Accounting for Pensions Items to be covered: Types of retirement plans Defined contribution Defined benefit Accounting for pensions (defined benefit plans) Measurement of pension liability Capitalization, non-capitalization, partial capitalization Measurement of pension expense Smoothing
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Items to be covered:
There are two kinds of pension plans: defined contribution
plans and defined benefit plans.
Defined contribution plans (e.g., 401k plans) have become increasingly more popular. In this type of plan,
The following is an example of the accounting for a defined contribution plan from the annual report of The Sharper Image. The company matched contribution to the plan by its employees and recorded an expense in its income statement for the amount contributed to the plan.
Note H -- 401k Savings Plan
The Company maintains a defined contribution, 401k Savings Plan, covering all employees who have completed one year of service with at least 1,000 hours and who are at least 21 years of age. The Company makes employer matching contributions at its discretion. Company contributions amounted to $73,000, $77,000, and $81,000 for the fiscal years ended January 31, 1999, 1998, and 1997, respectively.
The defined benefit plan is the second type of plan in use today. For this type of plan:
There are two issues we need to consider from an accounting standpoint:
We will consider each of these questions in turn.
Remember - all of the assets of the pension plan are retained by the employer until paid out to the employees at retirement. Also, the pension obligation is determined by the terms of the pension plan and is not satisfied until retirement payments are made.
When the accounting standards for pensions were revised in 1996, the FASB wanted both the assets and the liability to appear on the face of the balance sheet. Companies were concerned, however, that liability this would negatively impact their credit ratings and increase their cost of raising funds as a result.
A compromise was reached and the FASB only required the net amount to be reported on balance sheet. This is called “partial capitalization”. If the plan is over funded, an asset appears on the balance sheet and if the plan is under funded, companies report a net pension liability.
Future Benefits as
promised by the
Present value of the
Fair Market Value
of the Pension Assets
The future benefit
obligations are first
to the present
to compute the PBO
Accrued Pension Asset /
Liability (Balance Sheet)
In general, pension expense reported in the income statement is related to how much the pension liability increased during the year compared with the return on the plan’s assets.
Pension liability increases as employees continue to work (benefits are usually related to the years of service), get closer to retirement, or if the company increases its promised benefits. All of these factors that increase the pension liability also increase the pension expense in the income statement.
Pension assets increase with earnings that the company realizes on its investments. These earnings reduce the pension expense reported in the income statement.
This is the increase in the pension liability due to the passage of time
This is the increase in the pension liability resulting from employees working another year for the company
This is the long-run expected rate that the company expects to earn on the pension fund assets
Overview - Pension Expense
+ Interest cost
- Expected return on plan assets
The following is an example of the computation of pension cost form Hasbro’s annual report:
Don’t worry about
amortization and deferrals
for now. We’ll cover these
a little later
Once the pension expense has been computed, an example of the journal entry to record pension activity is as follows:
Pension expense (I/S)100
Accrued pension liability (B/S)25
In this example, the first line is the recognition of expense in the income statement (I/S). The second and third lines reflect on the balance sheet (B/S) the amount of the expense that has been funded by the company. If the company underfunds the expense as liability is created as in this example. If it overfunds the expense, an asset is created (prepaid pension cost).
Let’s look at an example of the computation of pension expense, the net pension liability and the required journal entry:
(Click here to view an example of the basic pension computations and journal entry.)
When pension plans are initially adopted or amended, the future benefit amounts and, consequently, the PBO change significantly in the year of adoption or change. These changes are, essentially, a reward for the prior service of the employees.
Using the procedures we have developed thus far, this increase in the PBO would be reflected as pension expense, thereby reducing profitability in the year of the change.
The FASB took the position that these costs should be recognized in the service periods of those employees expected to receive benefits under the new plan, that is, when the benefits arising from the plan through motivation of its employees will be realized by the company.
(Click here to view an example of the accounting for prior service costs.)
A second complication arises in the area of the return on plan assets. Remember, we utilize the expectedreturn in computing pension expense. It is likely, however, that the actual return will not equal the expected return.
It may also be the case that the assumptions we used in estimating the PBO may turn out to be incorrect (we may not accurately estimate the inflation in wage rates, the turnover of our employees, etc.).
These unexpected gains and losses on plan assets and PBO actuarial assumptions are accumulated in a memo account just like prior service costs and are amortized in a similar manner, but utilizing the corridor approach.
The next slide is an example of the corridor approach. The accumulated unexpected gains/losses account is compared with the beginning PBO balance and the FMV of the plan assets. Any amounts greater than 10% of the larger of the two are amortized over remaining service lives of the employees
Let’s look at an example of unexpected gains on plan assets when we relax the assumption that actual returns and expected returns are equal.
(Click here to view an example relating to unexpected gains and losses.)
The following is an example of the computation of pension expense that includes the amortization of prior service cost and unrealized gains from Anheuser-Busch’s annual report:
Recording a minimum liability involves the following:
Intangible asset - deferred pension costxxx
Additional pension liabilityxxx
If the minimum liability is greater than the balance in the prior service cost account, if any, the excess is debited to a contra equity equity account rather than an intangible asset and stockholder’s equity is reduced accordingly.
(Click here to view an example of the accounting for minimum pension liability)
The following is an example of a minimum pension liability disclosure from Honeywell’s annual report. Since the ABO is less than the FMV of the plan assets, an additional minimum liability must be recorded. Also, since the minimum liability is in excess of the prior service cost balance, the excess must be recognized as contra equity rather than an intangible asset