Chapter 17 Pensions and Other Postretirement Benefits

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1 Chapter 17 Pensions and Other Postretirement Benefits AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise and problem in Intermediate Accounting, 7e, with the following AACSB learning skills: Questions AACSB Tags Brief Exercises AACSB Tags (cont.) 17 1 Reflective thinking Analytic 17 2 Reflective thinking Analytic 17 3 Reflective thinking Analytic 17 4 Reflective thinking Exercises 17 5 Reflective thinking 17 1 Reflective thinking 17 6 Reflective thinking 17 2 Analytic 17 7 Reflective thinking 17 3 Reflective thinking 17 8 Reflective thinking 17 4 Analytic 17 9 Reflective thinking 17 5 Analytic Reflective thinking 17 6 Analytic Reflective thinking 17 7 Analytic Reflective thinking 17 8 Analytic Reflective thinking 17 9 Diversity, Analytic Reflective thinking Analytic Reflective thinking Analytic Reflective thinking Analytic Reflective thinking Analytic Reflective thinking Analytic, Communications Reflective thinking Analytic Reflective thinking Analytic Reflective thinking Reflective thinking Reflective thinking Diversity, Analytic Reflective thinking Analytic Analytic Analytic Diversity, Reflective thinking Analytic Diversity, Reflective thinking Diversity, Analytic Brief Exercises Reflective thinking 17 1 Analytic Analytic 17 2 Analytic Analytic 17 3 Analytic Analytic 17 4 Analytic Analytic 17 5 Analytic Analytic 17 6 Analytic Analytic 17 7 Analytic Analytic 17 8 Analytic Analytic 17 9 Analytic Reflective thinking, Communications Analytic Reflective thinking, Communications Analytic Analytic 17 1 Intermediate Accounting 7e

2 CPA/CMA AACSB Tags Problems 1 Analytic 17 1 AACSB Tags Analytic 2 Reflective thinking 17 2 Analytic 3 Reflective thinking 17 3 Analytic 4 Reflective thinking 17 4 Analytic 5 Reflective thinking 17 5 Analytic 6 Diversity, Reflective thinking 17 6 Analytic 7 Diversity, Reflective thinking 17 7 Analytic 8 Diversity, Reflective thinking 17 8 Analytic 1 Reflective thinking 17 9 Analytic 2 Analytic Diversity, Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Solutions Manual, Vol.2, Chapter

3 QUESTIONS FOR REVIEW OF KEY TOPICS Question 17 1 Pension plans are arrangements designed to provide income to individuals during their retirement years. Funds are set aside during an employee s working years so that the accumulated funds plus earnings from investing those funds are available to replace wages at retirement. An individual has a pension fund when she or he periodically invests in stocks, bonds, CDs, or other securities for the purpose of saving for retirement. When an employer establishes a pension plan, the employer provides some or all of the periodic contributions to the retirement fund. The motivation for corporations to establish pension plans comes from several sources. Pension plans provide employees with a degree of retirement security. They may fulfill a moral obligation many employers feel toward employees. Pension plans often enhance productivity, reduce turnover, satisfy union demands, and allow employers to compete in the labor market. Question 17 2 A qualified pension plan gains important tax advantages. The employer is permitted an immediate tax deduction for amounts paid into the pension fund. Conversely, the benefits to employees are not taxed until retirement benefits are received. Also, earnings on the funds set aside by the employer accumulate tax-free. For a pension plan to be qualified for special tax treatment, these general requirements must be met: 1. It must cover at least 70% of employees. 2. It cannot discriminate in favor of highly compensated employees. 3. It must be funded in advance of retirement through contributions to an irrevocable trust fund. 4. Benefits must vest after a specified period of service, commonly five years. 5. It complies with specific restrictions on the timing and amount of contributions and benefits. Question 17 3 This is a noncontributory plan because the corporation makes all contributions. When employees make contributions to the plan in addition to employer contributions, it s called a contributory plan. This is a defined contribution plan because it promises fixed annual contributions to a pension fund, without further commitment regarding benefit amounts at retirement. Question 17 4 The vested benefit obligation is the pension benefit obligation that is not contingent upon an employee's continuing service. Question 17 5 The accumulated benefit obligation is the discounted present value of retirement benefits calculated by applying the pension formula with no attempt to forecast what salaries will be when the formula actually is applied. The projected benefit obligation is the present value of those benefits when the actuary includes projected salaries in the pension formula Intermediate Accounting 7e

4 Answers to Questions (continued) Question 17 6 The projected benefit obligation can change due to periodic service cost, accrued interest, revised estimates, plan amendments, and the payment of benefits. Question 17 7 The balance of the plan assets can change due to investment returns, employer contributions, and the payment of benefits. Question 17 8 The pension expense reported on the income statement is a composite of periodic changes that occur in both the pension obligation and the plan assets. These include service cost, interest cost, return on the plan assets, and the amortization of prior service cost and of net gains or losses. Question 17 9 The service cost in connection with a pension plan is the present value of benefits attributed by the pension formula to employee service during the period, projecting future salary levels (i.e., the projected benefits approach). Question The interest cost is the projected benefit obligation outstanding at the beginning of the period multiplied by the actuary's interest (discount) rate. This is the interest expense that accrues on the PBO and is included as a component of pension expense rather than being separately reported. Question GAAP specifies that the actual return be included in the determination of pension expense. However, the actual return is adjusted for any difference between actual and expected return, meaning that the expected return is really the amount reflected in the calculation of pension expense. This investment revenue is deducted as a component of pension expense rather than being separately reported. The difference between actual and expected return on plan assets is combined with gains and losses from other sources for possible future amortization to pension expense. Question Prior service cost is the obligation (present value of benefits) due to giving credit to employees for years of service provided before either the date of an amendment to (or initiation of) a pension plan. Prior service cost is recognized as other comprehensive income as incurred and then as a component of accumulated other comprehensive income in the company s balance sheet. The account is allocated (amortized) to pension expense over the service period of affected employees. The straight-line method allocates an equal amount of the prior service cost to each year. The service method recognizes the cost each year in proportion to the fraction of the total remaining service years worked in each of these years. Solutions Manual, Vol.2, Chapter

5 Answers to Questions (continued) Question Gains or losses related to pension plan assets represent the difference between the return on investments and what the return had been expected to be. They are recognized as other comprehensive income as incurred and then as a component of accumulated other comprehensive income in the company s balance sheet: either a net loss AOCI or a net asset AOCI depending on whether cumulative losses have exceeded gains, or vice versa. The account is amortized to pension expense only if the net loss AOCI or net asset AOCI exceeds a defined threshold. Specifically, a portion of the excess is included in pension expense only if it exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher. The amount that should be included is the excess divided by the average remaining service period of active employees expected to receive benefits under the plan. Gains or losses related to the pension obligation are treated the same way. In fact, gains and losses from both sources are combined to determine the net gains or net losses referred to above. Question A company s PBO is not reported among liabilities in the balance sheet. Similarly, the plan assets a company sets aside to pay those benefits are not reported among assets in the balance sheet. However, firms report the net difference between those two amounts, referred to as the funded status of the plan, as either a net pension liability (if underfunded) or a net pension asset (if overfunded). Question The two components of pension expense that may reduce pension expense are the return on plan assets (always) and the amortization of a net gain AOCI (amortizing a net loss AOCI increases the expense). Question The components of pension expense that involve delayed recognition are the prior service cost and gains and losses. Question The excess of the actual return on plan assets over the expected return is considered a gain. It does, in fact, decrease the employer s pension cost, but not immediately the pension expense. It is reported as other comprehensive income as it occurs, grouped with other gains and losses to create a net gain AOCI or net loss AOCI account, and then amortized as a component of pension expense only if the net gain AOCI or net loss AOCI exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher. Question The cash contribution is debited to the pension asset. It adds to plan assets, thereby reducing an underfunded status (PBO > assets) or increasing an overfunded status (assets > PBO). So, if the plan is underfunded so that a net pension liability exists, the liability is reduced. Otherwise, if the plan is overfunded so that a net pension asset exists, the asset is increased Intermediate Accounting 7e

6 Answers to Questions (continued) Question TFC Inc. revises its estimate of future salary levels causing its PBO estimate to increase by the $3 million. The $3 million is considered a loss and is reported in the statement of comprehensive income rather than being reported as part of traditional net income as would occur if included as part of pension expense. It then becomes part of accumulated other comprehensive income in the balance sheet as part of the net loss AOCI or net gain AOCI. A portion of that balance might possibly be amortized to pension expense if the net loss AOCI or net gain AOCI exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is higher. Question The difference between the employer s obligation (PBO) and the resources available to satisfy that obligation (plan assets) is the funded status of the pension plan. Firms must report the net difference between those two amounts, referred to as the funded status of the plan, in the balance sheet. It s reported as a net pension asset if the plan assets exceed the PBO or as a net pension liability if the PBO exceeds the plan assets. Question The expected postretirement benefit obligation (EPBO) is the actuary's estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants. When a plan is pay-related, future compensation levels are implicitly assumed. The accumulated postretirement benefit obligation (APBO) measures the obligation existing at a particular date, rather than the total amount expected to be earned by plan participants. The APBO is conceptually similar to a pension plan s projected benefit obligation. The EPBO has no counterpart in pension accounting. Question The cost of benefits is attributed to the years during which those benefits are assumed to be earned by employees. The attribution period spans each year of service from the employee s date of hire to the employee s full eligibility date, which is the date the employee has performed all the service necessary to have earned all the retiree benefits estimated to be received by that employee. The approach assigns an equal fraction of the EPBO to each of those years. The attribution period does not include any years of service beyond the full eligibility date, even if the employee is expected to work after that date. Question The service cost for pensions reflects additional benefits employees earn from an additional year s service, whereas the service cost for retiree health care plans is simply an allocation to the current year of a portion of a fixed total cost. Question The attribution period spans each year of service from the employee s date of hire to the employee s full eligibility date, 30 years in this case. The APBO is $10,000, which represents the portion of the EPBO earned after 15 years of the 30-year attribution period: $20,000 x 15 /30 = $10,000. Solutions Manual, Vol.2, Chapter

7 Answers to Questions (concluded) Question Mid-South Logistics prepares its financial statements according to U.S. GAAP. Under U.S. GAAP, prior service cost is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized over the average remaining service period. On the other hand, under IAS No. 19, prior service cost (called past service cost under IFRS) is combined with service cost and reported within the income statement, in the period in which it arises, rather than as a component of other comprehensive income as it is under U.S. GAAP, so it never is amortized to expense. Since Mid-South Logistics is amortizing a portion of the amount, U.S. GAAP is indicated. Question Under both U.S. GAAP and IFRS we report gains and losses among OCI items in the statement of comprehensive income; thus, they subsequently become part of AOCI. But, under IFRS the gains and losses are not subsequently amortized to expense and recycled or reclassified from other comprehensive income as is required under U.S. GAAP (when the accumulated net gain or net loss exceeds the 10% threshold). A second difference pertains to the make-up of the gain or loss on plan assets. This amount under U.S. GAAP is the difference in the actual and expected returns, where the expected return is different from company to company and usually different from the interest rate used to determine the interest cost. Under IFRS, though, we use the same rate (the rate for highgrade corporate bonds) for both the interest cost on the defined benefit obligation and the interest income on the plan assets. In fact, under IFRS, we multiply that rate times the net difference between the defined benefit obligation and plan assets and report the net interest cost/income Intermediate Accounting 7e

8 BRIEF EXERCISES Brief Exercise 17 1 Beginning of the year PBO $80 Service cost 10 Interest cost 4 (5% x $80) Loss (gain) on PBO 0 Less: Retiree benefits (6) End of the year PBO $88 Brief Exercise 17 2 Beginning of the year PBO $80 Service cost? Interest cost 4 (5% x $80) Loss (gain) on PBO 0 Less: Retiree benefits (6) End of the year PBO $85 Service cost = $ = $7 million Brief Exercise 17 3 Beginning of the year PBO $80 Service cost 10 Interest cost 4 (5% x $80) Loss (gain) on PBO 0 Less: Retiree benefits (?) End of the year PBO $85 Retiree benefits = $ = $9 million Solutions Manual, Vol.2, Chapter

9 Brief Exercise 17 4 Beginning of the year PBO $80 Service cost 10 Interest cost 4 (5% x $80) Loss (gain) on PBO? Less: Retiree benefits (6) End of the year PBO $85 Gain = $ = $3 million Brief Exercise 17 5 Plan assets Beginning of the year $80 Actual return 4 (5% x $80) Cash contributions 7 Less: Retiree benefits (6) End of the year $85 Brief Exercise 17 6 Plan assets Beginning of the year $80 Actual return 4 (5% x $80) Cash contributions 7 Less: Retiree benefits (?) End of the year $83 Retiree benefits = $ = $8 million 17 9 Intermediate Accounting 7e

10 Brief Exercise 17 7 Plan assets Beginning of the year $100 Actual return? (? % x $100) Cash contributions 7 Less: Retiree benefits (6) End of the year $104 Return on assets = $ = $3 million Rate of return on assets = $3 million $100 million = 3% Solutions Manual, Vol.2, Chapter

11 Brief Exercise 17 8 The difference between an employer s obligation (PBO) and the resources available to satisfy that obligation (plan assets) is the funded status of the pension plan. The employer must report the net difference between those two amounts, referred to as the funded status of the plan in the balance sheet. It s reported as a net pension liability if the PBO exceeds the plan assets or a net pension asset if the plan assets exceed the PBO. In the situation described, JDS would report a net pension liability of $15 million: PBO $40 Plan assets 25 Net pension liability $15 If the plan assets are $45 million, JDS would report a net pension asset of $5 million: Plan assets $45 PBO 40 Net pension asset $ Intermediate Accounting 7e

12 Brief Exercise 17 9 Service cost $10 Interest cost (5% x $80) 4 Expected return on the plan assets ($5 actual, less $1 gain) (4) Amortization of prior service cost 0 Amortization of net loss (gain) 0 Pension expense $10 Solutions Manual, Vol.2, Chapter

13 Brief Exercise Service cost $10 Interest cost 4 Expected return on the plan assets ($4 actual, plus $2 loss) (6) Amortization of prior service cost 2* Amortization of net loss (gain) 0 Pension expense $10 * $20 10 years = $ Intermediate Accounting 7e

14 Brief Exercise Gains or losses should not be part of pension expense unless and until total net gains or losses exceed a defined threshold. Specifically, a portion of the excess is included in pension expense only if it exceeds an amount equal to 10% of the PBO, or 10% of plan assets, whichever is larger. The amount that should be included is the excess divided by the average remaining service period of active employees expected to receive benefits under the plan. Amortization of net gains is deducted from pension expense; amortization of a net loss is added to pension expense. Pension expense in this instance is decreased by a $2 million amortization of the net gain: Net gain $30 Less: 10% corridor (threshold)* (10) Excess $20 Service period 10 Amortization $ 2 * 10% times either the PBO ($80) or plan assets ($100), whichever is larger. Solutions Manual, Vol.2, Chapter

15 Brief Exercise The net pension liability, which is the difference between the PBO and plan assets, increases by the combination of the service cost, interest cost, and the expected return ($ million) as is reflected in the following entry. To Record Pension Expense Pension expense (total) Plan assets ($55 expected return on assets) 55 PBO ($ ) Prior service cost AOCI... 2 The net pension liability (PBO minus plan assets) is affected only by the three components of pension expense that change either the PBO or plan assets. The pension expense also includes the $2 million of prior service cost amortization but, unlike the other three components, this amortization amount affects neither the PBO nor the plan assets and therefore doesn t change the net pension liability. However, the prior service cost (an accumulated other comprehensive income account) is reduced by $2 million. This reduction is reported as other comprehensive income in the statement of comprehensive income Intermediate Accounting 7e

16 Brief Exercise Pension gains and losses (either from changing assumptions regarding the PBO or the return on assets being higher or lower than expected) are deferred and not immediately included in pension expense and net income. They are, however, reported as other comprehensive income in the period they occur. Accordingly, these gains and losses are reported in Andrews s statement of comprehensive income as a gain of $4 million and a loss of $1 million. Here are the entries: Loss OCI (loss from actual return falling short of expected) 1 Plan assets... 1 PBO... 4 Gain OCI (gain from change in assumption)... 4 The net pension liability in the balance sheet declines by the $3 million net effect of the loss and the gain: PBO Less: Plan assets Net pension liability $4 1 $ 3 The Net loss AOCI in the balance sheet increases by the current $1 million Loss OCI and deceases by the current $4 million Gain OCI, a net reduction of $3 million. Plus: Loss OCI $ 1 Less: Gain OCI (4) Decrease in Net loss AOCI $(3) Solutions Manual, Vol.2, Chapter

17 Brief Exercise APBO Service Cost 2013 $50,000 x 6/ 30 = $10,000 $50,000 x 1 / 30 = $1, $54,000 x 7 / 30 = $12,600 $54,000 x 1 / 30 = $1, year attribution period (age 26 55). Brief Exercise Beginning of 2013 APBO $25 Service cost 7 Interest cost 2 (8% x $25) Gain on APBO (1) Less: Retiree benefits (3) End of 2013 APBO $ Intermediate Accounting 7e

18 EXERCISES Exercise 17 1 I N D I I D N D I N N Exercise 17 2 Events 1. Interest cost. 2. Amortization of prior service cost. 3. A decrease in the average life expectancy of employees. 4. An increase in the average life expectancy of employees. 5. A plan amendment that increases benefits is made retroactive to prior years. 6. An increase in the actuary s assumed discount rate. 7. Cash contributions to the pension fund by the employer. 8. Benefits are paid to retired employees. 9. Service cost. 10. Return on plan assets during the year lower than expected. 11. Return on plan assets during the year higher than expected. Beginning of 2013 $30 Service cost 12 Interest cost 3 (10% x $30) Loss (gain) on PBO 0 Less: Retiree benefits (4) End of 2013 $41 Solutions Manual, Vol.2, Chapter

19 Exercise 17 3 I I N D N N N N I N I D Events 1. Interest cost. 2. Amortization of prior service cost AOCI. 3. Excess of the expected return on plan assets over the actual return. 4. Expected return on plan assets. 5. A plan amendment that increases benefits is made retroactive to prior years. 6. Actuary s estimate of the PBO is increased. 7. Cash contributions to the pension fund by the employer. 8. Benefits are paid to retired employees. 9. Service cost. 10. Excess of the actual return on plan assets over the expected return. 11. Amortization of net loss AOCI. 12. Amortization of net gain AOCI Intermediate Accounting 7e

20 Exercise 17 4 Requirement 1 Pension expense (total) Plan assets (expected return on assets)... 4 PBO ($10 service cost + $6 interest cost) Net loss AOCI (current amortization) 2 Requirement 2 Pension expense (total) Plan assets (expected return on assets)... 4 Net gain AOCI (current amortization) 2 PBO ($10 service cost + $6 interest cost) Requirement 3 Pension expense (total) Plan assets (expected return on assets)... 4 PBO ($10 service cost + $6 interest cost) Net loss AOCI (current amortization) 2 Prior service cost (current amortization) 3 The amortization amounts are reported as other comprehensive income in the statement of comprehensive income. Solutions Manual, Vol.2, Chapter

21 Exercise 17 5 Plan assets Beginning of the year $600 Actual return 48 Cash contributions 100 Less: Retiree benefits (11) End of the year $737 Exercise 17 6 PBO: Beginning of the year $360 Service cost? Interest cost 36 (10% x $360) Loss (gain) on PBO 0 Less: Retiree benefits (54) End of the year $465 Service cost = $ = $123 million Exercise 17 7 Plan assets Beginning of the year $700 Actual return 77 (11% x $700) Cash contributions? Less: Retiree benefits (66) End of the year $750 Cash contributions = $ = $39 million Intermediate Accounting 7e

22 Exercise 17 8 ($ in 000s) Service cost $112 Interest cost (6% x $850) 51 Expected return on the plan assets ($99 actual, less $9 gain*) (90) Amortization of prior service cost 8 Amortization of net loss 1 Pension expense $82 * (11% x $900) (10% x $900) Exercise 17 9 Under IFRS the various components of pension expense are not reported as a single net amount. Instead, Sterling Properties would separately report service cost (including past service cost), net interest cost/income, and remeasurement gains and losses: ($ in 000s) Income statement: Service cost 2013 $112 Past service cost 80 Service cost (reported in income statement) $192 Net interest income* (6%** x [$ ]) $ 3 Statement of comprehensive income: Remeasurement gain OCI ([11% 6%] x $900]) $ (45) Net pension cost (not separately reported) $150 * Because plan assets exceed the DBO, we have net interest income rather than net interest cost ** This solution assumes that the 6% interest rate is also the interest rate for high-quality corporate bonds, which is the rate prescribed for determining the net interest cost/income. Note: Using IFRS, there would be no prior service cost in AOCI and no amortization of the net loss. Solutions Manual, Vol.2, Chapter

23 Exercise Requirement 1 Service cost $20 Interest cost 12 Expected return on the plan assets ($9 actual, less $1 gain) (8) Pension expense $24 Requirement 2 Pension expense (calculated above) 24 Plan assets (expected return on plan assets) 8 PBO ($20 service cost + $12 interest cost) 32 Plan assets 20 Cash (contribution) 20 PBO 9 Plan assets (given) 9 The following entry also would be required although it does not affect the pension expense or the plan asset funding: Plan assets 1 Gain OCI Intermediate Accounting 7e

24 Exercise Requirement 1 ($ in 000s) Service cost $310 Interest cost (7% x $2,300) 161 Expected return on the plan assets ($216 actual, plus $24 loss*) (240) Amortization of prior service cost 25 Amortization of net gain (6) Pension expense $250 * (10% x $2,400) (9% x $2,400) Requirement 2 Pension expense (calculated above) 250 Plan assets (expected return on assets) 240 Net gain AOCI (current amortization) 6 Prior service cost AOCI (current amortization) 25 PBO ($310 service cost + $161 interest cost) 471 Loss OCI ($216 actual return on assets $240 expected return) 24 Plan assets 24 Plan assets 245 Cash (contribution) 245 PBO 270 Plan assets (retiree payments) 270 The amortization amounts are reported as other comprehensive income in the statement of comprehensive income. Solutions Manual, Vol.2, Chapter

25 Exercise Requirement 1 1.2% x service years x final year s salary = 1.2% x 20 x $270,000 = $64,800 Requirement 2 Requirement 3 The present value of the retirement annuity at the end of 2038 is $64,800 x * = $590,193 * Present value of an ordinary annuity of $1: n = 15, i = 7% (from Table 4) The PBO is the present value of the retirement benefits at the end of 2013: $590,193 x.18425* = $108,743 * Present value of $1: n = 25, i = 7 % (from Table 2) Requirement 4 1.2% x 20 x $80,000 = $19,200 $19,200 x * = $174,872 $174,872 x.18425** = $32,220 * Present value of an ordinary annuity of $1: n = 15, i = 7% (from Table 4) ** Present value of $1: n = 25, i = 7% (from Table 2) Requirement 5 1.2% x 21 x $270,000 = $68,040 $68,040 x * = $619,702 $619,702 x.19715** = $122,174 * Present value of an ordinary annuity of $1: n = 15, i = 7% (from Table 4) ** Present value of $1: n = 24, i = 7% (from Table 2) Intermediate Accounting 7e

26 Exercise (concluded) Requirement 6 PBO at the end of 2014 $122,174 PBO at the end of 2013 (108,743) Change in PBO $ 13,431 Less: Interest cost ($108,743 x 7%) (7,612) Service cost $ 5,819 The change due to service cost can be verified as follows ($1 difference due to rounding): (1.2% x 1 yr. x $270,000) x x = $5,818 annual retirement benefits to discount to discount from 2014 service to 2036 * to 2014 ** * Present value of an ordinary annuity of $1: n = 15, i = 7% (from Table 4) ** Present value of $1: n = 24, i = 7% (from Table 2) Solutions Manual, Vol.2, Chapter

27 Exercise Requirement 1 ($ in 000s) Case 1 Case 2 Case 3 Net loss or gain $320 $330 $260 Less: 10% corridor (threshold)* Excess none $ 60 $ 90 Service period Amortization none $ 4 $ 9 * 10% times either the PBO or plan assets (beginning of the year), whichever is larger. Case 1 3,310 or 2,800: choose 3,310 Case 2 2,670 or 2,700: choose 2,700 Case 3 1,700 or 1,550: choose 1,700 Requirement 2 ($ in 000s) Case 1 Case 2 Case 3 January 1, 2013 net loss or (gain) $320 ($330) $ loss (gain) on plan assets (11) (8) amortization 0 4 (9) 2013 loss (gain) on PBO (23) 16 (265) January 1, 2014 $286 ($318) ($ 12) Note: The balance in this account is recognized as part of accumulated other comprehensive income in the balance sheet Intermediate Accounting 7e

28 Exercise In the balance sheet, Liabilities increase by $274 million: The PBO increases by $374 (service cost and interest cost); plan assets increase by $100 (expected return on assets plus the gain due to the actual return exceeding expectations). When those two accounts are reported in the balance sheet by netting the two together (PBO less plan assets), the net pension liability (underfunded plan) will increase by $274 million. Shareholders equity decreases by $274 million: Retained earnings: Retained earnings decreases by the reduction of earnings by the $294 million expense. Accumulated other comprehensive income: The prior service cost AOCI (a negative shareholders equity account) decreases by the $8 million amortization. The net loss AOCI (a negative shareholders equity account) decreases by the $2 million amortization and by the $10 million gain OCI. Retained earnings ($294) Prior service cost AOCI 8 Net loss AOCI 12 Shareholders equity $274 Journal entries (not required): To record expense ($ in 000s) Pension expense (given) 294 Plan assets (expected return on assets) 90 Prior service cost AOCI (current amortization) 8 Net loss AOCI (current amortization) 2 PBO ($224 service cost + $150 interest cost) 374 To record gain on assets... Plan assets Gain OCI (actual return exceeded expected return) 10 Solutions Manual, Vol.2, Chapter

29 Exercise ( )s indicate credits; debits otherwise Plan Assets Prior Service Cost AOCI Net Loss AOCI Pension Expense Net Pension (Liability ) / Asset ($ in 000s) PBO Cash Balance, Jan. 1, 2013 (800) (200) Service cost (84) 84 (84) Interest cost, 5% (40) 40 (40) Expected return on assets 48 (48) 48 Adjust for: Loss on assets (6) 6 (6) Amortization: Prior service cost (6) 6 Amortization: Net loss 0 (0) Gain on PBO 12 (12) 12 Prior service cost Cash funding 68 (68) 68 Retiree benefits 50 (50) Bal., Dec. 31, 2013 (862) (202) Intermediate Accounting 7e

30 Exercise Requirement 1 Pension expense (calculated below) 88* Plan assets (expected return on assets) 40 Net loss AOCI (current amortization) 2 Prior service cost AOCI (current amortization) 4 PBO ($80 service cost + $42 interest cost) 122 * Service cost $ 80 Interest cost 42 Expected return on the plan assets ($32 actual, plus $8 loss) (40) Amortization of prior service cost 4 Amortization of net loss 2 Pension expense $ 88 Computation of net loss amortization: Net loss AOCI (previous losses exceeded previous gains) $ 80 10% of $600 PBO (greater than $400 plan assets) (60) Amount to be amortized $ years Amortization $ 2 The amortization amounts are reported as other comprehensive income in the statement of comprehensive income. Requirement 2 Loss OCI ($32 actual return on assets $40 expected return) 8 Plan assets 8 PBO 14 Gain OCI (from change in assumption regarding the PBO) 14 Solutions Manual, Vol.2, Chapter

31 Exercise (concluded) Requirement 3 Plan assets 90 Cash (contribution) 90 Requirement 4 PBO 38 Plan assets (retiree benefit payments) Intermediate Accounting 7e

32 Exercise List A List B d_ 1. Future compensation levels estimated. a. Actual return exceeds expected f_ 2. All funding provided by the employer. b. Net gain AOCI a_ 3. Credit to OCI and debit to c. Vested benefit obligation plan assets. d. Projected benefit obligation l_ 4. Retirement benefits specified e. Choice between PBO and ABO by formula. f. Noncontributory pension plan e_ 5. Trade-off between relevance g. Accumulated benefit obligation and reliability. h. Plan assets b_ 6. Cumulative gains in excess of losses. i. Interest cost g_ 7. Current pay levels implicitly assumed. j. Delayed recognition in earnings i_ 8. Created by the passage of time. k. Defined contribution plan c_ 9. Not contingent on future employment. l. Defined benefit plan k_ 10. Risk borne by employee. m. Prior service cost h_ 11. Increased by employer contributions. n. Amortize net loss AOCI m_ 12. Caused by plan amendment. j_ 13. Loss on plan assets. n_ 14. Excess over 10% of plan assets or PBO. Solutions Manual, Vol.2, Chapter

33 Exercise Requirement 1 A decrease in the discount rate from 7% to 6% increases the projected benefit obligation. The lower the discount rate in a present value calculation, the higher the present value. When the obligation increases, it is reported as a loss. Requirement 2 Loss OCI (from change in discount rate) 13 PBO 13 U.S. GAAP requires that actuarial gains and losses be included among OCI items in the statement of comprehensive income, thus subsequently become part of AOCI. Requirement 3 Reporting actuarial gains and losses among OCI items in the statement of comprehensive income also is required under IAS No. 19, referred to as remeasurement gains and losses. Under IAS No. 19 they are not subsequently amortized to expense and recycled or reclassified from other comprehensive income as is required under U.S. GAAP (if the net gain or net loss exceeds the 10% corridor threshold). So, the entry might be identical to the one in Requirement 2 except we call it a remeasurement loss and the projected benefit obligation is called the defined benefit obligation (DBO): Remeasurement loss OCI (from change in discount rate) 13 DBO Intermediate Accounting 7e

34 Exercise Requirement 1 Pension expense (calculated below) 67* Plan assets (expected return on assets) 45 Net gain AOCI (current amortization) 2 Prior service cost AOCI (current amortization) 8 PBO ($82 service cost + $24 interest cost) 106 * Service cost $ 82 Interest cost 24 Expected return on the plan assets ($40 actual, plus $5 loss) (45) Amortization of prior service cost 8 Amortization of net gain (2) Pension expense $ 67 Computation of net gain amortization: Net gain AOCI (previous gains exceeded previous losses) $ 80 10% of $500 plan assets (greater than $480 PBO) (50) Amount to be amortized $ years Amortization $ 2 Requirement 2 Journal entries to record gains and losses PBO (given) Gain OCI (from change in assumption regarding the PBO) 10 Loss OCI ($40 actual return on assets $45 expected return) 5 Plan assets... 5 Requirement 3 Plan assets 70 Cash (contribution) 70 PBO 40 Plan assets (benefit payments) 40 Solutions Manual, Vol.2, Chapter

35 Exercise (continued) Requirement 4 PBO 480 Jan. 1 balance 82 Service cost 24 Interest cost New gain 10 Benefits paid Dec. 31 balance Plan Assets Jan. 1 balance 500 Expected return 45 5 New loss Cash funding Benefits paid Dec. 31 balance Intermediate Accounting 7e

36 Exercise (concluded) SHAREHOLDERS EQUITY: ACCUMULATED OTHER COMPREHENSIVE INCOME Net Gain AOCI 80 Jan. 1 balance 10 New gain New loss 5 Amortized in Dec. 31 balance Prior Service Cost AOCI Jan. 1 balance 48 8 Amortized in 2013 Dec. 31 balance 40 Requirement 5 The pension plan is overfunded. Beale will report a net pension asset of $34 million in its 2013 balance sheet: Plan assets PBO = Net pension asset 2012 $ = $ $ = $34 Solutions Manual, Vol.2, Chapter

37 Exercise ( )s indicate credits; debits otherwise Plan Assets Prior Service Cost AOCI Net Gain AOCI Pension Expense Net Pension (Liability) / Asset PBO Cash Balance, Jan. 1, 2013 (480) (80) 20 Service cost (82) 82 (82) Interest cost, 5% (24) 24 (24) Expected return on assets 45 (45) 45 Adjust for: Loss on assets (5) 5 (5) Amortization of: Prior service cost (8) 8 Net gain 2 (2) Gain on PBO 10 (10) 10 Cash funding 70 (70) 70 Retiree benefits 40 (40) Balance, Dec. 31, 2013 (536) (83) Intermediate Accounting 7e

38 Exercise Requirement 1 Service cost $ 60 Interest cost 27 Expected return on the plan assets ($27 actual, less $3 gain) (24) Amortization of prior service cost 0* Amortization of net gain or net loss AOCI 0 Pension expense $ 63 * Since the amendment was at the end of the year, there is no amortization of prior service cost in Requirement 2 Pension expense (calculated above) 63 Plan assets (expected return on assets) 24 PBO ($60 service cost + $27 interest cost) 87 Plan assets 3 Gain OCI ($27 actual return on assets $24 expected return) 3 Prior service cost OCI (from 2013 amendment) 12 PBO 12 Plan assets 60 Cash (funding contribution) 60 PB O 37 Plan assets (retiree benefits) 37 Solutions Manual, Vol.2, Chapter

39 Exercise Under U.S. GAAP, prior service cost is included among other comprehensive income items in the statement of comprehensive income and thus subsequently becomes part of accumulated other comprehensive income where it is amortized over the average remaining service period. Under IAS No. 19, past service cost (called prior service cost under U.S. GAAP) is expensed immediately as part of the service cost for the year. Requirement 1 Income statement: Service cost 2013 $ 60 Past service cost 12 Service cost $ 72 Net interest cost (7.5% x [$ ]) $ 9 Other comprehensive income: Remeasurement gain OCI ($27 [7.5% x $240]) ($ 9) Net pension cost (not separately reported) $ Intermediate Accounting 7e

40 Exercise (concluded) Requirement 2 Service cost 72 DBO (2013 service cost) 60 DBO (past service cost) 12 Net interest cost (7.5% x [$ ]) 9 Plan assets (7.5% x $240: interest income) 18 DBO (7.5% x $360: interest cost) 27 Plan assets (actual return in excess of 7.5%) 9 Remeasurement gain OCI ($27 [7.5% x $240]) 9 When Lacy adds its annual cash investment to its plan assets, the value of those plan assets increases by $60 million: To Record Funding Plan assets 60 Cash (contribution to plan assets) 60 Lacy s retired employees were paid benefits of $37 million in Paying those benefits, of course, reduces the obligation to pay benefits (the DBO), and since the payments are made from the plan assets, that balance is reduced as well: To Record Payment of Benefits DBO 37 Plan assets 37 Solutions Manual, Vol.2, Chapter

41 Exercise B 1. Change in actuarial assumptions for a defined benefit pension plan. C 2. Determination that the accumulated benefits obligation under a pension plan exceeded the fair value of plan assets at the end of the previous year by $17,000. The only pension-related amount on the balance sheet was net pension liability of $30,000. D 3. Pension plan assets for a defined benefit pension plan achieving a rate of return in excess of the amount anticipated. D 4. Instituting a pension plan for the first time and adopting GAAP for employers accounting for defined benefit pension and other postretirement plans Intermediate Accounting 7e

42 Exercise Requirement 1 $72,000 EPBO 2013 Requirement 2 $72,000 x 2/ [2+28] = $4,800 EPBO fraction APBO 2013 earned 2013 Requirement 3 $72,000 x 1.06 = $76,320 EPBO to accrue EPBO 2013 interest 2014 Requirement 4 $76,320 x 3/ 30 = $7,632 EPBO fraction APBO 2014 earned 2014 Solutions Manual, Vol.2, Chapter

43 Exercise Requirement 1 $50,000 x 3/ 25 = $6,000 EPBO fraction APBO earned Requirement 2 Requirement 3 $6,000 (beginning APBO) x 6% = $360 $53,000 x 1/ 25 = $2,120 EPBO attributed service 2013 to 2013 cost Requirement 4 Postretirement benefit expense ($ ,120)... 2,480 Postretirement benefit liability... 2, Intermediate Accounting 7e

44 Exercise Requirement 1 22 years Requirement 2 $44,000 Requirement 3 $44,000 x? / 22 = $20,000 EPBO fraction APBO earned $44,000 x 10/ 22 = $20,000 EPBO fraction APBO earned Requirement 4 10 years before 2012: beginning of 2003 (or end of 2002) $? x 1.10 = $44,000 EPBO interest EPBO beg. multiple end $40,000 x 1.10 = $44,000 EPBO interest EPBO beg. multiple end or, alternatively: $? x 9/ 22 = $16,364 EPBO fraction APBO earned $40,000 x 9/ 22 = $16,364 EPBO fraction APBO earned Solutions Manual, Vol.2, Chapter

45 Exercise Requirement 1 ($ in 000s) Service cost $124 Interest cost (7% x $700) 49 Return on the plan assets (10% x $50) (5) Amortization of prior service cost 0 Amortization of net gain (1) Postretirement benefit expense $167 Requirement 2 ($ in 000s) Postretirement benefit expense (calculated above) Plan assets (expected return on assets)... 5 Net gain AOCI (current amortization)... 1 APBO ($124 service cost + $49 interest cost) Plan assets Cash (contributions to fund) PBO Plan assets (retiree benefits) The amortization amount is reported as other comprehensive income on the statement of comprehensive income Intermediate Accounting 7e

46 Exercise Requirement 1 ($ in 000s) Net loss (previous losses exceeded previous gains) $336 10% of $2,800 ($2,800 is greater than $500) 280 Excess at the beginning of the year $ 56 Average remaining service years 14 Amount amortized to 2013 expense $ 4 Requirement 2 ($ in 000s) Postretirement benefit expense exclusive of net loss amortization $212 Amortization of net loss 4 Postretirement benefit expense $216 Requirement 3 ($ in 000s) Net loss, beginning of 2013 $ gain on plan assets ([10% 9%] x $500) (5) 2013 amortization (4) 2013 loss on PBO 39 Net loss, end of 2013 $366 Solutions Manual, Vol.2, Chapter

47 Exercise Requirement 1 Service cost $34 Interest cost 12 (8% x [$ ]) Return on plan assets (0) Amortization of prior service cost 1 ($20 20 yrs) Postretirement benefit expense $47 Requirement 2 Postretirement benefit expense (calculated above) Prior service cost AOCI (amortization)... 1 APBO ($34 service cost + $12 interest cost) The amortization amount is reported as other comprehensive income in the statement of comprehensive income Intermediate Accounting 7e

48 Exercise Requirement 1 The negative prior service cost is first offset against any existing prior service cost before it is amortized. ($ in 000s) Prior service cost $ 50 Reduction for amendment (80) Negative prior service cost $(30) Service period to full eligibility 15 years Amortization $ 2 Requirement 2 Service cost $114 Interest cost 36 (8% x [$530 80]) Return on plan assets (0) Amortization of prior service cost (2) ([$50 80] 15 yrs) Postretirement benefit expense $148 Solutions Manual, Vol.2, Chapter

49 Exercise Requirement 1 ($ in 000s) Number of Fraction of Prior Year Employees Total Service Service Amount Still Employed Years Cost Amortized / 550 x $110 = $ / 550 x 110 = / 550 x 110 = / 550 x 110 = / 550 x 110 = / 550 x 110 = / 550 x 110 = / 550 x 110 = / 550 x 110 = / 550 x 110 = 2 Totals 550* 550/ 550 $110 Total Number of Service Years Total Amount Amortized Requirement 2 $110, years* = $20,000/year * The average service life is the total estimated service years divided by the total number of employees in the group: 550 years 100 = 5.5 years total number total number average of service years of employees service years Intermediate Accounting 7e

50 Exercise Requirement 1 The specific citation that describes the guidelines is found in FASB ASC : Compensation-Retirement Benefits Defined Benefit Plans Other Postretirement Subsequent Measurement. a. What is the objective for attributing expected postretirement benefit obligations to years of service: b. When does the attribution period for expected postretirement benefits begin for an employee: c. When does the attribution period for expected postretirement benefits end for an employee: Requirement 2 Specifically, the guidelines are: Attribution In the context of this Subtopic, attribution is the process of assigning the expected cost of benefits to periods of employee service. The general objective is to assign to each year of service the cost of benefits earned or assumed to have been earned in that year The beginning of the attribution period generally is the date of hire. However, if the plan's benefit formula grants credit only for service from a later date and that credited service period is not nominal in relation to employees' total years of service before their full eligibility dates, the expected postretirement benefit obligation is attributed from the beginning of that credited service period In all cases, the end of the attribution period shall be the full eligibility date. For postretirement benefit plans that are pay-related or that otherwise index benefits during employees' service periods to their retirement date, the full eligibility date and retirement date may be the same. The attribution period for those benefits will differ from the attribution period for a similarly defined pension benefit with a capped credited service period. Solutions Manual, Vol.2, Chapter

51 Exercise The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1. The disclosure required in the notes to the financial statements for plan assets: FASB ASC b: Compensation-Retirement Benefits Defined Benefit Plans-General Disclosure Disclosures by Public Entities. 2. Recognition of the net pension asset or net pension liability: FASB ASC : Compensation-Retirement Benefits Defined Benefit Plans-Pension Recognition Recognition of Liabilities and Assets. 3. Disclosures required in the notes to the financial statements for pension cost for a defined contribution plan: FASB ASC : Compensation-Retirement Benefits Defined Contribution Plans-Disclosure General Intermediate Accounting 7e

52 CPA / CMA REVIEW QUESTIONS CPA Exam Questions 1. d. A company doesn t report its PBO among liabilities in the balance sheet. Neither does it report the plan assets it sets aside to pay those benefits among assets in the balance sheet. However, a company must report the net difference between those two amounts, referred to as the funded status of the plan. The funded status for Wolf at Dec. 31, 2013, is $385, ,000 = $130, b. Gains and losses (either from changing assumptions regarding a pension obligation or the return on assets being higher or lower than expected) are deferred and not immediately included in pension expense and net income. They are, instead, reported in the statement of comprehensive income. The statement includes not only items of other comprehensive income, but net income as well. 3. d. The statement of comprehensive income will report a $2 million loss and an $8 million gain. This will cause the net pension liability to decrease by $6 million. Accumulated other comprehensive income will increase by $6 million, the $8 million gain less the $2 million loss. 4. d. Amortizing a net gain for pensions and other postretirement benefit plans will increase retained earnings and decrease accumulated other comprehensive income. Amortization of a net gain reduces the expense and thus increases net income and therefore retained earnings. Here s the entry to record the expense: Postretirement expense... xxx Plan assets (expected return on assets)... xxx Net gain AOCI... xxx APBO (service cost and interest cost)... Net loss AOCI... Prior service cost AOCI... xxx xxx xxx Solutions Manual, Vol.2, Chapter

53 CPA Exam Questions (concluded) 5. a. Gains and losses are deferred and not immediately included in postretirement benefit expense and net income. They are, instead, reported in the statement of comprehensive income. J&J, then, records a loss other comprehensive income when it revises its estimate of future health care costs, causing its postretirement benefit obligation estimate to increase. 6. c. Gains and losses are reported in the statement of comprehensive income as other comprehensive income under both sets of standards. Under IFRS, they remain in AOCI while under GAAP they may be recycled to net income if a net gain or net loss exceeds the corridor. 7. a. Under U.S. GAAP, prior service cost is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized over the average remaining service period. On the other hand, under IAS No. 19, prior service cost (called past service cost under IFRS) is combined with service cost and reported within the income statement rather than as a component of other comprehensive income as it is under GAAP, so it never is amortized to expense. 8. b. Under U.S. GAAP, prior service cost is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized over the average remaining service period. On the other hand, under IAS No. 19, prior service cost (called past service cost under IFRS) is combined with service cost and reported within the income statement rather than as a component of other comprehensive income as it is under GAAP, so it never is amortized to expense. CMA Exam Questions 1. a. The PBO is the actuarial present value of all future benefits attributable to past employee service at a moment in time. It is based on assumptions as to future compensation if the pension plan formula is based on future compensation. 2. b. Prior service cost arises from the awarding of retroactive benefits resulting from plan initiation or amendments. Prior service cost is assigned to the future service periods of active employees using either a straight-line or another acceptable method of allocation. Given that the average remaining service life of the firm s employees is 10 years, the annual charge is $19,000 ($190,000 10) Intermediate Accounting 7e

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