Intermediate Financial Accounting

Intermediate Financial Accounting Accounting for Employee Benefits

Chapter Objectives • To identity types of pension plans and their characteristics. • To discuss alternative measures for valuing the pension obligation. • Identify the components of pension expense. • Utilize a work sheet for employer's plan entries. pensions

Chapter Objectives (contd.) • Discuss the amortization of Unrecognized prior service costs. • Discuss the accounting procedure for unrecognized gains and losses. • Explain the corridor approach to amortize unrecognized gains and losses. pensions

Chapter Objectives (contd.) • Discuss the transition cost. • Describe the pension reporting in financial statements. • Discuss pension terminations. pensions

Pension Plans • A pension plan is an agreement between a company and its employees that the company promises to provide benefits to its retired employees in return for the employees’ services during their employment. pensions

Types of Pension Plans a. Defined contribution plan: the employers’ contribution to the plan is defined by the terms of the plan. Future benefits are limited to those that can be provided by the contributions and the returns earned on the investment of those contributions. pensions

Types of Pension Plans (contd.) b. Defined benefit plan: a pension plan that states either the benefits to be received by employees after retirement or the method of determining such benefit. pensions

Types of Pension Plans (contd.) • The accounting for defined contribution plan simply recognizes compensation expense for the amount of the contribution as follows: Pension expense $$$ Cash $$$ • This chapter focus on the complex accounting issues of a defined benefit plan. pensions

Defined Benefit Plans • A defined benefit plan may be funded or unfunded. • Under a funded plan, the company typically makes periodic payments to a funding agency which assumes the responsibilities for safeguarding, investing the pension assets and making payments to the recipients of benefits. pensions

Defined Benefit Plans (contd.) • For an unfunded plan, no periodic payments are made to an external agency and the pension payments to retired employees are made from current company resources. • The Pension Reform Act of 1974 has eliminated unfunded plans. • However, some plans are underfunded. pensions

Defined Benefit Plans (contd.) • The amounts needed to fund a pension plan are estimated by actuaries. • In addition, a defined benefit plan can be contributory or non contributory. pensions

Contributory Plans • Under a contributory plan, an employee bears part of the cost and makes contributions from his/her salary into the pension fund. • For the non-contributory plans, the entire cost is borne by the employer. • This chapter is concerned with the non- contributory plan. pensions

Contributory Plans (contd.) • For a qualified plan, the Internal Revenue Code allows: 1. Employers contribution are tax deductible 2. Pension fund earnings are tax exempt. pensions

Contributory Plans (contd.) 3. Employers' contribution to the pension fund not to be taxable to the employees until pension benefits are actually received. 4. Employees' contributions to the pension fund not to be taxable until benefits are actually received. pensions

Contributory Plans (contd.) For a pension plan to be a qualified plan, the following requirements must be met: 1. It must cover at least 70% of employees. 2. It cannot discriminate in favor of highly compensated employees. 3. It must be funded in advance of retirement through contributions to an irrevocable trust fund. pensions

Contributory Plans (contd.) 4. Benefits must be vested after a specified period of service, commonly five years. 5. It complies with specific restrictions on the timing and amount of contributions and benefits. pensions

Historical Prospective of Pension Plans 1. Accounting Research Bulletin No. 47 recommends the accrual basis rather than the cash basisto account for the pension expense.However, due to ARB No. 47 is not mandatory, many companies were still using cash basis. pensions

Historical Prospective of Pension Plans (contd.) 2. APB No. 8 “ Accounting for the cost of Pension Plans” requires the use of accrual method but allowing flexibility in calculating pension expense through the use of various actuarial methods. 3. FASB statement No. 35 (1980) “Accounting for reporting by Defined Benefit Pension Plans” which defines the disclosure principles for the funding agencies. pensions

Historical Prospective of Pension Plans (contd.) 4. FASB statement No. 36 (1980) “Disclosure of Pension Benefit information “requires certain disclosures but superseded by Statement of Financial Accounting Standard (SFAS) No. 87 (1985) “ Employers' Accounting for Pensions”. pensions

Historical Prospective of Pension Plans (contd.) 5. SFAS No. 158 (“Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans- an amendment of FASB Statements No. 87,88,106 and 132 (R) ”, issued in 9/2006) amends SFAS 87. • The discussion of pension accounting in this chapter is based on SFAS 87 and SFAS 158. pensions

Pension Obligation • Pension obligation (liability): The deferred compensation that companies have promised to their employees for their service under the terms of pension plan. pensions

Alternative Measures of Pension Obligation a. Vested Benefits: The benefits that the employee is entitled even if the employee leaves the company today. This benefit is computed based on current salary level. pensions

Other Alternative Measures of Pension Obligation (contd.) b. Accumulated benefit obligation: Vested benefits plus nonvested benefits. Computed based on current salary level. c. Projected benefit obligation: Vested benefit plus nonvested benefit. Computed based on future salary level. Projected benefit obligation is FASB’s choice of pension obligation/benefits. pensions

Capitalization vs. Non-Capitalization • Capitalization (accrual basis): Pension liability is recognized in the balance sheet. • Non capitalization: Pension liability is only reported in the footnotes (off-balance-sheet financing). • Prior to FASB No. 87, the accounting for pension plan was a non- capitalization approach. pensions

Capitalization vs. Non Capitalization • FASB No. 87 adopts a partial capitalization approach. • SFAS No. 158 also adopts a partial capitalization approach. pensions

Pension Liability • Accrual accounting concept is when pension expense (i.e., pension benefits promised by the employers) occurs (regardless paid or not), pension expense and pension liability would be recognized. • Pension liability will only be reduced when benefits are paid. • Funding of pension plans does not reduce pension liability. pensions

Pension Liability (contd.) • The funded assets are considered as a pledged collateral against pension liability. • Pension liability is affected by two factors: • employers’ promises (↑ pension lia.) • the benefit payment (↓ pension lia.) pensions

Pension Liability (contd.) • Therefore, the under or overfunding pension plans does not affect pension liabilities at all. pensions

Accrual Basis Pension Accounting • Determine the pension benefits earned by employees and record: • Pension Expense $$$ Pension Liability $$$ • Funding of Pension Plan: • Pension Assets $$$ Cash $$$ • Payments of Pension Benefits: • Pension Liability $$$ Pension Assets $$$ pensions

SFAS 87 and SFAS 158 (Partial Accrual Basis) • Pension cost (expense) is determined by five components (detailed in p34) and the funding is used to reduce the pension liability: • Pension Expense $$$ Cash $$$ Pension Liability $$$ pensions

SFAS 87 (Partial Accrual Basis) (contd.) • Thus, under SFAS 87, Pension liability is the difference between pension expense (as defined in SFAS 87) and funding, not the pension benefits earned by employees. • Under SFAS 87, pension assets and pension liability are off balance sheet items. pensions

SFAS 158 (partial accrual basis) • SFAS 158 intends to improve pension reporting by requiring companies recognize the funded status of defined benefit postretirement plans on the financial statement. • The funded status is the difference of the fair value of the plan assets and the projected pension obligation. pensions

SFAS 158 (partial accrual basis) (cont.) • Therefore, under SFAS158, both pension assets and some pension liabilities are still off balance sheet items. • The pension liability recognized under SFAS 158 is the funded status of the plan, not the entire pension liability. pensions

Prior Service Cost (PSC) • Under accrual basis, PSC should be recognized as pension expense and pension liability immediately. • SFAS87: The PSC expense is deferred and amortized in the current and future years. The PSC liability is disclosed in the footnotes. pensions

PSC under SFAS 158 • To recognize the funded status as pension liability on the balance sheet, SFAS 158 requires the recognition of prior service cost as pension liability as follows: • Other Comprehensive Income-PSC $$$ • Pension Liability $$$ • The OCI will be amortized as expense in the current and future years. • Under accrual basis, the PSC should be recognized as expense in the current year. pensions

Asset Net loss/gain and Liability loss/gain • Accrual basis will require the recognition of both asset net loss/gain and liability net loss/gain as pension expense and pension liability immediately. • SFAS 87: disclose net loss/gain in footnotes only and amortized it only when the amount is too big. pensions

Asset Net loss/gain and Liability loss/gain • SFAS 158 requires the recognition of both asset net loss/gain and liability loss/gain as pension liability as follows: • OCI – net loss $$$$ • Pension Liability $$$ or • Pension Liability $$$ • OCI-net gain $$$ • The OCI will be amortized in the future only if it gets too big. pensions

Pension Cost of SFAS 87 • The determination of pension cost (expense) in SFAS 87 is extremely complicated. It is a function of the following components: 1.(+) Service Cost 2.(+) Interest on the Liability 3. (-) Expected Return on Plan Assets 4. (+) Amortization of Unrecognized Prior Service Cost 5.(- or +) Amortization of Unrecognized Net Gain or Loss pensions

Pension Cost of SFAS 87 (contd.) • 3. (-) Expected Return on Plan Assets • Expected return = Actual return +unexpected loss (or Actual return – unexpected gain). • Therefore, item 3 of pension cost can be rewritten as • 3. (-) Actual return • (-) Unexpected loss or • (+) unexpected gain pensions

Pension Cost1.(+) Service Cost • The present value of the new benefits earned by the employees during the year. The service cost for the year is provided by actuary. • Effect on pension expense: increases pension expense. pensions

Pension Cost2.(+) Interest on the Liability • Interest expense accrues each year on the projected benefit obligation using a settlement rate. • Effect: increases pension expense. pensions

Pension Cost3. (-) Expected Return on Plan Assets • The expected return earned by the accumulated pension fund assets in a particular year. The return includes interests, dividends and the changes in the market value of the fund assets. • Effect: decreases pension expense. • Expected return = actual return + unexpected loss or – unexpected gain pensions

Pension Cost4. (+) Amortization of Unrecognized Prior Service Cost (PSC) • Sources of PSC: 1)benefits earned by employees for the service years prior to the inception of a pension plan; 2)additional benefits earned by employees due to plan amendments. • PSC are amortized as pension expense over the remaining service years of active employees to reduce earnings volatility. • Effect: increases pension expense. pensions

Pension Cost5.(- or +) Amortization of Unrecognized Net Gain or Loss • The gain or loss includes: (a) the difference between the actual return and the expected return on plan assets; (b) the changes in the projected benefit obligation due to changes in actuarial assumptions or when actual experience differs from expected experience. pensions

Pension Cost5.(- or +) Amortization of Unrecognized Net Gain or Loss (contd.) • The amount of unrecognized net gain or loss from (a) plus (b) is amortized over the future years only ifit exceeds 10% of the greater of the projected benefit obligation or the fair value of the plan assets. • The amortized net gain or loss is a component of the pension expense. pensions

Pension Cost5.(- or +) Amortization of Unrecognized Net Gain or Loss (contd.) • An amortization of a net gain (loss) will reduce (increase) pension expense. • The purpose of the amortization of net gain or loss is to smooth the effect of changes and reduce the volatility of the reported pension expense. pensions

+ Interest on liability - Expected return on plan asset + Service cost for the year Pension Expense + Amortization of prior service cost + or - Gain or loss The components of pension expense are exhibited in the diagram below. pensions

Accounting for Pension Example 1 • To illustrate the use of a work sheet and how it helps in accounting for a pension plan, assume that on January 1, 20x2, Zarle Company adopts SFAS No. 87 to account for its defined benefit pension plan. • The following facts apply to the pension plan for the year 20x2: pensions

Example 1 (contd.) • Plan assets, January 1, 20x2, are $100,000. • Projected benefit obligation, January 1, 20x2, is $100,000. • Annual service cost for 20x2 is $9,000. • Settlement rate for 20x2 is 10%. • Actual and expected return on plan assets for 20x2 is $10,000. • Contributions (funding) in 20x2 are $8,000. • Benefits paid to retirees in 20x2 are $7,000. pensions

Example 1 (contd.) • Using the data presented above, the work sheet presents the beginning balances and all of the pension entries recorded by Zarle Company in 20x2. • The beginning balances for the projected benefit obligation and the pension plan assets are recorded in the first line of the work sheet in the memo record. pensions

Intermediate Financial Accounting