978-1259722660 Chapter 17 Lecture Note Part 1

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CHAPTER 17

PENSIONS AND OTHER POSTRETIREMENT BENEFITS

Overview

Employee compensation comes in many forms. Salaries and wages, of course, provide direct and

current payment for services provided. However, it’s commonplace for compensation also to include

benefits payable after retirement. We discuss pension benefits and other postretirement benefits in

this chapter. Accounting for pension benefits recognizes that they represent deferred compensation

for current service. Accordingly, the cost of these benefits is recognized on an accrual basis during

the years that employees earn the benefits.

Learning Objectives

After studying this chapter, you should be able to:

LO17–1 Explain the fundamental differences between a defined contribution pension plan and a

defined benefit pension plan.

LO17–2 Distinguish among the vested benefit obligation, the accumulated benefit obligation, and

the projected benefit obligation (PBO).

LO17–3 Describe the five events that might change the balance of the PBO.

LO17–4 Explain how plan assets accumulate to provide retiree benefits and understand the role of

the trustee in administering the fund.

LO17–5 Describe the funded status of pension plans and how that amount is reported.

LO17–6 Describe how pension expense is a composite of periodic changes that occur in both the

pension obligation and the plan assets.

LO17–7 Record for pension plans the periodic expense and funding as well as new gains and

losses and new prior service cost as they occur.

LO17–8 Understand the interrelationships among the elements that constitute a defined benefit

pension plan.

LO17–9 Describe the nature of postretirement benefit plans other than pensions and identify the

similarities and differences in accounting for those plans and pensions.

LO17–10 Explain how the obligation for postretirement benefits is measured and how the

obligation changes.

LO17–11 Determine the components of postretirement benefit expense.

LO17–12 Discuss the primary differences between U.S. GAAP and IFRS with respect to

accounting for postretirement benefit plans.

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Lecture Outline

Part A: The Nature of Pension Plans

I. Nature of Pension Plans

A. Pension plans provide income to employees during their retirement years.

B. Employers set aside funds during an employee’s working years so that at retirement, the

accumulated funds plus earnings from investing those funds are available to replace

wages.

C. Defined contribution pension plans and defined benefit pension plans have the common

objective of providing income to employees during their retirement years. However, they

differ regarding who bears the risk of ensuring that the objective is achieved.

II. Defined Contribution Pension Plans

A. Defined contribution pension plans promise fixed annual contributions to a pension fund

(4% of employees’ pay, for example).

1. Employees choose where funds are invested, within set options.

2. The employees’ retirement pay depends on the accumulated balance of the invested

funds at retirement.

3. As a result, the employee bears the risk of uncertain investment returns. The

employer is free of any further obligation.

4. Defined contribution pension plans have several variations, but the most common

are 401(k) plans—named after the Tax Code section that specifies the conditions for

the favorable tax treatment of these plans. Such plans permit voluntary

contributions by employees, which often are matched by employers (dollar for

dollar, 1 for 2, etc.).

5. The employer simply records pension expense equal to the cash contribution.

III. Defined Benefit Pension Plans

A. Defined benefit pension plans promise fixed retirement benefits that are “defined” by a

pension formula.

1. The employer is accountable for ensuring that sufficient funds are available to

provide the promised benefits.

2. A typical pension formula specifies that a retiree will receive annual retirement

benefits based on the employee’s years of service and annual pay at retirement.

B. The fundamental components of a defined benefit pension plan are:

1. The employer’s obligation to pay retirement benefits in the future.

2. The plan assets set aside by the employer from which to pay the retirement benefits

in the future.

3. The periodic expense of having a pension plan.

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C. The employer’s obligation and plan assets are not individually reported in a company’s

primary financial statements, but the difference between the two, the funded status, is

reported as a pension liability if underfunded or as a pension asset if overfunded.

D. The third component, pension expense, is reported in the income statement. The pension

expense is comprised of several elements that include changes in the employer’s

obligation and plan assets, so we discuss those first before looking at the components of

pension expense.

IV. Pension Expense—An Overview

A. The annual pension expense reflects changes in both the pension obligation and the plan

assets. Illustration 17–3 provides a brief overview of how these changes are included in

pension expense. Next we explore each of these pension expense components in the

context of its being a part of either (a) the pension obligation or (b) the plan assets.

Part B: The Pension Obligation and Plan Assets

I. The Pension Obligation

A. There are three different ways to measure the pension obligation:

1. Accumulated benefit obligation (ABO): The present value of estimated retirement

benefits earned so far by employees, estimated by plugging existing compensation

levels into the pension formula.

2. Vested benefit obligation (VBO): The vested portion of the accumulated benefit

obligation—the part that plan participants are entitled to receive regardless of their

continued employment.

3. Projected benefit obligation (PBO): The present value of estimated retirement

benefits earned so far by employees, estimated by plugging projected compensation

levels into the pension formula. A company usually hires an actuary to make these

estimates.

B. The PBO can change due to:

1. Service cost: The increase in the PBO attributable to employee service this year.

2. Interest cost: The accrual of interest as time passes (beginning PBO × discount

rate).

3. Prior service cost: The cost of making plan amendments retroactive to prior years.

4. Loss (gain) on PBO: The periodic adjustments to PBO when estimates change.

5. Retiree benefits paid: The benefits actually paid to retired employees.

II. Pension Plan Assets

A. To pay the pension obligation, companies accumulate funds known as the pension plan

assets.

B. A trustee usually is hired who:

1. Accepts employer contributions.

2. Invests the contributions.

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3. Accumulates the earnings on the investments.

4. Pays benefits from the plan assets to retired employees or their beneficiaries.

C. The balance in pension plan assets is not formally recognized on the balance sheet, but is

actively monitored in the employer’s informal records.

D. The pension plan assets can change due to:

1. Return on plan assets: dividends, interest, market price appreciation.

2. Cash contributions: employer contributions.

3. Retiree benefits paid: benefits actually paid to retired employees.

Part C: Determining Pension Expense

I. The Relationship between Pension Expense and Changes in the PBO and Plan Assets

A. Employees receive pension benefits long after they earn those benefits. However, the

employer’s cost of providing those benefits is allocated to the periods the services are

performed.

B. The periodic pension expense is a composite of periodic changes in both the pension

obligation and the plan assets.

1. The service cost is the increase in the PBO attributable to employee service and is

the primary component of pension expense.

2. The interest and return-on-assets components are “financial items” created only

because the compensation is delayed and the obligation is funded currently.

a. The actual return on assets is increased by the loss on plan assets so that,

effectively, the expected return is the component of pension expense.

b. This is due to the desire to achieve income smoothing by delaying the

recognition of both the loss (gain) on the PBO and the loss (gain) on plan

assets.

c. If gains and losses were immediately recognized in pension expense, the

annual pension expense, and therefore earnings, would rise and fall frequently

with each difference between results and expectations.

C. Prior service cost is recognized over the average remaining service life of the active

employee group.

D. Delaying the recognition in expense of both the loss (gain) on the PBO and the loss

(gain) on plan assets means these amounts are set aside for possible future

recognition.

a. When a net gain or net loss gets “too large,” a portion of the excess is included

in pension expense.

b. The FASB defines “too large” as being greater than 10% of either plan assets

or the PBO (at the beginning of the year), whichever is larger.

c. The amount amortized is the excess divided by the average remaining service

life of the active employee group.

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Part D: Reporting Issues

I. Recording Gains and Losses

A. Gains and losses (either from changing assumptions regarding the PBO or the return on

assets being higher or lower than expected) are deferred and not immediately included in

pension expense and net income. They are, instead, reported as other comprehensive

income in the statement of comprehensive income as a gain–other comprehensive income

or a loss–other comprehensive income in the reporting period they occur.

B. Gains and losses increase or decrease either the PBO or plan assets.

1. Actuarial gains decrease the PBO, and losses increase the PBO. Similarly, gains

from the return on assets being higher than expected increase plan assets while

losses decrease plan assets.

2. Because the pension liability (or asset) is the difference between the PBO and plan

assets, that difference changes when either the PBO or plan assets change.

C. Gains and losses become part of either a net loss–AOCI or a net gain–AOCI account,

which is a component of accumulated other comprehensive income, a shareholders’

equity account.

D. International Financial Reporting Standards

1. Under both U.S. GAAP and IFRS, we report gains and losses among OCI items in

the statement of comprehensive income, thus subsequently become part of AOCI.

But under IFRS, the gains and losses are not subsequently amortized to expense

and recycled or reclassified from other comprehensive income as is required under

U.S. GAAP (when the accumulated net gain or net loss exceeds the 10%

threshold). A second difference pertains to the make-up of the gain or loss on plan

assets. This amount under GAAP is the difference in the actual and expected

returns, where the expected return is different from company to company and

usually different from the interest rate used to determine the interest cost. Under

IFRS, though, we use the same rate (the rate for high grade corporate bonds) for

both the interest cost on the defined benefit obligation and the interest revenue on

the plan assets. In fact, under IFRS, we multiply that rate times the net difference

between the DBO and plan assets and report the net interest cost/income.

2. Under U.S. GAAP, prior service cost is included among OCI items in the statement

of comprehensive income and thus subsequently becomes part of AOCI where it is

amortized over the average remaining service period. On the other hand, under IAS

No. 19, prior service cost (called past service cost under IFRS) is combined with

service cost and reported within the income statement rather than as a component

of other comprehensive income as it is under GAAP, so it never is amortized to

expense.

3. Under IFRS, the various components of pension expense are not reported as a

single net amount. We separately report service cost (including past service cost)

net interest cost/income, and amortization of remeasurement gains and losses.

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Service cost and net interest cost/income are reported within the income statement.

Remeasurement gains and losses are reported as other comprehensive income in

the statement of comprehensive income. Under U.S. GAAP, all components of

pension expense are reported as a single net amount in the operating profit (loss)

section of the income statement.

II. Recording the Pension Expense

A. The pension expense includes the service cost, the interest cost, and a reduction for the

expected return on plan assets. The service cost and interest cost add to the PBO, and the

return on plan assets adds to the plan assets.

B. The pension expense also might include amortization of prior service cost–AOCI or

amortization of either a net loss–AOCI or a net gain–AOCI. But unlike the other three

components, these amortization amounts affect neither the PBO nor the plan assets.

1. Amortization reduces the prior service cost–AOCI and the net loss–AOCI or net

gain–AOCI.

2. These are shareholders’ equity accounts, components of accumulated other

comprehensive income.

C. When the cash investment is added to plan assets, that account is increased.

D. In the income statement, companies report the service cost component of pension

expense as part of the total compensation costs arising from services rendered by the

employees during the period, separate from the other components of pension expense.

This presentation reflects the nature of service cost being different from that of the other

elements of pension cost. The other components of pension expense are presented in the

income statement also but separate from the service cost component and outside the

subtotal of income from operations.

III. Recording the Funding of Plan Assets

A. The PBO is not reported among liabilities in the balance sheet nor are plan assets

reported among assets in the balance sheet.

B. However, the net difference between those two amounts, referred to as the “funded

status” of the plan is reported as a pension liability if underfunded or as a pension asset if

overfunded.

IV. Comprehensive Income

A. Comprehensive income encompasses all changes in equity other than from transactions with

owners. So, in addition to net income, comprehensive income includes up to four other

changes in equity.

B. Other comprehensive income (OCI) items are reported both (a) as they occur and then (b)

as an accumulated balance within shareholder’s equity in the balance sheet.

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C. In addition to reporting gains or losses (and other elements of comprehensive income)

that occur in the current reporting period, we also report these amounts on a cumulative

basis in the balance sheet.

V. Income Tax Considerations

A. As gains and losses occur, they are reported along with their tax effects (tax expense for a

gain, tax savings for a loss) in the statement of comprehensive income. This can be

accomplished by presenting components of other comprehensive income either net of

related income tax effects or before income tax effects with disclosure of the income

taxes allocated to each component in a disclosure note or parenthetically in the statement.

B. AOCI in the balance sheet also is reported net of tax.

VI. Putting the Pieces Together

A. A pension spreadsheet can be useful to see how each element relates to the others.

B. It also serves as a check that all changes tie together.

VII. Settlement or Curtailment of Pension Plans

A. To cut down on paperwork and lessen their exposure to the risk posed by defined benefit

plans, many companies are providing defined contribution pans instead. When a plan is

terminated, a change in earnings is reported at that time.

Part E: Postretirement Benefits Other Than Pensions

I. Nature of Postretirement Benefit Plans

A. Postretirement benefits include all retiree health and welfare benefits other than pensions

and can include:

1. Medical coverage.

2. Dental coverage.

3. Life insurance.

4. Group legal services.

5. Other benefits.

B. The most common is health care benefits.

C. Eligibility usually is based on age and/or years of service.

II. What Is a Postretirement Benefit Plan?

A. Keep in mind that retiree health benefits differ fundamentally from pension benefits in

some important respects:

1. The amount of pension benefits generally is based on the number of years an

employee works for the company. The amount of postretirement health care benefits

typically is unrelated to service. It’s usually an all-or-nothing plan in which a certain

level of coverage is promised upon retirement, independent of the length of service

beyond that necessary for eligibility.

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2. Although coverage might be identical, the cost of providing the coverage might

vary significantly from retiree to retiree and from year to year due to differing

medical needs.

3. Postretirement health care plans often require the retiree to share in the cost of

coverage through monthly contribution payments. The net cost of providing

coverage is reduced by these contributions and by any portion of the cost paid by

Medicare or other insurance.

4. Coverage often is provided to spouses and eligible dependents.

B. To determine the postretirement benefit obligation and the postretirement benefit

expense, the company’s actuary first must make estimates of what the postretirement

benefit costs will be for current employees. Then, contributions to those costs by

employees are deducted, as well as Medicare’s share of the costs to determine the

estimated net cost of benefits to the employer.

C. Remember, postretirement health care benefits are anticipated actual costs of providing

the promised health care, rather than an amount estimated by a defined benefit formula.

D. Estimating postretirement benefits costs is similar in many ways to estimating pension

costs. Both estimates entail a variety of assumptions to be made; for instance, both

require estimates of:

1. A discount rate.

2. Expected return on plan assets (if the plan is funded).

3. Employee turnover.

4. Expected retirement age.

5. Expected compensation increases (if the plan is pay-related).

6. Expected age of death.

7. Number and ages of beneficiaries and dependents.

E. Additional assumptions become necessary as a result of differences between pension

plans and other postretirement benefit plans. It’s necessary to estimate:

1. The current cost of providing health care benefits at each age that participants might

receive benefits.

2. Demographic characteristics of plan participants that might affect the amount and

timing of benefits.

3. Benefit coverage provided by Medicare, other insurance, or other sources that will

reduce the net cost of employer-provided benefits.

4. The expected health care cost trend rate.

III. Postretirement Benefit Obligation

A. An actuary estimates what the net cost of postretirement benefits will be for current

employees (and dependents) in each year of their expected retirement.

B. The discounted present value of those costs is the company’s liability.

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1. The actuary’s estimate of the total postretirement benefits (at their discounted

present value) expected to be received by plan participants is the Expected

Postretirement Benefit Obligation (EPBO).

2. The portion of the EPBO attributed to employee service to date is the Accumulated

Postretirement Benefit Obligation (APBO).

a. The APBO changes for much the same reasons as the PBO in pension

accounting.

i. Prior service cost: Cost of making plan amendments retroactive to prior

years.

ii. Service cost: Portion of the EPBO attributed to the current period.

iii. Interest cost: Accrual of interest as time passes (beginning APBO ×

discount rate).

iv. Loss (gain) on APBO: Periodic adjustments to APBO when estimates

change.

v. Less: Retiree benefits paid: Benefits actually paid to retired employees.

b. The attribution period for service cost spans each year of service from the

employee’s date of hire to the employee’s “full eligibility date.”

IV. Accounting for Postretirement Benefit Plans Other Than Pensions

A. Accounting for postretirement benefits is, to the extent possible, the same as for pension

benefits.

B. Any differences are due to fundamental differences between pensions and other

postretirement benefits.

C. There are more similarities than differences.

D. The main difference from an accounting perspective is that postretirement health care

benefits usually are “all-or-nothing” plans in which a certain level of coverage is

promised upon retirement, and the coverage is independent of the length of service

beyond the eligibility date. Cost is unrelated to service and is “attributed” to the years

from the employee’s date of hire to the “full eligibility date.”

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