Accounting for pensions

Accounting for PensionsItems to be covered: Types of retirement plans – Defined contribution – Defined benefit Accounting for pensions defined benefit plans – Measurement of pension lia

Accounting for Pensions

Items to be covered:

Types of retirement plans

– Defined contribution – Defined benefit

Accounting for pensions (defined benefit plans)

– Measurement of pension liability

– Capitalization, non-capitalization, partial capitalization

– Measurement of pension expense

– Smoothing

Accounting for postretirement benefits

Defined contribution plans (e.g., 401k plans) have become

increasingly more popular In this type of plan,

The employer contributes funds to a third-party trust for benefit of employees Companies usually require

employees to contribute to the retirement plan as well

The funds are invested by trustee for the benefit of the employees and the fund balance is paid to employees over time after retirement

The accounting for this type of plan is relatively simple:

the employer’s expense is the amount it is obligated to contribute to the plan and a liability is recorded only if the

There are two kinds of pension plans: defined contribution

plans and defined benefit plans.

Note H 401k Savings Plan

The Company maintains a defined contribution, 401k Savings Plan,

covering all employees who have completed one year of service with at least 1,000 hours and who are at least 21 years of age The

Company makes employer matching contributions at its discretion

Company contributions amounted to $73,000, $77,000, and $81,000

for the fiscal years ended January 31, 1999, 1998, and 1997,

respectively

The following is an example of the accounting for a defined

contribution plan from the annual report of The Sharper

Image The company matched contribution to the plan by

its employees and recorded an expense in its income

statement for the amount contributed to the plan

The plan agreement defines the benefits employees will receive at retirement

All of the pension assets belong to employer - no funds are paid to a third party

If plan is under funded, employees must look to employer for the deficit This can be a problem if the employer becomes insolvent

As we will see later, the amount of the pension liability and expense are a function of the amount of the pension obligation to the employees and the returns on the

pension fund assets

Accounting for this type of plan is complex and the

The defined benefit plan is the second type of

plan in use today For this type of plan:

There are two issues we need to consider from an

accounting standpoint:

How should the pension liability be reported on the company’s balance sheet? Here, we have a couple of

items to consider: first, since the company keeps the

pension assets until they are paid out to employees at

retirement, should the investments appear as assets?

And second, the company has a liability to make

payments to its employees after retirement Should this

liability be reported on its balance sheet?

How should the expense for the pension plan be computed and reported in the company’s income

statement?

We will consider each of these questions in turn.

Measurement of Net Pension Liability

A compromise was reached and the FASB only required the net

amount to be reported on balance sheet This is called “partial

capitalization” If the plan is over funded, an asset appears on the

balance sheet and if the plan is under funded, companies report a

net pension liability.

Remember - all of the assets of the pension plan are retained by

the employer until paid out to the employees at retirement Also, the

pension obligation is determined by the terms of the pension plan

and is not satisfied until retirement payments are made.

When the accounting standards for pensions were revised in 1996,

the FASB wanted both the assets and the liability to appear on the

face of the balance sheet Companies were concerned, however,

that liability this would negatively impact their credit ratings and

increase their cost of raising funds as a result.

Overview - Pension Liability

Fair Market Value

of the Pension Assets

Accrued Pension Asset / Liability (Balance Sheet)

PV

The future benefit obligations are first

estimated, then discounted back

to the present

to compute the PBO

Measurement of Pension Expense

In general, pension expense reported in the income statement

is related to how much the pension liability increased during

the year compared with the return on the plan’s assets

Pension liability increases as employees continue to work

(benefits are usually related to the years of service), get closer

to retirement, or if the company increases its promised

benefits All of these factors that increase the pension liability

also increase the pension expense in the income statement

Pension assets increase with earnings that the company

realizes on its investments These earnings reduce the

pension expense reported in the income statement

Service cost

This represents the increase in the PBO resulting from employee service during the period That is, the increase in benefits due to working another year (example ).

Expected return on plan assets

Pension expense is reduced each year by the increase in the plan assets available to pay the pension liability These assets increase due to investment returns Whereas the first two

components increase the net pension liability and result in increased expense, this component reduces the net liability and also pension expense (example )

Service cost

+ Interest cost

- Expected return on plan assets

Pension expense

Overview - Pension Expense

This is the increase in the pension liability resulting from employees working another year for the

company

This is the increase in the pension liability due

to the passage of time

This is the long-run expected rate that the company expects to earn on the pension fund assets

The following is an example of the computation of

pension cost form Hasbro’s annual report:

Don’t worry about amortization and deferrals for now We’ll cover these

a little later

Basic Accounting Entry

Once the pension expense has been computed, an

example of the journal entry to record pension activity is

as follows:

Accrued pension liability (B/S) 25

In this example, the first line is the recognition of expense in

the income statement (I/S) The second and third lines reflect

on the balance sheet (B/S) the amount of the expense that has been funded by the company If the company underfunds the

expense as liability is created as in this example If it overfunds

Let’s look at an example of the computation

of pension expense, the net pension liability

and the required journal entry:

(Click here to view an example of the basic pension computations and journal entry.)

When pension plans are initially adopted or amended, the

future benefit amounts and, consequently, the PBO change

significantly in the year of adoption or change These changes

are, essentially, a reward for the prior service of the

employees.

Using the procedures we have developed thus far, this

increase in the PBO would be reflected as pension expense,

thereby reducing profitability in the year of the change.

The FASB took the position that these costs should be

recognized in the service periods of those employees

expected to receive benefits under the new plan, that is, when

the benefits arising from the plan through motivation of its

employees will be realized by the company.

Prior Service Costs

Increases in the PBO arising from adoption of a new plan or amendment of a plan are called Prior Service

A second complication arises in the area of the return on plan

assets Remember, we utilize the expected return in computing

pension expense It is likely, however, that the actual return will

not equal the expected return.

It may also be the case that the assumptions we used in

estimating the PBO may turn out to be incorrect (we may not

accurately estimate the inflation in wage rates, the turnover of

our employees, etc.).

These unexpected gains and losses on plan assets and PBO

actuarial assumptions are accumulated in a memo account just

like prior service costs and are amortized in a similar manner, but

utilizing the corridor approach.

The next slide is an example of the corridor approach The

accumulated unexpected gains/losses account is compared with

the beginning PBO balance and the FMV of the plan assets Any

amounts greater than 10% of the larger of the two are amortized

Let’s look at an example of unexpected gains on

plan assets when we relax the assumption that

actual returns and expected returns are equal.

(Click here to view an example relating

to unexpected gains and losses.)

The following is an example of the computation of

pension expense that includes the amortization of

prior service cost and unrealized gains from

Anheuser-Busch’s annual report:

Minimum Liability

As we have seen thus far, companies generally report only the net amount of the pension liability, that is, the FMV of the

plan assets minus the PBO (as adjusted for prior service cost

and unrecognized gains or losses) When companies

underfund their pension obligation, this is reported as an

accrued pension cost in the liability section of the balance

sheet.

When the amount of underfunding is large enough, however, the FASB requires companies to report a minimum liability

which is equal to the difference between the FMV of the plan

assets and the accumulated benefit obligation (ABO). The

ABO differs from the PBO in that the obligation in that benefits

are based on current salaries, whereas the PBO is based on

expected salaries at retirement.

Recording a minimum liability involves the following:

The amount of the liability is computed as the ABO less any accrued pension cost (or plus any prepaid pension cost) currently reported on the balance sheet

The company makes the following journal entry:

Intangible asset - deferred pension cost xxx

If the minimum liability is greater than the balance in the prior

service cost account, if any, the excess is debited to a contra

equity equity account rather than an intangible asset and

stockholder’s equity is reduced accordingly

(Click here to view an example of the accounting for minimum pension liability)

The following is an example of a minimum pension liability

disclosure from Honeywell’s annual report Since the ABO is

less than the FMV of the plan assets, an additional minimum

liability must be recorded Also, since the minimum liability is

in excess of the prior service cost balance, the excess must

be recognized as contra equity rather than an intangible asset

over the remaining service lives of the employees or

20 years, whichever is longer

The End