Intermediate Accounting

Chapter 20
Accounting For Pensions and
Postretirement Benefits
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Learning Objectives
After studying this chapter, you should be able to:
1. Discuss the fundamentals of pension plan accounting.
2. Use a worksheet for employer’s pension plan entries.
3. Describe the accounting and amortization of prior
service costs.
4. Explain the accounting and amortization for
unexpected gains and losses.
5. Describe the requirements for reporting pension plans
in financial statements.

2
 Learning Objective 1
Discuss the Fundamentals of Pension
Plan Accounting

LO 1 3
 Pension Plan Accounting
An arrangement whereby an employer provides benefits
(payments) to retired employees for services they
provided in their working years.

LO 1 4
 Pension Plan Accounting
Types of Plans
Pension plans can be:
• Contributory: employees voluntarily make payments to
increase their benefits.
• Noncontributory: employer bears the entire cost.
• Qualified pension plans: offer tax benefits.
Pension fund should be a separate legal and accounting
entity.

LO 1 5
 Pension Plan Accounting
Pension Funds and Pension Expense
Company 2020 Pension Pension Expense as
($ in millions) Size of Pension Fund Expense (Income) % of Pretax Income
General Motors $74,421 $(1,173) −9.89%
Hewlett-Packard 10,176 (132) −4.03
Deere & Company 11,137 106 3.36
Merck 17,560 201 3.08
The Coca-Cola 8,371 368 5.46
Company
Molson Coors 5,946 (68) -4.91
Brewing

The two most common types of pension plans are defined

contribution plans and defined benefit plans.
LO 1 6
 Pension Plan Accounting
Contribution versus Benefit Plans
Defined-Contribution Plan Defined-Benefit Plan
• Employer contribution • Benefit determined by plan
determined by plan (fixed) • Employer contribution
• Risk borne by employees varies (determined by
• Benefits based on plan Actuaries)
value • Risk borne by employer

LO 1 7
 The Role of Actuaries in Pension
Accounting
Actuaries make predictions (called actuarial assumptions)
of mortality rates, employee turnover, interest and
earnings rates, early retirement frequency, future
salaries, and any other factors necessary to operate a
pension plan.

LO 1 8
 Measures of the Liability
Two questions:
1. What is the pension obligation that a company should
report in the financial statements?
2. What is the pension expense for the period?

LO 1 9
 Measures of the Liability
Different Measures of the Pension Obligation

LO 1 10
 Measures of the Liability
Recognition of the Net Funded Status of the Pension
Plan
• Companies must recognize on their balance sheet the
full overfunded or underfunded status of their defined
benefit pension plan.
• The overfunded or underfunded status is measured as
the difference between the fair value of the plan assets
and the projected benefit obligation.

LO 1 11
 Components of Pension Expense

LO 1 12
 Components of Pension Expense
Service Costs
Effect on
Expense

1 Service Costs +

Actuarial present value of benefits attributed by the

pension benefit formula to employee service during the
period

LO 1 13
 Components of Pension Expense
Interest on the Liability
Effect on
Expense
2 Interest on the Liability +

Interest for the period on the projected benefit obligation

outstanding during the period
The interest rate use is referred to as the settlement rate.

LO 1 14
 Components of Pension Expense
Actual Return on Plan Assets
Effect on
Expense
3 Actual Return on Plan Assets +−

Increase in pension funds from interest, dividends, and realized and

unrealized changes in the fair value of the plan assets.

LO 1 15
 Components of Pension Expense
Amortization of Prior Service Costs
Effect on
Expense
4 Amortization of Prior Service Costs +

Plan amendments often include provisions to increase benefits for

employee service provided in prior years.
Company allocates the cost (prior service cost) of providing these
retroactive benefits to pension expense in the future, specifically to
the remaining service-years of the affected employees.

LO 1 16
 Components of Pension Expense
Gain or Loss
Effect on
Expense
5. Gain or Loss +−

Volatility in pension expense can result from sudden and large

changes in the fair value of plan assets and by changes in projected
benefit obligation.

LO 1 17
 Learning Objective 2
Use a Worksheet for Employer’s
Pension Plan Entries

LO 2 18
 Using a Pension Worksheet

LO 2 19
 Using a Pension Worksheet
Illustration
On January 1, 2020, Zarle Company provides the following
information related to its pension plan for the year 2020.
Plan assets, January 1, 2020, are $100,000.
Projected benefit obligation, January 1, 2020, is $100,000.
Annual service cost is $9,000.
Settlement rate is 10 percent.
Actual return on plan assets is $10,000.
Funding contributions are $8,000.
Benefits paid to retirees during the year are $7,000.

LO 2 20
 Using a Pension Worksheet
Prepare a pension worksheet for 2020

LO 2 21
 Using a Pension Worksheet
Journal Entry for 2020

Pension Expense 9,000

Cash 8,000
Pension Asset/Liability 1,000
LO 2 22
 Learning Objective 3
Describe the Accounting and
Amortization of Prior Service Costs

LO 3 23
 Prior Service Cost (PSC)
Amortization
Company should not recognize the retroactive benefits
as pension expense in the year of amendment.
Employer should recognize the pension expense over the
remaining service lives of the employees who are
expected to benefit from the change in the plan.
Amortization Method:
• Board prefers a years-of-service method.
• Employers may use straight-line amortization over the
average remaining service life of the employees.
LO 3 24
 Years-of-Service Method
Illustration: Assume that Zarle Company’s defined benefit pension
plan covers 170 employees. In its negotiations with the employees,
Zarle Company amends its pension plan on January 1, 2021, and
grants $80,000 of prior service costs to its employees. The
employees are grouped according to expected years of retirement,
as follows.
Group Number of Employees Expected Retirement on
Dec. 31
A 40 2021
B 20 2022
C 40 2023
D 50 2024
E 20 2025
170

LO 3 25
 Years-of-Service Method
Computation of Service-Years
Illustration 20-10 shows computation of the service-years per
year and the total service-years.
Service-Years
Year A B C D E Total
2021 40 20 40 50 20 170
2022 Blank 20 40 50 20 130
2023 Blank Blank 40 50 20 110
2024 Blank Blank Blank 50 20 70
2025 Blank Blank Blank Blank 20 20
Blank 40 40 120 200 100 500

LO 3 26
 Years-of-Service Method
Computation of Annual Prior Service Cost Amortization
Computed on the basis of a prior service cost of $80,000 and
a total of 500 service-years 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.

LO 3 27
 Learning Objective 4
Explain the Accounting and
Amortization for Unexpected Gains and
Losses

LO 4 28
 Gains and Losses
Unexpected swings in pension expense can result from:
1. Sudden and large changes in the fair value of plan
assets, and
2. Changes in actuarial assumptions that affect the
amount of the projected benefit obligation.

LO 4 29
 Gains and Losses
Question
What is the potential negative impact on net income of
these unexpected swings?

Volatility
The profession decided to
reduce the volatility with
smoothing techniques.

LO 4 30
 Gains and Losses
Smoothing Unexpected Gains and Losses on Plan
Assets
• Companies include the expected return on the plan
assets as a component of pension expense, not the
actual return in a given year.
• Companies record asset gains and asset losses in an
account, Other Comprehensive Income (G/L),
combining them with gains and losses accumulated in
prior years.

LO 4 31
 Gains and Losses
Smoothing Unexpected Gains and Losses on Plan
the Pension Liability
• Companies report liability gains and liability losses in
Other Comprehensive Income (G/L).
• Companies combine the liability gains and losses in the
same Other Comprehensive Income (G/L) account.
• They accumulate the asset and liability gains and losses
in Accumulated Other Comprehensive Income and
report on the balance sheet in the stockholders’ equity
section.

LO 4 32
 Gains and Losses
Corridor Amortization
• FASB invented the corridor approach for amortizing the
accumulated net gain or loss balance when it gets too
large. How large is too large?
• 10% of the larger of the beginning balances of the
projected benefit obligation or the market-related
value of the plan assets.
• Any Accumulated OCI net gain or loss balance above
the 10% must be amortized.

LO 4 33
 Gains and Losses
Illustration
Data for Callaway Co.’s projected benefit obligation and plan assets
over a period of six years.
Beginning-of-the- Projected Benefit Market-Related Corridor* +/− 10%
Year Balances Obligation Asset Value
2019 $1,000,000 $ 900,000 $100,000
2020 1,200,000 1,100,000 120,000
2021 1,300,000 1,700,000 170,000
2022 1,500,000 2,250,000 225,000
2023 1,700,000 1,750,000 175,000
2024 1,800,000 1,700,000 180,000

*The corridor becomes 10% of the larger (in red type) of the projected benefit obligation
or the market-related plan asset value.
LO 4 34
 Gains and Losses
Graphic Illustration of the Callaway

LO 4 35
 Learning Objective 5
Describe the Requirements for
Reporting Pension Plans in Financial
Statements

LO 5 36
 Reporting Pension Plans in Financial
Statements
Four categories
• Assets and liabilities
• Net Income
• Comprehensive Income
• Notes to the financial statement

LO 5 37
 Reporting Pension Plans in Financial
Statements
Assets and Liabilities
• Companies must recognize on their balance sheet the
overfunded (pension asset) or under-funded (pension
liability) status of their defined benefit pension plan.
• If fair value exceeds the projected benefit obligation,
companies will report a net pension asset.
• No portion of the pension asset is reported as a current
asset

LO 5 38
 Reporting Pension Plans in Financial
Statements
Net Income
• Pension expense includes multiple components (service
cost, interest cost, return on assets, and amortization)
• The FASB requires presentation of the components of
pension expense as follows.
1. Service cost component is reported as pension expense in
income from operations.
2. Other components of pension expense are generally
reported as one net amount in the “Other expenses and
losses” section below income from operations.
LO 5 39
 Reporting Pension Plans in Financial
Statements
Comprehensive Income
• Companies are required to recognize actuarial gains
and losses and prior service costs that originate in the
current period in other comprehensive income.
• Actuarial gains and losses not recognized as part of
pension expense.
• The Board requires that the prior service cost arising in
the year of the amendment be recognized by an
offsetting debit to other comprehensive income.

LO 5 40
 Reporting Pension Plans in Financial
Statements
Within the Financial Statements
• Recognition of the Net Funded Status of the Plan
• Classification of Pension Asset or Pension Liability
• Aggregation of Pension Plans
• Actuarial Gains and Losses/Prior Service Cost

LO 5 41
 Reporting Pension Plans in Financial
Statements
Within the Notes to the Financial Statements
1. Major components of pension expense.
2. Reconciliation showing how the projected benefit
obligation and the fair value of the plan assets changed.
3. A disclosure of the rates used in measuring the benefit
amounts (discount rate, expected return on plan assets,
rate of compensation).

LO 5 42
 Within the Notes to the Financial
Statements
4. A table indicating the allocation of pension plan assets by
category (equity securities, debt securities, real estate, and
other assets), and showing the percentage of the fair value
to total plan assets.
5. The expected benefit payments to be paid to current plan
participants for each of the next five fiscal years and in the
aggregate for the five fiscal years thereafter. Also required
is disclosure of a company’s best estimate of expected
contributions to be paid to the plan during the next year.

LO 5 43
 Within the Notes to the Financial
Statements (continued)
6. The nature and amount of changes in plan assets and
benefit obligations recognized in net income and in other
comprehensive income of each period.
7. The accumulated amount of changes in plan assets and
benefit obligations that have been recognized in other
comprehensive income and that will be recycled into net
income in future periods.

LO 5 44
 Reporting Pension Plans in Financial
Statements
Special Issues
• The Pension Reform Act of 1974
• Pension Terminations

LO 5 45