other postretirement benefits,” thereby excluding postemployment benefits related to severance pay orwage continuation to disabled, terminated, or laid-off employees.YOU WILLWANT TOREADTHE IFRSINSIGHTS ONPAGES 1180–1193For discussion ofIFRS related topension accounting.IBM’s adoption of the GAAP requirements on postretirement benefits resulted in a$2.3 billion charge and a historical curiosity—IBM’s first-ever quarterly loss. GeneralElectric disclosed that its charge for adoption of the same GAAP rules would be$2.7 billion. AT&T absorbed a $2.1 billion pretax hit for postretirement benefits uponadoption. What is GAAP in this area, and how could its adoption have so grave animpact on companies’ earnings?ACCOUNTING GUIDANCEAfter a decade of study, the FASB in December 1990 issued GAAP for “Employers’Accounting for Postretirement Benefits Other Than Pensions.” [9] It alone was thecause for the large charges to income cited above. These rules cover healthcare and other“welfare benefits” provided to retirees, their spouses, dependents, and beneficiaries.21These other welfare benefits include life insurance offered outside a pension plan;medical, dental, and eye care; legal and tax services; tuition assistance; day care; andhousing assistance.22 Because healthcare benefits are the largest of the other postretirement benefits, we use this item to illustrate accounting for postretirement benefits.For many employers (about 95 percent), these GAAP rules required a change fromthe predominant practice of accounting for postretirement benefits on a pay-as-you-go(cash) basis to an accrual basis. Similar to pension accounting, the accrual basis necessitates measuring the employer’s obligation to provide future benefits and accrual ofthe cost during the years that the employee provides service.One of the reasons companies had not prefunded these benefit plans was that paymentsto prefund healthcare costs, unlike excess contributions to a pension trust, are not taxdeductible. Another reason was that postretirement healthcare benefits were once perceivedLEARNING OBJECTIVE *6Identify the differencesbetween pensions andpostretirement healthcarebenefits.APPENDIX 20A ACCOUNTING FOR POSTRETIREMENT BENEFITSAppendix 20A: Accounting for Postretirement Benefi ts 1149to be a low-cost employee benefit that could be changed or eliminated at will and thereforewere not a legal liability. Now, the accounting definition of a liability goes beyond the notionof a legally enforceable claim; the definition now encompasses equitable or constructiveobligations as well, making it clear that

What Students Are Saying About Us

.......... Customer ID: 12*** | Rating: ⭐⭐⭐⭐⭐
"Honestly, I was afraid to send my paper to you, but splendidwritings.com proved they are a trustworthy service. My essay was done in less than a day, and I received a brilliant piece. I didn’t even believe it was my essay at first 🙂 Great job, thank you!"

.......... Customer ID: 14***| Rating: ⭐⭐⭐⭐⭐
"The company has some nice prices and good content. I ordered a term paper here and got a very good one. I'll keep ordering from this website."

"Order a Custom Paper on Similar Assignment! No Plagiarism! Enjoy 20% Discount"