Accounting for Pensions

Items to be covered:
Types of retirement plans

Defined contribution
Defined benefit

Accounting for pensions (defined benefit plans)

Measurement of pension liability

Capitalization, non-capitalization, partial capitalization

Measurement of pension expense

Smoothing

Accounting for postretirement benefits

1999 by Robert F. Halsey

There are two kinds of pension plans: defined contribution

plans and defined benefit plans.
Defined contribution plans (e.g., 401k plans) have become
increasingly more popular. In this type of plan,
The employer contributes funds to a third-party trust for
benefit of employees. Companies usually require
employees to contribute to the retirement plan as well.
The funds are invested by trustee for the benefit of the
employees and the fund balance is paid to employees
over time after retirement.
The accounting for this type of plan is relatively simple:
the employers expense is the amount it is obligated to
contribute to the plan and a liability is recorded only if the
contribution has not been made in full
1999 by Robert F. Halsey

The following is an example of the accounting for a defined

contribution plan from the annual report of The Sharper
Image. The company matched contribution to the plan by
its employees and recorded an expense in its income
statement for the amount contributed to the plan.

Note H -- 401k Savings Plan

The Company maintains a defined contribution, 401k Savings Plan,
covering all employees who have completed one year of service with at
least 1,000 hours and who are at least 21 years of age. The
Company makes employer matching contributions at its discretion.
Company contributions amounted to $73,000, $77,000, and $81,000
for the fiscal years ended January 31, 1999, 1998, and 1997,
respectively.
1999 by Robert F. Halsey

The defined benefit plan is the second type of

plan in use today. For this type of plan:
The plan agreement defines the benefits employees will
receive at retirement
All of the pension assets belong to employer - no funds
are paid to a third party
If plan is under funded, employees must look to
employer for the deficit. This can be a problem if the
employer becomes insolvent.
As we will see later, the amount of the pension liability
and expense are a function of the amount of the pension
obligation to the employees and the returns on the
pension fund assets.
Accounting for this type of plan is complex and the
concepts we will be discussing in this section relate to
this type of pension plan

1999 by Robert F. Halsey

There are two issues we need to consider from an

accounting standpoint:
How should the pension liability be reported on the
companys balance sheet? Here, we have a couple of
items to consider: first, since the company keeps the
pension assets until they are paid out to employees at
retirement, should the investments appear as assets?
And second, the company has a liability to make
payments to its employees after retirement. Should this
liability be reported on its balance sheet?
How should the expense for the pension plan be
computed and reported in the companys income
statement?
We will consider each of these questions in turn.
1999 by Robert F. Halsey

Measurement of Net Pension Liability

Remember - all of the assets of the pension plan are retained by the
employer until paid out to the employees at retirement. Also, the
pension obligation is determined by the terms of the pension plan
and is not satisfied until retirement payments are made.
When the accounting standards for pensions were revised in 1996,
the FASB wanted both the assets and the liability to appear on the
face of the balance sheet. Companies were concerned, however, that
liability this would negatively impact their credit ratings and increase
their cost of raising funds as a result.
A compromise was reached and the FASB only required the net
amount to be reported on balance sheet. This is called partial
capitalization. If the plan is over funded, an asset appears on the
balance sheet and if the plan is under funded, companies report a
net pension liability.

1999 by Robert F. Halsey

Overview - Pension Liability

Future Benefits as
promised by the
company

The future benefit

obligations are first
estimated, then
discounted back
to the present
to compute the PBO

1999 by Robert F. Halsey

PV

Present value of the

Projected Benefit
Obligation (PBO)

Fair Market Value

of the Pension Assets

Accrued Pension Asset /

Liability (Balance Sheet)

Measurement of Pension Expense

In general, pension expense reported in the income statement
is related to how much the pension liability increased during
the year compared with the return on the plans assets.
Pension liability increases as employees continue to work
(benefits are usually related to the years of service), get closer
to retirement, or if the company increases its promised
benefits. All of these factors that increase the pension liability
also increase the pension expense in the income statement.
Pension assets increase with earnings that the company
realizes on its investments. These earnings reduce the
pension expense reported in the income statement.

1999 by Robert F. Halsey

Service cost
This represents the increase in the PBO resulting from employee
service during the period. That is, the increase in benefits due to
working another year. (example
).

Interest cost
This is the interest accrued on the pension liability. Think of this
like a bond sold at a discount. Each year the carrying value
increases as the discount is amortized, reflecting the accrual of
interest. (example
).

Expected return on plan assets

Pension expense is reduced each year by the increase in the
plan assets available to pay the pension liability. These assets
increase due to investment returns. Whereas the first two
components increase the net pension liability and result in
increased expense, this component reduces the net liability and
also pension expense. (example
)

1999 by Robert F. Halsey

Overview - Pension Expense

Service cost
+ Interest cost

This is the increase in

the pension liability due
to the passage of time

- Expected return on plan assets

Pension expense
This is the increase in the
pension liability resulting
from employees working
This is the long-run expected
another year for the
rate that the companycompany
expects to
earn on the pension fund assets
1999 by Robert F. Halsey

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The following is an example of the computation of

pension cost form Hasbros annual report:

Dont worry about

amortization and deferrals
for now. Well cover these
a little later

1999 by Robert F. Halsey

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Basic Accounting Entry

Once the pension expense has been computed, an
example of the journal entry to record pension activity is
as follows:
Pension expense (I/S)

100

Accrued pension liability (B/S)

25

Cash (B/S)

75

In this example, the first line is the recognition of expense in

the income statement (I/S). The second and third lines reflect
on the balance sheet (B/S) the amount of the expense that has
been funded by the company. If the company underfunds the
expense as liability is created as in this example. If it overfunds
the expense, an asset is created (prepaid pension cost).
1999 by Robert F. Halsey

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Lets look at an example of the computation

of pension expense, the net pension liability
and the required journal entry:

(Click here to view an example of the basic

pension computations and journal entry.)

1999 by Robert F. Halsey

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When pension plans are initially adopted or amended, the

future benefit amounts and, consequently, the PBO change
significantly in the year of adoption or change. These changes
are, essentially, a reward for the prior service of the
employees.
Using the procedures we have developed thus far, this
increase in the PBO would be reflected as pension expense,
thereby reducing profitability in the year of the change.
The FASB took the position that these costs should be
recognized in the service periods of those employees
expected to receive benefits under the new plan, that is, when
the benefits arising from the plan through motivation of its
employees will be realized by the company.

1999 by Robert F. Halsey

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Prior Service Costs

Increases in the PBO arising from adoption of a new

plan or amendment of a plan are called Prior Service
Costs.
Under GAAP, these costs must be amortized over the
expected service-years to be worked by all of the
participating employees.

(Click here to view an example of the

accounting for prior service costs.)
1999 by Robert F. Halsey

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A second complication arises in the area of the return on plan

assets. Remember, we utilize the expected return in computing
pension expense. It is likely, however, that the actual return will
not equal the expected return.
It may also be the case that the assumptions we used in
estimating the PBO may turn out to be incorrect (we may not
accurately estimate the inflation in wage rates, the turnover of
our employees, etc.).
These unexpected gains and losses on plan assets and PBO
actuarial assumptions are accumulated in a memo account just
like prior service costs and are amortized in a similar manner, but
utilizing the corridor approach.
The next slide is an example of the corridor approach. The
accumulated unexpected gains/losses account is compared with
the beginning PBO balance and the FMV of the plan assets. Any
amounts greater than 10% of the larger of the two are amortized
over remaining service lives of the employees
1999 by Robert F. Halsey

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 1999 by Robert F. Halsey

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Lets look at an example of unexpected gains on

plan assets when we relax the assumption that
actual returns and expected returns are equal.

(Click here to view an example relating

to unexpected gains and losses.)

1999 by Robert F. Halsey

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The following is an example of the computation of

pension expense that includes the amortization of
prior service cost and unrealized gains from
Anheuser-Buschs annual report:

1999 by Robert F. Halsey

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Minimum Liability
As

we have seen thus far, companies generally report only

the net amount of the pension liability, that is, the FMV of the
plan assets minus the PBO (as adjusted for prior service cost
and unrecognized gains or losses). When companies
underfund their pension obligation, this is reported as an
accrued pension cost in the liability section of the balance
sheet.
When

the amount of underfunding is large enough, however,

the FASB requires companies to report a minimum liability
which is equal to the difference between the FMV of the plan
assets and the accumulated benefit obligation (ABO). The
ABO differs from the PBO in that the obligation in that benefits
are based on current salaries, whereas the PBO is based on
expected salaries at retirement.
1999 by Robert F. Halsey

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Recording a minimum liability involves the following:

The amount of the liability is computed as the ABO less
any accrued pension cost (or plus any prepaid pension
cost) currently reported on the balance sheet
The company makes the following journal entry:
Intangible asset - deferred pension cost xxx
Additional pension liability
xxx
If the minimum liability is greater than the balance in the prior
service cost account, if any, the excess is debited to a contra
equity equity account rather than an intangible asset and
stockholders equity is reduced accordingly.
(Click here to view an example of the
accounting for minimum pension liability)

1999 by Robert F. Halsey

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The following is an example of a minimum pension liability

disclosure from Honeywells annual report. Since the ABO is
less than the FMV of the plan assets, an additional minimum
liability must be recorded. Also, since the minimum liability is
in excess of the prior service cost balance, the excess must
be recognized as contra equity rather than an intangible asset

1999 by Robert F. Halsey

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Postretirement Benefits

Post-retirement benefits relate to medical benefits

provided to employees after retirement.

The expense and liability for these benefits are

computed similarly to pension expense and liability.

The major difference relates to the amount of any

underfunding existing upon the adoption of the
postretirement plan. If not recognized immediately, this
transition amount is amortized on a straight-line basis
over the remaining service lives of the employees or
20 years, whichever is longer.

1999 by Robert F. Halsey

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The End
1999 by Robert F. Halsey

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