and Postretirement Benefits ‘CHAPTER LEARNING OBJECTIVES 1. Distinguish between accounting for the einployer’s pension plan and accounting for the pension fund. #2. Identify types of pension plans and their characteris ics. j} 3. Explain alternative measures for valuing the pension obligation, 4, List the components of pension expense. 5. Use a work sheet for employer’s pension plan entries. 6, Describe the amortization of past service costs. 7. Explain the accounting for unexpected gains and losses. 8. Explain the corridor approach to amortizing gains and losses. 9. Describe the requirements for reporting pension plans in financial statements, t 10, Explain special issues related to postretirement benefit plans. [|APTER REVIEW Chapter 20 discusses the various aspects of accounting for the cost of pension plans. for pension costs is somewhat complicated because of the variety of social concepts, legal considerations, actuarial techniques, income tax regulations, and varying business philosophies that affect he development and maintenance of pension plans. ‘This chapter relates these issues to the recommended 4 2. (L.O. 1) A pension plan is an arrangement whereby an employer provides benefits (payments) b employees after they retire for services they provided while they were working. In the accounting for a ension plan, consideration must be given to accounting for the employer and accounting for the pension plan itself. A pension plan is said to be funded when the employer sets funds aside for future pension enefits by making payments to a funding agency that is responsible for accumulating the assets of the foension fund and for making payment to the recipients as the benefits come due. 3. Pension plans can be contributory or noncontributory. In a contributory plan, the employees r part of the cost of the stated benefits or voluntarily make payments to increase their benefits. If the lan is noncontributory, the employer bears the entire cost. This chapter focuses on the accounting and ; issues faced by employers who sponsor pension plans. The pension fund is a separate legal and ' ting entity with its own set of books and financial statements and is not the subject ofthis chapter.20-2 student Study Gude for KiewoJteriedioneAecouing: IFRS Eddon ‘Types of Pension Plans 4. (L.0, 2) The most common types of pension arrangements are defined contribution plans and defined benefit plans. In a defined contribution plan, the employer agrees to contribute a certain sum each period based on a formula, ‘The formula might consider such factors as age, Iength of service, employer's profits, and compensation level. The accounting for a defined contribution plan is straightforward. The employer's responsibility is simply to make a contribution each year based on the formula established in the plan. Thus, the employer’s annual cost is the amount it is obligated to contribute to the pension trust. If the contribution is made in full each year no pension asset or liability is reported on the statement of financial position, 5. A defined benefit plan defines the benefits that the employee will receive at the time of retirement. The formula that is typically used provides for the benefits to be a function of the level of ‘compensation near retirement and of the number of years of service. The accounting for a defined benefit plan is complex. Because the benefits are defined in terms of uncertain future variables, an appropriate funding pattern must be established to insure that enough monies will be available at retirement to meet the benefits promised. Because the problems associated with pension plans involve complicated actuarial considerations, actuaries are engaged to ensure that the plan is appropriate for all employee groups covered. Acwaties make predictions (actuarial assumptions) of mortality rates, employee tumover, interest and earings rates, early retirement frequency, future salaries, and other factors necessary to operate a pension plan. ‘Thus, accounting for defined benefit pension plans is highly reliant upon information and measurements provided by actuaries. Measures of Liability 6. (L.O. 3) Most accountants agree that an employer's pension obligation is the deferred ‘compensation obligation it has to its employees for their services under the terms of the pension plan. However, there are three ways to measure this liability. One approach is to base the obligation on the vested benefits current employees are entitled to receive even if they render no additional years of service. The vested benefits pension obligation is computed using current salary levels and includes only vested benefits, A second approach to the measurement of the pension obligation is to base the computation on all years of service performed by employees under the plan-both vested end nonvested—using current salary levels. This measurement of the pension obligation is called the accumulated benefit obligation. A third measurement technique bases the computation on both vested and nonvested serviee using future salaries. Because future salaries are expected to be higher than current salaries, this approach, known as the defined benefit obligation, results in the largest measurement of the pension obligation. counted to ty for the 7, Regardless of the approach used, the estimated future benefits to be paid are present value. The profession has adopted the defined benefit obligation to measure the lit pension obligation. Components of Pension Expense 8. (L.0.4) Accounting for pension plans requites measurement of the cost and its identification with.the appropriate time periods. The determination of pension cost is very complicated because it isa function of a number of factors. ‘These factors are identified and described below. Serviee Cost. ‘The expense caused by the increase in pension benefits payable (the defined benefit obligation) to employees because of their services rendered during the current year. Actuaries compute service cost as the present value of the new benefits earned by employees during the year,‘Chnplee 20: Accounting for Peasions nnd Postretirement Benefits 20-3 Interest. Because a pension is a deferred compensation arrangement, It is recorded on a discounted basis. Rinterest expense accrues each year on the defined benefit obligation based on a selected interest rate jcalled the discount rate. tual Return on Plan Assets. Annual expense is adjusted for interest and dividends that accumulate ithin the fund as well as increases and decreases in the market value of the fund assets. Computation of actual retum on plan assets is illustrated by the following schedule: Fair value of plan assets at end of the period $2,500,000 Deduct: Fair value of plan assets at beginning of period 1,800,000 Increase/decrease in fair value of plan assets "700,000 Deduct: Contributions to plan during period $275,000 Less benefits paid during the period 120,000 155.090) ‘Actual return on plan assets 3.545,000 jthe actual return on the plan assets is positive (gain) during the period, it is subtracted in the expense. Ifthe actual retum is negative (loss) during the period, itis added in the ive benefits is allocated to pension expense in the future, specifically to the remaining service- of the affected employees. or Loss. Two items comprise gain or loss: (1) the difference between the actual return and the ted return on plan assets and (2) amortization of the unrecognized net gain or loss from previous 9, (LO. 5) In illustrating the accounting for these factors the text material makes use of a work approach. The work sheet is unique to pension accounting and is utilized to record both the formal fesand memo emtries that are necessary to keep track of all the employer’s relevant pension plan items mmponents. The format of the work sheet is as follows: : Pension Work Sheet ‘General Journal Entries Memo Record ‘Annual Pension Defined Pension Asset! Benefit | Plan Items | Expense} Cash | Liability Obligation | Assets Ei-tand “General Journal Entries” columns of the work sheet record entries in the formal general Eficounts, The right-hand “Memo Record” columns maintain balances on the unrecognized jalized) pension items. On the first line of the work sheet, the beginning balances (if any) are ‘Subsequently, transactions and events related to the pension plan are recorded, using debits and using both sets of records as if they were one for recording the entries. For each transaction or20-4 Student Stay Guide for Keo Intsmntate Accoung: IFRS Editon event, the debits must equal the credits. The balance in the Pension Asset/Lial iy column should equal the net balance in the memo record. ‘The work sheet approach to accumulating, balances for pension accounting is a most effective means of keeping track of complicated computations. 2012 Entries and Work Sheet 10, To illustrate the use of a work sheet, the following facts apply to Ochler Company for the year 2012: Plan assets, 1/12 $450,000 Defined benefit obligation, 1/1/12 $450,000 Annual service cost for 2012 27,000 Discount rate for 2012 % ‘Actual return on plan assets for 2012 30,000 Contributions (funding) in 2012 32,000 Benefits paid to retirees in 2012 17,000 The work sheet would be completed as follows: Ochfer Company General Journal Entries, Memo Record ‘Annual Pension | | Defined Pension Asset Benefit Plan hers Expense | Cash_| Liability |_| Obligation | Assets Balance, 1/2 “450,000 Cr. | 450,000 Dr. (a) Service Cost | 27,000Dr. 27,000Cr. (y Interest Cost [451,500 Dr. 31,500 Cr. ¢e) Actual Retum | 30,000 Cr. 30,000 Dr. (@ Contributions 92,000 Cr. 32,000 Dr. (©) Benefits 17,000 Dr. | 17.000 Cr. Jounal Entry foc || 2012 128,500 Dx. | 32,000 cr. Balance, 12/31/12 #5450,000X.07 * *(Chapter 20: Accoonting for Pensions and Postretrement Benefits 20-5 2013 Entries and Work Sheet 11, To illustrate the use of a work sheet with amortization of unrecognized past service costs, the following facts continue to apply to Oehler Company for the year 2013: Present value of past service benefits granted I/M/13 $42,000* Annual service cost for 2013, 28,000 Discount rate for 2013 % Actual return on plan assets for 2013 31,000 Contributions (funding) in 2013 29,000 Benefits paid retirees in 2013 24,000 Amortization of past service costs 17,500" *The past service cost is not vested, and the past service cost is to be amortized at the rate of $17,500 per year, ‘The work sheet would be completed as follows: Ochler Company General Journal Entries ‘Memo Record Annual Pension | Defined Unrecog- Pension Asset? | Benefit Plan | nized Past Items Expense | Cash | Liability | Obtigation | Assets jService Cosi] Balance, 12/31/12 3.500 Dr. | 491,500Cx. | 495,000 De Past Service Cost 42,000 Cr. 42,000 Dr. Balance, WI/13 3.500Dr. | $33,00Cr.| 495,000 Dr. | 42,000 Dr. Service Cost 28,000Dr, 28,000 Cr. Interest Cost 937,345 Dr, 37345 Cr. ‘Actual Return 31,000 De. feoaation or 47,500 Cr. Contributions 29,000 Dr Benefits 24,000Dr. | 24,000 Cr. lodimat Entry for 2083 Batance, 12/31/13 331,000 Dr. | 24,500 Dr. 5333,500 X..07 ‘The pension reconciliation schedule is as follows: Defined benefit obligation (Credit) (574,845) Plan assets at fair value (Debit) 531,000 Funded status (43,845) Unrecognized past service cost (Debit) 24,500 Pension asset/iability (Credit) $19,345)20-6 Student Study Gaide for KiesoIermediats Accounting: IFRS Edition tion of Past Ser Se 12. (LO. 6} Past Service Costs (PSC) occur when a company provides benefits to employees for years of service before the date of initiation or amendment. The cost of the retroactive benefits (including any benefits provided to existing retirees) is the increase in the defined benefit obligation at the date of ‘the amendment, If the benefits from the amendment to the plan vest immediately, then the company should recognize the expense and related liability at the amendment date. If the benefits do not vest immediately, past service cost should be recognized as an expense on a straight-line basis over the average remaining period until the benefits become vested. Gain or Loss 13. (L.0. 7) Because of the concer to companies that pension plans would have uncontrollable and unexpected swings in pension expense, the IASB decided to reduce the volatility by using smoothing techniques. Asset gains (occurring when actual return is greater than expected return) and asset losses {ocourring when actual return is less than expected return) are recorded in an Unrecognized Net Gain ot Loss account and combined with unrecognized gains and losses accumulated in prior years. Liability gains (resuiting from unexpected decreases in the liability balance) and liability losses (resulting from unexpected increases) are deferred and combined in the same Unrecognized Net Gain or Loss account used for asset gain or losses. 14, (L.O. 8) ‘The Unrecognized Net Gain or Loss account can continue to grow if asset gains and losses are not offset by I ‘gains and losses, To limit this potential growth, the IASB invented the corridor approach for amortizing the accumulated balance in the Unrecognized Gain or Loss account when it gets too large. The unrecognized net gain or loss account balance gets too large and must be amortized when it execeds the arbitrarily selected criterion of 10% of the larger of the beginning balance of the defined benefit obligation or the fair value of plan assets. Any systematic method of amortizing the excess may be used but it cannot be less than the amount computed by dividing the ‘amount to be amortized by the average remaining service-life of all active employees who are expected to benefit under the plan. 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 unrecognized net gain of loss exceeded the corridor, 15, To illustrate the amortization of unrecognized gains and losses, assume the following information related to Scott Inc.’s pension plan: Beginning of the Year 2012 2013 Defined benefit obligation $3,600,000 $4,100,000 Fair value of assets 4,100,000 4,300,000 Unrecognized Net Loss -0- 900,000 800,000(Chapter 20: Accounting for Pensions end Postreticement Benefits 20-7 ifthe average remaining service life of all remaining employees is 8 years, the schedule to amortize the unrecognized net loss is as follows: Corridor Test and Gain/Loss Amortization Schedule ‘Minimum Defined Cumulative Amortization Benefit Plan Unrecognized of Loss Year Obligation —_Assets Corridor Net Loss (Current Year) 2012 $3,600,000 $4,100,000 $410,000 $ $ -0- 2013 4,100,000 4,300,000 430,000 900,000 58,750(@) 2014 4,400,000 4,200,000 440,000 1,641,250(b) 150,156(b) (a) $900,000 ~- 430,000 = $470,000; $470,000/8 = $58,750 (b) $900,000 - 58,750 + 800,000 = $1,641,250 $1,641,250 — 440,000 = $1,201,250; $1,201,250/8 = $150,156 loss recognized in 2012 would increase pension expense by $58,750. This amount is far less than the $900,000 that would be recognized if the corridor method was not applied. The rationale for the corridor that gains and losses result from refinements in estimates as well as real changes in economic value and at, over time, some of these gains and losses will offset one another, 16. Continuing the Oehler Company illustration into 2014, the following facts apply to the pension Annual service cost for 2014 $29,000 Discount rate is 7%; expected earnings rate is 7% ‘Actual return on plan assets for 2014 28,000 Amortization of PSC in 2014 21,000 Contributions (funding) in 2014 32,000 Benefits paid to retirees in 2014 20,000 Changes in actuarial assumptions establish the end-of-year defined benefit obligation 640,00020-8 Student Study Guide for Kieso termediate Accounting: IFRS Ealtion “The work sheet would be completed as follows: Oebler Company ‘General Journal Enis ‘Meno Record ‘Annas Pension] Defined Unrecog Pensi Asse’ | Benefit | Plan — | nized Past stems Expense | Cash} Liability | Obligation | Assets Service Cosi] or Loss Banc. 1213 woaasce | s74sisce, [531.000Dr, | 24.500Dr Ke Service 29.0006. 29.000Cr. (o)terest Cost 40.2390. 40.239 (0) Aetuat Retwen | 28.00%. R000 Pr (Unexpected toss | 49.170C%. 9,170 De, qyAmonization of | 21.9000. 21.000 cr. Psc (9 Contibtions s2000cr. 32.000 De. (6) Benctits 20,000 De. | ano00¢r. (y Liabity nereose — |__ s18916c%, 13916 De Jounal Gry for 2014 | s3069 Dr. | 3200¢r. | 21.069. Balance. 2231/14 anata ce | 540000 cr 3500. {51,000 * 07) ~ $28 000 «$9,170 ‘#5574845 + $29,000 + $40,239-~$20,000 ~ $624,084 640,000 ~$824084 =515,916 ‘The pension reconciliation schedule is as follows: Defined benefit obligation (Credit) '5(640,000) Plan assets at fair value (Debit) 571,000 Funded status (69,000) Unrecognized past service cost (Debit) 3,500 Unrecognized net loss (Debit) 25.086 Pension Asset/Liability (Credit) $140,414) 17, ‘The minimum amout of actuarial gains and losses that must be recognized is that amount computed using the corridor approach. However, the IASB favors immediate recognition of actuarial gains and losses, with the adjustment made to either net income or comprehensive income. Reporting Pension Plans Iii Financial Statements 18 (L.O. 9) Within the financial statements, companies report a pension assetliabifity in the statement of financial position, and within the income statement pension expense is reported. Also, any actuarial gains and losses recorded in other comprehensive income are reported in the statement of comprehensive income.