ACTG 344 Exam #3

Chapters 17 and 18

Pensions

designed to provide income to individuals during their retirement years

benefits to retirees in return for prior service (deferred payment arrangement)

Plan administrator

pension plan “CEO”

1. invest assets

2. benefits to retirees

3. maintain record keeping

Two journal entries for

• pension expense

• change in pension asset/liability

• change in other comprehensive income (AOCI)

Employee Retirement Income Security Act (ERISA)

requires companies to set up a separate legal trust and fulfill minimum funding requirements

Defined contribution pension plan

fixed annual contributions to a pension plan

employees choose where funds are invested

usually stocks or fixed-income securities

• defined by agreement

• depends on success of employee’s investments

• employer contribution determined by plan

• the risk is on the employee

Accounting for a defined contribution pension plan

debit pension expense

credit cash

Defined benefit pension plan

fixed retirement benefits are defined by a designated formula

• depends on success of employers’ investments

• formula depends on: years of service, annual compensation, age (occasionally)

• the risk is on the employer

Actuary

a professional who estimates retirement benefits based on factors such as mortality rates, employee turnover, interest and earning rates, salary levels, early retirement frequency, etc.

Accounting for other postemployment benefits (OPEB)

similar accounting to pensions with 2 minor differences

1. no funding requirement

2. slight vocabulary differences

3 main pension reporting issues

1. what is the pension expense to be reported on the company’s income statement?

2. what is the adjustment to the pension asset/liability the company reports on its balance sheet?

3. what is the adjustment to AOCI that a company reports on its balance sheet?

What creates either a gain or loss in a PBO?

differences from actual outcome when the pension obligation is lower or higher than expected

Pension expense formula

+ service cost

+ interest cost

± actual return on plan assets

± unexpected gain or loss

+ amortization of prior service cost

± corridor amortization of gain/loss - OCI

Projected benefit obligation (PBO) calculation

beginning balance

+ service cost

+ prior service cost

+ interest cost

± gain or loss from change in actuarial assumptions

- benefits paid to retirees

= ending balance

Plan assets calculation

beginning balance

± actual return on plan assets

+ contributions to the plan by the sponsoring company

- benefits paid to retirees

= ending balance

• the assets are creating money by being invested

• contributions are added to the plan by the sponsoring company

• when benefits are paid to retirees, money is leaving the fund

Pension expense

cost incurred by the employer related to pension liabilities

Vested benefit obligation (VBO)

portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment

benefits for vested employees at current salaries

Accumulated benefit obligation (ABO)

actuary’s estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels

benefits for both vested and nonvested employees at current salaries

Projected benefit obligation (PBO)

actuary’s estimate of present value of retirement benefits by applying the pension formula using projected future compensation levels

benefits for vested and nonvested employees at future salaries

Vested vs. nonvested employees

vested employees keep the benefits even if they are terminated or resign

nonvested employees will not receive certain benefits if they leave a company

• that money/benefits go back into the fund

Plan assets

the resources that the company will use to satisfy the obligation to provide retirement benefits to the employee in the future

Trustee

holds and manages pension plan assets

• accepts employer contributions

• invests the contributions

• accumulates the earnings on the investments

• pays benefits from the plan assets to retired employees or their beneficiaries

Expected return on plan assets

the amount the employer expects to get back on their investments

the higher the rate, the less the employer has to contribute

expected return on plan assets = actual return ± unexpected gain or loss

expected return on plan assets = beginning plan assets * expected rate of return

subtract from pension expense because the earnings from the plan assets offset the cost of providing the benefit

Underfunded vs overfunded pension plan

underfunded: PBO > plan assets

overfunded: plan assets > PBO

This makes sense because if there are not enough plan assets to satisfy the pension obligation, it would be underfunded.

Pension expense: service cost

increases pension expense

actuarial present value of benefits attributed by the pension benefit formula to employee service during the period

debit pension expense

credit PBO

Pension expense: interest expense

increases pension expense

interest for the period on the PBO outstanding during the period

rate at which companies can effectively settle pension benefits

beginning PBO * discount/settlement rate

debit pension expense

credit PBO

Pension expense: actual return on plan assets

increases or decreases pension expense

the increase in pension funds from interest, dividends, and unrealized changes in the fair-market value of the plan assets

debit plan assets

credit pension expense

OR

debit pension expense

credit plan assets

Pension expense: unexpected gain or loss

increases or decreases pension expense

the actual return is greater than the expected return on plan assets

debit pension expense

credit gain-OCI

OR

the actual return is less than the expected return on plan assets

debit loss-OCI

credit pension expense

Pension expense: amortization of prior service cost

increases pension expense

amendments to pension plans to make them more generous, that cost is then allocated over remaining service-years of the affected employees

original entry:

debit prior service cost-OCI

credit PBO

amortization entry:

debit pension expense

credit prior service cost-OCI

Cash contributions journal entry

debit plan assets

credit cash

Benefits paid journal entry

debit PBO

credit plan assets

Change in actuarial assumptions journal entry

unfavorable

debit loss-OCI

credit PBO

OR

favorable

debit PBO

credit gain-OCI

Recognition of pensions in the financial statements

income statement

• pension expense

balance sheet

• pension asset (or liability)

• accumulated other comprehensive income (AOCI)

Required footnote disclosures

1. major components of pension expense

2. reconciliation showing how the PBO and plan assets have changed

3. the net funded status of the plan (difference between PBO and plan assets)

4. rates used in measuring the benefit amount (discount rate, expected rate of return on plan assets, rate of compensation increase)

5. table indicating the allocation of pension plan assets by category (equities, fixed income, alternative investments)

6. the expected benefit payments to be paid to current plan participants for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter

Corridor amortization

used to recognize gains or losses in pension cost overtime

calculate 10% of the greater of beginning projected benefit obligation or fair market value of plan assets

if the gain or loss is equal to or less than the corridor, then there is no amortization. This makes sense because if the gain/loss was equal to the corridor, the denominator would be zero. If the gain/loss is less than the corridor, the denominator would be negative.

corridor amortization = [gain/loss - (greater of PBO or FMV of plan assets * 10%)] / years remaining in the service period

Shareholder’s equity

residual amount

what’s left over after creditor claims have been subtracted from assets (net assets)

shareholder’s equity = assets - liabilities

net assets = assets - liabilities

shareholder’s equity = net assets

Equity section of balance sheet

Paid in capital:

Capital stock

• preferred stock

• common stock

• common stock dividends distributable

Additional paid-in capital

• PIC - excess of par, preferred

• PIC - excess of par, common

• PIC - share repurchase

• PIC - conversion of bonds

• PIC - stock options

• PIC - restricted stock

• PIC - lapse of stock options

Total paid-in capital

Retained earnings

Accumulated OCI

• gain (loss) on AFS investments (unrealized)

• net unrecognized gain (loss) on pensions

• deferred gain (loss) on derivatives

• adjustments from foreign currency translations

Treasury stock (at cost)

Total shareholders’ equity

Paid-in capital

arise when shareholder’s purchase stocks or when a company buys stock back

total amount investors give a company

Retained earnings

total cumulative profits held by a company over time