Chapter 15: Pensions and Other Postretirement Benefits Instructor Manual
Accounting Theory (9
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CHAPTER HIGHLIGHT
Chapter 15 is intended to give the student a comprehensive overview of legal, funding, and
accounting aspects of corporate-sponsored pension plans. The lengthy background material at
the beginning of the chapter is necessary in order to understand the accounting implications of
defined contribution and defined benefit plans. A weakness of most accounting discussion on
pensions is the avoidance of technical issues. As a result, the accounting theory and policy
issues are not clearly delineated. For example, it is not possible to discuss accounting issues
independent of legal and funding aspects. Because of this, it is highly recommended that
students read Appendix 15-A on actuarial funding. The chapter also introduces post-retirement
benefits other than pensions arising from SFAS No. 106.
SFAS No. 87 allows only one actuarial method for calculating pension expense, a rigid
uniformity approach. SFAS No. 87 also came down in favor of liability recognition. This
position is little more than a belated acknowledgment that ERISA created a legally unavoidable
obligation for pension plan sponsors. At this point, the policy issue turns to measuring the
liability. Two theories from the labor economics literature, implicit and explicit contract views,
are useful in relating what the FASB attempted in Preliminary Views (the implicit contract view,
i.e., using projected future salaries to value the pension benefit in real terms) versus the
compromise position in SFAS No. 87 (the explicit contract view, i.e., using current salary levels
to value projected benefits).
The economic consequences literature is reviewed in the pension area. One set of studies
focuses on whether stocks are priced “as if” pensions are a liability (pre-SFAS No. 87 studies).
Generally, the evidence, not surprisingly, is that they are treated as if they are liabilities. There is
some limited research that suggests a firm’s bond ratings also reflect pensions as debt
equivalents. However, as in other areas, there could still be economic consequences arising from
balance sheet recognition, and this is likely to explain why a record number of firms lobbied
against the proposal.
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Appendix 15-A gives a concise example of service cost determination under both projected and
accrued benefit cost approaches, and also illustrates two funding approaches.
QUESTIONS
Q-1 What do the following actuarial terms mean: accumulated benefits, actuarial liability,
vested benefits, service cost, and unfunded accumulated benefits? How are they
measured? How are projected benefit obligations, accumulated benefit obligations, and
vested benefit obligations defined in SFAS No. 87, and how are they actuarially
calculated?
Accumulated benefits and actuarial liability are the same terms, and are calculated by any of
several primary actuarial methods for accrued benefits earned to date. Vested benefits are those
no longer contingent upon continued employment (i.e., they are legally binding), and unfunded
Q-2 Why is there a pension accounting problem with defined benefit pension plans, but not
with defined contribution plans?
Q-3 Explain how previous pension accounting standards were based on a revenue-expense
approach to the financial statements.
APB Opinion No. 8 focuses almost exclusively on the problem of determining annual pension
Q-4 Why did APB Opinion No. 8 only minimally improve uniformity between companies?
APB Opinion No. 8 closed the “GAAP” between discretionary and nondiscretionary funders
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Q-5 Is the treatment of unrecognized prior service cost and actuarial gains/ losses in SFAS
No. 87 an example of the asset-liability or revenue-expense orientation?
Both would be examples of an expense-revenue orientation because both use an
accrual/matching orientation rather than bringing the liability from prior service costs onto the
Q-6 Why is there a “double counting” problem if the accumulated benefit obligation is used
to measure the pension liability and what can be done about it?
Economic conceptions of pensions take a long-term implicit contract approach and are thus tied
to future salary projections. The accounting view is more difficult to pin down. Current service
cost determination is likewise tied to future salaries under SFAS No. 87, but for the presumed
Q-7 How has ERISA affected pension accounting?
Q-8 Given the evidence from the research in the stock market, does it matter whether
pension information is disclosed in the formal financial statements or as supplemental
disclosure?
Looking solely at direct cash consequence, it would not appear to make any difference.
Q-9 What economic consequences of SFAS No. 87 were suggested in the chapter?
Recognition of a liability would affect debt-equity ratios, which are specified in restrictive debt
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Q-10 Research has shown that discount rates used by firms are generally above rates
suggested by the FASB. Will this make the interest cost portion of pension expense
higher or lower than if discount rates were lower? Why do you think firms favor using
a higher rate?
The higher interest rate, in and of itself, would lead to a higher interest expense but it also leads
Q-11 Is SFAS No. 87’s argument favoring recognition of a pension liability for accumulated
benefits consistent with the conceptual framework project?
The analysis in the chapter concluded that unfunded accumulated benefits are an unambiguous
legal liability in terms of SFAC No. 6 definitions.
Q-12 If actuarial gains and losses and prior service costs, in line with SFAS No. 158, are to
be recognized in the period when incurred, is there a double counting effect when these
elements are recognized as part of net pension expense?
The answer would seem to be yes. Projected benefit obligations (to use SFAS No. 87
terminology) must be funded under ERISA and, in the event of plan termination, the sponsor is
Q-13 How did the “give-and-take” differ between the FASB and its constituents in the
drafting of SFAS No. 87 on pensions versus SFAS No. 106?
The battle over SFAS No. 87 was quite stormy. The initial proposal was not put out as an
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Q-14 Voluntary pension plan terminations have been increasing [see Stone (1987)] in which
surplus plan assets are recaptured by sponsoring companies after deferred annuities (of
equivalent value to accrued benefits) are purchased for plan participants. Why do you
think this practice has been criticized by some employee groups, and how might SFAS
No. 87 affect voluntary terminations?
A very serious issue is at stake—who owns pension fund assets. While there are court
challenges in process, to date the answer has been that they belong to the sponsoring company as
long as they “pay off” existing plan members by buying them insured annuities equal in value to
Q-15 What issues of qualitative characteristics of accounting information (SFAC No. 2) are
important relative to accrual accounting for OPEBs?
Costs of measurement may be quite high, which relates to the benefits > costs pervasive
Q-16 What types of economic consequences may arise from accrual accounting for OPEBs
in SFAS No. 106?
Bond covenants could be affected as a result of higher debt-equity ratios. Management
Q-17 According to The Wall Street Journal article on February 1, 1996 (“Intrinsic Value” by
Roger Lowenstein, p. C1), pension fund assets in the United States grew
dramatically—by approximately 29 percent—during 1995, an excellent year in the
stock market. However, underfunding of pension plans increased by a very sizable
amount. Why do you think that this occurred?
The problem is that pension liabilities can increase even faster if the discount declines as in
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Q-18 While ERISA has been helpful, how well are employees protected in situations where
overfunded pension plans exist?
Loopholes still exist. As with the Dillard’s case mentioned in the chapter, if 25% of surplus
Q-19 What is the danger, particularly to older employees of restructuring pension plans into
“cash benefit plans?”
A movement to “cash benefit plans” may well work to the detriment of older employees in favor
Q-20 What differences exist, relative to the use of future costs and future salaries, in the case
of OPEBs (SFAS No. 106) and pensions (SFAS No. 87)?
The minimum liability determines any underfunding by using the accrued benefit obligation,
whereas the transition gain or loss determines underfunding (or possibly overfunding) using the
projected benefit obligation. Both amounts are then combined with the balance of the
prepaid/accrued pension cost account.
Q-21 Is it inconsistent to use future salaries for service cost calculations and current salaries
for minimum liability calculation purposes?
It is somewhat unsettling but not necessarily inconsistent. The purpose of using future salaries in
service cost calculations is to help predict future cash flows. Future salaries would be preferable
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Accounting Theory (9
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CASES, PROBLEMS, AND WRITING ASSIGNMENTS
1. Refer to Appendix 15-A. Assume that the firm is using projected accrued benefit cost
funding. Suppose that a plan amendment was introduced during 2002 granting one year
of prior service (for the year 2000) to each employee.
Required:
Determine the contribution to the pension fund for 2002 and 2003.
First find the increase in final benefits as a result of the plan amendment. This can be done by
modifying equation 15.1 and using the additional number of years covered, which is one:
Additional benefit equals expected final salary times expected number of employees who will be
with the firm times the proportion of salary to be received times one year:
$25,000 = $50,000 × 5 employees × .10 × 1 year
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Accounting Theory (9
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2. Smurfit-Stone Container Corporation’s 2004 annual report shows the following
information pertaining to its minimum pension liability (this is before SFAS No. 158;
000’s omitted):
Accumulated benefits obligation
$3,336
Fair value of plan assets 2,466
Underfunded status 870
Unrecognized actuarial loss 762
Unrecognized prior service cost 79
Net unrecognized costs 841
Net minimum liability $ 29
Required:
How do you think Smurfit-Stone would justify their calculation of the minimum
liability and do you agree with them?
You can access a PDF copy of Smurfit-Stone Container Corporation’s 2004 annual report at
http://phx.corporate-ir.net/phoenix.zhtml?c=75794&p=irol-reportsannual, but will need to access
its 10K report on the SEC’s EDGAR database at http://www.sec.gov . The company’s
3. Using SFAS No. 87 and SFAS No. 106 for additional background, list and briefly
discuss as many similarities and differences as you can between pension accounting
and OPEB accounting.
Appendix B of SFAS No. 106 provides a good comparison between SFAS Nos. 87 and 106. We
start with similarities.
Similarities
• Both appear to be liabilities according to SFAC No. 6 and both are so interpreted.
• Both use the benefits/years of service approach and both are based on projected numbers:
projected salaries in the case of pensions, and projected health care costs in the case of
Differences
• The attribution period for pensions covers years of service ending with retirement, but
under OPEB it goes only to the date of full eligibility (which frequently may be the
retirement date).
• There is no minimum liability under OPEB.
Chapter 15: Pensions and Other Postretirement Benefits Instructor Manual
CRITICAL THINKING AND ANALYSIS
1. To qualify as a liability, a past transaction must exist. Is this the case with pensions and
OPEBs? How does the use of financial statements for predicting future cash flows as
opposed to evaluating management performance enter the picture?
First of all it would have put the debt in the balance sheet where, we believe it belongs.
2. Biggs (2010) presents a bleak picture for future generations attempting to meet the
obligations related to public pension plans (e.g., State of New York; Jefferson County,
Alabama)). How does his logic hold up when reviewing U.S. public corporations?
Biggs, Andrew G. (March 22, 2010). “Public Pension Deficits Are Worse Than You Think: How
Chapter 15: Pensions and Other Postretirement Benefits Instructor Manual
3. How might standards setters address the concerns that Gordon and Gallery (2012)
highlight related to pension accounting comparability?
Gordon, Isabel and Natalie Gallery (2012). “Assessing Financial Reporting Comparability
Across Institutional Settings: The Case of Pension Accounting,” The British Accounting Review
44: 11–20.
The authors suggest that convergence of local accounting standards to international financial
reporting standards (IFRS) may render increased comparability of financials unrealistic. They
4. Novy-Marx and Rauh (2011) estimate state employee pension liabilities in the United
States. What thoughts do you have on their findings?
Novy-Marx, Robert and Joshua Rauh (August 2011). “Public pension promises: how big are they
and what are they worth?” The Journal of Finance, 1211–1249.