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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 accumulated benefit obligation, the vested benefit obligation, and
the projected benefit obligation.
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 and other postretirement benefit 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.
17-2 Intermediate Accounting, 8/e
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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. (T17-1)
II. Types of 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 which 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.
B. 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.
(T17-2)
III. Defined Benefit Pension Plans
A. 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.
B. 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.
C. 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.
Part B: The Pension Obligation and Plan Assets
I. The Pension Obligation
A. There are three different ways to measure the pension obligation: (T17-3)
1. Accumulated Benefit Obligation (ABO) – 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) – vested portion of the accumulated benefit
obligation – part that plan participants are entitled to receive regardless of their
continued employment.
3. Projected Benefit Obligation (PBO) – 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. (T17-4) (T17-5)
B. The PBO can change due to:
1. Service cost – the increase in the PBO attributable to employee service this year.
(T17-6) (T17-7)
2. Interest cost – the accrual of interest as time passes (beginning PBO x discount rate).
3. Prior service cost – the cost of making plan amendments retroactive to prior years
(T17-8)
4. Loss (gain) on PBO – the periodic adjustments to PBO when estimates change.
(T17-9)
5. Retiree benefits paid – the benefits actually paid to retired employees. (T17-10)
II. The Plan Assets
A. To pay the pension obligation companies accumulate funds known as the plan assets.
B. A trustee usually is hired who:
1. Accepts employer contributions.
2. Invests the contributions.
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 plan assets can change due to: (T17-11)
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.
17-4 Intermediate Accounting, 8/e
Part C: Determining Pension Expense
I. Composition of Pension Expense
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. (T17-12) (T17-13)
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. (T17-14)
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. (T17-15)
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. (T17-16)
Part D – Reporting Issues
I. Reporting the Funded Status of the Pension Plan
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. (T17-17)
II. 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.
a. 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. (T17-18)
b. 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.
III. Recording the Periodic Expense and Periodic Funding
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.
(T17-19)
a. Amortization reduces the prior service cost–AOCI and the net loss–AOCI or net
gain–AOCI.
b. 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. (T17-20)
IV. A Pension Spreadsheet
A. A pension spreadsheet can be useful to see how each element relates to the others. (T17–
21)
B. It also serves as a check that all changes tie together.
V. International Financial Reporting Standards
A. 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
(T17-22)
B. 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
17-6 Intermediate Accounting, 8/e
income statement rather than as a component of other comprehensive income as it is under
GAAP, so it never is amortized to expense. (T17-23)
C. 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. 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. (T17-24)
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.
3. Life insurance.
5. Other benefits.
B. The most common is health care benefits.
C. Eligibility usually is based on age and/or years of service.
II. Accounting for Postretirement Benefits
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.”
III. The 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.
1. The actuary’s estimate of the total postretirement benefits (at their discounted
2. The portion of the EPBO attributed to employee service to date is the Accumulated
Postretirement Benefit Obligation (APBO). (T17-25)
IV. The Accumulated Postretirement Benefit Obligation
A. The APBO changes for much the same reasons as the PBO in pension accounting. (T17–
26)
1. Prior service cost – Cost of making plan amendments retroactive to prior years.
2. Service cost – Portion of the EPBO attributed to the current period.
4. Loss (gain) on APBO – Periodic adjustments to APBO when estimates change.
5. 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.”(T17-27)
V. The Plan Assets
17-8 Intermediate Accounting, 8/e
A. Many postretirement benefit plans are not funded, so no plan assets are specifically set
aside to pay benefits when they come due.
B. Funded plans often are significantly underfunded.
C. When postretirement benefit plans are funded, the plan assets change for the same
reasons they do with pension plans.
2. Cash contributions – Employer contributions.
3. Less: Retiree benefits paid – Benefits actually paid to retired employees.
VI. The Postretirement Benefit Expense
A. Postretirement benefit expense includes essentially the same components as does pension
expense. (T17-28)
B. It is a composite of periodic changes in both the APBO and the plan assets (if any):
2. Interest cost – Accrual of interest as time passes (beginning APBO x discount rate).
3. Expected return on the plan assets – Dividends, interest, price appreciation
a. Actual return minus any gain – when actual exceeds expected return.
b. Actual return plus any loss – when expected exceeds actual return.
c. It is subtracted in the calculation of postretirement benefit expense.
5. Amortization of the net loss or net gain.
Instructors Resource Manual 17-9
Copyright © 2015 McGraw-Hill Education. All rights reserved.
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A PowerPoint presentation of the chapter is available at the textbook website.
An alternate version of the PowerPoint presentation also is available.
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The following can be reproduced on transparency film as they appear here, or
17–10 Intermediate Accounting, 8/e
PENSION PLANS
Pension plans are designed to provide income to individuals
during their retirement years. This is accomplished by setting
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.
TYPES OF PENSION PLANS
➢ Defined contribution pension plans promise fixed annual
contributions to a pension fund (say, 10% of the employees’
pay). The employee chooses (from designated options)
➢ Defined benefit pension plans promise fixed retirement
benefits “defined” by a designated formula. Typically, the
pension formula bases retirement pay on the employees’ (a)
DEFINED BENEFIT PENSION PLANS
A pension formula might define annual retirement benefits as:
T17-2
17–12 Intermediate Accounting, 8/e
PENSION OBLIGATION
Three different ways to measure the pension obligation have
meaning in pension accounting:
➢ Accumulated benefit obligation (ABO) – The actuary’s
estimate of the total retirement benefits (at their discounted
T17-3
PROJECTED BENEFIT OBLIGATION
Jessica Farrow was hired by Global Communications in 2005.
The company has a defined benefit pension plan that specifies
annual retirement benefits equal to:
1.5% x service years x final year’s salary
Farrow is expected to retire in 2044 after 40 years service. Her
What is the company’s projected benefit obligation with
respect to Jessica Farrow?
Steps to calculate the projected benefit obligation:
T17-4
17–14 Intermediate Accounting, 8/e
PBO IN 2014
present value [n=30, i=6%] actuary estimates employee has
of retirement benefits at 2014 is earned (as of 2014) retirement benefits of
T17-4 (continued)
PBO IN 2015
If the actuary’s estimate of the final salary hasn’t changed, the
PBO at the end of 2015 would be $139,715:
present value [n=29, i=6%] actuary estimates employee has
Notice that the PBO increased during 2015 from $119,822 to
$139,715 for two reasons:
17–16 Intermediate Accounting, 8/e
CHANGES IN THE PBO
1 – SERVICE COST
The PBO increases each year by the amount of that year’s
service cost. This represents the increase in the projected benefit
obligation attributable to employee service performed during the
period.
2 – INTEREST COST
The second reason the PBO increased is called the interest cost.
T17-6
HOW THE PBO CHANGED IN 2015
PBO at the beginning of 2015 (end of 2014) $119,822
T17-7
17–18 Intermediate Accounting, 8/e
3 – Prior Service Cost
Assume the formula’s salary percentage is increased in 2015
from 1.5% to 1.7%:
1.7% x Service years x Final year’s salary
The increase in the PBO attributable to making a plan
amendment retroactive is referred to as prior service cost.
PBO Without Amendment PBO With Amendment
T17-8
4 – GAIN OR LOSS ON THE PBO
A number of estimates are necessary to derive the PBO. When
one or more of these estimates requires revision, the estimate of the
PBO also will require revision. The resulting decrease or increase
Assume the estimate of Farrow’s final salary should be
increased by 5% to $420,000. This would affect the estimate of
the PBO as follows:
PBO Without PBO With
Revised Estimate Revised Estimate
1.7 x 12 years x $400,000 = $81,600 1.7 x 12 years x $420,000 = $85,680
5 – PAYMENT OF RETIREMENT BENEFITS
Another change in the PBO occurs when the obligation is
reduced as benefits actually are paid to retired employees.
T17-9
17–20 Intermediate Accounting, 8/e
ILLUSTRATION EXPANDED TO THE
ENTIRE EMPLOYEE POOL
($ in millions)
PBO at the beginning of 2016 (amount assumed) $400