Module 15Pensions and Other Post-Employment Benefits

Pension plans

Post-employment benefits refer to promises made by a company to terminated or laid-off employees. These benefits include pensions, health-care benefits, unemployment pay, job-training, or employment counseling. Thus, the phrase “post-employment benefits” is broader than “post-retirement benefits.” However, post-retirement benefits are the most important of the post-employment benefits, and constitute the focus of this module. Pensions and health-care benefits are the two primary post-retirement benefits.

Statement of Financial Accounting Standard (SFAS) No. 87 provides guidance related to accounting for pension plans. Accounting for other post-retirement benefits other than pensions (primarily related to health care) is governed by SFAS No. 106.

Pension plans pay benefits to employees after retirement. There are two broad categories of pension plans Defined-contribution plan, and Defined-benefit plan.

In a defined-contribution plan, the employer contributes a known amount (usually based on a specified percent of employee salary) to a pension plan. The only obligation for the employer is to pay this amount each period, as long as the employee is working for the company. Usually, the employee also contributes some amount to the pension plan. The assets are invested in a variety of securities (such as stocks, bonds, money market funds, and real estate investment trusts). The account “belongs” to the employee who withdraws from the account after retirement. The widely popular 401-k plans are defined contribution plans.

The key point to note is that once the periodic payment is made, there is no other future financial obligation for the employer in a defined-contribution plan. That is, the risk associated with the plan is borne entirely by the employee. If the employee invests wisely and successfully, then he or she will have a comfortable pension during retirement. However, if the employee is not successful in his or her investment decisions, then there will be less money available during retirement.

From an accounting perspective, defined-contribution plans are very easy. There is only one journal entry each period. When the company makes a payment to the pension plan, there will be a debit to Wages (or Compensation) Expense and a credit to Cash. (Alternatively, the company may first credit a Payable account and then once the payment is made, credit the Payable account. That is, there may be two journal entries each period.)

The excellent performance of the stock market during the 1980s and 1990s also has contributed to the rising popularity of defined-contribution plans. In addition, as noted below, the employer has to bear the risks associated with defined-benefit plans. Hence, employers have become increasingly more likely to offer defined-contribution plans.

Defined Benefit Plans

In a defined-benefit plan, the ultimate pension benefit to be received by the employee is specified in the employment contract. The periodic payments are not specified in the contract. (Hence, the name –since it is the benefit that is defined, the plan is called “defined-benefit plan.”) Thus, the employer is responsible for making sure there is enough assets in the retirement plan to pay the specified amounts during retirement. That is, the risk associated with the plan rests with the employer. The employer has to make the investment decisions that will ensure there is enough money in the plan to pay for the specified retirement benefits. The rest of this module will focus on defined-benefit plans.

The usual formula for calculating the retirement benefits under a defined-benefit plan is as follows:Annual pension = Number of years of service x Specified percent x Average salary

The percent specified is usually between two to three percent. In many plans, only the average of the salaries over the last few years (usually between two to five years) before retirement is used in the formula. Some plans use the average of the highest salaries received (that is, the average used may be the average of the three or five highest salaries received). (However, since salaries usually increase with time, the difference may not matter.)

Example.Jim Jones retired from Webb Company on December 31, 2002, after working for 30 years. The Company’s defined-benefit pension plan specifies a credit of 2% for each year of service, and calculated benefits based on the average of the last three years’ salaries. Jones salaries for the years 2000, 2001, and 2002 were $48,500, $49,500 and $52,000, respectively. Calculate the annual pension that Jones will receive.

The average of the last three years’ salaries = $50,000 ([$48,500 + $49,500 + $52,000]/3).Thus, the annual pension for Jones = 30 years x 2% per year x $50,000 = $30,000.Jones will receive $30,000 a year as long as he lives.

Benefit Obligations (PBO and ABO)

The accounting issue for the employer is that the pension will be paid in the future, but it represents an obligation of the company today. Hence, the employer must calculate the present value of the future pension payments. The interest rate used for the present value calculation of the future pension obligation is known as the settlement rate. This interest rate is chosen by management, and can have a significant impact on the amount of the pension obligations recognized by the company.

Continuing with our Webb Company example, assume that Jim Jones is expected to live for 10 years after retirement. For the sake of simplicity, we assume that the first retirement check will be given on January 1, 2003 and that pension checks are mailed on January 1 of each year. Since the annual pension for Jim Jones was calculated to be $30,000 paid at the beginning of each year, the pension payments represent an annuity due of $30,000 per period for 10 periods. Also, assume that the settlement rate used by Webb Company is 8%. Then, the current obligation of Webb Company for the future pension payments to be made to Jim Jones is

= Present value of an annuity of $30,000 for 10 periods, 8% per period= $30,000 x PV factor for annuity due of 10 periods, 8%= $30,000 x 7.25= $217,500.

Example.As of December 31, 2002, Sally Jones has worked with Webb Company for 25 years. Sally is expected to retire on December 31, 2007, and live for 10 years after retirement. Her current annual salary is $40,000 but her average annual salary for the last three years before retirement is expected to be $50,000.

Note that Sally’s salaries during the last three years before retirement and her expected life are the same as that of Jim Jones. Further, as of the date she retires, she also will have the same 30 years of service with the Company as Jim Jones. Thus, her pension benefits will be exactly the same as that of Jim Jones, and the Company’s obligation with respect to her pension is the same as the obligation for the pension of Jim Jones.

The difference is that Sally is expected to retire not tomorrow (as will Jim Jones) but only five years from now. The present value of Sally’s future pension obligation to the Company also will be $217,500 but that is as of the date Sally retires. Since Sally will retire only five years from now, that amount has to be discounted back to the present. Thus, as of December 31, 2002, the present value of the future pension obligation related to Sally is:

= Present value of a single sum of $217,500, due five years from nowSince the discount rate used by the Company is 8%, the present value is

= $217,500 x PV of single sum, five years from now at 8%= $217,500 x 0.68= $147,900.

This amount is known as the projected benefit obligation (PBO). This is the present value of all pension benefits earned by Sally Jones based on her past service to the Company.

Note the difference between the situations of Jim Jones and Sally Jones. In the case of Jim Jones, only one present value calculation was needed. That is because Jim is retiring today, and the present value of his pension benefits as of today is needed. In the case of Sally Jones, there was a two-step process. In the first step, the expected future obligation to the Company as of the date she will retire was calculated. In the second step, since Sally’s retirement is in the future, the present value of that amount as of today was calculated. Note that only the pension represents an annuity. The amount calculated in the first step represents a “single-sum equivalent” as of the date the employee will retire, so only a single-sum discounting is needed in the second stage.

The PBO was calculated using EXPECTED FUTURE SALARIES. Instead of using expected salaries, the present value of pension benefits earned by Sally Jones can also be calculated using her CURRENT AND PAST SALARIES. This amount is known as the accumulated benefit obligation (ABO).

Thus, the only difference between the PBO and ABO is that the PBO uses expected future salary levels while the ABO uses current and past salary levels. Since salaries are usually increasing over time, the PBO will usually be higher than the ABO.

Interest Cost and Service Cost

The PBO is a discounted present value amount. Any present value number automatically increases over time. For example, assume that today is December 31, 2002. Consider a single

sum of $1,000 due five years from now (on December 31, 2007). If the interest rate used for discounting is 8%, the present value factor for discounting is 0.68. Thus, the present value of the $1,000 due five years from now equals $680 ($1,000 x 0.68) now.

Assume that one year has elapsed. There are only four more years left before the $1,000 becomes due. The present value of the $1,000 as of December 31, 2003 can be obtained by discounting the $1,000. The discount factor for four years at 10% per period equals .735, so the present value of the $1,000 as of now (that is, December 31, 2003) is $735.

This amount can also be calculated as follows. The present value due as of December 31, 2002 was $680. Since one year has gone by, this amount has “earned” interest at 8% for one year. Hence the interest on the $680 for one year equals $55 (8% of $680, with a small adjustment for rounding), and the total amount due as of December 31, 2003 equals $735 ($680 due as of December 31, 2002 plus one year’s interest of $55).

Thus, the rule is that any present value amount increases simply with the passage of time as it earns interest. Since the PBO is a present value amount, there is interest associated with the PBO each year. The interest cost is calculated based on the beginning balance of the PBO, and the settlement rate is used to calculate the interest.

Continuing with the Webb Company example, as one year goes by Sally Jones has worked for one more year. Based on the pension plan, she receives a 2% credit for each extra year she works for the Company. The average of her three highest salaries was assumed to be $50,000. Thus, by working one more year up to December 31, 2003, the extra pension she receives will be

= $50,000 x 2% per year x one year= $1,000 per year.

Thus, the pension annuity increases by $1,000 because Sally Jones works for one more year. Since this is in the future, the present value of this extra annuity must be calculated as of now. Since Sally is expected to live for 10 years in retirement, the total present value of this extra $1,000 pension annuity as of the date she will retire will be

= $1,000 x Present value factor for annuity due, 10 years, 8% per period= $1,000 x 7.25= $7,250.

However, this is the present value as of the date Sally will retire which is December 31, 2007 or four years from December 31, 2003. So the present value of this extra benefit as of now (that is, December 31, 2003 –remember Sally has now worked for one more year) will be

= $7,250 x Present value factor for single sum, four years, 8% per period = $7,250 x 0.735= $5,329 (rounded).

This amount is known as the service cost and is the present value of the benefits attributed by the pension plan because the employee has worked during the current year.

Note the difference between interest cost and service cost. Interest cost arises simply because of the passage of time, regardless of whether or not the employee has worked during the year. Thus, interest cost will be relevant for all employees covered by the pension plan, irrespective of whether they are still working or have retired or have been laid-off by the Company during the

year. Service cost arises because the employee has worked for one more year. Service cost will not arise for retired employees or for employees who did not work during the current year.

Prior Service Cost and Pension benefits

Companies may introduce a new pension plan or make changes to their existing pension plan. For example, a company may decide to adopt a new pension plan and give credit to current employees. For example, assume that the Webb Company introduced the pension plan during the year 2002. The Company may decide that employees will receive credit for their previous years of service with the company, as opposed to starting the benefits for everyone from scratch. That is, someone like Sally Jones who has worked for 25 years with the Company may get the credit for her past service with the Company on the day that the pension plan is adopted. This in turn means the Company has assumed new obligations on the day the pension plan was adopted.

Companies also may decide to change the terms of their pension plan. For example, Webb Company may decide that employees will receive a credit of 3% (as opposed to 2%) for each year of service with the Company. Such a change increases the obligations for the Company related to the pension plan.

Thus, the pension obligations of the Company change as a result of adopting a new plan or making changes to an existing plan. The present value of such changes in the obligations of the Company are known as prior service costs. The Company grants such extra benefits in appreciation of services rendered in the past, and expects to receive benefits in the future (in the form of happier employees who may be more loyal and work better). Thus, the extra benefits granted to the employees are accounted for as assets (because they are expected to provide future benefits). Hence, when pension benefits are newly granted or increased the obligations increase and an asset is recognized.

The journal entry when new pension benefits are granted is:Debit Prior Service Costs (Asset)

Credit Projected Benefit Obligation (Liability)

Prior Service Cost is an intangible asset. Hence, it is amortized each period. The asset is amortized over the estimated useful service life of the employees, using the straight-line method. Assume that the Prior Service Cost when Webb Company introduced a new pension plan was $500,000 and that the estimated average remaining service life of the employees is 20 years. Then, the annual amortization of the Prior Service Cost will be $25,000 ($500,000 divided over 20 years). The journal entry for amortizing Prior Service Cost each period is

Debit Amortization ExpenseCredit Prior Service Costs

Pension benefits are paid to employees after they retire. As the benefits are paid, the obligations of the company decrease. Hence, the PBO will decrease by the amount of pension benefits paid.

Recall that the PBO is a present value discounted number, and hence will increase with the passage of time. This is the interest cost associated with the PBO. Further, the PBO will increase during a period by the amount of the service cost.

This gives the following relationship:PBO at the end of a year = PBO at the beginning of the year +

Current period service costs + Interest cost on PBO for the period – Benefits paid in current period

Review Question 1

1. In a _______ pension plan, the employer contributes a known amount (usually based on a specified percent of employee salary) to a pension plan.

2. In a _______ pension plan, the payments to be received by the employee is specified in the employment contract.

3. The ______ is the present value of all pension benefits earned by employees based on past service to a Company, using current and past salary levels.

4. ________ is a cost which arises each period merely because of the passage of time.5. ________ is a cost which arises each period because the employee has worked for one

more year. 6. The ______ is the present value of all pension benefits earned by employees based on past

service to a Company, using expected future salary levels.

Answers1. Defined contribution 2. Defined benefit 3. Accumulated benefit obligation4. Interest cost 5. Service cost 6. Projected benefit obligation

Pension funding and Pension expense

Recall that defined-benefit pension plans specify the benefits but are silent about the funding each period. However, the Employee Retirement Security Act (ERISA) of 1974 specifies minimum funding standards. Management decides the amount of funding for the pension plan, subject to the requirements of ERISA.

The assets in the pension plan are invested in a variety of assets and earn returns. The fair value of the pension assets increases by the amount of return on the assets, and also by any additional contributions to the pension plan by the company. The plan assets decrease when benefits are paid to employees. Thus, Ending balance of pension plan assets

= Beginning balance of pension plan assets + Return on plan assets for the period + New contributions to plan by the company – Benefits paid during period

There are two issues from an accounting perspective related to pension plan assets and pension funding. First, the pension plan assets and the PBO are not shown separately as asset and liability on the balance sheet. Instead, they are netted and the balance is shown as an asset or liability (called Prepaid/Accrued Pension Cost).

The second point to note is that the amount of funding for the pension plan during a period is not the same as the pension expense for a period. However, the return on the pension assets decreases the pension expense to be recognized in any period.

The pension expense for a period will be= Current period service costs + Interest cost on PBO for the period + Amortization expense of Prior Service Costs – Return on pension plan assets during the current period

At the end of each period, the Company will record a journal entry for the periodic pension expense and the funding for the period. Since expenses are debited and cash outflows are credited, the journal entry is

Debit Pension CostCredit Cash (for the amount of pension-plan funding during the year)

The two need not be equal. That is, a Company need not fund the pension plan by the exact amount of the periodic pension expense for that period. Hence, a plug entry (to make debits equal credits) is usually required. The name of the account for the plug entry is “Prepaid / Accrued Pension Cost.” This is a combined asset / liability account, and will be called an asset or liability depending on the balance at any given point in time.

Assume that during 2003 the pension cost is $30,000 while the pension funding was only $26,000. This means there is a plug credit entry of $4,000 required for the Prepaid/Accrued Pension Cost account. If the balance in the account at the start of the year was zero, then as of the end of 2003 the Prepaid/Accrued Pension Cost account will have a credit balance of $4,000 and hence will be a liability.

Continuing with the example above, assume that during 2004 the pension cost is $33,000 while the pension funding was $38,000. This means there is a plug debit entry of $5,000 required for the Prepaid/Accrued Pension Cost account. Note that the balance in the Prepaid/Accrued Pension Cost account at the start of 2004 was a credit balance of $4,000. Hence, the balance as of the end of 2004 in the Prepaid/Accrued Pension Cost account will be a net debit of $1,000 (that is, it will be an asset with a balance of $1,000 at the end of 2004).

Actual and Expected Returns on Plan Assets

Accounting standards are often the products of compromises. SFAS 87 is a primary example of an accounting standard issued on the basis of practical compromises. Theoretically, the pension cost calculation noted above (Current period service costs + Interest cost on PBO for the period + Amortization expense of Prior Service Costs – Return on pension plan assets during the current period) makes sense. However, when the draft of SFAS 87 was issued, there were vehement protests from many companies. One of the reasons for the protests was that the return on pension plan assets could vary significantly each period. This in turn would lead to significant variations in the pension expense, and hence the reported net income. (Managers usually do not like great fluctuations in reported net income.) The protesters noted that pension plans have long-term focus and hence short-term fluctuations would distort reality.

As a compromise the FASB decided that companies should subtract not the actual returns, but the expected returns in calculating the periodic pension expense. Since expected returns do not vary significantly from period to period, this compromise leads to smoothing the periodic pension expense.

Example.Information about the pension plan details of Bristol Company for the year ending December 31, 2002 are given below:Service cost for 2002 $ 90,000Interest on Projected benefit obligation 34,000Amortization of prior service cost 6,000Fair market value of pension plan assets, 1/1/2002 300,000Actual return on pension plan assets 40,000Expected Rate of return on plan assets 10%Calculate pension expense for 2002.

The expected return on plan assets = $300,000 x 0.10 = $30,000.Hence, the pension expense for 2002 is calculated as follows:Service cost for 2002 $ 90,000+ Interest on Projected benefit obligation 34,000+ Amortization of prior service cost 6,000– Expected return on plan assets (30,000)= Pension expense for 2002 100,000

The actual return on plan assets for the period was $40,000. Thus, there is an “excess return” of $10,000 over the expected return. This excess is like a rainy-day reserve, and will be useful in future periods if the actual returns are less than expected returns.

Note.Excess return = Actual return – Expected return, or Expected return = Actual return – Excess return.Thus, Some amount – Expected return = Some amount – Actual return + Excess return.Thus, the table above to calculate the periodic pension expense can be rearranged as follows:Service cost for 2002 $ 90,000+ Interest on Projected benefit obligation 34,000+ Amortization of prior service cost 6,000– Expected return on plan assets = Actual return on plan assets (40,000) Deferral of excess gain during year 10,000

(30,000)= Pension expense for 2002 100,000

The excess return is referred to as gain on plan assets. It is possible that in other periods the actual returns may be lower than the expected return on plan assets. In such instances, the difference between the actual return and expected return is referred to as a loss on plan assets. Note that the term “loss” does not mean the company had a negative return, but only means that the actual return was less than the expected return.

Corridor Amortization

In the Bristol Company example above, the excess return that has been deferred (that is, postponed) for future periods was $10,000. The expectation was that such gains would balance

out losses (or returns lower than expected) in other periods. However, it is possible that there could be prolonged periods when a company experiences gains (or losses) each year. In such cases, the gains (or losses) could keep adding up, and become significant.

Assume that the Bristol Company had $8,000 of excess returns in the next year (2003). Thus, as of the end of 2003, the cumulative excess returns (gains) that have been deferred are $18,000 ($10,000 in 2002 and $8,000 in 2003). (This assumes that the Company had a zero balance of gains and losses as of the beginning of 2002). This amount is known as the cumulative uncreognized net gain or loss.

If the cumulative unrecognized net gain or loss becomes large, then it has to be amortized over the expected average future service periods of the employees. This is known as the corridor method. The calculations for the corridor method are as follows.

Step 1. Determine the larger of the PBO or plan assets, as of the beginning of the period.

Step 2. Calculate 10% of the amount in step 1. This amount is known as the corridor. Note that the corridor is based on absolute values (that is, plus or minus; the plus side is used in dealing with excess gains, and the negative side is used in dealing with excess losses).

Step 3. Check the cumulative unrecognized net gain or loss as of the beginning of the period. If this amount is less than the absolute value of the corridor amount, then do nothing. Otherwise, calculate the difference between the cumulative unrecognized net gain or loss and the corridor calculated in step 2. This difference is the amount that has to be amortized.

Step 4. Amortize the difference calculated in step 3, over the average future service periods of the employees. Note that when excess gains are amortized, they reduce the current period pension expense. Conversely, if excess losses from past periods are amortized, they will increase current period pension expense.

The corridor calculations have to be performed each year. It is possible that one year excess gains have to be amortized, but the second year may not require any amortization because the excess gains or losses have come within the corridor for the second year. It also is possible (though it would be rare) that one year excess gains have to be amortized, while excess losses have to be amortized in the second year.

Example.The following information is available about the pension plan of Brown Company:

Year January 1, PBO January 1, Plan Assets

Actual return minus expected return

2002 $ 370,000 $ 360,000 $ (8,000)2003 420,000 450,000 6,000The cumulative unrecognized gain as of January 1, 2001 was $45,000. Assuming an average remaining service life of 10 years in both years, calculate for each year (a) the amount of gain or loss to recognize (amortize) and (b) the cumulative unrecognized gain or loss at year end.

Calculations for 2002:Step 1. The PBO is greater than the plan assets as of January 1, 2002, and the PBO balance is $360,000 as of January 1, 2002.

Step 2. 10% of the amount in step 1 is $36,000. This is the corridor.

Step 3. The cumulative unrecognized gain as of January 1, 2002 is $45,000. This is greater than the corridor ($36,000). The difference is $9,000 ($45,000 – $36,000).

Step 4. The amortization this year is $9,000 divided by the average expected service lives which is 10 years. So the amortization this year is $900 ($9,000/10). This is amortization of excess gains, so this will reduce the current period pension expense.

After the amortization, the balance in the cumulative unrecognized gain or loss account is $44,100 ($45,000 – $900). Further, there was a loss (remember that loss only means the actual returns were less than expected returns; both actual and expected returns could be positive) of $8,000 during 2002. Hence, the balance in the cumulative unrecognized gain or loss account as of the end of 2002 would be $36,100 ($44,100 – $8,000).

Calculations for 2003:Step 1. The plan assets are more than the PBO as of January 1, 2003, and the plan assets total $450,000 of January 1, 2003.

Step 2. 10% of the amount in step 1 is $45,000. This is the corridor.

Step 3. The cumulative unrecognized gain as of January 1, 2003 is $36,100. This is less than the corridor ($45,000), so no amortization is required in 2003.

The excess gain during 2003 was $15,000. This means that the balance in the cumulative unrecognized gain or loss account as of the end of 2003 would be $36,100 + $6,000 = $42,100.

Minimum Pension Liability

The FASB was concerned that the approach is SFAS 87 might lead to companies reporting a very low amount as a liability related to pensions in some circumstances. Hence, the FASB requires companies to report a minimum liability related to pensions.

The calculations in this module have so far used the PBO. However, for the purposes of the minimum pension liability calculations, SFAS 87 requires the use of the ABO. Note that the ABO uses current and past salary levels, while the PBO is based on expected future salary levels. Hence, the ABO is usually lower than the PBO.

The ABO must be compared against the fair value of plan assets as of the end of a period. If the plan assets are greater than the ABO, then no adjustment is required for the minimum pension liability. However, if the plan assets are lower than the ABO, then the balance sheet must show at least the difference between the two amounts as a pension related liability.

Example.The balance in pension related accounts of Garcia Company and Harris Company as of December 31, 2002 are given below.

ABO Fair value of plan assets

Minimum pension liability

Garcia Company $ 300,000 $ 340,000 0Harris Company 400,000 380,000 $ 20,000

Because the ABO of Garcia Company is lower than the fair value of its plan assets, there is no minimum liability required. In the case of Harris Company, since the ABO exceeds the fair value of plan assets by $20,000, a minimum pension liability of $20,000 is required on the balance sheet.

After calculating the minimum pension liability, the next step involves examining the existing balance in the Prepaid/Accrued Pension Cost account. Recall that this is an account which can have either a debit or credit balance, and accordingly will be characterized as an asset or liability on the balance sheet. Recall also that liabilities have credit balances.

Assume that Harris Company has a credit balance of $8,000 in its Prepaid/Accrued Pension Cost account. Since the minimum liability required is $20,000 and there is already a credit balance of $8,000, the additional pension liability to be shown on the balance sheet is only $12,000 ($20,000 – $8,000).

However, if Harris Company has a debit balance of $5,000 in its Prepaid/Accrued Pension Cost account then the additional pension liability to be shown on the balance sheet will be $25,000. This is because to go from a debit balance of $5,000 to a credit balance of $20,000 requires a credit entry of $25,000.

The creation of this liability ($12,000 or $25,000, as may be the case) requires a journal entry. The credit entry will be made to the Prepaid/Accrued Pension Cost account. The debit entry is made to an account called “Intangible Pension Asset.” However, the balance in this account cannot be more than the amount of unrecognized prior service costs. Any remaining amounts are debited to an account called Excess of Additional Pension Liability Over Unrecognized Prior Service Costs. This is a contra-equity account, and is shown on the balance sheet as a deduction from Stockholders’ Equity.

Other Post-retirement Benefits

In addition to pensions, retirees (and their spouses) may receive other benefits from the company. As noted previously, health-care benefits constitute the most financially significant issue related to such benefits. Accounting for post-retirement health benefits is governed by SFAS 106, which parallels SFAS 87 (governing accounting for pensions).

As with pensions, the annual cost related to post-retirement health care includes the following components. Service cost Interest cost Amortization of prior-service cost Return on plan assets (actual less deferred gain [or plus deferred loss]) Amortization of unrecognized transition obligation.

Accounting for post-retirement health care benefits is even more imprecise than accounting for pension plans. This is because in a pension plan a company must make estimates related to future increases in the compensation of its employees. The company may be able to control such future increases. However, in accounting for post-retirement health care benefits a company must make estimates related to future increases in the cost of health care. A company may only have a limited ability to predict future innovations in health care and to control costs associated with medical technology in the future. The assumptions related to

future health-benefit payments may be impacted by changes in, among others, the following factors government regulations related to medicare and medicaid. innovations in medical technology health-care cost trends. retirement age of employees. mortality rates (or, how long people will live). lifestyle choices by retirees. number of covered dependents.Thus, it is essential to keep in mind that the accounting for post-retirement health-care benefits is based on numbers that may be very imprecise and subject to change over time.

Review Question 2

1. The PBO is reduced by the amount of _________.2. The PBO is increased by the amount of _______.3. The pension expense for a period is reduced by the amount of ________.4. When the plan funding for a year is less than the pension expense, the ______ account is

credited.5. The minimum liability adjustment is required when the plan assets are lower than the _____.6. The pension plan assets are increased by the amount of ______.

Answers:1. Benefits paid 2. Service costs 3. Expected return on plan assets4. Prepaid/accrued pension cost 5. ABO 6. Actual return on plan assets

Glossary

Accumulated benefit obligation (PBO) is the present value of all pension benefits earned by employees based on past service to a Company, using current and past salary levels to calculate the amount of the pension benefits.

Corridor method is used to amortize cumulative unrecognized net gain or loss.

Defined-benefit plan is a pension plan in which the pension payments to be received by the employee is specified in the employment contract.

Defined-contribution plan is a pension plan in which the employer contributes a known amount (usually based on a specified percent of employee salary) to a pension plan. 401-k plans are defined contribution plans.

Interest cost is the increase in the PBO based on the passage of time. It is calculated based on the beginning balance of the PBO, and the settlement rate of interest.

Minimum liability is the amount required to be shown on the balance sheet, and equals the amount by which the ABO exceeds the fair value of the pension plan assets.

Post-employment benefits refer to promises made by a company to terminated or laid-off employees. These benefits include pensions, health-care benefits, unemployment pay, job-training, or employment counseling.

Post-retirement benefits are received by employees after retirement, and include pensions and health-care benefits.

Pension benefits are paid to employees after they retire, and reduce the PBO (and the pension plan assets).

Pension plans pay benefits to employees after retirement.

Prior service costs are the present value of changes in the pension obligations of a company as a result of adopting a new plan or making changes to an existing plan.

Projected benefit obligation (PBO) is the present value of all pension benefits earned by employees based on past service to a company, using expected future salaries to calculate the amount of the pension benefits.

Service cost is the present value of the benefits attributed by the pension plan because the employee has worked during the current year.

Settlement rate is the interest rate used for the present value calculation of the future pension obligation.

Demonstration Problem 1Warner Company

Information about the pension plan details of Warner Company as of January 1, 2002 are given below:Fair market value of pension plan assets $ 700,000Projected benefit obligation 500,000Unamortized prior service cost 180,000Prepaid (accrued) pension cost (35,000)Service cost for 2002 200,000Contribution to pension fund during 2002 165,000Actual return on pension plan assets 74,000Amortization of unrecognized net loss 6,000Settlement rate 9%Rate of return on plan assets 10%Amortization period for prior service cost 20 yearsCalculate (a) pension expense for 2002, and (b) prepaid (accrued) pension cost as of December 31, 2002.

Solution to Demonstration Problem 1, Warner Company

a. Pension expense for 2002

Service cost for 2002 $ 200,000Interest on the PBO ($500,000 x .09) 45,000 Amortization of prior service cost ($180,000/20) 9,000 Actual return on plan assets (74,000)Deferral of excess gain during year 4,000Net deduction (see below) (70,000)Amortization of net loss 6,000Pension expense $ 190,000 Note that another way of arriving at the amount to deduct is by considering only the expected return on plan assets. Since plan assets at the beginning of the year were $700,000 and the expected return is 10%, the deduction for expected return would be $700,000 x 0.10 = $70,000.

b. Prepaid (accrued) pension cost as of December 31, 2002

The beginning balance of prepaid (accrued) pension cost is given to be $(35,000). This means the beginning balance is accrued pension cost, with a credit balance in the account.

Debit CreditPension expense (step 1) $ 190,000 Funding of pension plan during year (step 2) $ 165,000 Difference (plug number, step 3) 25,000

Beginning balance, prepaid/accrued pension cost $ 35,000 Hence, ending balance, prepaid/accrued pension cost $ 60,000Since the plug number is a credit entry, it adds to the accrued pension cost balance. The ending balance of accrued pension cost is $35,000 + $25,000 = $60,000.

Demonstration Problem 2Green Company

The following information is available about the pension plan of Green Company:

Year January 1, PBO January 1, Plan Assets

Actual return minus expected return

2001 $ 570,000 $ 600,000 $ 9,0002002 720,000 700,000 (20,000)2003 900,000 800,000 10,000The cumulative unrecognized gain as of January 1, 2001 was $100,000. Assuming an average remaining service life of 10 years throughout the three years, calculate for each year (a) the amount of gain or loss to recognize (amortize) and (b) the cumulative unrecognized gain or loss at year end.

Solution to Demonstration Problem 2, Green Company

Item 2001 2002 2003Cumulative gain/loss as of January 1 A $ 100,000 $ 105,000 $ 81,700Larger of PBO or Plan assets, January 1 B 600,000 720,000 900,000

Corridor C =

|10% of B| |60,000| |72,000| |90,000|Amount subject to amortization

D = |A| – |C| If |A| > |C| |40,000| |33,000| |0|

Amortization for the year (corridor/service life) E 4,000 3,300 0Excess gain (loss) for year F 9,000 (20,000) 10,000Cumulative gain/loss as of year end

G =A – E +F 105,000 81,700 91,700

Note1. The ‘|x|’ symbol means the absolute value (ignoring the plus or minus) of a number. The

amortization requirement is for both sides of the corridor. Hence the corridor amount is shown as an absolute number.

2. Similarly, the amount subject to amortization also is shown as an absolute amount. 3. The ending balance of the cumulative gain (loss) of any year becomes the beginning

balance for the next year.

Demonstration Problem 3Butler Company

Information about the pension plan details of Butler Company are given below:Fair (market) value of pension plan assets, 1/1/2002 $ 520,000Fair (market) value of pension plan assets, 12/31/2002 600,000Projected benefit obligation, 1/1/2002 1,200,000Projected benefit obligation, 12/31/2002 1,400,000Accumulated benefit obligation 1/1/2002 500,000Accumulated benefit obligation 12/31/2002 630,000Unrecognized prior service cost, 12/31/2002 40,000Prepaid (accrued) pension cost, 12/31/2002 15,000Amortization of prior service cost in 2002 4,000Service cost for 2002 190,000Amortization of unrecognized net loss 6,000Settlement rate 9%Rate of return on plan assets 10%1. Calculate the pension expense for 2002.2. Calculate the following amounts as of December 31, 2002.(a) Minimum pension liability.(b) Additional pension liability.3. What is the amount of the debit entry for the contra equity adjustment account for pension

liability made at the end of 2002?

Solution to Demonstration Problem 3, Butler Company

1. Pension expense for 2002Service cost for 2002 $ 190,000Interest on the PBO ($1,200,000 x .09) 108,000 Amortization of prior service cost 4,000 Expected return on plan assets ($520,000 x 0.10) (52,000)Amortization of net loss 6,000Pension expense $ 256,000

2. Liability calculationsABO as of 12/31/2002 A $ 630,000Fair (market) value of pension plan assets, 12/31/2002 B 600,000Underfunding (Minimum pension liability) C = A – B 30,000 Prepaid pension cost D 15,000 Additional pension liability E = C + D 45,000 Unrecognized prior service cost F 40,000Contra equity adjustment account G = E – F 5,000

3. The amount of Additional Pension Liability is $45,000. The balance of Unrecognized Prior Service Cost is $40,000. Hence, the debit to the contra equity account will be $5,000.

Practice Problem 1Gannon Company

Information about the pension plan details of Gannon Company as of January 1, 2002 are given below:Fair market value of pension plan assets $ 800,000Projected benefit obligation 600,000Unamortized prior service cost 300,000Prepaid (accrued) pension cost (50,000)Service cost for 2002 180,000Contribution to pension fund during 2002 170,000Actual return on pension plan assets 90,000Amortization of unrecognized net gain 5,000Settlement rate 8%Rate of return on plan assets 10%Amortization period for prior service cost 25 yearsCalculate (a) pension expense for 2002, and (b) prepaid (accrued) pension cost as of December 31, 2002.

Solution to Practice Problem 1, Gannon Company

a. Pension expense for 2002

Service cost for 2002 $ 180,000Interest on the PBO ($600,000 x .08) 48,000 Amortization of prior service cost ($300,000/25) 12,000 Actual return on plan assets (90,000)Deferral of excess gain during year 10,000Net deduction (see below) (80,000)Amortization of net gain (5,000)Pension expense $ 155,000 Note that another way of arriving at the amount to deduct is by considering only the expected return on plan assets. Since plan assets at the beginning of the year were $800,000 and the expected return is 10%, the deduction for expected return would be $800,000 x 0.10 = $80,000.

b. Prepaid (accrued) pension cost as of December 31, 2002

The beginning balance of prepaid (accrued) pension cost is given to be $(50,000). This means the beginning balance is accrued pension cost, with a credit balance in the account.

Debit CreditPension expense (step 1) $ 155,000 Funding of pension plan during year (step 2) $ 170,000 Difference (plug number, step 3) 15,000

Beginning balance, prepaid/accrued pension cost $ 50,000 Hence, ending balance, prepaid/accrued pension cost $ 35,000Since the plug number is a debit entry, it reduced the accrued pension cost balance. The ending balance of accrued pension cost is $50,000 – $15,000 = $35,000.

Practice Problem 2Campo Company

The following information is available about the pension plan of Campo Company:

Year January 1, PBO January 1, Plan Assets

Actual return minus expected return

2001 $ 1,000,000 $ 950,000 $ 22,0002002 1,100,000 1,120,000 (270,000)2003 1,200,000 900,000 60,000The cumulative unrecognized gain as of January 1, 2001 was $80,000. Assuming an average remaining service life of 10 years throughout the three years, calculate for each year (a) the amount of gain or loss to recognize (amortize) and (b) the cumulative unrecognized gain or loss at year end.

Solution to Practice Problem 2, Campo Company

Item 2001 2002 2003Cumulative gain (loss) as of January 1 A $ 120,000 $ 140,000 $ (132,800)Larger of PBO or Plan assets, January 1 B 1,000,000 1,120,000 1,200,000

Corridor C =

|10% of B| |100,000| |112,000| |120,000|Amount subject to amortization

D = |A| – |C| If |A| > |C| |20,000| |28,000| |12,800|

Amortization for the year (corridor/service life) E 2,000 2,800 (1,280)Excess gain (loss) for year F 22,000 (270,000) 60,000Cumulative gain (loss) as of year end

G =A – E +F 140,000 (112,800) (71,520)

Note1. Amortization requirement is for both sides of the corridor. Thus, in the year 2003, the

beginning balance of the cumulative loss is $132,800. The absolute value of the amount subject to amortization is $132,800 – $120,000 = $12,800.

2. This $12,800 of excess loss is amortized over ten years, giving annual amortization for this year of $1,280. Because it is a loss that is being amortized, the amortization amount is shown as a negative number.

3. When $1,280 is amortized, the remaining excess (unamortized) loss is $(132,800) – $(1,280) = $131,520.

4. However, the excess return for 2003 was a gain of $60,000. This amount when added to the remaining unamortized balance of $(131,520) reduces the excess (unamortized) loss to $(71,520).

Practice Problem 3Baker Company

Information about the pension plan details of Butler Company are given below:Fair (market) value of pension plan assets, 1/1/2002 $ 700,000Fair (market) value of pension plan assets, 12/31/2002 800,000Projected benefit obligation, 1/1/2002 1,300,000Projected benefit obligation, 12/31/2002 1,500,000Accumulated benefit obligation 1/1/2002 680,000Accumulated benefit obligation 12/31/2002 820,000Unrecognized prior service cost, 12/31/2002 50,000Prepaid (accrued) pension cost, 12/31/2002 (12,000)Amortization of prior service cost in 2002 5,000Service cost for 2002 150,000Amortization of unrecognized net gain 7,000Settlement rate 8%Rate of return on plan assets 11%1. Calculate the pension expense for 2002.2. Calculate the following amounts as of December 31, 2002.(a) Minimum pension liability.(b) Additional pension liability.3. What is the amount of the debit entry for the contra equity adjustment account for pension

liability made at the end of 2002?

Solution to Practice Problem 3, Baker Company

1. Pension expense for 2002Service cost for 2002 $ 150,000Interest on the PBO ($1,300,000 x .08) 104,000 Amortization of prior service cost 5,000 Expected return on plan assets ($700,000 x 0.11) (77,000)Amortization of net gain (7,000)Pension expense $ 175,000

2. Liability calculationsABO as of 12/31/2002 A $ 820,000Fair (market) value of pension plan assets, 12/31/2002 B 800,000Underfunding (Minimum pension liability) C = A – B 20,000 Prepaid (Accrued) pension cost D (12,000) Additional pension liability E = C + D 8,000 Unrecognized prior service cost F 50,000Contra equity adjustment account G 0

3. The amount of Additional Pension Liability is $8,000. The balance of Unrecognized Prior Service Cost is $50,000. Since the Additional Pension Liability is less than the Unrecognized Prior Service Cost, there is no need for a debit entry to the contra equity account.So the amount of the debit to the contra equity account = 0.

Practice Problem 4

1. Which of the following is not included in calculating periodic pension cost?a. Interest costb. Service costc. Amount of funding for pension pland. Return on plan assets

2. The present value of all pension benefits earned by employees based on past service to a Company, using current and past salary levels to calculate the amount of the benefits, is calleda. Projected benefit obligationb. Accumulated benefit obligationc. Prepaid/accrued pension costd. Minimum liability

3. Net periodic pension cost is increased bya. Amortization of prior service costb. Amortization of cumulative unrecognized gainc. Actual return on plan assetsd. Expected return on plan assets

4. When periodic pension cost is lower than pension funding, which account must be debited?a. Projected benefit obligationb. Accumulated benefit obligationc. Prepaid/accrued pension costd. Prior service cost

5. The present value of pension obligations of a company as a result of adopting a new plan is calleda. Projected benefit obligationb. Accumulated benefit obligationc. Prepaid/accrued pension costd. Prior service cost

6. The minimum liability adjustment is required when the plan assets are lower thana. Projected benefit obligationb. Accumulated benefit obligationc. Prepaid/accrued pension costd. Prior service cost

7. The following data are available related to the pension plan of Fox Company as of December 31, 2002: Accumulated Benefit Obligation, $300,000; Projected Benefit Obligation, $400,000; service cost for the year, $75,000; settlement rate, 10%; return on plan assets, $60,000; amortization of prior service cost, $12,000. The pension expense for 2002 is

a. $27,000b. $43,000c. $57,000d. $67,000

8. The following data are available related to the pension plan of Boxer Company as of December 31, 2002: Accumulated Benefit Obligation, $430,000; Projected Benefit Obligation, $520,000; plan assets, $410,000; unamortized prior service cost, $150,000. The minimum pension liability isa. $20,000b. $90,000c. $110,000d. $260,000

Homework Problem 1Plummer Company

Information about the pension plan details of Plummer Company as of January 1, 2002 are given below:Fair market value of pension plan assets $ 500,000Projected benefit obligation 400,000Unamortized prior service cost 150,000Prepaid (accrued) pension cost (60,000)Service cost for 2002 125,000Contribution to pension fund during 2002 105,000Amortization of unrecognized net loss 7,000Settlement rate 9%Rate of return on plan assets 12%Amortization period for prior service cost 20 yearsCalculate (a) pension expense for 2002, and (b) prepaid (accrued) pension cost as of December 31, 2002.

Solution to Homework Problem 1, Plummer Company

a. Pension expense for 2002

Service cost for 2002 $ 125,000Interest on the PBO ($400,000 x .09) 36,000 Amortization of prior service cost ($150,000/20) 7,500 Expected return on plan assets (60,000) Amortization of net loss 7,000Pension expense $ 115,500

b. Prepaid (accrued) pension cost as of December 31, 2002

The beginning balance of prepaid (accrued) pension cost is given to be $(60,000). This means the beginning balance is accrued pension cost, with a credit balance in the account.

Debit CreditPension expense (step 1) $ 115,500 Funding of pension plan during year (step 2) 105,000 Difference (plug number, step 3) $ 10,500

Beginning balance, prepaid/accrued pension cost $ 60,000 Hence, ending balance, prepaid/accrued pension cost $ 70,500Since the plug number is also a credit entry, it adds to the accrued pension cost balance. The ending balance of accrued pension cost is $70,500.

Homework Problem 2Fassel Company

The following information is available about the pension plan of Fassel Company:

Year January 1, PBO January 1, Plan Assets

Actual return minus expected return

2001 $ 300,000 $ 320,000 $ (15,000)2002 350,000 360,000 10,0002003 420,000 410,000 5,000The cumulative unrecognized gain as of January 1, 2001 was $50,000. Assuming an average remaining service life of 10 years throughout the three years, calculate for each year (a) the amount of gain or loss to recognize (amortize) and (b) the cumulative unrecognized gain or loss at year end.

Solution to Homework Problem 2, Fassel Company

Item 2001 2002 2003Cumulative gain (loss) as of January 1 A $ 50,000 $ 33,200 $ 43,200Larger of PBO or Plan assets, January 1 B 320,000 360,000 420,000

Corridor C =

|10% of B| |32,000| |36,000| |42,000|Amount subject to amortization

D = |A| – |C| If |A| > |C| |18,000| |0| |1,200|

Amortization for the year (corridor/service life) E 1,800 0 120Excess gain (loss) for year F (15,000) 10,000 5,000Cumulative gain (loss) as of year end

G =A – E +F 33,200 43,200 48,080

Homework Problem 3Barber Company

Information about the pension plan details of Butler Company are given below:Fair (market) value of pension plan assets, 1/1/2002 $ 400,000Fair (market) value of pension plan assets, 12/31/2002 460,000Projected benefit obligation, 1/1/2002 700,000Projected benefit obligation, 12/31/2002 850,000Accumulated benefit obligation 1/1/2002 380,000Accumulated benefit obligation 12/31/2002 520,000Unrecognized prior service cost, 12/31/2002 30,000Prepaid (accrued) pension cost, 12/31/2002 12,000Amortization of prior service cost in 2002 3,000Service cost for 2002 100,000Amortization of unrecognized net gain 4,000Settlement rate 8%Rate of return on plan assets 10%1. Calculate the following amounts as of December 31, 2002.(a) Minimum pension liability.(b) Additional pension liability.2. What is the amount of the debit entry for the contra equity adjustment account for pension

liability made at the end of 2002?

Solution to Homework Problem 3, Barber Company

1. Liability calculationsABO as of 12/31/2002 A $ 520,000Fair (market) value of pension plan assets, 12/31/2002 B 460,000Underfunding (Minimum pension liability) C = A – B 60,000 Prepaid (Accrued) pension cost D 12,000 Additional pension liability E = C + D 72,000 Unrecognized prior service cost F 30,000Contra equity adjustment account G 42,000

2. The amount of Additional Pension Liability is $72,000. The balance of Unrecognized Prior Service Cost is $30,000. Hence the amount of the debit entry to the contra equity account will be $42,000 ($72,000 – $30,000).

Homework Problem 4

1. Which of the following is not included in calculating periodic pension cost?a. Amortization of net gainb. Service costc. Amortization of PBOd. Amortization of Prior Service Cost

2. The present value of all pension benefits earned by employees based on past service to a Company, using expected future salary levels to calculate the amount of the benefits, is calleda. Projected benefit obligationb. Accumulated benefit obligationc. Prepaid/accrued pension costd. Minimum liability

3. Net periodic pension cost is decreased bya. Interest on the ABOb. Amortization of cumulative unrecognized lossc. Amortization of prior service costd. Amortization of cumulative unrecognized gain

4. For the year 2002, the pension cost and pension funding of Mitchell Company were $40,000 and $50,000, respectively. This will result ina. Debiting Prior Service Cost by $10,000 b. Debiting Prepaid/Accrued Pension Cost by $10,000 c. Crediting Prior Service Cost by $10,000 d. Crediting Prepaid/Accrued Pension Cost by $10,000

5. During 2002, Powell Company changed the pension benefit formula by increasing the yearly credit from 2% to 3%. The present value of the change in pension obligations as a result of this change in the pension formula will increase the a. Projected benefit obligationb. Accumulated benefit obligationc. Prepaid/accrued pension costd. Prior service cost

6. When a journal entry is made to recognize the minimum pension liability, which account will be debited?a. Service costb. Projected benefit obligationc. Intangible pension assetd. Prepaid/accrued pension cost

7. The following data are available related to the pension plan of Cabot Company as of December 31, 2002: Projected Benefit Obligation, $500,000; plan assets at beginning of year, $600,000; service cost for the year, $85,000; settlement rate, 9%; expected return on plan assets, $10%; amortization of prior service cost, $12,000. The pension expense for 2002 isa. $58,000b. $82,000c. $93,000d. $69,000

8. The following data are available related to the pension plan of Boxer Company as of December 31, 2002: Accumulated Benefit Obligation, $630,000; Projected Benefit Obligation, $780,000; plan assets, $710,000; unamortized prior service cost, $510,000. The minimum pension liability isa. $0b. $70,000c. $80,000d. $200,000