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Financial Accounting II
Table of Contents
Unit 8 Overview: Pensions & Postretirement Benefits
8.1 Defined Benefit and Defined Contribution Plans
8.2 Pension Expense Components and Reporting
8.3 Other Postretirement Benefits Accounting

Pension expense components are crucial in understanding a company's financial obligations to its employees. These elements, including service cost and interest cost, impact both the income statement and balance sheet, reflecting the ongoing cost of providing retirement benefits.

Calculating pension expense involves complex factors like actuarial assumptions and plan asset returns. Proper reporting and disclosure of these components allow stakeholders to assess the company's pension obligations and their potential impact on financial performance and position.

Pension Expense Components

Elements of Pension Expense

  • Service cost represents the actuarial present value of benefits attributed to employee services rendered during the current period
    • Increases pension expense and the projected benefit obligation (PBO)
  • Interest cost is the interest accrued on the PBO during the period, calculated using the discount rate
    • Increases pension expense and the PBO
  • Expected return on plan assets is the anticipated earnings on invested pension funds, reducing pension expense
    • Actual returns differing from expected returns create gains or losses
  • Amortization of prior service cost systematically allocates the cost of retroactive benefits over the remaining service lives of active employees
    • Increases pension expense and reduces the PBO
  • Recognition of gains and losses arising from changes in actuarial assumptions or differences between actual and expected returns on plan assets
    • Generally amortized into pension expense over time

Impact on Financial Statements

  • Pension expense components impact both the income statement and balance sheet
    • Service cost, interest cost, amortization of prior service cost, and recognition of gains/losses increase pension expense on the income statement
    • Expected return on plan assets decreases pension expense on the income statement
    • Changes in the PBO affect the pension liability or asset on the balance sheet
      • Increases in PBO from service cost, interest cost, and losses increase the pension liability
      • Decreases in PBO from gains and amortization of prior service cost decrease the pension liability

Pension Expense Calculation

Service Cost Calculation

  • Multiply the applicable service cost per year of service by the number of years of service attributable to the current accounting period for each employee
    • Sum the amounts for all employees to determine total service cost
    • Example: If an employee's pension benefit increases by $1,000 for each year of service, and the employee works for 5 years, the service cost for that employee would be $5,000

Interest Cost Calculation

  • Multiply the PBO at the beginning of the period by the settlement rate (discount rate used to calculate the PBO)
    • The settlement rate is based on high-quality corporate bond yields that match the timing and amount of expected benefit payments
    • Example: If the PBO at the beginning of the year is $100,000 and the discount rate is 5%, the interest cost would be $100,000 × 5% = $5,000

Expected Return on Plan Assets Calculation

  • Multiply the fair value of plan assets at the beginning of the period by the expected long-term rate of return on those assets
    • The expected rate of return should be based on the composition of plan assets and their associated risks
    • Example: If the fair value of plan assets at the beginning of the year is $80,000 and the expected rate of return is 6%, the expected return on plan assets would be $80,000 × 6% = $4,800

Actuarial Gains and Losses

Sources of Gains and Losses

  • Actuarial gains and losses result from changes in the PBO due to:
    • Experience different from what was assumed (e.g., higher or lower employee turnover, salary increases, or mortality rates)
    • Changes in actuarial assumptions (e.g., discount rate, expected rate of return on plan assets, or future salary increase rates)
  • Gains decrease the PBO and future pension expense, while losses increase the PBO and future pension expense
    • Example: If the actual return on plan assets is higher than the expected return, it results in an actuarial gain, reducing future pension expense

Recognition of Gains and Losses

  • Immediate recognition of gains and losses would cause significant volatility in pension expense and the PBO
    • The FASB allows delayed recognition through amortization to mitigate this volatility
  • The corridor approach amortizes accumulated gains and losses exceeding 10% of the greater of the PBO or market-related value of plan assets
    • Amortization occurs over the average remaining service period of active employees
    • Example: If the accumulated losses exceed the 10% corridor by $50,000 and the average remaining service period is 10 years, $5,000 would be amortized into pension expense each year

Pension Expense Journal Entries

Recording Pension Expense

  • Debit Pension Expense for the sum of service cost, interest cost, amortization of prior service cost, and amortization of net loss
  • Credit Pension Expense for expected return on plan assets and amortization of net gain
    • Example: If service cost is $10,000, interest cost is $5,000, expected return on plan assets is $4,000, and amortization of net loss is $1,000, the journal entry would be:
      • Debit Pension Expense $12,000
      • Credit Pension Asset/Liability $12,000

Recording Contributions and Gains/Losses

  • Credit Cash for contributions made to the pension plan, with the debit going to Pension Asset/Liability
    • Example: If the company contributes $15,000 to the pension plan, the journal entry would be:
      • Debit Pension Asset/Liability $15,000
      • Credit Cash $15,000
  • Debit or credit Pension Asset/Liability for gains or losses from actual returns differing from expected returns, with the offsetting entry to Other Comprehensive Income (G/L)
    • Example: If the actual return on plan assets is $5,000 higher than the expected return, the journal entry would be:
      • Debit Pension Asset/Liability $5,000
      • Credit Other Comprehensive Income (G/L) $5,000

Recording Prior Service Cost Amendments

  • Debit Prior Service Cost (an off-balance sheet account) and credit PBO for the cost of retroactive benefits granted in a plan amendment
    • The cost is then amortized into pension expense over the remaining service lives of active employees
    • Example: If a plan amendment grants $50,000 in retroactive benefits and the average remaining service period is 10 years, the initial journal entry would be:
      • Debit Prior Service Cost $50,000
      • Credit PBO $50,000
    • Each year, $5,000 would be amortized into pension expense with the following entry:
      • Debit Pension Expense $5,000
      • Credit Prior Service Cost $5,000

Pension Disclosure Interpretation

Reconciliation of PBO and Plan Assets

  • Disclosures include a reconciliation of beginning and ending balances of the PBO and plan assets, showing the impact of:
    • Service cost, interest cost, contributions, benefits paid, and gains/losses
    • Helps users understand the reasons for changes in the PBO and plan assets during the period
    • Example: The reconciliation might show that the PBO increased by $20,000 due to service cost and interest cost, decreased by $15,000 due to benefits paid, and increased by $5,000 due to actuarial losses

Funded Status and Balance Sheet Reporting

  • The funded status (plan assets minus PBO) is reported on the balance sheet as a net pension asset or liability
    • A positive funded status indicates the plan is overfunded and is reported as a net pension asset
    • A negative funded status indicates the plan is underfunded and is reported as a net pension liability
    • Example: If the PBO is $500,000 and the fair value of plan assets is $450,000, the funded status would be a net pension liability of $50,000

Key Assumptions Disclosure

  • Key assumptions used in pension calculations are disclosed, including:
    • Discount rate, expected return on assets, rate of compensation increase
    • Allows users to assess the reasonableness of the assumptions and their impact on pension measurements
    • Example: The disclosure might state that the discount rate is 5%, the expected return on plan assets is 7%, and the rate of compensation increase is 3%

Plan Asset Composition and Fair Value

  • The composition of plan assets by category (equity securities, debt securities, real estate, etc.) and fair value measurements are reported
    • Helps users understand the risk and return characteristics of the plan assets
    • Example: The disclosure might show that 60% of plan assets are invested in equity securities, 30% in debt securities, and 10% in real estate, with all assets measured at Level 1 fair value

Future Benefit Payments

  • Estimated future benefit payments for each of the next five years and in aggregate for the five years thereafter are disclosed
    • Provides information about the timing and amount of expected cash outflows for benefit payments
    • Example: The disclosure might show that the company expects to pay $10,000 in benefits in Year 1, $12,000 in Year 2, $15,000 in Year 3, $18,000 in Year 4, $20,000 in Year 5, and a total of $120,000 for Years 6-10

Key Terms to Review (19)

GAAP: GAAP, or Generally Accepted Accounting Principles, is a framework of accounting standards, principles, and procedures used in the preparation of financial statements. It ensures consistency and transparency in financial reporting, which is essential for stakeholders to make informed decisions based on comparable financial information across different organizations.
Actuarial gain or loss: An actuarial gain or loss refers to the changes in the value of a company's pension obligations that arise from differences between expected and actual outcomes, such as changes in life expectancy, salary increases, or turnover rates. These gains or losses affect the funded status of a pension plan and are important for calculating pension expense and reporting pension liabilities accurately.
Net periodic pension cost: Net periodic pension cost is the total expense recognized in a company’s financial statements for its defined benefit pension plan over a specific period. This cost is composed of various components including service cost, interest cost, expected return on plan assets, amortization of prior service cost, and gains or losses. Understanding this cost is crucial for accurate financial reporting and assessing a company's long-term obligations related to employee pensions.
Required Disclosures: Required disclosures are specific pieces of information that companies must provide in their financial statements and accompanying notes to inform stakeholders about various aspects of their financial performance and position. These disclosures help enhance transparency, ensuring that investors, creditors, and other interested parties can make informed decisions based on the company’s financial health and the risks associated with its operations.
Vesting: Vesting refers to the process by which an employee earns the right to receive benefits from an employer's retirement plan or pension after meeting certain conditions, usually based on length of service. This concept is essential for understanding how retirement benefits are secured and delivered over time, as it ensures that employees will ultimately receive their pension or retirement savings, even if they leave the company before retirement age.
Notes to financial statements: Notes to financial statements are supplementary disclosures that provide additional information and context to the financial statements of an organization. They help clarify accounting policies, assumptions, and any potential risks that may affect the financial position of the company, particularly in relation to complex topics like pension expenses.
Projected Unit Credit Method: The projected unit credit method is an actuarial valuation approach used to determine the present value of future pension obligations. This method considers an employee's expected salary growth and the probability of their future service, providing a more accurate estimate of pension liabilities over time. It helps in calculating the pension expense components, which are essential for financial reporting.
Mortality rates: Mortality rates refer to the measure of the number of deaths in a specific population over a given period, typically expressed per 1,000 individuals. This statistic is crucial in assessing the financial implications for pension plans, as higher mortality rates can impact the funding requirements and expenses associated with retirement benefits, thereby influencing overall pension expense calculations.
Expected return on plan assets: The expected return on plan assets is the anticipated income generated from the investments held within a pension plan. This figure is crucial for calculating pension expense, as it offsets the cost of pension benefits that a company must report. The expected return helps companies understand how well their invested funds are performing and what future payouts might look like based on those returns.
Pension obligation: A pension obligation represents the total amount a company is required to pay to its employees upon retirement, based on the terms of its pension plan. This obligation is recorded as a liability on the company's balance sheet and reflects the present value of future pension payments, which must be carefully calculated to ensure proper funding and reporting of pension expenses over time.
Service cost: Service cost refers to the present value of the benefits earned by employees during a given period for their service, often related to pension and other postretirement benefits. It is a critical component in measuring the total pension expense and is recognized in the financial statements to reflect the employer's obligation to its employees. Understanding service cost is essential for accurately reporting pension obligations and ensuring compliance with accounting standards.
Interest cost: Interest cost refers to the expense incurred by a company when it recognizes the time value of money related to its pension and other postretirement benefit obligations. This cost reflects the increase in the present value of these obligations over time as the employees earn benefits, acknowledging that money available now is worth more than the same amount in the future. Understanding interest cost is crucial for accurately calculating pension expenses and managing other retirement-related liabilities.
Contribution: In the context of pension expense, contribution refers to the amounts that an employer or employee pays into a pension plan to fund future benefits. This term is crucial as it directly influences the funding status of a pension plan and affects the pension expense reported in financial statements. Contributions are essential for ensuring that there are enough assets to meet future obligations to retirees.
Discount rate: The discount rate is the interest rate used to determine the present value of future cash flows. It's crucial for valuing long-term liabilities like pension obligations and leases, as it impacts how much those future obligations are worth today. A higher discount rate results in a lower present value, which affects financial reporting and decision-making regarding employee benefits and lease agreements.
Funded status: Funded status refers to the financial health of a pension plan, indicating whether the plan has sufficient assets to meet its future obligations to retirees. A plan is considered fully funded when its assets equal or exceed its liabilities; otherwise, it is underfunded. Understanding funded status is crucial as it impacts how companies report pension expenses, assess their long-term liabilities, and manage retirement benefits for employees.
Defined benefit plan: A defined benefit plan is a type of retirement plan where an employer guarantees a specific payout upon retirement, based on factors like salary history and duration of employment. This means employees know exactly what they will receive when they retire, providing financial security for the future. The employer is responsible for managing the investments and assumes the investment risk, making these plans distinct from other retirement plans.
Balance Sheet: A balance sheet is a financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It shows what the company owns and owes, offering insight into its financial health and stability.
Income Statement: An income statement is a financial report that summarizes a company's revenues, expenses, and profits or losses over a specific period, typically a quarter or a year. It provides key insights into the company's operational performance, allowing stakeholders to assess profitability and efficiency in generating income.
IFRS: International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. IFRS provides a common global language for business affairs, ensuring consistency in the financial reporting and making it easier for investors to compare financial statements from different countries.