1. Accounting for Postemployment Benefits C hapter 20 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones Including FASB 158

2. 2 1.Understand the characteristics of pension plans. 2.Explain the historical perspective of accounting for pension plans. 3.Explain the accounting principles for defined benefit plans, including computing pension expense and recognizing pension liabilities and assets. 4.Account for pensions. 5.Understand disclosures of pensions. Objectives

3. 3 6.Explain the conceptual issues regarding pensions. 7.Understand several additional issues related to pensions. 8.Explain other post-employment benefits. 9.Account for OPEBs. 10.Explain the conceptual issues regarding OPEBs. 11.Understand present value calculations for pensions. (Appendix) Objectives

4. 4 Defined Contribution Plans employer contributes a defined sum to a third party plan trust.  The employer contributes a defined sum to a third party plan trust.  Amounts to be funded are determined by the plan.  The plan invests the contributed assets, which earn income, and makes distributions to retirees.  There is no promise for specific future benefits.  Market risk is borne by the employee.  Accounting for the firm is relatively straightforward.  For profit companies contribute to 401(k) plans and non- profit organizations contribute to 403(b) plans.

5. 5 A pension plan requires that a company provide income to its retired employees in return for services they provided during their employment. Characteristics of a Pension Plan

6. 6 The retirement income, normally paid monthly, usually is determined on the basis of the employees earnings and length of service with the company. Defined Benefit Plans $50,000 average salary X 2.5% per year X 30 years = $37,500 pension per year $50,000 average salary X 2.5% per year X 30 years = $37,500 pension per year

7. 7 Most companies design their pension plans to meet the Internal Revenue Code qualifications, which state that: 1.Employer contributions are deductible for income tax purposes when paid. 2.Pension fund earnings are exempt from income taxes. 3.Employer contributions to the pension fund are not taxable to the employees until they receive their pension benefits. Internal Revenue Qualifications

8. 8 Pension Relationships

9. 9 promised a certain amount of benefits at retirement  The employee is promised a certain amount of benefits at retirement.  The amount received is based upon variables such as -Years of service -Ending salary or average of best (three) years -Multiplier, such as 2.5% per year of service -Age, if retiring early, a deduction will be made  The employer remains liable for the benefits and bears the market risk.  The employer is the trust-beneficiary.  The accounting by the firm is complex. promised a certain amount of benefits at retirement  The employee is promised a certain amount of benefits at retirement.  The amount received is based upon variables such as -Years of service -Ending salary or average of best (three) years -Multiplier, such as 2.5% per year of service -Age, if retiring early, a deduction will be made  The employer remains liable for the benefits and bears the market risk.  The employer is the trust-beneficiary.  The accounting by the firm is complex. Defined Benefit Plans

10. 10 The projected benefit obligation is the actuary’s estimate of the present value of benefits attributed to date based on future salary levels. Projected Benefit Obligation

11. 11 The accumulated benefit obligation is the actuary’s estimate of the present value of benefits attributed to date based on current salary levels. Accumulated Benefit Obligation

12. 12 Components of Pension Expense 1.+Service cost for the year. Increases pension expense. 2.+Interest on projected benefit obligation (liability). Beginning PBO times the discount or settlement rate. Increases pension expense. 3.-Expected return on plan assets during the year. Fair value of plan assets at beginning of year times expected long-term rate of return on plan assets. Generally decreases pension expense. 4.+Amortization of prior service cost = Present value of additional benefits/modification of the plan amortized over the remaining service lives of active employees. Generally increases pension expense. 5.+Gain or loss = Amortization of the cumulative net gain or loss from previous periods that has not yet been included in pension expense, in excess of the corridor.

13. 13 Service cost is the actuarial present value of the benefits attributed by the pension benefit formula to service rendered by the employees during the current period. Service Cost

14. 14 Interest cost is the increase in the projected benefit obligation due to the passage of time. Interest Cost

15. 15 The expected return on plan assets, if positive, will decrease pension expense. Expected Return on Assets The expected return on plan assets is the expected increase in plan assets due to investing activities.

16. 16 Projected Benefit Obligations at Beginning of Period = Present Value of Benefits Earned to Date Plan assets at Beginning of Period at Fair Value Interest = Projected Benefit x Discount Cost Obligation Rate Expected Return on Plan Assets During Period Projected Benefit Obligation Grows to Equal Expected Retirement Obligation Assets Grow to Equal the Amounts Needed to Pay Retirement Benefits Assets Used to Pay Retirement Benefits Retirement Expected Return on Plan Assets

17. 17 When a defined benefit plan is either initiated or amended, credit is often given to employees for years of service provided before the date of initiation or amendment. Prior Service Cost

18. 18 The retroactive benefit to a pension plan is the prior service cost. Prior Service Cost Prior service cost is reported as a liability and as a negative element of Other Comprehensive Income for the year at the date of the plan amendment.

19. 19 Prior service cost may be amortized to pension expense over future service periods of employees active at the time of the plan amendment using either the straight-line or years-of-service method. Methods of Amortization

20. 20 The average remaining service life of employees expected to receive benefits is calculated by dividing the total future service years by the number of employees. Total future service years = average remaining service life Number of employees expected to receive benefits The average remaining service life of employees expected to receive benefits is calculated by dividing the total future service years by the number of employees. Total future service years = average remaining service life Number of employees expected to receive benefits Straight-line Method

21. 21 The Board prefers a years-of-service amortization method where prior service cost is divided by the number of future service years to be worked by participating employees, to obtain a cost per service-year. This cost per service-year is multiplied by the number of service years consumed each year. Years-of-Service Method

22. 22 Years-of-Service Method At the beginning of 2007, Watts Company had nine employees who are expected to receive pension benefits. One employee (A) is expected to retire after three years, one (B) after 4, two (C,D) after 5, two (E,F) after 6 and three (G,H,I) after 7 years.

23. 23 Years-of-Service Method At that time, the company’s actuary computed the prior service cost at $400,000.

24. 24 Straight-Line Amortization The seven employees will provide 50 years of service, so the average service provided will be 50 / 7 = 5.56 years. The prior service cost of $400,000 divided by 5.56 years equals $71,942 to be amortized to pension expense each year.

25. 25 A gain or loss from previous periods arises because the actual amount of the PBO is different from what was assumed and because of changes in actuarial assumptions. Gain or Loss

26. 26 The gain or loss for the year is recorded as a liability or asset and in Other Comprehensive Income for the year. Gain or Loss Accrued/Prepaid Pension Cost15,300 Other Comprehensive Income (gain)15,300

27. 27 The excess of the accumulated gain or loss over a “corridor” amount is amortized over the remaining service life of active employees expected to receive benefits under the plan. Gain or Loss

28. 28 Amortization of Gain or Loss minimum subject to amortization  The minimum amortization required is computed by dividing the total accumulated gain or loss subject to amortization at the beginning of the year by the average remaining service period of active employees expected to receive benefits.  The amount subject to amortization is the excess of 10% of the greater of the beginning balances of the projected benefit obligation and the fair value of the assets value. Use absolute values. minimum subject to amortization  The minimum amortization required is computed by dividing the total accumulated gain or loss subject to amortization at the beginning of the year by the average remaining service period of active employees expected to receive benefits.  The amount subject to amortization is the excess of 10% of the greater of the beginning balances of the projected benefit obligation and the fair value of the assets value. Use absolute values.

29. 29 1.Amortization of any unrecognized net loss from previous periods is added to compute pension expense, or 2.Amortization of any unrecognized net gain from previous periods is deducted to compute pension expense. 1.Amortization of any unrecognized net loss from previous periods is added to compute pension expense, or 2.Amortization of any unrecognized net gain from previous periods is deducted to compute pension expense. Amortization of Gain or Loss

30. 30 Jan. 1 Projected Fair Cumulative Benefit Value Excess Amortized Net Loss Obligation of Plan Net Loss Net Loss Year (Gain) Actual Assets Corridor (Gain) (Gain) 2007$13,000 $110,000$100,000$11,000$2,000$200 2008(2,300)135,000130,00013,500-------- 200918,700 168,000170,00017,0001,700170 201027,500230,000215,00023,0004,500450 Assume the average remaining service period is 10 years. Computation of Net Gain or Loss Component of pension expenseComponent expense Divide By 10 years Use January 1 cumulative gain or loss for computation.

31. 31 Net Gain or Loss December 31, 2007: Amortized $200 of January 1 accumulated net loss to pension expense. December 31, 2007: Accrued/Prepaid Pension Cost200 Other Comprehensive Income200 (Amount amortized to pension expense during 2007)

32. 32 Net Gain or Loss December 31, 2007: Accrued/Prepaid Pension Cost15,300 Other Comprehensive Income15,300 (Difference between $13,000 loss on January 1 and $2,300 gain on December 31) December 31, 2008: Other Comprehensive Income21,000 Accrued/Prepaid Pension Cost21,000 (Difference between $2,300 accumulated gain on January 1 and $18,700 accumulated loss on December 31)

33. 33 Projected Benefit Obligation Beginning projected benefit obligation + Prior service cost added this year = Adjusted beginning projected benefit obligation + Service cost for the period + Interest cost on beginning PBO + Actuarial losses (or – Actuarial gains) - Payments to retirees = Ending projected benefit obligation

34. 34 Plan Assets Beginning fair value of plan assets + Actual return on pension plan assets + Contributions by the company - Payment to retirees = Ending fair value of plan assets

35. 35 Facts for the Carlisle Company 1.The company adopts a pension plan on January 1, 2007. No retroactive benefits were granted to employees. 2.The service cost each year is: 2007, $400,000; 2008, $420,000; 2009, $432,000. 3.The projected benefit obligation at the beginning of each year is: 2008, $400,000; and 2009, $840,000. ContinuedContinued Pension Expense Equal to Funding

36. 36 4.The discount rate is 10%. 5.The expected long-term rate of return on plan assets is 10%. 6.The company adopts a policy of funding an amount equal to the pension expense and makes a payment at the end of each year. 7.Plan assets are based on the amounts contributed each year, plus a return of 10%, less $20,000 to retired employees (beginning 2008). Pension Expense Equal to Funding

37. 37 December 31, 2007: Pension Expense400,000 Cash400,000 December 31, 2008: Pension Expense420,000 Cash420,000 Pension Expense Equal to Funding Service cost (from actuary)$420,000 Interest cost ($400,000 x 10%)40,000 Expected return on plan assets ($400,000 x 10%) (40,000) Pension expense$420,000 Service cost (from actuary)$420,000 Interest cost ($400,000 x 10%)40,000 Expected return on plan assets ($400,000 x 10%) (40,000) Pension expense$420,000

38. 38 Balance-Plan Assets Plan Assets Cash from 2007 400,000 Paid to Return in 200840,000 retirees Cash from 2008 420,000 2008 20,000 Bal. 1/1/09 840,000

39. 39 Balance-PBO Projected Benefit Obligation 400,000 Service cost 2007 420,000 Service cost 2008 40,000 Interest on 1/1/08 PBO Benefits paid to retirees in 2008 20,000 840,000Bal. 1/1/09

40. 40 December 31, 2009: Pension Expense432,000 Cash432,000 Note that the interest cost and the return on the plan assets offset each other each year. Pension Expense Equal to Funding Service cost (from actuary)$432,000 Interest cost ($840,000 x 10%)84,000 Expected return on plan assets ($840,000 x 10%) (84,000) Pension expense$432,000 Service cost (from actuary)$432,000 Interest cost ($840,000 x 10%)84,000 Expected return on plan assets ($840,000 x 10%) (84,000) Pension expense$432,000

41. 41 December 31, 2007: Pension Expense400,000 Accrued/Prepaid Pension Cost5,000 Cash405,000 Carlisle Company funds $405,000 in 2007, $425,000 in 2008, and $435,000 in 2009. AssetAsset Funding Greater Than Pension Expense

42. 42 Service cost (from actuary)$420,000 Interest cost ($400,000 x 10%)40,000 Expected return on plan assets ($405,000 x 10%) (40,500) Pension expense$419,500 Service cost (from actuary)$420,000 Interest cost ($400,000 x 10%)40,000 Expected return on plan assets ($405,000 x 10%) (40,500) Pension expense$419,500 December 31, 2008: Pension Expense419,500 Accrued/Prepaid Pension Cost5,500 Cash425,000 Funding Greater Than Pension Expense Asset balance is now $5,000 + $5,500

43. 43 Balance-Plan Assets Plan Assets Cash from 2007 405,000 Paid to Return 200840,500 retirees Cash from 2008 425,000 2008 20,000 Bal. 1/1/09 850,500

44. 44 December 31, 2009: Pension Expense430,950 Accrued/Prepaid Pension Cost4,050 Cash435,000 The balance in the asset account is $14,550 ($5,000 + $5,500 + $4,050) The balance in the asset account is $14,550 ($5,000 + $5,500 + $4,050) Funding Greater Than Pension Expense Service cost (from actuary)$432,000 Interest cost ($840,000 x 10%)84,000 Expected return on plan assets ($850,500 x 10%) (85,050) Pension expense$430,950 Service cost (from actuary)$432,000 Interest cost ($840,000 x 10%)84,000 Expected return on plan assets ($850,500 x 10%) (85,050) Pension expense$430,950

45. 45 December 31, 2007: Pension Expense400,000 Prepaid/Accrued Pension Cost15,000 Cash415,000 Carlisle Company funds $415,000 in 2007, $425,000 in 2008, and $440,000 in 2009. The expected return is 11% and the actual return is 12% each year. Pension Expense Less Than Pension Funding & Expected Return Different from Both Actual Return & Discount Rate

46. 46 December 31, 2008: Pension Expense414,350 Prepaid/Accrued Pension Cost10,650 Cash425,000 The balance in the asset account is $25,650 Pension Expense Less Than Pension Funding & Expected Return Different From Both Actual Return & Discount Rate Service cost (assumed)$420,000 Interest cost ($400,000 x 10%)40,000 Expected return on plan assets ($415,000 x 11%) (45,650) Pension expense$414,350 Service cost (assumed)$420,000 Interest cost ($400,000 x 10%)40,000 Expected return on plan assets ($415,000 x 11%) (45,650) Pension expense$414,350

47. 47 Balance-Plan Assets Plan Assets Cash from 2007 415,000 Paid to Return 200849,800 retirees Cash from 2008 425,000 2008 20,000 Bal. 1/1/09 869,800

48. 48 Balance-PBO Projected Benefit Obligation 400,000 Service cost 2007 420,000 Service cost 2008 40,000 Interest on 1/1/08 PBO Benefits paid to retirees in 2008 20,000 840,000Bal. 1/1/09

49. 49 December 31, 2009: Pension Expense420,322 Prepaid/Accrued Pension Cost19,678 Cash440,000 The balance in the asset account is $49,478 Pension Expense Less Than Pension Funding and Expected Return Different From Both Actual Return &Discount Rate Service cost$432,000 Interest cost ($840,000 x 10%)84,000 Expected return on plan assets ($869,800 x 11%) (95,678) Pension expense$420,332 Service cost$432,000 Interest cost ($840,000 x 10%)84,000 Expected return on plan assets ($869,800 x 11%) (95,678) Pension expense$420,332

50. 50 Difference Between Expected and Actual Return Because the 12% actual return is $49,800, which is $4,150 higher than the $45,650 expected return, a journal entry must be made to Accrued/ Prepaid Pension Cost and Other Comprehensive Income for the year. A gain increases income. Accrued/ Prepaid Pension Cost4,150 Other Comprehensive Income4,150

51. 51 Carlisle Company awarded retroactive benefits to employees when it adopted the pension plan. The prior service costs were estimated to be $2 million, which is to be amortized over 20 years. Carlisle decided to increase its contributions to $705,000 in 2007, $715,000 in 2008, and $730,000 in 2009. Pension Expense Including Amortization of Prior Service Cost

52. 52 As required by FAS 158, the prior service costs of $2 million must be recorded as a liability and also as a negative element of Other Comprehensive Income for the year. Pension Expense Including Amortization of Prior Service Cost Other Comprehensive Income2,000,000 Accrued/Prepaid Pension Cost2,000,000

53. 53 Pension Expense700,000 Accrued/Prepaid Pension Cost5,000 Cash705,000 December 31, 2007: Service cost$400,000 Interest cost ($2,000,000 x 10%)200,000 Amortization of prior service cost ($2,000,000/ 20 years) 100,000 Pension expense$700,000 Service cost$400,000 Interest cost ($2,000,000 x 10%)200,000 Amortization of prior service cost ($2,000,000/ 20 years) 100,000 Pension expense$700,000 Pension Expense Including Amortization of Prior Service Cost

54. 54 The 2007 pension expense includes $100,000 amortization of prior service cost ($2,000,000/ 20 years). Therefore, the company must record an adjusting entry to increase 2007 Other Comprehensive Income. Pension Expense Including Amortization of Unrecognized Prior Service Cost Accrued/Prepaid Pension Cost100,000 Other Comprehensive Income100,000

55. 55 Balance-PBO Projected Benefit Obligation 400,000 Service cost 2007 2,000,000Prior service cost 200,000 Interest on 1/1/07 PBO 2,600,000Bal. 1/1/08

56. 56 Pension Expense702,450 Prepaid/Accrued Pension Cost12,550 Cash 715,000 December 31, 2008: Service cost (assumed)$420,000 Interest cost ($2,600,000 x 10%)260,000 Expected return on plan assets ($705,000 x 11%)(77,550) Amortization of prior service cost 100,000 Pension expense$702,450 Service cost (assumed)$420,000 Interest cost ($2,600,000 x 10%)260,000 Expected return on plan assets ($705,000 x 11%)(77,550) Amortization of prior service cost 100,000 Pension expense$702,450 Pension Expense Including Amortization of Prior Service Cost

57. 57 The 2008 pension expense also includes $100,000 amortization of prior service cost so the company must record an adjusting entry to increase 2008 Other Comprehensive Income. Pension Expense Including Amortization of Prior Service Cost Accrued/Prepaid Pension Cost100,000 Other Comprehensive Income100,000

58. 58 Balance-PBO Projected Benefit Obligation 400,000 Service cost 2007 Benefits paid 2,000,000Prior service cost to retirees 200,000 Interest on 1/1/07 PBO in 2008 420,000 Service cost 2008 20,000 260,000 Interest on 1/1/07 PBO 3,260,000Bal. 1/1/09

59. 59 Balance-Plan Assets Plan Assets Cash from 2007 705,000 Paid to Return in 200884,600 retirees Cash from 2008 715,000 2008 20,000 Bal. 1/1/09 1,484,600

60. 60 Pension Expense694.694 Accrued/Prepaid Pension Cost35,306 Cash 730,000 December 31, 2009: Pension Expense Including Amortization of Prior Service Cost Service cost$432,000 Interest cost ($3,260,000 x 10%)326,000 Expected return on plan assets ($1,484,600 x 11%)(163,306) Amortization of prior service cost 100,000 Pension expense$694,694 Service cost$432,000 Interest cost ($3,260,000 x 10%)326,000 Expected return on plan assets ($1,484,600 x 11%)(163,306) Amortization of prior service cost 100,000 Pension expense$694,694

61. 61 According to FASB Statement No. 132R and 158, a company must disclose specific information about a defined benefit pension plan, including the following: Disclosures

62. 62 1.A reconciliation of the beginning and ending balances of the projected benefit obligation. 2.A reconciliation of the beginning and ending balances of the fair value of the plan assets. Disclosures 3.The components and amount of pension expense. 4.The discount rate, the rate and the expected long-term rate of return on the plan assets.

63. 63 Required Funding A company must fund its pension plan each year at an amount that at least equals the service cost for the year plus the amount needed to amortize any underfunding over a maximum of seven years.

64. 64 Summary of Journal Entries 1.Pension expense. Entries to Accrued/Prepaid Pension Cost and Other Comprehensive Income 2.Record prior service cost. 3.Record difference between expected return and actual return. 4.Record amortization of prior service cost. 5.Record amortization of cumulative gain or loss. 6.Record changes in PBO (not illustrated in text). ---------------------------------------------------- 7.Close Other Comprehensive Income to Accumulated Other Comprehensive Income

65. 65 FASB Statement No. 88 requires that a company record a loss and a liability for termination benefits when the following two conditions are met: 1.The employee accepts the offer, and 2.The amount can be reasonably estimated. Termination Benefits Paid to Employees

66. 66 Many companies offer additional benefits to former employees after their retirement--widely referred to as OPEB. What are the major differences between postretirement healthcare benefits and pensions? Other Postemployment Benefits

67. 67 BeneficiaryRetired employee (someRetired employee, residual benefit tospouse, and surviving spouse)dependents BenefitsDefined, fixed dollar Not limited, paid as amount, paid monthlyused, varies geographically FundingFunding legally requiredUsually not funded and tax deductiblebecause not legally required and not tax deductible Item Pensions Healthcare Other Postemployment Benefits

68. 68 1.Service cost 2.Interest cost 3.Expected return on plan assets 4.Amortization of prior service cost 5.Amortization of net gain or loss The net postretirement benefit expense includes the following components: OPEB Benefits

69. 69 Livingston Company adopts a healthcare plan for retired employees on January 1, 2007. At that time the company has two employees and one retired employee. The discount rate is 10%, all employees were hired at age 25 and will become eligible for full benefits at age 55. The retired employee was paid $1,500 postretirement healthcare benefits in 2007. The company determines its accumulated postretirement benefit obligations to be $100,000. ContinuedContinued Illustration of Accounting for OPEB

70. 70 Service cost (actuarially determined)$ 1,100 Interest cost ($100,000 x 0.10)10,000 Expected return on plan assets0 Amortization of prior service cost ($100,000 ÷ 5)20,000 Gain or loss0 Postretirement Benefit Expense$31,100 Service cost (actuarially determined)$ 1,100 Interest cost ($100,000 x 0.10)10,000 Expected return on plan assets0 Amortization of prior service cost ($100,000 ÷ 5)20,000 Gain or loss0 Postretirement Benefit Expense$31,100 ContinuedContinued Illustration of Accounting for OPEB

71. 71 Other Comprehensive Income100,000 Accrued Postretirement Benefit Cost100,000 January 1, 2007 Illustration of Accounting for OPEB Postretirement Benefit Expense31,100 Accrued Postretirement Benefit Cost31,100 December 31, 2007

72. 72 Accrued Postretirement Benefit Cost1,500 Cash1,500 To record the payment of retirement benefits Illustration of Accounting for OPEB Accrued Postretirement Benefit Cost20,000 Other Comprehensive Income20,000 To record amortization of prior service cost

73. 73 C hapter 20 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.