Intermediate Financial Accounting Accounting for Employee Benefits

Intermediate Financial Accounting

Accounting for Employee Benefits

pensions 2

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.

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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 4

Chapter Objectives (contd.)

Discuss the transition cost. Describe the pension reporting in

financial statements. Discuss pension terminations.

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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.

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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.

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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.

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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.

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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 10

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.

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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.

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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.

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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.

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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.

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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.

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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.

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Historical Prospective of Pension Plans1. Accounting Research Bulletin No. 47

recommends the accrual basis rather than the cash basis to account for the pension expense. However, due to ARB No. 47 is not mandatory, many companies were still using cash basis.

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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.

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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”.

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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.

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Pension Obligation

Pension obligation (liability):

The deferred compensation that companies have promised to their employees for their service under the terms of pension plan.

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Alternative Measures of Pension Obligationa. 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.

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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.

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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.

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Capitalization vs. Non Capitalization

FASB No. 87 adopts a partial capitalization approach.

SFAS No. 158 also adopts a partial capitalization approach.

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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.

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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.)

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Pension Liability (contd.)

Therefore, the under or overfunding pension plans does not affect pension liabilities at all.

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 29

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 $$$

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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.

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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.

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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.

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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.

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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 35

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.

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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 37

pensions 38

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

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

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Pension Cost

1.(+) 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.

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Pension Cost

2.(+) Interest on the Liability Interest expense accrues each year on

the projected benefit obligation using a settlement rate.

Effect: increases pension expense.

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Pension Cost

3. (-) 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

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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.

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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.

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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 if it 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.

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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.

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+Interest

onliability

Pension Expense

-Expectedreturn on plan asset

+ or -Gain or loss

+Amortization

of priorservice cost

+Servicecost for the year

The components of pension expense are exhibited in the diagram below.

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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:

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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.

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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.

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Example 1 (contd.)

The projected benefit obligation and the pension plan assets are not recorded in the formal general journal.

Thus, they are not reported as a liability and as an asset in the financial statements of Zarle Company.

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Example 1 (contd.)

They (the benefit obligation and the pension assets) are off-balance-sheet item.

They affect pension expense but are not recorded as assets and liabilities in the balance sheet of employers.

Assumptions for example 1: actual return equals expected return, no prior service costs, and no net gain or loss.

pensions 5353Accounting for Post Employment Benefits

Example 1 (contd.)

20X2

20X2

20X2

20X2

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Example 1 (contd.)

Entry (a) records the service cost component, which increases pension expense $9,000 and increase the liability (projected benefit obligation)$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 obligation multiplied by the settlement rate of 10%).

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Example 1 (contd.)

Entry (c) records the actual return on the plan assets, which increases the plan assets and decreases the pension expense.

Entry (d) records Zarle Company’s contribution (funding) of assets to the pension fund; cash is decreased $8,000 and plan assets are increased $8,000.

Entry (e) records the benefit payments made to retirees, which results in $7,000 decrease to the plan assets and the projected benefit obligation.

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Example 1 (contd.)

The journal entry on 12/31/x2 is:Pension Expense 9,000

Cash8,000

Pension Liabilities 1,000

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Example 1 (contd.)

The $1,000 of pension liabilities represents the difference between the pension expense and the funded amount.

This also represents a liability because the plan is underfunded by $1,000.

Both the projected benefit obligation,$112,000, and plan assets, $111,000, are off-balance-sheet items.

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Example 1 (contd.)

The reconciliation of the off-balance-sheet items and the prepaid/accrued pension cost account reported on the statement is shown below (reconciliation schedule is eliminated by SFAS 158):

Proj. benefit obligation(Cr.) ($112,000)Plan Assets at fair value(Dr.) 111,000 Pension Liabilities (Cr.) (1,000)

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The unrecognized prior service cost (PSC) When a defined benefit plan is adopted

(or amended), credit is often given to employees for years of service provided before the date of adoption or amendment.

This credit is referred to as the prior service cost.

PSC also represents the retroactive benefit.

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The unrecognized prior service cost (PSC) (contd.) The PSC is amortized over the

remaining service life of the covered active employees.

It is not recognized as pension expense entirely in the year of adoption (or amendment).

The amortized PSC increases the pension expense.

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The unrecognized prior service cost (PSC) (contd.) (skip p56-p63) The Board prefers a “years-of-service

method” in amortizing the PSC. To illustrate the amortization of the

unrecognized PSC under the “year-of-service-method”, assume Zarle Company's defined benefit pension plan covers 170 employees.

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The unrecognized prior service cost (PSC) (contd.) Zarle amends its pension plan on

1/1/x3 and grants $80,000 of PSC to its employees.

The employees are grouped according to their expected years of retirement as follows:

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The unrecognized PSC (contd.)

Number of ExpectedGroup Employees Retirement on 12/ 31 A 40 20x3 B 20 20x4 C 40 20x5 D 50 20x6 E 20 20x7____________

170

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The computation of the service-year per year and the total service-years is shown as follows:

Computation of Service-Years

Year A B C D E Total2003 40 20 40 50 20 1702004 20 40 50 20 1302005 40 50 20 1102006 50 20 702007 20 20

40 40 120 200 100 500

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Computed on the basis of a prior service cost of $80,000 and a total of 500 service-year for all years, the cost per service-year is $160 ($80,000 / 500).

The annual amount of amortization based on a $160 cost per service-year is computed as follows:

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Computation of Annual Prior Service Cost Amortization

Total Cost Per AmountYear Service-Year Service-Year= Amortization20x3 170 $160 $27,20020x4 130 160 20,80020x5 110 160 17,60020x6 70 160 11,20020x7 20 160 3,200

500 $80,000

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An Alternative Method in Amortizing the PSC SFAS No. 87 allows employers to use a

straight-line method to amortize the PSC over the average remaining service life of the employees.

In this case, with 500 service years and 170 employees, the average remaining service life is 2.94 years (500 / 170).

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An Alternative Method in Amortizing the PSC (contd.) Using the straight line method, the

$80,000 cost would be charged to expense at $27,211 ($80,000/2.94) in 20x3, $27,211 in 20x4, and $25,578 ($27,211 .94) in 20x5.

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Recognition of the PSC (under SFAS 87) Although PSC is not recognized as

pension expense/liability immediately under SFAS87, it is added to the off-balance sheet pension liability and would subsequently be amortized over the remaining service years of active employees.

This amortization will increase the pension expense.

Recognition of the PSC (under SFAS 158) Under SFAS 158, the following entry is

required to recognize PSC as liability immediately to reflect the funded status on the balance sheet:

OCI – PSC $$$ Pension Liability $$$

OCI = other comprehensive item (reported in the equity section of the balance sheet)

The OCI -PSC would be amortized (as pension expense) over the remaining service years of active employees and the amortization will increase the pension expense. pensions 70

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Example 2 (with the PSC)

Continuing the Zarle Company illustration into 20x3, the amendment on 1/1/x3 grants employees' PSC with a present value of $80,000.

In addition, the following facts also apply to pension plan of Zarle for the year of 20x3:

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Example 2 (with the PSC)

Annual service cost for 20x3 is $9,500. Settlement rate for 20x3 is 10%. Actual and expected return on plan assets

for 20x3 is $11,100. Annual contributions* (funding) are

$20,000. Benefits paid to retirees in 20x3 are $8,000. Amortization of prior service cost (PSC)

using the years-of -service method is $27,200.

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The following work sheet presents all of the pension entries and information recorded by Zarle Company in 20X3 (based on SFAS87). (Skip 68-72)

20X2

20X3

20X320X3

20X3

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Example 2 (contd.) (skip)

The first line of the work sheet shows the beginning balances of the Prepaid/Accrued Pension Cost account and the memo accounts.

Entry (f) records Zarle Company’s granting of prior service cost by adding $80,000 to the projected benefit obligation and to the unrecognized (noncapitalized)prior service cost.

Entries (g), (h), (i), (k),(l) are similar to the corresponding entries in 20x2.

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Entry (j) records the 20x3 amortization of unrecognized prior service cost by debiting Pension Expense by $27,200 and crediting the new Unrecognized Prior Service Cost account by the same amount.


The journal entry on 12/31/x3 is (under SFAS 87):

Pension Expense 44,800 Cash 20,000 Pension Liabilities 24,800 Following SFAS 87, the ending balance of pension liabilities equals $25,800, which is $52,800 less than the (under)funded status of $78,600.

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Example 2 (contd.) (skip) The reconciliation (eliminated by SFAS158) of

prepaid/accrued pension cost and the off-balance-sheet items is in the following schedule:Reconciliation Schedule--December 31,20x3Projected benefit obligation (Cr.) $(212,700)Plan assets at fair value (Dr.) 134,100 Funded status (78,600)Unrecognized PSC (Dr.) 52,800 Pension Liabilities (Cr.) $(25,800)

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Example 2 Worksheet Prepared Based on SFAS 158

Journal Entries

Pension Cash Pension OCI-

Exp. Lia./Ass. PSC

1/1/20x3 bal. 1,000 Cr.

PSC 80,000Cr. 80,000Dr.*

Service Cost 9,500 Dr.

Interest Cost 19,200 Dr.

Actual Ret 11,100 Cr..

Unexp. Loss 0

Amort. of PSC 27,200 Dr.

Contributions 20,000 Cr.

Benefits Paid

Journal Entry 44,800 Dr. 20,000 Cr. 2,400Dr. 27,200Cr.*

Bal.12/31/20x3 78,600Cr.52,800Dr.

*Journal entry required.

Disclosures

Projected Plan

Benefit Obligation Assets

112,000 Cr. 111,000 Dr.

80,000 Cr.

9,500 Cr.

19,200 Cr.

11,100 Dr.

20,000 Dr.

8,000 Dr. 8,000 Cr.

212,700 Cr. 134,100 Dr.

Funded status = $78,600 underfunded

pensions 78

Applying SFAS 158 to Example 2 Based on SFAS 158, the following entry is

recorded on 1/1/20x3 to reflect the funded status and to prevent earnings volatility:

OCI-PSC* 80,000 Pension liabilities 80,000 *This entry is to recognize the PSC arising during

20x3. *OCI (Other Comprehensive Income- an equity

account) would be amortized as pension expense annually over the remaining service life of active employees.

pensions 79

pensions 80

Applying SFAS 158 to Example 2

• On 12/31/20x3, the following entry is recorded to recognize pension expense of 20x3 (including the $27,200 amortization of OCI):

• Pension Expense 44,800 Pension liabilities 2,400

• OCI-PSC 27,200 Cash 20,000

•

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To report the funded status on the balance sheet, the PSC (i.e., 80,000) needs to be recognized as pension liabilities on 1/1/20x3.

To prevent income volatility (i.e., achieve income smoothing), the PSC is not recognized as pension expense immediately on 1/1/20x3 but only recognized into Other Comprehensive Income account –an equity account on 12/31/20x3.

pensions 82


SFAS No. 158 improves the reporting of pension liabilities by requiring the pension liabilities reported equal the funded status (i.e., $78,600 underfunding).

SFAS 158 does Not require the projected pension benefit obligation (PBO) and pension assets be reported on the balance sheet.

A full capitalization approach would require the PBO and pension assets be reported on the balance sheet.


• Thus, after recording the entries on p70 and p71, the pension liabilities equals the funded status of the pension plan - $78,600 underfunded (i.e., $1,000+ 80,000-2,400 = $78,600).

• The remaining unamortized OCI (i.e., $52,800) would be amortized annually as pension expense in the future.

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Comparisons of Pension Liabilities Reported under SFAS 158 versus under SFAS 87

• Even though the pension liability reported on the balance sheet under SFAS158 (i.e., $78,600) is greater than that reported under SFAS 87 (i.e., $25,800, see p68), the pension liability of $78,600 is still far less than the PBO of $212,700 (see p73).

pensions 84

pensions 85

Gain or Loss

A. unexpected gains and losses on plan assets returns (referred to as “ asset gains & losses”).

B. unexpected gains and losses on the pension liability (referred to as “liability gains and Losses”) due to changes in actuarial assumptions, etc.

pensions 86

A. Smoothing unexpected gains and losses on plan assets returns

The actual return on plan assets reduces pension expense.

However, the funding amount estimated by the actuaries is based on the expected return on plan assets ,not on the actual return to avoid the fluctuations and to achieve income smoothing.

Therefore, the calculation of pension expense is reduced by the expected return on assets, not the actual return.

pensions 87

A. Smoothing unexpected gains and losses on plan assets returns (cotd.)

When pension expense is calculated based on the expected return, both the actual return and the difference between the expected return and the actual return need to be considered.

This difference is referred to as the unexpected gain (i.e., actual return > expected return) or unexpected loss (actual return < expected return).

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A. Smoothing unexpected gains and losses on plan assets returns – An Example

Assume that Shierer Company in 20x4 has an actual return of $12,000 while the expected return is $13,410.

The actual return, $12,000, is subtracted from pension expense and followed by the subtraction of the unexpected loss, $1,410.

Thus, the pension expense is reduced by the expected, not the actual return on pension assets.

Thus, the unexpected loss will decrease pension expense.

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A.Smoothing unexpected gains and losses on plan assets returns (cotd.)

In addition, the following entry is recorded under SFAS 158 to reflect the funded status in the balance sheet:

O.C.I.- Net Gain/Loss 1,410 Pension liability 1,410

pensions 90

B. Smoothing unexpected gains and Losses in the pension liability

In estimating the projected pension obligation, the actuaries make assumptions about items such as retirement rate, turnover rate, disability rate, and salary amount, etc.

Any changes in these actuarial assumptions will change the amount of projected pension obligation.

pensions 91

B. Smoothing unexpected gains and Losses in the pension liability

The unexpected gains or losses from changes in the projected pensions obligation are called “liability gains and losses.”

Liability gains and liability losses (unexpected increase in the liability) are recognized under SFAS 158 using the following entry:

OCI- Net Gain/Loss $$ Pension Liability $$

pensions 92

B. Smoothing unexpected gains and Losses in the pension liability (contd.)

These liability gains or losses are added to the pension liability and are also added to the OCI -net gain/loss account used for the asset gains and losses discussed on p84.

The OCI –net gain/loss are accumulated from year to year and is reported in the equity section of the balance sheet..

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Corridor Amortization

Because the asset gains and losses and the liability gains and losses can be offsetting, the OCI –net gain/loss may not grow too large.

But, it is possible that no offsetting occurs and that the OCI –net gain/loss balance in the account continues to grow.

pensions 94

Corridor Amortization (contd.)

To limit its growth, the FASB invented the corridor approach for amortizing the balance in the OCI – net gain/loss account when it gets too large.

The OCI -net gain or loss balance need to be amortized only when it exceeds the arbitrarily selected FASB criterion.

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This criterion is 10% of the larger of the beginning balances of the projected benefit obligation or the market-related value of the plan assets.

pensions 96

Corridor Amortization (contd.)To illustrate the corridor approach, assume data on the projected benefit obligation and the plan assets over a period of 6 years as shown in the schedule below.

Projected Market-Related Beginning-of-the- Benefit Asset Corridor*

Year Balance Obligation Value +/- 10% 20x1 $1,000,000 $ 900,000 $100,00020x2 $1,200,000 1,100,000 120,00020x3 $1,300,000 1,700,000 170,00020x4 $1,500,000 2,250,000 225,00020x5 $1,700,000 1,750,000 175,00020x6 $1,800,000 1,700,000 180,000

* The corridor is 10% of the larger of the projected benefit obligation or the market-related plan asset value.

pensions 97


If the balance of the OCI – net gain/loss stays within the upper and lower limits of the corridor, no amortization is required– the OCI – net gain/loss balance is carried forward unchanged.

pensions 98


If amortization is required, the minimum amortization shall be the excess divided by the average remaining service period of active employees expected to receive benefits under the plan.

pensions 99


Any systematic method of amortization of OCI – net gain/loss may be used instead of the minimum, as long as the amortized amount is greater than the minimum and the method is used for both gains and losses.

The method should also be disclosed.

pensions 100


In applying the corridor, the Board decided that amortization of the excess unrecognized net gain or loss should be included as a component of pension expense only if, as of the beginning of the year, the OCI – net gain/loss exceeds the corridor.

pensions 101

Corridor Amortization Example (skip 96-98)

To illustrate the amortization of unrecognized net gains and losses,assume the following information for Soft-White, Inc.:

20x2 20x3 20x4 (beginning of the year)

Projected benefit obligation $2,100,000 $2,600,000 $2,900,000

Market-related asset value 2,600,000 2,800,000 2,700,000

OCI – net gain/ net loss -0- 400,000 300,000

pensions 102

Corridor Amortization Example(contd.) If the average remaining service life of all active

employees is 5.5 years, the schedule to amortize the unrecognized net loss is as follows:Corridor Test and gain/Loss Amortization schedule

20X320X4

20X2

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Corridor Amortization Example(contd.)a. All as of the beginning of the period.

b. 10% of the greater of projected benefit obligation or plan market-related value.

c. $400,000 - $280,000 = $120,000 / 5.5 = $21,818.

d. $400,000- $21,818 + $300,000 = $678,182; $678,182 - $290,000 = $388,182; $388,182 / 55

= $70,579.

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The Corridor Approach

As indicated from the schedule, the OCI – net gain/loss amoritzed in 20x3 increased pension expense by $21,818.

This amount is small in comparison with the total loss of $400,000.

Thus, the corridor approach reduces volatility of these gains and losses on pension expense.

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Summary of Gain and Loss Adjustment

After considering the unexpected gain or loss on assets, it is really the expected return on plan assets (not the actual return) that determines current pension expense.

Unexpected gain on asset return increases pension expense while unexpected loss on asset return decreases pension expense.

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Summary of Gain and Loss Adjustment

The amortization of OCI – net gain/loss at the beginning of the year is subject to the corridor limitation.

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Summary of Gain and Loss Adjustment (contd.)

Only if the OCI – net gain/loss exceeds the corridor, these OCI net gains or losses are subject to amortization.

This amortization is computed by dividing the net gains or loses over the average service period.

Amortization of OCI - net gain will reduce pension expense while amortization of net loss will increase pension expense.

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Example 3: With Unrecognized Net Gain or Loss Continuing the Zarle company illustration into

20x4, the following facts apply to the pension plan:

Annual service cost for 20x4 is $13,000. Settlement rate is 10%;expected earnings rate is

10%. Actual return on plan assets for 20x4 is $12,000. Amortization of prior service cost (PSC) in 20x4 is

$20,800.

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Example 3: With Unrecognized Net Gain or Loss Annual contributions (funding) are $24,000 Benefits paid to retirees in 20x4 are $10,500. Changes in actuarial assumptions establish the

end-of-year projected benefit obligation at $265,000.

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Example 3 (Contd.) (skip 105-109) The 2004 pension work sheet of Zarle is presented as

follows: (under SFAS 87)

20X3

20X420X4

Dr.


In 20x4 the expected return of $13,410 is higher than the actual return of $12,000.

To smooth pension expense, the net gain or loss item is debited for $1,410 and the Pension Expense is credited for $1,410.

As a result of this adjustment, the expected return on the plan assets is the amount actually used to compute the pension expense.

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Entry (t) records the changes in the projected benefit obligation resulting from a change in actuarial assumptions.

As indicated, the actuary has now computed the ending balance to be $265,000

Given that the memo record balance for the projected benefit obligation at December 31 is $236,470, a difference of $28,530 ($265,000 - $236,470) is indicated.

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This $28,530 will increase (credit) employer’s benefit obligation and will also be added (debit) to the Unrecognized Net gain or Loss account.

By debiting it to the Unrecognized Net gain or Loss account, this $28,530 difference is deferred (not recognized)

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As illustrated in the work sheets of 2002 and 2003, the balance of the Prepaid/Accrued pension Cost account at December 31, 2004 of $43,460 is equal to the net of the balances in the memo accounts as shown below (Required by SFAS 87, not by SFAS 158):

Projected benefit obligation (Cr.) (265,000) Plan assets (Dr.) 159,600 Funded Status (105,400) Unrecognized PSC 32,000 Unrecognized Net Loss 29,940 Pension Liability (Cr.) 43,460

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Example 3 Worksheet under SFAS 158

Journal Entries

Pension Cash Pension OCI- OCI-

Exp. Lia./Ass. PSC Net G/L

1/1/20x4 bal. 78,600 Cr. 52800 Dr.

Service Cost 13,000 Dr.

Interest Cost 21,270 Dr.

Actual Ret. 12,000 Cr. .

Unept. Loss 1,410 Cr. 1,410 Cr. 1,410 Dr.*

Amort. of PSC 20,800 Dr.

Contributions 24,000 Cr.

Benefits Paid

Liabilities Inc. 28,530 Cr. 28,530 Dr.*

Journal entry 41,660 Dr. 24,000Cr. 3,140Dr. 20,800Cr. *

Bal.12/31/x4 41,660 Dr. 105,400 Cr. 32,000Dr. 29,940Dr.

* Journal entry required.

Disclosure

Projected Plan

Benefit Obl. Assets 212,700 Cr. 134,100Dr.

13,000 Cr.

21,270 Cr.

12,000 Dr.

24.000 Dr.

10,500 Dr. 10,500 Cr.

28,530 Cr.

265,000 Cr. 159,600 Dr.

Funded Status=105,400 Cr.

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Example 3 (contd.) (Applying SFAS 158) The journal entry on December 31 to record pension

expense for 20x4 under SFAS 158 is as follow (Ignore income tax effect):

Pension Expense 41,660 Pension Liabilities 3,140

Cash24,000

Other Comp. Income* 20,800*Amortize PSC as pension exp.

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Example 3 (contd.) (Applying SFAS 158) The journal entry to recognize the additional

net loss arising during 20x4: OCI – net Gain/Loss 29,940*

Pension Liability 29,940

* $1,410 (the actual return is less than the expected return for $1,410) plus $28,530 (an increase in pension liabilities from changes in actuarial assumptions)

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Example 3 (contd.) (Applying SFAS 158) The bal. of pension lia. after the above

entries is: $78,600 (beg. Bal.) -$3140+ $29,940

=$105,400 $105,400 is the funded status as of 12/31/x4

(the difference between the projected pension liabilities of$265,000 and pension assets of159,600).

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Example 3 (cont.)-Amortization of Net Gain/Loss for 20x5 (Applying SFAS158)

• Since the balance of net loss on 1/1/20x5 (i.e.,$29,940 )is greater than 10% of the greater of projected benefit or plan assets on1/1/x5 (i.e.,$265,000), this net loss needs to be amortized as pension expense in 20x5.

• Assuming the remaining average service years for the active employees is 10 years, the net loss will be amortized as: (29,940- 26,400)/10 =354. Journal entry for this amortization in 20x5 is: Pension Expense 354

• OCI-Net Gain/Loss 354pensions 119

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Transition Obligations (TO)

The transition obligations are calculated as:

Balance at transition (1985): Projected benefit obligations (220) Plan assets 70 Transition Obligation 150

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Amortization of Transaction Liability

The transition liability is amortized using a straight-line method over the average remaining service life of employees.

This amortization is the sixth component of pension expense.

This treatment is to avoid an immediate recognition of the transition liability (i.e., income smoothing).

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Amortization of Transition Obligation(contd.) This transition obligation is mostly or fully

amortized by now due to SFAS 87 became effective in 1985.

If there is any unamortized transition obligation as of 12/31/2006, pension liability account would be credited for this amount and the Other Comprehensive income would be debited.

The amortized transition obligation will be another component of the pension expense.

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Statement of Financial Accounting Standards No. 158 (SFAS 158)

SFAS 158 requires the sponsors of defined benefit plans to:

1. Recognize the funded status* of pension plans;

2. Aggregate the statuses of all overfunded (underfunded) plans and report that amount as a noncurrent asset (a current or noncurrent liability);

* For a pension (a postretirement plan other than pensions) plan, it is the difference between the fair value of pension assets and the projected (accumulated) benefit obligation.

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Statement of Financial Accounting Standards No. 158 (contd.)

3. Recognize the unrecognized net gains or losses, prior service costs and unamortized transition obligation (based on the provisions of SFAS 87 and 106) as components of accumulated other comprehensive income, net of tax.

4. The amounts recognized as other comprehensive income is subsequently amortized as components of pension expense.

5. Apply SFAS 109, Accounting for Income taxes for the tax effects of items 1 to 4.

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Statement of Financial Accounting Standards No. 158 (SFAS 158) (contd.)

6. The measurement date of plan assets and obligations shall be the fiscal year end date;

7. Disclosure requirements:1) details of pension liabilities recognized in other comprehensive income; 2)the amounts in accumulated other comprehensive income not yet been amortized as pension expense; 3)the amounts in accumulated other comprehensive income expected to be amortized next fiscal year, etc.

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The Implementation of Statement of Financial Accounting Standards No. 158 For examples of the implementation of

SFAS 158, see Examples 1 and 2 (p13-p19) of the statement on FASB’s website at www.fasb.org.

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The Implementation of SFAS 158-An Example with Tax Consideration

1. Recognition of unamortized PSC of $100 million and net loss of $50 million with tax=40% on 12/31/2006:

Accumulated other comprehensive income 150

Deferred tax asset 60 Deferred tax benefit –accu. OCI 60 Pension Liability 150 Recognize a liability for the underfunded status and adjusts ending

accu. other comprehensive income, net of tax, for PSC and net loss which have not been recognized as a component of pension expense.

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The Implementation of Statement of Financial Accounting Standards No. 158

2. Amortize $30 million of the unamortized PSC in 2007:

Pension Expense 30 Deferred tax benefit – OCI 12

Deferred tax benefit – net income 12 Other compre. Income 30

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Footnote Disclosure for Pensions

The following information should be discloseda:

1. A schedule showing all the major components of pension expense should be reported .

a. These disclosure requirements are based on SFAS No. 132: Employers' Disclosure about Pensions and Other Postretirement Benefits.

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Footnote Disclosure for Pensions(contd.) 2. A reconciliation showing how the

projected benefit obligation (PBO) and the fair value of plan assets changed during a fiscal year period (required by SFAS 87).

3. The rates used in measuring the benefit amounts.

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Pension Disclosure- Components of Pension Expense The disclosure of the pension expense

components include:

a. Service cost. b. Interest cost. c. Expected return on assets. d. Other deferrals and amortization.

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Pension Disclosure- Components of Pension Expense (Contd.) The components of pension expense of Zarle

Company for 20x2,20x3 and 20x4 are as follows:

Components of Pension Expense 20x2 20x3 20x4

Service 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 0 27,200 20,800net periodic pension expense 9,000 44,800 41,660

Zarle Company

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Pension Disclosure- Reconciliation of PBO & Fair Value of Plan Assets The changes in plan assets and benefit obligation of

Zarle for year s 20x2,20x3 and 20x4 are as follows:

20x2 20x3 20x4Change in benefit obligationBenefit obligation at beg. Of year 100,000$ 112,000$ 212,700$ Service cost 9,000 9,500 13,000Interest cost 10,000 19,200 21,270Amend. ( prior service cost) 0 80,000 0Acturial loss 0 0 28,530Benefits paid (7,000) (8,000) (10,500)Benefit obligation at end of year 112,000$ 212,700$ 265,000$

Change in plan assetsFair value of plan assets at beg. of year 100,000$ 111,000$ 134,100$ actural return on plan assets 10,000 11,100 12,000Contribution 8,000 20,000 24,000Benefits paid (7,000) (8,000) (10,500)Fair value of plan assets at end of year 111,000$ 134,100$ 159,600$

Zarle Company Pension Disclosure

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Pension Disclosure- Rates Used in Measuring the Benefit Amounts Assumptions used in determining plan information are:

Assumptions used in determining plan inf. are as follows:

20x2 20x3 20x4Discout rate 7.50% 7.75% 6.75%Expected rate of 10.0 10.0 10.0 return on plan assets Salary growth rate 4.50 4.50 4.50

XYZ Corporation

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Pension terminations

Employers sometimes perceive overfunded pension plans as company piggy banks.

Companies cannot obtain the excess assets unless the plans are terminated.

To terminate pension plans, companies must pay participants what they owed to them (ERISA's requirement).

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Pension terminations (contd.)

Thus, companies can buy annuities to pay off the pension claimants and uses the excess fund for other purposes.

Examples of pension plan terminations: Occidental Petroleum revered $363

million from plan termination; $95 milllion for Stroh's Vrewery Co.; and $58 million Kellogg Co., etc.

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Pension terminations (contd.)

The question is: whose money is the excess assets of an overfunded pension plan?? The company or the plan participants?

Documents

Intermediate Financial Accounting Accounting for Employee Benefits