Intermediate accounting 19th by stice stice chapter 17

Funding of Employer Pension PlansThere are two basic classifications of pension plans: 1 defined contribution plan 2 defined benefit plan... Defined Benefit Pension PlansA pension fund m

Intermediate

Accounting

James D Stice Earl K Stice

Employee Compensation—Payroll, Pensions, and Other

Compensation Issues

Chapter 17

19 th

Edition

Payroll and Payroll Taxes

1. Federal old-age, survivors’, and disability (tax to

both the employee and employer)

2. Federal hospital insurance (tax to both

employer and employee)

3. Federal unemployment insurance (tax to

employer only)

4. State unemployment insurance tax (tax to

Social security and income tax legislation impose five taxes based on payrolls:

5. Individual income tax (tax to employee only but

withheld and paid by employer)

Payroll and Payroll Taxes

Federal Old-Age, Survivors’,

and Disability Tax

• The Federal Insurance Contributions Act (FICA) provides for FICA taxes from both

employers and employees to provide funds for federal old-age, survivors’, and disability benefits for certain individuals and members

• The Federal Insurance Contribution Act

(FICA) also includes a provision for

Medicare tax.

• This tax differs from the tax previously

discussed in that the tax is applied to all

wages earned; there is no upper limit

• The tax rate for 2010 was 1.45% for both

employer and employee.

Federal Hospital Insurance

Federal Unemployment Insurance

• The Federal Social Security Act and the

Federal Unemployment Tax Act (FUTA)

provide for the establishment of

unemployment insurance plans

• Employers with insured workers employed

in each of 20 weeks during a calendar

year or who pay $1,500 or more in wages during a calendar quarter are affected.

• Tax rate on the first $7,000 of wages earned has been 6.2% since 1985.

• Employer can apply for a credit limited to

5.4% for taxes paid on state unemployment tax, effectively reducing the federal tax to

0.8% (6.2% – 5.4%).

• No tax is levied on the employee.

• Payment to the federal government is

required quarterly.

Federal Unemployment Insurance

State Unemployment Insurance

• State unemployment compensation laws

(SUTA) are not the same in all states In

most states, laws call for tax only on

employers, but a few states tax both

employer and employee.

• Although the normal rate on employers may

be 5.4%, states have merit rating or

experience plans providing for lower rates based on employer’s individual employment experiences.

Income Tax

• Federal income taxes on the wages of

individuals are collected in the period in

which the wages are paid.

• The “pay-as-you-go” plan requires

employers to withhold income tax from

wages paid to their employees.

• Most states and many local governments

also impose income taxes on the earnings

of employees that the employer must

withhold and remit.

• Withholding is required not only of

employers engaged in a trade or business but also of religious and charitable

organizations, educational institutions,

social organizations, and governments of the United States, the states, the territories, and their agencies, instrumentalities, and political subdivisions.

Income Tax

Salaries Expense 16,000 FICA Taxes Payable

Salaries for the month of January for a retail

store are $16,000 The SUTA tax rate is 5.4% Withholdings are $1,600 and FICA tax rate is

7.65% The employer records the payroll as

follows:

Accounting for Payroll Taxes

Payroll Tax Expense 2,216

.008 (0.062 – 0.054) × $16,000

Accounting for Payroll Taxes

Payroll Tax Expense 583

FICA Taxes Payable

Compensated Absences

 Vacations

 Holidays

 Illnesses

 Other personal activities

by employers for:

• The longer an employee works for a

company, the longer the vacation allowed or the more liberal the time allowed for

illnesses

• At the end of any given period, the firm has a liability for the earned but unused

compensated absences

• The estimated amounts earned must be

charged against current revenue and a

liability established for that amount

• The difficult part comes when estimating how much should be accrued

Compensated Absences

The FASB, in ASC paragraphs 710-10-25-1

through 3 , requires a liability to be recognized for compensated absences that:

1 have been earned through services already

rendered

2 vest or can be carried forward to

subsequent years, and

3 are estimable and probable.

Compensated Absences

Stock-Based Compensation

and Bonuses

• Photo Graphics, Inc gives its store

managers a 10% bonus based on

individual store earnings

• The bonus is to be based on income

after deducting the bonus, but before

deducting income taxes Income for a

particular store is $100,000 before

charging any bonus or income taxes.

Postemployment Benefits

• Because of downsizing, an employee cannot count on remaining with one employer for his

or her entire career

• Some employees change jobs to facilitate

career advancement and to enhance their

family’s quality of life

• It is common for an employee to be

terminated

• Compensation issues following employment

but preceding retirement have increased in

magnitude

Stock-Based Compensation

and Bonuses

• Examples of the types of benefits granted

to terminated employees include:

 Supplemental unemployment benefits

 Severance benefits

 Disability-related benefits

 Job training and counseling

• And, continuation of benefits such as:

 Health care benefits

 Life insurance coverage

Accounting for Pensions

Financing retirement years is accomplished

by establishing some type of pension plan

that sets aside funds during an employee’s

working years so that at retirement the funds and earnings from investment of the funds

may be returned to the employee in lieu of

earned wages.

Accounting for Pensions

In the United States, three major categories of pension plans have emerged:

1 Government plans, primarily Social

Security

2 Individual plans, such as individual

retirement accounts (IRAs)

3 Employer plans

(continued)

Postretirement benefits other than pensions

extend benefits beyond the active years of

employment and include such items as:

• Health care

• Life insurance

• Legal services

• Special discounts on items produced or

sold by the employer

• Tuition assistance

Accounting for Pensions

Funding of Employer Pension Plans

• ERISA requires companies to fund their

pension plans in an orderly manner so that the employee is protected at retirement.

• Noncontributory pension plans are

funded entirely by the employer.

• Plans where the employee also contributes

to the cost of the plan are referred to as

contributory pension plans

(continued)

Funding of Employer Pension Plans

There are two basic classifications of pension plans:

1) defined contribution plan

2) defined benefit plan

• Defined contribution pension plans are relatively simple in their construction and

raise very few accounting issues for

employers.

• The employer pays a periodic contribution amount into a separate trust fund, which is administered by an independent third-party trustee.

Defined Contribution Pension Plans

(continued)

• When an employee retires, the

accumulated value in the fund is used to

determine the pension payout to the

employee.

• The employee’s retirement income

therefore depends on how the fund has

been managed In effect, the investment

risk is borne by the employee.

Defined Contribution Pension Plans

• Defined benefit pension plans are much more complex than defined contribution

plans.

• Under defined benefit plans, the employee

is guaranteed a specified retirement income often related to his or her number of years

of employment and average salary over a certain number of years.

• Because the benefits are defined, the

funding must vary as conditions change.

Defined Benefit Pension Plans

Defined Benefit Pension Plans

A pension fund may be viewed essentially

as funds set aside to meet the employer’s

future pension obligation just as funds may

be set aside for other purposes.

Vesting of Pension Benefits

Vesting occurs when an employee has

met certain specified requirements and is eligible to receive pension benefits at

retirement regardless of whether or not the employee continues working for the

employer.

Funding of Defined

Benefit Plans

• The periodic amounts to be contributed to a

defined benefit plan by the employer are

directly related to the future benefits

expected to be paid to current employees

• All funding methods are based on present

values The additional future benefits earned

by employees each year must be discounted

to their present value, referred to as the

rate of return on pension plan investments

Issues in Accounting for Defined Benefit Plans

A list of issues relating to accounting and

reporting by employers follows:

1 The amount of net periodic pension expense

to be recognized on the income statement

2 The amount of pension liability or asset to be

reported on the balance sheet

3 Accounting for pension settlements,

curtailments, and terminations

4 Disclosures needed to supplement the

amounts reported in the financial statements

Simple Illustration of Pension Accounting

• Lorien Bach is 35 years old

• She has worked for Thakkar for 10 years

• Her salary for 2012 was $40,000

• Pension payments begin after the employee

turns 65; payments made at the end of the year

• The annual payment is equal to 2% of the

highest salary times the number of years with the company

• Thakkar knows for certain that Bach will live

exactly 75 years Her benefits are fully vested.

• In valuing pension fund liabilities, Thakkar uses a discount rate of 10%

• As of January 1, 2013, Thakkar had a pension

• Thakkar expects to earn an average return of 12%

on pension fund assets.

Simple Illustration of Pension Accounting

Estimate Pension Obligation

(2% × 10 years) × $40,000 = $8,000

The annual amount that Bach should receive on her retirement at age 65.

Estimation of Pension

Obligation

Accumulated Benefit Obligation (ABO) Accumulated Benefit Obligation (ABO)

X X X X X X X X X X

$8,0

0 0

Accumulated benefit obligation (ABO)

Estimation of Pension

Obligation

is the actuarial present value of expected

future pension payments, using the current

salary as the basis for forecasting the amount

of the pension benefit payments

• The alternative measure of the pension

obligation that does not consider the impact of future salary increases is called the projected

Projected Benefit Obligation (PBO)

Projected Benefit Obligation (PBO)

Thakkar Company expects Bach’s 2012 salary

of $40,000 to increase 5% every year until

retirement Bach’s salary is expected to increase

to $172,877 by the year 2043 The pension

benefit payment based on this salary is as

Estimation of Pension

Obligation

• The PBO at January 1, 2013, is $12,176

This is the present value of the 10 future

annual payments of $34,575 that Bach is

expected to received.

would have been labeled

If the fair value of the pension fund had exceeded the projected benefit obligation, the resulting net asset

would have been labeled

Bach’s work for Thakkar Company during the

year results in an increase in forecasted annual pension benefit payments from Thakkar to Bach The impact of this extra year of service is to

increase the December 31, 2013, PBO by $1,339 over what it would have been if Bach had just

vacationed for the entire year Therefore, the

Pension expense is reduced by the return on the pension fund for the year Because

Thakkar expects a 12% rate of return, the

original $10,000 will have a return of $1,200

in 2013 Thakkar’s net pension expense is

reduce by $1,200 ($10,000 x 0.12).

Return on the Pension Fund

Return on the Pension Fund

Computation of Pension

Expense for 2013

Computation of Pension

Expense for 2013

In addition to these changes in the PBO and the pension fund, two additional events are

common when dealing with pension plans:

1 Contributions to the plan

2 Benefits paid from the plan

(continued)

Projected Benefit Obligation, End of Year

Projected Benefit Obligation, End of Year

Service cost and interest cost

±

Change in actuarial assumptions

(continued)

Computation of Pension

Expense for 2013

Computation of Pension

Expense for 2013

The fair value of the pension fund is based

on its market value at a given measurement date.

Fair Value of Pension Fund, End of Year

Fair Value of Pension Fund, End of Year

Employer contribu- tions

To record 2013 pension expense.

Service cost ($1,339) + Interest cost ($1,218) – Expected return ($1,200)

New contributions to

pension fund

Basic Pension Journal Entries

Prior Service Cost

When a pension plan is initially adopted or amended to provide increased benefits,

employees are granted additional benefits for services performed in years prior to the plan’s adoption or amendment The cost of these additional benefits is called prior

service cost

(continued)

Prior Service Cost

• The amount of prior service cost is

determined by actuaries and represents

the increase in the PBO arising from the

adoption or amendment of the plan.

• The accounting profession has been in

general agreement that prior service cost

should not be recognized as part of

expense at the plan’s adoption or

amendment date but should be amortized

IAS 19

According to paragraph 96 of IAS 19 , past

service cost (equivalent to prior service cost)

is recognized as an expense over the period when the retroactive benefits vest.

If the retroactive benefits vest immediately, then under IAS 19 the entire amount of past service cost is expensed immediately.

The Basic Spreadsheet

Financial Statement Accounts Detailed Accounts

(h) Amort of Deferred Loss

Summary Journal Entries

Pension Related Asset/

(Liability)

Net Pension Expense

Accumulated Other Comprehen

Income

Fair Value of Pension Fund

Periodic Pension Expense Items

The work sheet is divided into two sections: the Financial Statement Accounts section and the Detailed Accounts section

Amortization of Prior

Service Cost

benefits granted to employees for past service when a pension plan is adopted or amended

• The FASB states that prior service cost should

be amortized by “assigning an equal amount

to each future period of service of each

employee active at the date of the amendment who is expected to receive benefits under the plan.” The future period of service is referred

to as the expected service period

Plan Contributions

• Under the Pension Protection Act of 2006,

companies are required to contribute an

amount equal to their service cost and interest cost each year plus an additional contribution designed to eliminate any remaining shortfall within seven years

Deferral of Gains and Losses

• Because pension costs include many

assumptions and estimates, frequent

adjustments must be made for variations

between the actual results and the estimates

or projections that were used in determining net periodic pension expense for the previous period

• Such differences between expected results

and actual experience give rise to a deferred

Deferral of Current-Year Difference between Actual and Expected Return on Pension Fund

• In estimating the return on the pension

fund, the expected long-term rate of return

on assets should be used rather than a

more volatile short-term rate.

• In the short run, the actual return on the

pension fund usually will differ from the

expected return.