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 • Accounting for postretirement benefits
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 employer contributes funds to a third-party trust for benefit of employees. Companies usually require employees to contribute to the retirement plan as well. • The funds are invested by trustee for the benefit of the employees and the fund balance is paid to employees over time after retirement. • The accounting for this type of plan is relatively simple: the employer’s expense is the amount it is obligated to contribute to the plan and a liability is recorded only if the contribution has not been made in full
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: • The plan agreement defines the benefits employees will receive at retirement • All of the pension assets belong to employer - no funds are paid to a third party • If plan is under funded, employees must look to employer for the deficit. This can be a problem if the employer becomes insolvent. • As we will see later, the amount of the pension liability and expense are a function of the amount of the pension obligation to the employees and the returns on the pension fund assets. • Accounting for this type of plan is complex and the concepts we will be discussing in this section relate to this type of pension plan
There are two issues we need to consider from an accounting standpoint: • How should the pension liability be reported on the company’s balance sheet? Here, we have a couple of items to consider: first, since the company keeps the pension assets until they are paid out to employees at retirement, should the investments appear as assets? And second, the company has a liability to make payments to its employees after retirement. Should this liability be reported on its balance sheet? • How should the expense for the pension plan be computed and reported in the company’s income statement? We will consider each of these questions in turn.
Measurement of Net Pension Liability 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.
Overview - Pension Liability Future Benefits as promised by the company Present value of the Projected Benefit Obligation (PBO) PV Fair Market Value of the Pension Assets The future benefit obligations are first estimated, then discounted back to the present to compute the PBO Accrued Pension Asset / Liability (Balance Sheet)
Measurement of Pension Expense 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.
Service cost • This represents the increase in the PBO resulting from employee service during the period. That is, the increase in benefits due to working another year. (example ). • Interest cost • This is the interest accrued on the pension liability. Think of this like a bond sold at a discount. Each year the carrying value increases as the discount is amortized, reflecting the accrual of interest. (example ). • Expected return on plan assets • Pension expense is reduced each year by the increase in the plan assets available to pay the pension liability. These assets increase due to investment returns. Whereas the first two components increase the net pension liability and result in increased expense, this component reduces the net liability and also pension expense. (example )
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 Service cost + Interest cost - Expected return on plan assets Pension expense
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
Basic Accounting Entry 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 Cash (B/S) 75 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.
Prior Service Costs • Increases in the PBO arising from adoption of a new plan or amendment of a plan are called Prior Service Costs. • Under GAAP, these costs must be amortized over the expected service-years to be worked by all of the participating employees. (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:
Minimum Liability • As we have seen thus far, companies generally report only the net amount of the pension liability, that is, the FMV of the plan assets minus the PBO (as adjusted for prior service cost and unrecognized gains or losses). When companies underfund their pension obligation, this is reported as an accrued pension cost in the liability section of the balance sheet. • When the amount of underfunding is large enough, however, the FASB requires companies to report a minimum liabilitywhich is equal to the difference between the FMV of the plan assets and the accumulated benefitobligation (ABO). The ABO differs from the PBO in that the obligation in that benefits are based on current salaries, whereas the PBO is based on expected salaries at retirement.
Recording a minimum liability involves the following: • The amount of the liability is computed as the ABO less any accrued pension cost (or plus any prepaid pension cost) currently reported on the balance sheet • The company makes the following journal entry: Intangible asset - deferred pension cost xxx Additional pension liability xxx 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
Postretirement Benefits • Post-retirement benefits relate to medical benefits provided to employees after retirement. • The expense and liability for these benefits are computed similarly to pension expense and liability. • The major difference relates to the amount of any underfunding existing upon the adoption of the postretirement plan. If not recognized immediately, this transition amount is amortized on a straight-line basis over the remaining service lives of the employees or 20 years, whichever is longer.