2. Intermediate Financial Accounting Accounting for Employee Benefits

3. pensions2 Chapter Objectives n To identity types of pension plans and their characteristics. n To discuss alternative measures for valuing the pension obligation. n Identify the components of pension expense. n Utilize a work sheet for employer's plan entries.

4. pensions3 Chapter Objectives (contd.) n Discuss the amortization of Unrecognized prior service costs. n Discuss the accounting procedure for unrecognized gains and losses. n Explain the corridor approach to amortize unrecognized gains and losses.

5. pensions4 Chapter Objectives (contd.) n Discuss the transition cost. n Describe the pension reporting in financial statements. n Discuss pension terminations.

6. pensions5 Pension Plans n 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.

7. pensions6 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.

8. pensions7 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.

9. pensions8 Types of Pension Plans (contd.) n The accounting for defined contribution plan simply recognizes compensation expense for the amount of the contribution as follows: Pension expense $$$ Cash $$$ n T his chapter focus on the complex accounting issues of a defined benefit plan.

10. pensions9 Defined Benefit Plans n A defined benefit plan may be funded or unfunded. n 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.

11. pensions10 Defined Benefit Plans (contd.) n 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. n T he Pension Reform Act of 1974 has eliminated unfunded plans. n However, some plans are underfunded.

12. pensions11 Defined Benefit Plans (contd.) n The amounts needed to fund a pension plan are estimated by actuaries. n In addition, a defined benefit plan can be contributory or non contributory.

13. pensions12 Contributory Plans n Under a contributory plan, an employee bears part of the cost and makes contributions from his/her salary into the pension fund. n For the non-contributory plans, the entire cost is borne by the employer. n This chapter is concerned with the non- contributory plan.

14. pensions13 Contributory Plans (contd.) n For a qualified plan, the Internal Revenue Code allows: 1.Employers contribution are tax deductible 2.Pension fund earnings are tax exempt.

15. pensions14 Contributory Plans (contd.) 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.

16. pensions15 Contributory Plans (contd.) 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.

17. pensions16 Contributory Plans (contd.) 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.

18. pensions17 Historical Prospective of Pension Plans 1. 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.

19. pensions18 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.

20. pensions19 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”.

21. pensions20 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. n The discussion of pension accounting in this chapter is based on SFAS 87 and SFAS 158.

22. pensions21 Pension Obligation n Pension obligation (liability): The deferred compensation that companies have promised to their employees for their service under the terms of pension plan.

23. pensions22 Alternative Measures of Pension Obligation a. 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.

24. pensions23 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.

25. pensions24 Capitalization vs. Non-Capitalization n Capitalization (accrual basis): Pension liability is recognized in the balance sheet. n Non capitalization: Pension liability is only reported in the footnotes (off- balance-sheet financing). n Prior to FASB No. 87, the accounting for pension plan was a non- capitalization approach.

26. pensions25 Capitalization vs. Non Capitalization n FASB No. 87 adopts a partial capitalization approach. n SFAS No. 158 also adopts a partial capitalization approach.

27. pensions26 Pension Liability n 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. n Pension liability will only be reduced when benefits are paid. n Funding of pension plans does not reduce pension liability.

28. pensions27 Pension Liability (contd.) n The funded assets are considered as a pledged collateral against pension liability. n Pension liability is affected by two factors: u employers’ promises (↑ pension lia.) u the benefit payment (↓ pension lia.)

29. pensions28 Pension Liability (contd.) u Therefore, the under or overfunding pension plans does not affect pension liabilities at all.

30. 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 $$$ Pension Assets $$$ pensions29

31. 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 $$$ pensions30

32. 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. pensions31

33. SFAS 158 (partial accrual basis) n SFAS 158 intends to improve pension reporting by requiring companies recognize the funded status of defined benefit postretirement plans on the financial statement. n The funded status is the difference of the fair value of the plan assets and the projected pension obligation. pensions32

34. 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. pensions33

35. 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. pensions34

36. 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. pensions35

37. 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. pensions36

38. 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. pensions37

39. pensions38 Pension Cost of SFAS 87 n 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

40. 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 pensions39

41. pensions40 Pension Cost 1.(+) Service Cost n The present value of the new benefits earned by the employees during the year. The service cost for the year is provided by actuary. n Effect on pension expense: increases pension expense.

42. pensions41 Pension Cost 2.(+) Interest on the Liability n Interest expense accrues each year on the projected benefit obligation using a settlement rate. n Effect: increases pension expense.

43. pensions42 Pension Cost 3. (-) Expected Return on Plan Assets n 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. n Effect: decreases pension expense. n Expected return = actual return + unexpected loss or – unexpected gain

44. pensions43 Pension Cost 4. (+) Amortization of Unrecognized Prior Service Cost (PSC) n 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. n PSC are amortized as pension expense over the remaining service years of active employees to reduce earnings volatility. n Effect: increases pension expense.

45. pensions44 Pension Cost 5.(- or +) Amortization of Unrecognized Net Gain or Loss n 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.

46. pensions45 Pension Cost 5.(- or +) Amortization of Unrecognized Net Gain or Loss (contd.) n 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. n The amortized net gain or loss is a component of the pension expense.

47. pensions46 Pension Cost 5.(- or +) Amortization of Unrecognized Net Gain or Loss (contd.) n An amortization of a net gain (loss) will reduce (increase) pension expense. n 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.

48. pensions47 + Interest on liability Pension Expense - Expected return on plan asset + or - Gain or loss + Amortization of prior service cost + Service cost for the year The components of pension expense are exhibited in the diagram below.

49. pensions48 Accounting for Pension Example 1 n 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. n The following facts apply to the pension plan for the year 20x2:

50. pensions49 Example 1 (contd.) n Plan assets, January 1, 20x2, are $100,000. n Projected benefit obligation, January 1, 20x2, is $100,000. n Annual service cost for 20x2 is $9,000. n Settlement rate for 20x2 is 10%. n Actual and expected return on plan assets for 20x2 is $10,000. n Contributions (funding) in 20x2 are $8,000. n Benefits paid to retirees in 20x2 are $7,000.

51. pensions50 Example 1 (contd.) n Using the data presented above, the work sheet presents the beginning balances and all of the pension entries recorded by Zarle Company in 20x2. n 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.

52. pensions51 Example 1 (contd.) n The projected benefit obligation and the pension plan assets are not recorded in the formal general journal. n Thus, they are not reported as a liability and as an asset in the financial statements of Zarle Company.

53. pensions52 Example 1 (contd.) n They (the benefit obligation and the pension assets) are off-balance-sheet item. n They affect pension expense but are not recorded as assets and liabilities in the balance sheet of employers. n Assumptions for example 1: actual return equals expected return, no prior service costs, and no net gain or loss.

54. pensions53 Accounting for Post Employment Benefits Example 1 (contd.) 20X2

55. pensions54 Example 1 (contd.) n Entry (a) records the service cost component, which increases pension expense $9,000 and increase the liability (projected benefit obligation)$9,000. n 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%).

56. pensions55 Example 1 (contd.) n Entry (c) records the actual return on the plan assets, which increases the plan assets and decreases the pension expense. n 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. n Entry (e) records the benefit payments made to retirees, which results in $7,000 decrease to the plan assets and the projected benefit obligation.

57. pensions56 Example 1 (contd.) n The journal entry on 12/31/x2 is: Pension Expense 9,000 Cash8,000 Pension Liabilities 1,000

58. pensions57 Example 1 (contd.) n The $1,000 of pension liabilities represents the difference between the pension expense and the funded amount. n This also represents a liability because the plan is underfunded by $1,000. n Both the projected benefit obligation,$112,000, and plan assets, $111,000, are off-balance-sheet items.

59. pensions58 Example 1 (contd.) n 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)

60. pensions59 The unrecognized prior service cost (PSC) n 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. n This credit is referred to as the prior service cost. n PSC also represents the retroactive benefit.

61. pensions60 The unrecognized prior service cost (PSC) (contd.) n The PSC is amortized over the remaining service life of the covered active employees. n It is not recognized as pension expense entirely in the year of adoption (or amendment). n The amortized PSC increases the pension expense.

62. pensions61 The unrecognized prior service cost (PSC) (contd.) (skip p56-p63) n The Board prefers a “years-of-service method” in amortizing the PSC. n 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.

63. pensions62 The unrecognized prior service cost (PSC) (contd.) n Zarle amends its pension plan on 1/1/x3 and grants $80,000 of PSC to its employees. n The employees are grouped according to their expected years of retirement as follows:

64. pensions63 The unrecognized PSC (contd.) Number ofExpected GroupEmployeesRetirement on 12/ 31 A40 20x3 B2020x4 C4020x5 D5020x6 E2020x7 ____________ 170

65. pensions64 The unrecognized PSC (contd.) 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 Total 20034020405020170 200420405020130 2005 405020110 2006 502070 2007 20 20 40 40120200 100500

66. pensions65 The unrecognized PSC (contd.) n 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). n The annual amount of amortization based on a $160 cost per service-year is computed as follows:

67. pensions66 Computation of Annual Prior Service Cost Amortization TotalCost PerAmount YearService-Year  Service-Year=Amortization 20x3170$160$27,200 20x4130160 20,800 20x5110160 17,600 20x6 70160 11,200 20x7 20160 3,200 500$80,000

68. pensions67 An Alternative Method in Amortizing the PSC n SFAS No. 87 allows employers to use a straight-line method to amortize the PSC over the average remaining service life of the employees. n In this case, with 500 service years and 170 employees, the average remaining service life is 2.94 years (500 / 170).

69. pensions68 An Alternative Method in Amortizing the PSC (contd.) n 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.

70. pensions69 Recognition of the PSC (under SFAS 87) n 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. n This amortization will increase the pension expense.

71. Recognition of the PSC (under SFAS 158) n Under SFAS 158, the following entry is required to recognize PSC as liability immediately to reflect the funded status on the balance sheet: n OCI – PSC $$$ Pension Liability $$$ n OCI = other comprehensive item (reported in the equity section of the balance sheet) n 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. pensions70

72. pensions71 Example 2 (with the PSC) n Continuing the Zarle Company illustration into 20x3, the amendment on 1/1/x3 grants employees' PSC with a present value of $80,000. n In addition, the following facts also apply to pension plan of Zarle for the year of 20x3:

73. pensions72 Example 2 (with the PSC) n Annual service cost for 20x3 is $9,500. n Settlement rate for 20x3 is 10%. n Actual and expected return on plan assets for 20x3 is $11,100. n Annual contributions* (funding) are $20,000. n Benefits paid to retirees in 20x3 are $8,000. n Amortization of prior service cost (PSC) using the years-of -service method is $27,200.

74. pensions73 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

75. pensions74 Example 2 (contd.) (skip) n The first line of the work sheet shows the beginning balances of the Prepaid/Accrued Pension Cost account and the memo accounts. n 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. n Entries (g), (h), (i), (k),(l) are similar to the corresponding entries in 20x2.

76. pensions75 Example 2 (contd.) (skip) n 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.

77. Example 2 (contd.) (skip) n 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. pensions76

78. Example 2 (contd.) (skip) n The reconciliation (eliminated by SFAS158) of prepaid/accrued pension cost and the off- balance-sheet items is in the following schedule: Reconciliation Schedule--December 31,20x3 Projected 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) pensions77

79. 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 pensions78

80. Applying SFAS 158 to Example 2 n Based on SFAS 158, the following entry is recorded on 1/1/20x3 to reflect the funded status and to prevent earnings volatility: n OCI-PSC* 80,000 n Pension liabilities 80,000 n *This entry is to recognize the PSC arising during 20x3. n *OCI (Other Comprehensive Income- an equity account) would be amortized as pension expense annually over the remaining service life of active employees. pensions79

81. pensions80 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

82. pensions81 Applying SFAS 158 to Example 2 n 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. n 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.

83. pensions82 Applying SFAS 158 to Example 2 n SFAS No. 158 improves the reporting of pension liabilities by requiring the pension liabilities reported equal the funded status (i.e., $78,600 underfunding). n SFAS 158 does Not require the projected pension benefit obligation (PBO) and pension assets be reported on the balance sheet. n A full capitalization approach would require the PBO and pension assets be reported on the balance sheet.

84. Applying SFAS 158 to Example 2 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. pensions83

85. 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). pensions84

86. pensions85 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.

87. pensions86 A. Smoothing unexpected gains and losses on plan assets returns n The actual return on plan assets reduces pension expense. n 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. n Therefore, the calculation of pension expense is reduced by the expected return on assets, not the actual return.

88. pensions87 A. Smoothing unexpected gains and losses on plan assets returns (cotd.) n 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. n This difference is referred to as the unexpected gain (i.e., actual return > expected return) or unexpected loss (actual return < expected return).

89. pensions88 A. Smoothing unexpected gains and losses on plan assets returns – An Example n Assume that Shierer Company in 20x4 has an actual return of $12,000 while the expected return is $13,410. n The actual return, $12,000, is subtracted from pension expense and followed by the subtraction of the unexpected loss, $1,410. n Thus, the pension expense is reduced by the expected, not the actual return on pension assets. n Thus, the unexpected loss will decrease pension expense.

90. pensions89 A. Smoothing unexpected gains and losses on plan assets returns (cotd.) n In addition, the following entry is recorded under SFAS 158 to reflect the funded status in the balance sheet: n O.C.I.- Net Gain/Loss 1,410 n Pension liability 1,410

91. pensions90 B. Smoothing unexpected gains and Losses in the pension liability n In estimating the projected pension obligation, the actuaries make assumptions about items such as retirement rate, turnover rate, disability rate, and salary amount, etc. n Any changes in these actuarial assumptions will change the amount of projected pension obligation.

92. pensions91 B. Smoothing unexpected gains and Losses in the pension liability n The unexpected gains or losses from changes in the projected pensions obligation are called “liability gains and losses.” n Liability gains and liability losses (unexpected increase in the liability) are recognized under SFAS 158 using the following entry: n OCI- Net Gain/Loss $$ n Pension Liability $$ n

93. pensions92 B. Smoothing unexpected gains and Losses in the pension liability (contd.) n 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. n The OCI –net gain/loss are accumulated from year to year and is reported in the equity section of the balance sheet..

94. pensions93 Corridor Amortization n 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. n But, it is possible that no offsetting occurs and that the OCI –net gain/loss balance in the account continues to grow.

95. pensions94 Corridor Amortization (contd.) n 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. n The OCI -net gain or loss balance need to be amortized only when it exceeds the arbitrarily selected FASB criterion.

96. pensions95 Corridor Amortization (contd.) n 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.

97. pensions96 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-BenefitAssetCorridor* Year Balance Obligation Value +/- 10% 20x1$1,000,000$ 900,000$100,000 20x2$1,200,0001,100,000120,000 20x3$1,300,0001,700,000170,000 20x4$1,500,0002,250,000225,000 20x5$1,700,0001,750,000175,000 20x6$1,800,0001,700,000180,000 * The corridor is 10% of the larger of the projected benefit obligation or the market-related plan asset value.

98. pensions97 Corridor Amortization (contd.) n 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.

99. pensions98 Corridor Amortization (contd.) n 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.

100. pensions99 Corridor Amortization (contd.) n 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. n The method should also be disclosed.

101. pensions100 Corridor Amortization (contd.) 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.

102. pensions101 Corridor Amortization Example (skip 96-98) n 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 value2,600,0002,800,0002,700,000 OCI – net gain/ net loss-0-400,000300,000

103. pensions102 Corridor Amortization Example (contd.) n 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 20X3 20X4 20X2

104. pensions103 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.

105. pensions104 The Corridor Approach n As indicated from the schedule, the OCI – net gain/loss amoritzed in 20x3 increased pension expense by $21,818. n This amount is small in comparison with the total loss of $400,000. n Thus, the corridor approach reduces volatility of these gains and losses on pension expense.

106. pensions105 Summary of Gain and Loss Adjustment n 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. n Unexpected gain on asset return increases pension expense while unexpected loss on asset return decreases pension expense.

107. pensions106 Summary of Gain and Loss Adjustment n The amortization of OCI – net gain/loss at the beginning of the year is subject to the corridor limitation.

108. pensions107 Summary of Gain and Loss Adjustment (contd.) n Only if the OCI – net gain/loss exceeds the corridor, these OCI net gains or losses are subject to amortization. n This amortization is computed by dividing the net gains or loses over the average service period. n Amortization of OCI - net gain will reduce pension expense while amortization of net loss will increase pension expense.

109. pensions108 Example 3: With Unrecognized Net Gain or Loss n Continuing the Zarle company illustration into 20x4, the following facts apply to the pension plan: n Annual service cost for 20x4 is $13,000. n Settlement rate is 10%;expected earnings rate is 10%. n Actual return on plan assets for 20x4 is $12,000. n Amortization of prior service cost (PSC) in 20x4 is $20,800.

110. pensions109 Example 3: With Unrecognized Net Gain or Loss n Annual contributions (funding) are $24,000 n Benefits paid to retirees in 20x4 are $10,500. n Changes in actuarial assumptions establish the end-of-year projected benefit obligation at $265,000.

111. pensions110 Example 3 (Contd.) (skip 105-109) n The 2004 pension work sheet of Zarle is presented as follows: (under SFAS 87) 20X3 20X4 Dr.

112. Example 3 (contd.) (skip) n In 20x4 the expected return of $13,410 is higher than the actual return of $12,000. n To smooth pension expense, the net gain or loss item is debited for $1,410 and the Pension Expense is credited for $1,410. n As a result of this adjustment, the expected return on the plan assets is the amount actually used to compute the pension expense. pensions111

113. Example 3 (contd.) (skip) n Entry (t) records the changes in the projected benefit obligation resulting from a change in actuarial assumptions. n As indicated, the actuary has now computed the ending balance to be $265,000 n 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. pensions112

114. Example 3 (contd.) (skip) n This $28,530 will increase (credit) employer’s benefit obligation and will also be added (debit) to the Unrecognized Net gain or Loss account. n By debiting it to the Unrecognized Net gain or Loss account, this $28,530 difference is deferred (not recognized) pensions113

115. Example 3 (contd.) (skip) 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 pensions114

116. 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. pensions115

117. Example 3 (contd.) (Applying SFAS 158) n The journal entry on December 31 to record pension expense for 20x4 under SFAS 158 is as follow (Ignore income tax effect ): n Pension Expense41,660 Pension Liabilities 3,140 Cash24,000 Other Comp. Income* 20,800 *Amortize PSC as pension exp. pensions116

118. 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) pensions117

119. Example 3 (contd.) (Applying SFAS 158) n The bal. of pension lia. after the above entries is: n $78,600 (beg. Bal.) -$3140+ $29,940 =$105,400 n $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). pensions118

120. 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 354 pensions119

121. pensions120 Transition Obligations (TO) n The transition obligations are calculated as: Balance at transition (1985): Projected benefit obligations (220) Plan assets 70 Transition Obligation 150

122. pensions121 Amortization of Transaction Liability n The transition liability is amortized using a straight-line method over the average remaining service life of employees. n This amortization is the sixth component of pension expense. n This treatment is to avoid an immediate recognition of the transition liability (i.e., income smoothing).

123. pensions122 Amortization of Transition Obligation(contd.) n This transition obligation is mostly or fully amortized by now due to SFAS 87 became effective in 1985. n 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. n The amortized transition obligation will be another component of the pension expense.

124. pensions123 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.

125. pensions124 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.

126. pensions125 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.

127. pensions126 The Implementation of Statement of Financial Accounting Standards No. 158 n 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.www.fasb.org n

128. pensions127 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.

129. pensions128 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

130. pensions129 Footnote Disclosure for Pensions n The following information should be disclosed a : n 1. A schedule showing all the major components of pension expense should be reported. n a. These disclosure requirements are based on SFAS No. 132: Employers' Disclosure about Pensions and Other Postretirement Benefits.

131. pensions130 Footnote Disclosure for Pensions(contd.) n 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). n 3. The rates used in measuring the benefit amounts.

132. pensions131 Pension Disclosure- Components of Pension Expense n The disclosure of the pension expense components include: n a. Service cost. n b. Interest cost. n c. Expected return on assets. n d. Other deferrals and amortization.

133. pensions132 Pension Disclosure- Components of Pension Expense (Contd.) n The components of pension expense of Zarle Company for 20x2,20x3 and 20x4 are as follows:

134. pensions133 Pension Disclosure- Reconciliation of PBO & Fair Value of Plan Assets n The changes in plan assets and benefit obligation of Zarle for year s 20x2,20x3 and 20x4 are as follows:

135. pensions134 Pension Disclosure- Rates Used in Measuring the Benefit Amounts n Assumptions used in determining plan information are:

136. pensions135 Pension terminations n Employers sometimes perceive overfunded pension plans as company piggy banks. n Companies cannot obtain the excess assets unless the plans are terminated. n To terminate pension plans, companies must pay participants what they owed to them (ERISA's requirement).

137. pensions136 Pension terminations (contd.) n Thus, companies can buy annuities to pay off the pension claimants and uses the excess fund for other purposes. n 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.

138. pensions137 Pension terminations (contd.) n The question is: whose money is the excess assets of an overfunded pension plan?? The company or the plan participants?