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Pension Plans

Defined contribution plans require the employer and also normally the employee to contribute an amount, usually a percentage of salary, to a third party. This amount accumulates for the employee and provides the employee with retirement benefits. Employee bears the risk of the investments. Employer simply expenses contributions.

Defined benefit plan requires the employer to provide a defined benefit upon retirement of qualified employees. Usually a function of ending salary, and years of service. Employer pays a trustee but is ultimately responsible to the employee for benefits earned

Acct 387 - Chapter 21


Defined Benefit Plan


Beg bal Projected Benefit Obligation

+Contributions +Service cost

+Actual Return +Interest cost

- Distributions - Distributions

= Ending Balance = Ending Balance

If the liabilities exceed the assets, the plan is underfunded. The accounting issues involve how much of the net or gross position of the plan should go on the company's financials.

Acct 387 - Chapter 21


The Basic Accounting

The basic accounting from FAS No. 87 keeps the pension off the balance sheet for the most part. The portion of pension expense that is not funded each year (or overfunded) shows as a pension liability (or asset).

Items that are not capitalized include:

Projected benefit obligation

Pension plan assets

Unrecognized prior service cost

Unrecognized net gain or loss

Acct 387 - Chapter 21



Vested benefit obligation - the benefits employees have earned even if they quit now.

Accumulated benefit obligation - the benefits employees are expected to receive based on current salaries

Projected benefit obligation - the benefits employees are expected to receive based on their anticipated future salaries

FASB elected to base pension expense on the projected benefit obligation

Acct 387 - Chapter 21


Pension Expense

  • The amount of pension expense consists of the following:
    • Service cost - the increase in PBO as a result of employees working this year
    • + Interest cost - the increase in the liability because it is carried at present value
    • Actual return on plan assets - the earnings and unrealized gains and losses on the portfolio of assets held by the fund
    • + Amortization of unrecognized prior service costs - the cost of benefits given to employees for work already performed
    • +- Gain or Loss - adjust actual return on plan assets to expected return and amortization of unrecognized losses/gains from prior periods
  • Ex 2, 3

Acct 387 - Chapter 21


Service Cost

  • This comes from the actuary, and is based on the increase in PBO from the year's work.
  • Interest Cost
  • Since the liability is carried at present value, it increases by the amount of interest each year. The interest cost is the beginning of year PBO times the settlement rate. The settlement rate is the rate at which an insurance company would settle the obligations.
  • Actual Return on Plan Assets
  • The plan is holding investments to pay future benefits. This is the amount earned on them during the year.

Acct 387 - Chapter 21


Amortization of Unrecognized Prior Service Cost

When benefits are initially granted or amended to increase them, an immediate liability is created.

It is not recorded on the company's books.

It is amortized to pension expense over the average remaining service life of employees receiving the benefit or on years of service method

Acct 387 - Chapter 21



Part One is the difference between actual return on plan assets and expected return. It adjusts pension expense so that expected return on plan assets is the true component of expense. If actual return is greater than expected return, you will recognize a loss (to reduce the return to actual), if actual return is less than expected return, you will recognize a gain.

The difference between the actual and expected returns are called unexpected gains and losses or asset gains and losses. The same can happen on the liability side of the plan, and these are called liability gains and losses.

Asset and liability gains and losses are accumulated off balance sheet until they get outside the "corridor".

Acct 387 - Chapter 21


Corridor Amortization

The FASB believed that these gains and losses should be able to "ride" unless they get too large, as they often reverse themselves from one year to the next.

Must amortize the unrecognized net gain or loss balance when it exceeds 10% of the larger of the beginning balance of the projected benefit obligation or the market-related value of plan assets at the beginning of the year.

Amortization is the difference between the corridor and the unrecognized net gain/loss divided by the average remaining service life of all active employees.

Ex 8, 9

Acct 387 - Chapter 21


Minimum Pension Liability

Because so much is off balance sheet, the FASB decided that there are situations in which additional liability must be booked on the balance sheet.

Minimum liability must be recorded equal to the excess of the accumulated benefit obligation over the fair value of plan assets.

Increase the existing liability to this amount, and record a debit first to "Intangible Asset - Deferred pension cost" to the extent that unrecognized prior service costs exist, then put any excess to "Excess of additional pension liability over unrecognized prior service cost" which is a contra equity account.

Ex 14, 15, Pb 7

Acct 387 - Chapter 21