Pensions & Other Post Employment Benefits – after SFAS No. 158

1. Pensions & Other Post Employment Benefits – after SFAS No. 158 Includes certain slides provided by authors of Skousen, Stice & Stice and Kieso, Weygandt & Warfield Intermediate Accounting textbooks, as modified and adapted by Teresa Gordon

2. Types of plans • Contributory Plan • Non-Contributory Plan • Defined Contribution Plan • Defined Benefit Plan

3. Nature of Pension Plans A Pension Planis an arrangement whereby an employer provides benefits (payments) to employees after they retire for services they provided while they were working. Pension Plan Administrator Contributions Employer Retired Employees Benefit Payments Assets & Liabilities LO 1 Distinguish between accounting for the employer’s pension plan and accounting for the pension fund.

4. Nature of Pension Plans Some pension plans are: • 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 Distinguish between accounting for the employer’s pension plan and accounting for the pension fund.

5. Defined contribution plans • A plan that provides benefits based solely on what has been contributed and the earnings thereon < 401(k) > • Amounts to be funded are determined by the plan • No promise for specific future benefits. • Independent third party holds assets • Risk borne by employee • Accounting relatively straightforward

6. Defined benefit plans • A pension plan that determines the amount of benefit to be provided • Contributions based on estimated amounts needed to meet expected payments • Form versus substance of trust • Risk borne by employer • Accounting by employer is complicated Actuaries estimate the employer contribution by considering mortality rates, employee turnover, interest and earning rates, early retirement frequency, future salaries, etc.

7. Chart from UK but trend is probably same in US

8. Services Wages and Salaries Contributions Pension Fund Retired Employees Defined Benefits Defined Benefit Pension Plan Employer Current Employees

9. Pension Approaches • Before FASB 87 & 88: • “pay as you go” or “noncapitalization” • FASB 87 & 88 • Capitalization approach • Full obligation reported only in notes • FASB 158 • Pension & post-retirement benefit cost is same as FASB 87 • Full obligation is now reported on balance sheet • Additional items now on statement of comprehensive income

10. Accounting for Pensions Recognition of the Net Funded Status 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 3 Explain alternative measures for valuing the pension obligation.

11. Capitalization approach to pensions: • Employer has full liability for benefits related to service already rendered by employee • Expense is recognized as employees work (service cost) and this increases the liability • Liability balance increases every year since present value of future benefits is larger (less time remains to cash outflow) • Liability is reduced through payments to retirees • Assets of the plan are considered pledged, collateral against a liability • Liability less designated assets reported on balance sheet (net presentation)

12. PV of Expected Cash Flows Measures of Pension Liability Benefits for vested and nonvested employees at future salaries Benefits for vested and non- vested employees at current salaries Accumulated Benefit Obligation Projected Benefit Obligation Benefits for vested employees at current salaries Vested Benefit Obligation (GAAP)

13. Interest/return rates • Discount rate • Rates on high-quality fixed-income investments with maturities consistent with expected payments to retirees • Generally equivalent to a portfolio of zero-coupon bonds with appropriate maturities • Expected rate of return • Based on long-term rate of return anticipated given investment of plan assets

14. What happens when • Interest rates increase? • Interest rates decrease?

15. Accounting for Pensions Effect on Expense Components of Pension Expense 1. Service Costs + 2. Interest on the Liability + 3. Actual Return on Plan Assets +- 4. Amortization of Prior Service Costs + 5. Gain or Loss +- LO 4 List the components of pension expense.

16. Pension Items Not Recognized Companies do not recognize two main items in the accounts and in the financial statements: • Projected benefit obligation. • Pension plan assets. A company must disclose in notes to the financial statements, but not in the body of the financials. • Some items are recognized in other comprehensive income; changes in these items are amortized into expense through smoothing techniques. • Prior service costs. • Actuarial gains and losses. LO 5 Use a worksheet for employer’s pension plan entries.

17. A working paper for pensions

18. This is very similar to the one in textbook The “General Journal Entries” columns determine the journal entries to be recorded in the formal general ledger. The “Memo Record” columns maintain balances for the unrecognized pension items. LO 5 Use a worksheet for employer’s pension plan entries.

19. Accounts on Employer’s Books • Net Periodic Pension Cost (Expense) • Amount recognized by the employer on the income statement • Pension expense includes six basic elements (more later) • Other comprehensive income • Up to three amounts reported for changes in balance of AOCI amounts (see next slide)

20. Working Paper – Pension Expense

21. Interest cost = discount rate * beginning balance in PBO Expected return = expected return rate * beginning balance in Plan Assets A working paper for pensions

22. Accounts on Employer’s Books • On balance sheet – Net funded position • When PBO > Plan Assets, reported as noncurrent liability (with current liability if there are inadequate plan assets to cover current payments to retirees) • When Plan Assets > PBO, reported as noncurrent asset

23. A working paper for pensions

24. Accounts on Employer’s Books • Accumulated other comprehensive income (AOCI) • Account appears as part of owners’ equity section of balance sheet • Three pension related balances • Transition gain or loss • Prior service cost • Actuarial gains or losses

25. A working paper for pensions

26. Funded status must equal PBO + Plan Assets Plug to balance JE {row=0} Self-checking features Each blue row must add across to ZERO Balance forwards Balance forwards

27. Net Periodic Pension Cost • Net periodic pension cost (the expense) consists of six basic elements: • Service cost • Interest cost • Expected return on plan assets • Amortization (if any) of • Transition gain or loss • Prior service cost • Unrecognized gain or loss

28. Pension Definitions • Prior Service Cost (PSC) • Cost of benefits granted for service rendered prior to the inception of the plan • Increases PBO at date of amendment but cost is amortized to expense over future years • Reduces funded status since PBO is higher • Recognized as charge to OCI at date of plan amendment • Amortization method recommended: • Years of service method • Straight-line or other methods that amortize PSC faster are also acceptable

29. Actuarial Gains and Losses • Actuarial assumptions are subject to inaccuracies as time goes by and circumstances change • There is a materiality provision for determining when gains and losses are sufficiently large to require amortization (charge to expense) • 10% Corridor Rule

30. 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 7 Explain the accounting for unexpected gains and losses.

31. Gains and Losses Corridor Amortization FASB invented the corridor approachfor 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 (which may equal fair value) of the plan assets. Any accumulated net gain or loss balance above the 10% must be amortized. LO 8 Explain the corridor approach to amortizing gains and losses.

32. Kieso, Weygandt & Warfield 11th ed. Illustration 20-14, page 1034

33. 10% Corridor Amortization • Amortization is required only on the portion of unrecognized net gain or loss that exceeds 10% of the greater of: • PBO at beginning ofyear, or • market-related value of plan assets at the beginning of the year.

34. Settlements & Curtailments • Additional FASB standards govern major changes in pension plans: • Settlements • No further obligations to some or all employees • Curtailments • Results in significant reduction in expected years, or • No further accrual of benefits • Handling will require further research (primarily FASB 88)

35. Pension Disclosures [FAS 132(R)] • Amount and types of assets held • Assumptions related to discount rate, rate of increase in compensation, expected return on plan assets • Alternative amortization policies • Past practice or history of regular benefit increases

36. Pension Disclosures [FAS 132(R)] • The details for net periodic pension cost • the service cost component. • the interest cost component. • the expected return on plan assets [FAS 132] • the amortization of PSC, transition amount and unrecognized gain/loss (separately) • Gain or loss from settlement or curtailment of plan

37. Pension Disclosures:Reconciliations • The fair value of plan assets (changes between BOY and EOY) • PBO Obligation (changes between BOY and EOY) Easily obtained from our work paper! EoY = end of yearBoY = beginning of year

38. Pension Disclosures • Employers with multiple plans • Information can be combined but the computations are made for each individual plan • Net position for over-funded plans would be reported in noncurrent assets • Net position for under-funded plans would be reported in liabilities • Part may be reported as a current liability • See next slide

39. Current portion of liability • The current portion (determined on a plan-by-plan basis) is the amount by which the actuarial present value of benefits in PBO that are payable in the next 12 months* exceeds the fair value of plan assets * As always, the operating cycle might be longer than 12 months in which case we’d use the operating cycle

40. Other Postretirement Benefits FASB 106 Appendix Material in KWW text Also changed by FASB No. 158

41. Other Post-retirement Benefits • The accounting is similar to pension accounting EXCEPT that • the terminology is slightly different • EPBO • APBO

42. Kieso, Weygandt & Warfield 11th ed. Illustration 20A-3, page 1056

43. APBO vs EPBO • Prior to the date on which an employee attains full eligibility for the benefits that employee is expected to earn • APBO < EPBO • On and after the full eligibility date, • APBO = EPBO • In other words • EPBO > APBO until the employee has earned the right to full benefits • EPBO = APBO after the employee has worked long enough to earn full eligibility

44. Kieso, Weygandt & Warfield 11th ed. Illustration 20A-2, page 1056 • Cost attributed to period from hire to eligibility (vesting)

45. Postretirement Benefit Worksheet • Would be the same as a pension worksheet with modified labels at the top • Pension Expense becomes Postretirement Benefit Expense. • PBO becomes APBO.

46. Working paper for FAS106

47. Net periodic postretirement benefit cost. • The expense basically includes the same elements as pension cost: • Service cost -- the actuarial present value of benefits attributed to services rendered by employees during the period. • Interest cost -- the interest on the beginning balance of the accumulated postretirement benefit obligation • Less expected return on plan assets. • Amortizations (transition, prior service cost and unrecognized gain or loss)

48. Comparing FASB 87 & 106

49. iGAAP and U.S. GAAP separate pension plans into defined-contribution plans and defined-benefit plans. The accounting for defined-contribution plans is similar. • For defined-benefit plans, both iGAAP and U.S. GAAP recognize the net of the pension assets and liabilities on the balance sheet. Unlike U.S. GAAP, which recognizes prior service cost on the balance sheet (as an element of “Accumulated other comprehensive income”), iGAAP does not recognize prior service costs on the balance sheet. Both GAAPs amortize prior service costs into income over the expected service lives of employees.

50. Another difference in defined-benefit recognition is that under iGAAP companies have the choice of recognizing actuarial gains and losses in income immediately or amortizing them over the expected remaining working lives of employees. U.S. GAAP does not permit choice. • The IASB has recently issued a discussion paper on pensions proposing: (1) elimination of smoothing via the corridor approach, (2) a different presentation of pension costs in the income statement, and (3) a new category of pensions for accounting purposes—so-called “contribution-based promises.”