Accounting for Pensions
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Types of accounting for pension plans, e.g. DB and DC schemes
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Accounting for PensionsAccounting for Pensions
Measurement of pension liability
Capitalization, non-capitalization, partial capitalization
Measurement of pension expense
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 contribution has
not been made in full
There are two kinds of pension plans: defined contribution
plans and defined benefit plans.
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© 1999 by Robert F. Halsey
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.
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© 1999 by Robert F. Halsey
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 concepts we
will be discussing in this section relate to this type of pension
plan
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© 1999 by Robert F. Halsey
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.
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© 1999 by Robert F. Halsey
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.
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Overview - Pension Liability
Fair Market Value
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.
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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 ).
Interest cost
This is the interest accrued on the pension liability. Think of
this like a bond sold at a discount. Each year the carrying value
increases as the discount is amortized, reflecting the accrual of
interest. (example ).
Expected return on plan assets
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Service cost
+ Interest cost
Pension expense
Overview - Pension Expense
This is the increase in the pension liability resulting from
employees working another year for the company
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© 1999 by Robert F. Halsey
The following is an example of the computation of pension cost form
Hasbro’s annual report:
Don’t worry about
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:
Pension expense (I/S) 100
Cash (B/S) 75
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© 1999 by Robert F. Halsey
Let’s look at an example of the computation of pension expense, the
net pension liability and the required journal entry:
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© 1999 by Robert F. Halsey
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.
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Prior Service Costs
Increases in the PBO arising from adoption of a new plan or
amendment of a plan are called Prior Service Costs.
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© 1999 by Robert F. Halsey
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.
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© 1999 by Robert F. Halsey
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.
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© 1999 by Robert F. Halsey
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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.
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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
Additional pension liability 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.
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© 1999 by Robert F. Halsey
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Postretirement Benefits
Post-retirement benefits relate to medical benefits provided to
employees after retirement.
The expense and liability for these benefits are computed similarly
to pension expense and liability.
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The End