1. Unit 6 Seminar Accounting for Postemployment Benefits

2. 2 A pension plan requires that a company provide income to its retired employees for the services they provided during their employment. Characteristics of Pension Plans

3. 3 A defined benefit plan specifically states either the benefits to be received by employees after retirement or the method of determining such benefits. The method usually is determined on the basis of the employee’s earnings and length of service with the company. Defined Benefit Plans $100,000 average salary × 30 years × 0.0257 = $77,100 pension per year $100,000 average salary × 30 years × 0.0257 = $77,100 pension per year

4. 4 Most companies design their pension plans to meet the Internal Revenue Code rules: 1.There is a maximum amount of employer contributions that is deductible for income tax purposes. 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 Code Rules

5. 5 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

6. 6 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

7. 7 The service cost is the actuarial present value of the benefits attributed by the pension benefit formula to services rendered by the employees during the current period. Service Cost

8. 8 The interest cost is the increase in the projected benefit obligation due to the passage of time. Interest Cost

9. 9 The expected return on plan assets, if positive, will decrease pension expense. Expected Return on Plan Assets The expected return on plan assets is the expected increase in plan assets due to investing activities.

10. 10 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

11. 11 The cost of these retroactive benefits is the prior service cost. Prior Service Cost The prior service cost is reported as a liability and as a negative element of other comprehensive income at the date of the plan amendment.

12. 12 The prior service cost is amortized by assigning an equal amount to each future service period of each active employee who, at the date of the amendment, is expected to receive future benefits under the plan. Prior Service Cost Alternatively, straight-line amortization over the average remaining service life of active employees may be used for simplicity.

13. 13 A gain or loss from previous periods from changes in the amount of the projected benefit obligation and the fair value of the pension plan assets resulting from experience different from that assumed, and changes in the assumptions. Gain or Loss

14. 14 Any gain or loss that is not recognized in pension expense in the period it occurs is recognized as an asset or liability and as a component of other comprehensive income. Gain or Loss Accrued/Prepaid Pension Costxxx Other Comprehensive Income: Net Gain/Lossxxx

15. 15 Amortization of Gain or Loss  Amortization of any net gain or loss is included in the pension expense of a given year if, at the beginning of the year, the cumulative net gain or loss from previous periods (included in accumulated other comprehensive income) exceeds a “corridor.”  The “corridor” is defined as 10% of the greater of the actual projected benefit obligation or the fair value of the plan assets.

16. 16 Components of Pension Expense + Service cost (Present value of benefits earned during the year using the discount rate) + Interest cost (Projected benefit obligation at beginning of the year × Discount rate) – Expected return on plan assets (Fair value of plan assets at the beginning of the year × Expected long-term rate of return on plan assets) + Amortization of prior service cost (Present value of additional benefits granted at adoption or modification of the plan amortized over the remaining service lives of active employees) + Gain or loss (Amortization of the cumulative net gain or loss from previous periods in excess of the corridor) = Pension Expense

17. Ending Projected Benefit Obligation: Beginning projected benefit obligation + Prior service cost = Adjusted beginning projected benefit obligation + Service cost for period + Interest cost on beginning projected benefit obligation + Actuarial losses (or – Actuarial gains) – Payments to retirees = Ending projected benefit obligation 17 Projected Benefit Obligation

18. 18 Fair Value of Pension Plan Assets Ending Fair Value of Pension Plan Assets: Beginning fair value of pension plan assets + Actual return on plan assets + Contributions (amounts funded) by the company – Payments to retirees = Ending fair value of pension plan assets

19. 19 1.The company adopts a pension plan on January 1, 2010. No retroactive benefits were granted to employees. 2.The service cost each year is: 2010, $400,000; 2011, $420,000; 2012, $432,000. 3.The projected benefit obligation at the beginning of each year is: 2011, $400,000; and 2012, $840,000. Pension Expense Equal to Pension Funding Assume the following facts for the Carlisle Company: ContinuedContinued

20. 20 4.The discount rate is 10%. 5.The expected long-term rate of return on plan assets is 10%, which is also equal to the actual rate of return. 6.The company adopts a policy of funding an amount equal to the pension expense and makes the payment to the funding agency at the end of each year. 7.Plan assets are based on the amounts contributed each year, plus a return of 10% per year, less an assumed payment of $20,000 to retired employees (beginning in 2011). Pension Expense Equal to Pension Funding

21. 21 Pension Expense Equal to Pension Funding December 31, 2010 Pension Expense400,000 Cash 400,000 December 31, 2011 Pension Expense420,000 Cash 420,000 Service cost$420,000 Interest cost ($400,000 × 10%)40,000 Expected return on plan assets ($400,000 × 10%) (40,000) Pension expense$420,000 Service cost$420,000 Interest cost ($400,000 × 10%)40,000 Expected return on plan assets ($400,000 × 10%) (40,000) Pension expense$420,000

22. 22 2011 Projected Benefit Obligation Projected Benefit Obligation 400,000 Beginning projected benefit obligation (2010) 420,000 Service cost (2011) 40,000 Interest cost (2011) Payment to retired employees (2011) 20,000 840,000 Balance 1/1/12

23. 23 2011 Fair Value of Pension Plan Assets Pension Plan Assets Beginning fair value (2010) 400,000 Actual return on plan assets (2011) 40,000 Contribution (2011) 420,000 20,000 Payment to retired employees (2011) Balance 1/1/12 840,000

24. 24 Note that the interest cost and the return on the plan assets offset each other each year Pension Expense Equal to Pension Funding December 31, 2012 Pension Expense432,000 Cash 432,000 Service cost (assumed)$432,000 Interest cost ($840,000 × 10%)84,000 Expected return on plan assets ($840,000 × 10%) (84,000) Pension expense$432,000 Service cost (assumed)$432,000 Interest cost ($840,000 × 10%)84,000 Expected return on plan assets ($840,000 × 10%) (84,000) Pension expense$432,000

25. 25 As required by GAAP, the prior service cost 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 Income: Prior Service Cost2,000,000 Accrued/Prepaid Pension Cost2,000,000

26. 26 December 31, 2010 Pension Expense700,000 Accrued/Prepaid Pension Cost5,000 Cash 705,000 Service cost$400,000 Interest cost ($2,000,000 × 10%)200,000 Amortization of prior service cost 100,000 Pension expense$700,000 Service cost$400,000 Interest cost ($2,000,000 × 10%)200,000 Amortization of prior service cost 100,000 Pension expense$700,000 Pension Expense Including Amortization of Prior Service Cost

27. 27 The 2010 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 2010 other comprehensive income. Pension Expense Including Amortization of Prior Service Cost Accrued/Prepaid Pension Cost100,000 Other Comprehensive Income: Prior Service Cost100,000

28. 28 2010 Projected Benefit Obligation Projected Benefit Obligation 2,000,000 Beginning projected benefit obligation (2010) 400,000 Service cost (2010) 200,000 Interest cost (2010) 2,600,000 Balance 1/1/11

29. 29 2010 Fair Value of Pension Plan Assets Pension Plan Assets Beginning fair value (2010) 0 Actual return on plan assets (2010) 0 Contribution (2010) 705,000 Balance 1/1/11 705,000

30. 30 December 31, 2011 Pension Expense702,450 Accrued/Prepaid Pension Cost12,550 Cash 715,000 Service cost$420,000 Interest cost ($2,600,000 × 10%)260,000 Expected return on plan assets ($705,000 × 11%)(77,550) Amortization of prior service cost 100,000 Pension expense$702,450 Service cost$420,000 Interest cost ($2,600,000 × 10%)260,000 Expected return on plan assets ($705,000 × 11%)(77,550) Amortization of prior service cost 100,000 Pension expense$702,450 Pension Expense Including Amortization of Prior Service Cost

31. 31 The 2011 pension expense also includes $100,000 amortization of prior service cost so the company must record an adjusting entry to increase 2011 other comprehensive income. Pension Expense Including Amortization of Prior Service Cost Accrued/Prepaid Pension Cost100,000 Other Comprehensive Income: Prior Service Cost100,000

32. 32 2011 Projected Benefit Obligation Projected Benefit Obligation 2,000,000 Beginning projected benefit obligation (2010) 420,000 Service cost (2011) 260,000 Interest cost (2011) Payment to retired employees (2011) 20,000 3,260,000 Balance 1/1/12

33. 33 2011 Fair Value of Pension Plan Assets Pension Plan Assets Beginning fair value (2010) 705,000 Actual return on plan assets (2011) 84,600 Contribution (2011) 715,000 20,000 Payment to retired employees (2011) Balance 1/1/12 1,484,600

34. The actual return on plan assets was $7,050 higher than the expected return. Therefore, Other Comprehensive Income should be credited. Recognition of Gain on Plan Assets Accrued/Prepaid Pension Cost7,050 Other Comprehensive Income: Net Gain/Loss7,050 34

35. 35 December 31, 2012 Pension Expense694,694 Accrued/Prepaid Pension Cost35,306 Cash 730,000 Service cost$432,000 Interest cost ($3,260,000 × 10%)326,000 Expected return on plan assets ($1,484,600 × 11%)(163,306) Amortization of prior service cost 100,000 Pension expense$694,694 Service cost$432,000 Interest cost ($3,260,000 × 10%)326,000 Expected return on plan assets ($1,484,600 × 11%)(163,306) Amortization of prior service cost 100,000 Pension expense$694,694 Pension Expense Including Amortization of Prior Service Cost

36. 36 The 2012 pension expense also includes the $100,000 amortization of prior service cost, so the company must record an adjusting entry to increase 2012 other comprehensive income. Pension Expense Including Amortization of Prior Service Cost Accrued/Prepaid Pension Cost100,000 Other Comprehensive Income: Prior Service Cost100,000

37. 37 Difference Between Expected and Actual Return December 31, 2012 Accrued/Prepaid Pension Cost14,846 Other Comprehensive Income: Net Gain/Loss14,846 Because the 12% actual return is $178,152, which is $14,846 higher than the $163,306 expected return, a journal entry must be made to Accrued/Prepaid Pension Cost and Other Comprehensive Income for the year.

38. 38 The average remaining service life of employees expected to receive benefits is calculated by dividing the expected years of service for all employees by the number of employees. Calculation of Amortization of Prior Service Cost: Straight-Line Amortization Average Remaining Service Life Expected Years of Service Number of Employees =

39. 39 The preferred method assigns an equal amount to each future service period for each active participating employee who is expected to receive future benefits under the plan. Calculation of Amortization of Prior Service Cost: Years-of-Future-Service Method

40. 40 1.Amortization of any net loss from previous periods is added to compute pension expense. 2.Amortization of any net gain from previous periods is deducted to compute pension expense. 1.Amortization of any net loss from previous periods is added to compute pension expense. 2.Amortization of any net gain from previous periods is deducted to compute pension expense. Amortization of Gain or Loss

41. 41 According to GAAP, a company must disclose specific information about a defined benefit pension plan, including the following: Disclosures

42. 42 1.A reconciliation of the beginning and ending amounts of the projected benefit obligation 2.A reconciliation of the beginning and ending fair value of the plan assets Disclosures 3.The components of the pension expense 4.The discount rate used and the expected long- term rate of return on plan assets

43. 43 1.Funding to funding agency is a discharge of the pension liability. 2.Pension liability is not discharged until the retiree receives the pension payment. Conceptual Alternatives: Balance Sheet Presentation of Pension Plan Assets GAAP requires alternative 2.

44. 44 Pension Legislation 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.

45. 45 Summary of Journal Entries 1.Record pension expense. 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 projected benefit obligation (not illustrated in text). ---------------------------------------------------- 7.Close Other Comprehensive Income to Accumulated Other Comprehensive Income. Entries to Accrued/Prepaid Pension Cost and Other Comprehensive Income:

46. 46 GAAP 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. 2.The amount can be reasonably estimated. Termination Benefits Paid to Employees

47. 47 IFRS vs. U.S. GAAP 1.IFRS allow companies to report the components of pension expense in different line items on the income statement. For example, interest cost and the expected return on plan assets may be included with other interest expense and other investment income. The basic principles of accounting for defined benefit plans under IFRS are the same as U.S. GAAP. However, there are some differences. ContinuedContinued

48. 48 IFRS vs. U.S. GAAP 2.IFRS require any prior service cost that is vested immediately to be expensed in full on the income statement. If the prior service cost is not vested, IFRS do not allow the prior service cost to be recognized on the balance sheet as a component of accumulated other comprehensive income. Instead, these costs are amortized on a straight-line basis until they vest. ContinuedContinued

49. 49 IFRS vs. U.S. GAAP 3.IFRS allow actuarial gains and losses to be recognized by either amortizing them into income using a “corridor” approach or in full in the period in which they occur as other comprehensive income. If a company chooses to recognize the gain or loss directly in equity, it is not permitted to amortize this amount to expense. Therefore, IFRS allow recognition of gains and losses that is completely outside of the income statement. ContinuedContinued

50. 50 4.IFRS allow defined benefit accounting for multi-employer plans, whereas U.S. GAAP requires such plans to be accounted for on a defined contribution basis. Finally, it is important to understand that it is common for foreign governments to provide significantly higher state-funded benefits to retirees. Therefore, pension benefits provided by foreign companies are less likely to have a material effect on their financial statements. IFRS vs. U.S. GAAP

51. 51 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

52. 52 BeneficiaryRetired employee (someRetired employee, residual benefit tospouse, and dependents surviving spouse) BenefitDefined, fixed dollar Not limited, paid as used, amount, paid monthlyvaries geographically FundingFunding legally requiredUsually not funded and tax-deductible because not legally required and not tax- deductible Item Pensions Healthcare Major Differences Between Postretirement Healthcare Benefits and Pensions

53. 53 1.Service cost 2.Interest cost 3.Expected return on plan assets 4.Amortization of prior service cost 5.Amortization of the net gain or loss The net postretirement benefit expense that a company recognizes includes the following components: OPEB Expense

54. 54 Relevance and Reliability  Accrual accounting more relevant than cash- basis accounting.  Expenses matched with revenues.  Income Statement more relevant by including OPEB expense.  OPEB costs cannot be measured with sufficient reliability.  Health care plans require medical costs, trend rate, and marital and dependency status in retirement.