Module 10 - Pensions 1

What is a pension plan?

A pension plan is an arrangement in which an employer provides retirement benefits to employees in exchange for services they performed while working.

What are the three main parties involved in a pension plan?

(1) the employer, which sponsors and funds the plan

(2) the pension fund or trust, which holds and invests plan assets

(3) the employees or retirees, who receive the benefits.

How does cash flow through a pension plan?

The employer contributes cash to the pension fund, and the pension fund later pays benefits to retired employees.

What is the difference between a contributory and a noncontributory pension plan?

• Contributory plan: employees pay part of the cost or add voluntary contributions

• Noncontributory plan: employer pays the entire cost

What is a qualified pension plan?

A plan designed to receive federal tax benefits:

• deduction of employer contributions

• tax-free earnings within the pension fund

What is the basic feature of a defined contribution pension plan?

The employer promises a specified contribution each period, but does not guarantee the final retirement benefit.

In a defined contribution plan, who bears the investment risk?

The employee bears the risk because the final benefit depends on contributions plus investment performance.

What is the pension expense formula for a defined contribution plan?

Pension expense = the employer’s required contribution for the period

What is the journal entry for a defined contribution pension plan when the employer contributes cash immediately?

Dr Pension Expense

    Cr Cash

When does a defined contribution plan create a pension liability or pension asset for the employer?

Liability exists: if the employer contributes < the required amount

Asset exists: if the employer contributes > the required amount

What is the basic feature of a defined benefit pension plan?

The employer promises a specific retirement benefit, often based on years of service and salary levels.

In a defined benefit plan, who bears the risk?

The employer bears the risk because it must ensure enough assets will be available to pay the promised benefits.

Why is defined benefit pension accounting more complicated than defined contribution accounting?

It involves estimating future salaries, retirement timing, mortality, turnover, interest rates, and investment returns.

The obligation and expense are not simply equal to cash contributions.

What role do actuaries play in defined benefit pension accounting?

Estimate future events:

• salary growth

• mortality

• turnover

• retirement timing

Compute measures:

• projected benefit obligation

• service cost

• prior service cost

What are the three alternative measures of pension obligation discussed in the chapter?

1. Vested Benefit Obligation (VBO)

2. Accumulated Benefit Obligation (ABO)

3. Projected Benefit Obligation (PBO)

What is the Vested Benefit Obligation (VBO)?

VBO measures only vested benefits using current salary levels.

What is the Accumulated Benefit Obligation (ABO)?

ABO measures both vested and nonvested benefits using current salary levels.

What is the Projected Benefit Obligation (PBO)?

PBO measures vested and nonvested benefits using future salary levels.

Is the key pension obligation used in this chapter.

Which pension obligation measure is used for the funded-status calculation in this chapter?

The funded-status calculation uses the Projected Benefit Obligation (PBO).

Why does the PBO generally produce the largest pension obligation amount?

It includes both vested and nonvested service and uses future salary levels, which are usually higher than current salary levels.

What is the funded status of a defined benefit pension plan?

Difference between Fair Value of Plan Assets and Projected Benefit Obligation

Funded Status = Fair Value of Plan Assets − PBO

How do you determine whether the funded status is an asset or a liability?

If plan assets > PBO, plan is overfunded and a Pension Asset is reported

If PBO > plan assets, plan is underfunded and a Pension Liability is reported

What discount-rate rule should you remember for the pension obligation?

Lower discount rate increases pension obligation

Higher discount rate decreases pension obligation

What are the basic components of pension expense before prior service cost is added?

• service cost

• interest on the liability

• actual return on plan assets

What is service cost?

The present value of additional pension benefits employees earn during the current year of service.

How does service cost affect pension accounting?

Service cost increases pension expense and increases the projected benefit obligation.

What is the formula for interest cost in the problems from this chapter?

Interest Cost = Beginning PBO × Settlement (Discount) Rate

How does interest cost affect pension accounting?

Interest cost increases pension expense and increases the projected benefit obligation.

What PBO amount should be used to compute interest cost?

Use the beginning-of-year PBO.

If a prior service cost amendment occurs on January 1, use the next PBO after that amendment.

What is actual return on plan assets?

The true investment gain or loss earned by the pension fund during the year after adjusting for contributions and benefits paid.

What is the formula for actual return on plan assets?

Actual Return =

(Ending Plan Assets − Beginning Plan Assets)

− Contributions

+ Benefits Paid

Why are contributions subtracted in the actual-return formula?

Contributions are subtracted because they increase plan assets, but they are not investment income.

Why are benefits paid added back in the actual-return formula?

Benefits paid are added back because they reduce plan assets, but they are not investment losses.

How does a positive actual return affect pension expense?

A positive actual return reduces pension expense.

What is the basic pension expense formula before prior service cost amortization is included?

Pension Expense =

Service Cost

+ Interest Cost

− Actual Return on Plan Assets

In a pension expense problem, which given items should not be used directly in the pension expense formula?

Contributions and benefits paid

They are used elsewhere, such as in worksheets and actual-return calculations.

What is a pension worksheet used for?

A tool used to organize pension-related entries and memo records.

It helps compute the journal entry and reconcile ending pension asset or liability.

What are the two sides of the basic pension worksheet?

(1) General Journal Entry

• Helps form the actual entry

(2) Memo Record

• Tracks changes in PBO and plan assets

What columns appeared in the basic Wiley pension worksheet without PSC?

General Journal side:

• Pension Expense

• Cash

• Pension Asset/Liability

Memo side:

• Projected Benefit Obligation

• Plan Assets

In a basic pension worksheet without PSC, how is service cost entered?

Journal side

• Dr to Pension Expense

Memo side:

• Cr to PBO

In a basic pension worksheet without PSC, how is interest cost entered?

Journal side:

Dr Pension Expense

Memo side:

Cr PBO

In a basic pension worksheet without PSC, how is actual return entered?

Journal side:

Cr Pension Expense

Memo side:

Dr Plan Assets

In a basic pension worksheet without PSC, how are contributions entered?

Journal side:

Cr Cash

Memo side:

Dr Plan Assets

In a basic pension worksheet without PSC, how are benefits paid entered?

Journal side:

No entry

Memo side:

Reduce both PBO and Plan Assets

What is the basic year-end journal entry pattern from a worksheet when there is no PSC?

• If expense > contributions:

Dr Pension Expense

    Cr Cash

    Cr Pension Asset/Liability

• If contributions > expense:

Dr Pension Asset/Liability

Dr Pension Expense

Cr Cash

How do you compute the plug to Pension Asset/Liability in a basic worksheet?

1. Pension Expense - Cash Contributions

2. If expense > contributions, difference is a credit liability.

3. If contributions > expense, difference is a debit asset.

What final reconciliation must always work in a pension worksheet?

Pension Asset/Liability = PBO - Plan Assets

What is prior service cost (PSC)?

The increase in pension benefits granted for employee service provided in prior years when a defined benefit plan is adopted or amended.

How is prior service cost initially recorded?

Other Comprehensive Income (OCI)

What is the initial accounting pattern for PSC at the amendment date?

Journal side:

Dr OCI-Prior Service Cost

Memo side:

Cr PBO

Why is prior service cost not expensed immediately when a plan is amended?

The employer expects future benefit from employees and therefore allocates the cost over future service periods rather than recognizing it all at once.

How does amortization of prior service cost affect pension accounting?

Annual amortization of PSC increases Pension Expense and reduces the unamortized OCI-PSC balance.

What is the journal-side pattern for PSC amortization?

Dr Pension Expense

    Cr OCI—Prior Service Cost

What is the pension expense formula when prior service cost amortization is included?

Pension Expense =

Service Cost

+ Interest Cost

− Actual Return

+ PSC Amortization

What is the years-of-service formula for PSC amortization?

PSC Amortization =

(Current-Year Service Years ÷ Total Future Service Years)

× Total PSC

What are the steps to compute PSC amortization using the years-of-service method?

(1) Find total future service years

(2) total PSC ÷ total future service years = cost per service-year

(3) cost per service-year x service years = the current year

When a problem gives total future service years and current-year service years, what method for PSC amortization is being signaled?

That setup signals the years-of-service amortization method, not straight-line amortization.

What is the Wiley worksheet format for a pension problem that includes PSC?

General Journal side:

• Annual Pension Expense

• Cash

• OCI—Prior Service Cost

• Pension Asset/Liability

Memo side:

• Projected Benefit Obligation

• Plan Assets

In a PSC worksheet, what does the “Prior service cost” row do?

It records the initial amendment effect: OCI—PSC is debited on the journal side and the PBO is credited on the memo side.

In a PSC worksheet, why does interest cost sometimes use an adjusted beginning PBO?

If the plan amendment occurs on January 1, the PSC increases the PBO immediately, so interest must be computed on the updated beginning PBO.

In a PSC worksheet, what should the “Balance, Jan. 1” row reflect?

It should reflect the updated balances after the prior service cost amendment, not zeros or blanks.

In the expanded PSC worksheet, does prior service cost directly change Pension Asset/Liability on the “Prior service cost” row?

No. PSC affects OCI on the journal side and PBO on the memo side. It does not directly hit Pension Asset/Liability on that row.

In a PSC worksheet, what happens on the “Amortization of PSC” row?

Journal side:

Dr. Pension Expense

Cr OCI—Prior Service Cost

Memo side:

no entry

In a pension worksheet, where do benefits paid go?

Journal side:

no entry

Memo side:

Decrease both PBO and Plan Assets

What should you do if a cell requires no number in a row that accepts blanks?

Enter “-0-” and do not choose Dr. or Cr.

What is a Wiley worksheet trap involving benefits paid?

Placing benefits paid in the General Journal side. In the worksheet formats used here, benefits belong only on the memo side.

What is a Wiley worksheet trap involving return on plan assets?

Using the wrong sign for return. A positive actual return is a credit to Pension Expense and a debit to Plan Assets.

What is a Wiley worksheet trap involving prior service cost and Pension Asset/Liability?

Prior service cost does not directly create a debit or credit to Pension Asset/Liability on the “Prior service cost” row. It goes through OCI and PBO instead.

What final rule should always be used to check the ending Pension Asset/Liability in a worksheet?

Always verify that the ending Pension Asset/Liability equals ending PBO minus ending Plan Assets (for a liability) or ending Plan Assets minus ending PBO (for an asset).

How do you compute the ending PBO in a worksheet without gains/losses beyond the chapter sections used here?

Ending PBO =

Beginning PBO

+ Service Cost

+ Interest Cost

+ PSC (if granted)

− Benefits Paid

How do you compute the ending Plan Assets in a worksheet?

Ending Plan Assets =

Beginning Plan Assets

+ Actual Return

+ Contributions

− Benefits Paid

What is the shortcut for a simple pension journal entry problem that gives pension expense and contributions but no OCI?

Compute the plug using: Pension Expense − Contributions

Dr Pension Expense

Cr Cash

Use Pension Asset/Liability as the balancing amount

In a simple pension journal entry problem, when is Pension Asset/Liability credited?

When pension expense exceeds the contribution, because the company is recognizing an underfunded liability.

In a simple pension journal entry problem, when is Pension Asset/Liability debited?

When the contribution exceeds pension expense, indicating an overfunded asset position.

In a problem asking only for pension asset/liability at year-end, should OCI—Prior Service Cost be included in the funded-status calculation?

No. The pension asset/liability is based only on plan assets and the PBO. OCI—PSC is not part of the funded-status formula.

What is a trap in funded-status questions that mention OCI—Prior Service Cost?

The trap is to try to include OCI in the pension asset/liability calculation. Funded status uses only plan assets and the PBO.

What problem cue tells you a question is asking for actual return on plan assets?

The problem will usually give beginning plan assets, ending plan assets, contributions, and benefits paid, and ask for the actual return.

What problem cue tells you a question is asking for pension expense instead of funded status?

The problem will usually give service cost, beginning PBO, a discount or settlement rate, actual return, and possibly PSC amortization.

What problem cue tells you a question requires a full basic worksheet?

The problem will ask for pension expense and also ask you to prepare a pension worksheet showing the journal entry row and year-end balances in the related pension accounts.

What problem cue tells you a question requires a full PSC worksheet instead of a basic worksheet?

The problem will mention a plan amendment, prior service cost, OCI—Prior Service Cost, and a worksheet with an OCI column.

What should you do first when starting a worksheet problem?

Identify the type of worksheet (basic or PSC), list the given amounts, and compute any missing interest cost before filling the rows.

What should you compute first in most worksheet problems from this chapter?

Compute interest cost first, because it is often not given directly and is needed before finishing pension expense and the worksheet.

What is the safest order for filling a basic pension worksheet?

Start with beginning balances, then service cost, interest cost, actual return, contributions, benefits, the journal entry totals row, and finally the ending balances.

What is the safest order for filling an expanded PSC worksheet?

Start with beginning balances, then prior service cost, the updated Jan. 1 balance row, service cost, interest cost, actual return, amortization of PSC, contributions, benefits, the journal entry totals row, any accumulated OCI row, and the ending balances.

What should the journal-entry totals row represent in a Wiley pension worksheet?

It should represent the actual formal year-end entry to record pension expense, contribution, OCI-related effects if applicable, and the change in Pension Asset/Liability.

What should be true of the ending Pension Asset/Liability in a Wiley worksheet?

It should match both the net effect shown by the ending memo balances and the cumulative balance shown in the Pension Asset/Liability column.

What was one Wiley formatting exception discovered in the expanded PSC worksheet?

Some rows that might look like “no-entry rows,” such as “Balance, Jan. 1” in a PSC worksheet, actually require real carried balances rather than “-0-”.

What is the major conceptual difference between pension expense and pension funding?

Pension expense is based on accrual accounting, while pension funding is the actual cash contribution. In a defined benefit plan, the two amounts are often different.

Why is it wrong to assume “cash contribution = pension expense” in a defined benefit plan?

Because pension expense includes service cost, interest cost, return on assets, and possibly PSC amortization, while the cash contribution is simply the funding amount paid into the plan.

What is one of the most common sign mistakes in pension accounting problems?

Forgetting that actual return on plan assets reduces pension expense, so a positive return is subtracted in the pension expense formula and shown as a credit to Pension Expense in the worksheet.

What is one of the most common formula mistakes in actual-return problems?

Forgetting to subtract contributions and add back benefits paid when computing the actual return on plan assets.

What is one of the most common concept mistakes in funded-status problems?

Trying to include OCI—Prior Service Cost in the pension asset/liability calculation even though funded status depends only on PBO and plan assets.

What is one of the most common worksheet mistakes in PSC problems?

Posting the prior service cost to Pension Asset/Liability instead of recording it through OCI on the journal side and PBO on the memo side.

What should you always verify at the end of a pension worksheet problem?

Verify that the ending Pension Asset/Liability agrees with the ending funded status computed from ending PBO and ending Plan Assets.

In a PSC problem, what is the formula for the ending unamortized OCI—Prior Service Cost balance?

Ending OCI—PSC =

Beginning OCI—PSC

+ New PSC granted

− PSC amortization for the year

What does a debit balance in OCI—Prior Service Cost represent in this chapter’s worksheet problems?

It represents prior service cost that has been recognized in OCI but has not yet been fully amortized into pension expense.

What is the single most important final checkpoint for any pension worksheet from this chapter?

The final checkpoint is: Ending Pension Asset/Liability = Ending PBO − Ending Plan Assets

for an underfunded plan, or the reverse for an overfunded plan.