Nature of Pension Plans An arrangement whereby an

Nature of Pension Plans An arrangement whereby an employer provides benefits (payments) to retired employees for services they provided in their working years. Pension Plan Administrator Employer Retired Employees 20 -1 Contributions Benefit Payments Assets & Liabilities LO 1

Nature of Pension Plans Defined-Contribution Plan u Employer contribution determined by plan (fixed) u Risk borne by employees u Benefits based on plan value Defined-Benefit Plan u Benefit determined by plan u Employer contribution varies (determined by Actuaries) u Risk borne by employer 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 20 -2 LO 2

Defined Benefit Plans 20 -3 l Defines benefits that employees will receive when they retire. Benefits are typically a function of an employee’s year’s of service and compensation level. l The employer owns, is responsible for, is the beneficiary of the Pension Trust in a Defined Benefit Plan. l It is the Employer that is at risk in Defined Benefit Plans. They must contribute enough to meet the cost of future benefit payments.

Accounting for Pensions – Defined Benefit Plans Two questions for Defined Benefit Plans: 1) What is the pension obligation that a company should report on the Balance Sheet? 2) What is the pension expense that should be reported for the period on the Income Statement? 20 -4 LO 3

Accounting for Pensions – Defined Benefit Plans Employer’s pension obligation is the deferred compensation obligation it has to its employees for their service under the terms of the pension plan. Alternative Measures of the Liability FASB’s choice Illustration 20 -3 20 -5 LO 3

Accounting for Pensions – Defined Benefit Plans Recognition of the Net Funded Status of the Pension Plan u Companies must recognize on their balance sheet the full overfunded or underfunded status of their defined benefit pension plan. u The overfunded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation. 20 -6 LO 3

Accounting for Pensions Illustration 20 -4 Components of Annual Pension Expense 20 -7 LO 4

Accounting for Pensions Components of Pension Expense 1. Service Costs Effect on Expense + Actuarial present value of benefits attributed by the pension benefit formula to employee service during the period 20 -8 LO 4

Accounting for Pensions Components of Pension Expense 2. Effect on Expense Interest on the Liability + Interest for the period on the projected benefit obligation outstanding during the period The interest rate use is referred to as the settlement rate. 20 -9 LO 4

Accounting for Pensions Components of Pension Expense 3. Actual Return on Plan Assets Effect on Expense +- Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair value of the plan assets. Illustration 20 -5 20 -10 LO 4

Accounting for Pensions Components of Pension Expense 4. Amortization of Prior Service Costs Effect on Expense + Plan amendments often include provisions to increase benefits for employee service provided in prior years. Company 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. 20 -11 LO 4

Accounting for Pensions Components of Pension Expense 5. Gain or Loss Effect on Expense +- Volatility in pension expense can result from sudden and large changes in the fair value of plan assets and by changes in projected benefit obligation. 20 -12 LO 4

Gains and Losses Actual Returns vs Expected Returns on Plan Assets Actual Returns on Plan Assets (investments) can have a substantial affect on Pension Expense in a given year. In order to smooth out volatility and large fluxuations, actuaries develop an Expected rate of return to get an Expected Return on Plan Assets over a period of time. Companies include the Expected Return on Plan Assets as a component of Pension Expense, NOT the Actual Return. 20 -13 LO 7

Asset Gains and Losses The difference between the Expected Return and the Actual Return is the “Unexpected Gain/Loss” FASB calls this Asset Gains and Losses Asset Gains – When Actual Return exceeds Expected Asset Losses – When Actual Return is less than Expected Asset Gains and Losses are recorded in OCI Equity 20 -14 LO 7

Liability Gains and Losses Accuaries revalue (get a Fair Value) of the Projected Benefit Obligation (Pension Liability) every year as well. “Unexpected Gains and Losses” in the Projected Benefit Obligation are called Liability Gains and Losses Liability Gains – result from Unexpected decreases in the Pension Benefit Obligation. Liability Losses – result from Unexpected increases in the Pension Benefit Obligation. Liability Gains and Losses are recorded in OCI Equity 20 -15 LO 7

Using a Worksheet for Pension Accounting 20 -16

Using a Pension Worksheet The “General Journal Entries” columns determine the journal entries to be recorded in the formal general ledger. 20 -17 The “Memo Record” columns maintain balances for the unrecognized pension items. LO 5

Using a Pension Work Sheet Illustration: On January 1, 2014, Zarle Company provides the following information related to its pension plan for the year 2014. Plan assets, January 1, 2014, are $100, 000. Projected benefit obligation, January 1, 2014, is $100, 000. Annual service cost is $9, 000. Settlement rate is 10 percent. Actual return on plan assets is $10, 000. Funding contributions are $8, 000. Benefits paid to retirees during the year are $7, 000. Prepare the pension worksheet for 2014. 20 -18 LO 5

Using a Pension Work Sheet Prepare a pension worksheet for 2014. Illustration 20 -8 ($100, 000 x 10%) ($1, 000) net liability 20 -19 LO 5

Pension Journal Entry Illustration 20 -8 Pension Expense Cash Pension Asset/Liability 20 -20 9, 000 8, 000 1, 000 LO 5

Prior Service Cost Amortization of Prior Service Cost Pension plans may require amendments or adjustments for benefits for emplyee service provided in prior years. This Prior Service Cost is amortized (allocated) to Pension Expense in the future – over remaining service years of the affected employees. 20 -21 LO 6

Prior Service Cost 1 st The employer initially records ALL of the Prior Service Cost amendment as an Other Comprehensive Income adjustment (Loss) and an increase in the Pension Benefit Obligation at the beginning of the year of the amendment 20 -22

Prior Service Cost 2 nd The employer then amortizes the Prior Service Cost out of Other Comprehensive Income, as a component of Pension Expense at the end of each year – over the remaining service lives of the employees. 20 -23

Gains and Losses Corridor Amortization u FASB invented the corridor approach for amortizing the accumulated net gain or loss balance when it gets too large. How large is too large? u 10% of the larger of the beginning balances of the projected benefit obligation or the market-related value of the plan assets. u Any Accumulated OCI net gain or loss balance above the 10% corridor must be amortized. 20 -24 LO 8

See Class Lecture Note Examples 20 -25