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: Facy Francine Coandy : Akuntansi A : 1013065 CHAPTER 20 ACCOUNTING FOR PENSIONS AND POSTRETIREMENTS BENEFIT

Nature of Pension Plans A pension plan is an arrangement whereby an employer provides benefits (payments) to retired employees for services they provided in their working years. Pension accounting may be divided and separately treated as accounting for the employer and accounting for the pension fund. The company or employer is the organization sponsoring the pension plan. It incurs the cost and makes contributions to the pension fund. The fund or plan is the entity that receives the contributions from the employer, administers the pension assets, and makes the benefit payments to the retired employees (pension recipients). A pension plan is funded when the employer makes payments to a funding agency. Some pension plans are contributory. In these, the employees bear part of the cost of the stated benefits or voluntarily make payments to increase their benefits. Other plans are noncontributory. In these plans, the employer bears the entire cost. Companies generally design their pension plans so as to take advantage of federal income tax benefits. Plans that offer tax benefits are called qualified pension plans. They permit deductibility of the employers contributions to the pension fund and tax-free status of earnings from pension fund assets. The pension fund should be a separate legal and accounting entity. Defined-Contribution Plan In a defined-contribution plan, the employer agrees to contribute to a pension trust a certain sum each period, based on a formula. This formula may consider such factors as age, length of employee service, employers profits, and compensation level. The plan defines only the employers contribution. It makes no promise regarding the ultimate benefits paid out to the employees. The accounting for a defined-contribution plan is straightforward. The employee gets the benefit of gain (or the risk of loss) from the assets contributed to the pension plan. The employer simply contributes each year based on the formula established in the plan. In addition to pension expense, the employer must disclose the following for a defined-contribution plan: a plan description, including employee groups covered; the basis for determining contributions; and the nature and effect of significant matters affecting comparability from period to period. Defined-Benefit Plan A defined-benefit plan outlines the benefits that employees will receive when they retire. These benefits typically are a function of an employees years of service and of the compensation level in the years approaching retirement. To meet the defined-benefit commitments that will arise at retirement, a company must determine what the contribution

should be today (a time value of money computation). Companies may use many different contribution approaches. The employees are the beneficiaries of a defined-contribution trust, but the employer is the beneficiary of a defined-benefit trust. In form, the trust is a separate entity. In substance, the trust assets and liabilities belong to the employer. That is, as long as the plan continues, the employer is responsible for the payment of the defined benefits (without regard to what happens in the trust). Employers are at risk with defined-benefit plans because they must contribute enough to meet the cost of benefits that the plan defines. The expense recognized each period is not necessarily equal to the cash contribution. Similarly, the liability is controversial because its measurement and recognition relate to unknown future variables. The Role of Actuaries in Pension Accounting Companies engage actuaries to ensure that a pension plan is appropriate for the employee group covered. Actuaries are individuals trained through a long and rigorous certification program to assign probabilities to future events and their financial effects. Actuaries make predictions (called actuarial assumptions) of mortality rates, employee turnover, interest and earnings rates, early retirement frequency, future salaries, and any other factors necessary to operate a pension plan. They also compute the various pension measures that affect the financial statements, such as the pension obligation, the annual cost of servicing the plan, and the cost of amendments to the plan. Accounting for Pensions

Alternative Measures of the Liability

One measure of the pension obligation is to base it only on the benefits vested to the employees. Vested benefits are those that the employee is entitled to receive even if he or she renders no additional services to the company. Most pension plans require a certain minimum number of years of service to the employer before an employee achieves vested benefits status. Companies compute the vested benefit obligation using only vested benefits, at current salary levels. Another way to measure the obligation uses both vested and nonvested years of service. On this basis, the company computes the deferred compensation amount on all years of employees serviceboth vested and nonvestedusing current salary levels. This measurement of the pension obligation is called the accumulated benefit obligation. A third measure bases the deferred compensation amount on both vested and nonvested service using future salaries. This measurement of the pension obligation is called the projected benefit obligation. Because future salaries are expected to be higher than current salaries, this approach results in the largest measurement of the pension obligation. The profession adopted the projected benefit obligationthe present value of vested and nonvested benefits accrued to date, based on employees future salary levels.

Recognition of the Net Funded Status of the Pension Plan 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. Components of Pension Expense There is broad agreement that companies should account for pension cost on the accrual basis. The profession recognizes that accounting for pension plans requires measurement of the cost and its identification with the appropriate time periods. The determination of pension cost, however, is extremely complicated because it is a function of the following components. 1. Service Cost. Service cost is the expense caused by the increase in pension benefits payable (the projected benefit obligation) to employees because of their services rendered during the current year. Actuaries compute service cost as the present value of the new benefits earned by employees during the year. 2. Interest on the Liability. Because a pension is a deferred compensation arrangement, there is a time value of money factor. As a result, companies record the pension liability on a discounted basis. Interest expense accrues each year on the projected benefit obligation just as it does on any discounted debt. The actuary helps to select the interest rate, referred to as the settlement rate. 3. Actual Return on Plan Assets. The return earned by the accumulated pension fund assets in a particular year is relevant in measuring the net cost to the employer of sponsoring an employee pension plan. Therefore, a company should adjust annual pension expense for interest and dividends that accumulate within the fund, as well as increases and decreases in the market value of the fund assets. 4. Amortization of Prior Service Cost. Pension plan amendments (including initiation of a pension plan) often include provisions to increase benefits (or in rare situations, to decrease benefits) for employee service provided in prior years. A company grants plan amendments with the expectation that it will realize economic benefits in future periods. Thus, it allocates the cost (prior service cost) of providing these retroactive benefits to pension expense in the future, specifically to the remaining service-years of the affected employees. 5. Gain or Loss. Volatility in pension expense can result from sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation (which changes when actuaries modify assumptions or when actual experience differs from expected experience). Two items comprise this gain or loss: (1) the difference between the actual return and the expected return on plan assets, and (2) amortization of the net gain or loss from previous periods. We will discuss this complex computation later in the chapter. Using A Pension Worksheet The basic computation of pension expense using the first three components: (1) service cost, (2) interest on the liability, and (3) actual return on plan assets. We discuss the other pension-

expense components (amortization of prior service cost, and gains and losses) in later sections. Companies often use a worksheet to record pension-related information. As its name suggests, the worksheet is a working tool. A worksheet is not a permanent accounting record: it is neither a journal nor part of the general ledger. The worksheet is merely a device to make it easier to prepare entries and the financial statements. For each transaction or event, the debits must equal the credits. The ending balance in the Pension Asset/Liability column should equal the net balance in the memo record. Amortization For Prior Service Cost (PSC) A company should not recognize the retroactive benefits as pension expense in the year of amendment. Instead, the employer initially records the prior service cost as an adjustment to other comprehensive income. The employer then recognizes the prior service cost as a component of pension expense over the remaining service lives of the employees who are expected to benefit from the change in the plan. The cost of the retroactive benefits (including any benefits provided to existing retirees) is the increase in the projected benefit obligation at the date of the amendment. An actuary computes the amount of the prior service cost. Amortization of the prior service cost is also an accounting function performed with the assistance of an actuary. Gain or Loss Of great concern to companies that have pension plans are the uncontrollable and unexpected swings in pension expense that can result from (1) sudden and large changes in the market value of plan assets, and (2) changes in actuarial assumptions that affect the amount of the projected benefit obligation. If these gains or losses impact fully the financial statements in the period of realization or incurrence, substantial fluctuations in pension expense result. Smoothing Unexpected Gains and Losses on Plan Assets One component of pension expense, actual return on plan assets, reduces pension expense (assuming the actual return is positive). The market-related asset value of the plan assets is either the fair value of plan assets or a calculated value that recognizes changes in fair value in a systematic and rational manner. The difference between the expected return and the actual return is referred to as the unexpected gain or loss. Asset gains occur when actual return exceeds expected return; asset losses occur when actual return is less than expected return. Companies record asset gains and asset losses in an account, Other Comprehensive Income (G/L), combining them with gains and losses accumulated in prior years. Smoothing Unexpected Gains and Losses on The Pension Liability In estimating the projected benefit obligation (the liability), actuaries make assumptions about such items as mortality rate, retirement rate, turnover rate, disability rate, and salary amounts. Companies report liability gains (resulting from unexpected decreases in the liability balance) and liability losses (resulting from unexpected increases) in Other Comprehensive Income (G/L). Companies combine the liability gains and losses in the same Other

Comprehensive Income (G/L) account used for asset gains and losses. They accumulate the asset and liability gains and losses from year to year that are not amortized in Accumulated Other Comprehensive Income. This amount is reported on the balance sheet in the stockholders equity section. Corridor Amortization If the balance in the Accumulated OCI account related to gains and losses stays within the upper and lower limits of the corridor, no amortization is required. In that case, Callaway carries forward unchanged the accumulated OCI related to gains and losses. If amortization is required, the minimum amortization is the excess divided by the average remaining service period of active employees who are expected to receive benefits under the plan. Summary of Calculation The difference between the actual return on plan assets and the expected return on plan assets is the unexpected asset gain or loss component. This component defers the difference between the actual return and expected return on plan assets in computing current-year pension expense. Thus, after considering this component, it is really the expected return on plan assets (not the actual return) that determines current pension expense. Companies determine the amortized net gain or loss by amortizing the Accumulated OCI amount related to net gain or loss at the beginning of the year subject to the corridor limitation. In other words, if the accumulated gain or loss is greater than the corridor, these net gains and losses are subject to amortization. Reporting Pension Plans in Financial Statements A phenomenon as significant and complex as pensions involves extensive reporting and disclosure requirements. We will cover these requirements in two categories: (1) those within the financial statements, and (2) those within the notes to the financial statements. Within The Financial Statements Recognition of the Net Funded Status of the Pension Plan Companies must recognize on their balance sheet the overfunded (pension asset) or underfunded (pension liability) 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. Classification of Pension Asset or Pension Liability The excess of the fair value of the plan assets over the benefit obligation is classified as a noncurrent asset. The rationale for noncurrent classification is that the pension plan assets are restricted. The current portion of a net pension liability represents the amount of benefit payments to be paid in the next 12 months (or operating cycle, if longer), if that amount cannot be funded from existing plan assets. Otherwise, the pension liability is classified as a noncurrent liability.

Aggregation of Pension Plans Some companies have two or more pension plans. In such instances, a question arises as to whether these multiple plans should be combined and shown as one amount on the balance sheet. The Board takes the position that all overfunded plans should be combined and shown as a pension asset on the balance sheet. Similarly, if the company has two or more underfunded plans, the underfunded plans are combined and shown as one amount on the balance sheet. Actuarial Gains and Losses/Prior Service Cost Actuarial gains and losses not recognized as part of pension expense are recognized as increases and decreases in other comprehensive income. The same type of accounting is also used for prior service cost. The components of other comprehensive income must be reported in one of three ways: (1) in a second income statement, (2) in a combined statement of comprehensive income, or (3) as a part of the statement of stockholders equity. Regardless of the format used, net income must be added to other comprehensive income to arrive at comprehensive income. For homework purposes, use the second income statement approach unless stated otherwise. Earnings per share information related to comprehensive income is not required. Within the Notes to the Financial Statements Pension plans are frequently important to understanding a companys financial position, results of operations, and cash flows. Therefore, a company discloses the following information, either in the body of the financial statements or in the notes. 1. A schedule showing all the major components of pension expense. 2. A reconciliation showing how the projected benefit obligation and the fair value of the plan assets changed from the beginning to the end of the period. 3. A disclosure of the rates used in measuring the benefit amounts (discount rate, expected return on plan assets, rate of compensation). 4. A table indicating the allocation of pension plan assets by category (equity securities, debt securities, real estate, and other assets), and showing the percentage of the fair value to total plan assets. 5. The expected benefit payments to be paid to current plan participants for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter. 6. The nature and amount of changes in plan assets and benefit obligations recognized in net income and in other comprehensive income of each period. 7. The accumulated amount of changes in plan assets and benefit obligations that have been recognized in other comprehensive income and that will be recycled into net income in future periods. 8. The amount of estimated net actuarial gains and losses and prior service costs and credits that will be amortized from accumulated other comprehensive income into net income over the next fiscal year.

Special Issues The Pension Reform Act of 1974 The Employee Retirement Income Security Act of 1974ERISAaffects virtually every private retirement plan in the United States. It attempts to safeguard employees pension rights by mandating many pension plan requirements, including minimum funding, participation, and vesting. Pension Terminations The accounting issue that arises from these terminations is whether a company should recognize a gain when pension plan assets revert back to the company (often called asset reversion transactions). The issue is complex: in some cases, a company starts a new defined-benefit plan after it eliminates the old one. Thus, some contend that there has been no change in substance, but merely a change in form. However, the FASB disagrees. It requires recognition in earnings of a gain or loss when the employer settles a pension obligation either by lump-sum cash payments to participants or by purchasing nonparticipating annuity contracts.