Lecture 14

Pensions, Part I
Material to be covered:
Kieso/Weygandt/Warfield, Chapter 20
Warren Buffett Says That Pension Accounting Encourages Cheating
Rewriting Pension History
Why the Pension Gap is Soaring (Source: WSJ Feb. 25, 2013)
A Pension Plan is an arrangement whereby an employer provides
benefits (payments) to employees after they retire for services
they provided while they were working.
Pension Plan
Administrator
Employer
Retired
Employees Benefit Payments
Assets &
Liabilities
Nature of Pension Plans

Pension: An agreement between employer and employees that determines
i. what benefits will be paid to the employees upon retirement
ii. how these benefits will be earned by the employees
iii. what procedures are required by the employer to provide for the benefits.
Pension fund is administered by a separate legal entity (Trust), who invests funds in capital assets
(stocks, bonds, real estate, etc.) to earn additional funds.
Accounting for pension plans is complex because the measurement and recognition of pension
expense and liability depend upon uncertain future variables.
Example: An employer has a group of employees who will be retiring at the age of 62. Under the terms of the
pension plan, they will receive 80% of their final salary each year after retirement for the rest of their lives.
What are the uncertainties associated with this pension plan?
a. How long will the employees live beyond age 62?
b. How many employees stay with the company until retirement age?
c. What will be the final salary?
d. What will be the return on the pension fund assets?
e. How much are these future payments worth today?
Numerous factors creating uncertainties as to what the pension liability will be. Need help of a
specialist, Actuary. The actuary gives estimates based on actuarial assumptions.
Overview of Pension Plans
Two Types of Pension Plans (1)
(1) Defined Contribution Plan:
Specifies the employers periodic contributions to the pension fund (say, $10,000,000 per month), but
does not specify what the retirement benefits will be.
Employees bear risk because they are uncertain about the retirement benefit.
Accounting for a defined contribution plan is straightforward:
Pension Expense ($ amount of contributions)
Cash (or assets given up) (Same amount as above)
Pension Liability is reported on B/S only when the promised contribution has not been made in full as
of the B/S date.
(2) Defined Benefit Plan:
Specifies the retirement benefits; necessary to determine what the contribution to a pension trust
should be today to meet the pension benefit commitments at retirement.
Employers are at risk because they must be sure to make enough contributions to meet the cost of
benefits promised in the pension plan.
Any deficiency in the pension assets must be made up by the employer. Any excess accumulated in the
trust can be recaptured by the employer either through reduced future funding or through a reversion of
funds.
In form, the pension trust is a separate entity, and the employees are the beneficiary. In substance, (i)
the trust assets and liabilities belong to the employer, and (ii) the employer is the beneficiary of the trust.
Our discussion mainly concerns accounting procedures for defined benefit plans.
Two Types of Pension Plans (2)
.
The employers pension
obligation is the deferred
compensation obligation it
has to its employees for
their service under the
terms of the pension plan.
FASBs
choice
Alternative measures of the Liability
Accounting for Pensions
Illustration 20-3
Pension liability = PV of promised benefits to be provided at retirement.
(1) Vested Benefit Obligation:
Vested benefits: The employee is entitled to the benefits even if he/she renders no more
services to the employer under the plan. Under most plans, a certain minimum number of
years of service to the employer is required before the benefit is vested. Vested Benefit
Obligation includes only vested benefits computed using current salary levels, i.e., ignores
years of non-vested employment and the possibility of future increase in salaries.
(2) Accumulated Benefit Obligation:
Includes all benefits, vested and non-vested, computed using current salary levels.
(3) Projected Benefit Obligation:
Includes all benefits, both vested and non-vested, computed using future (projected)
salary levels. By definition, VBO < ABO < PBO.
Which measure did the accounting profession adopt?
In general, the profession adopted the PBO (Conservatism!). However, the ABO is used
in certain situations. Information on VBO is also required to be disclosed.
Alternative Measures of Pension Obligation
Accounting for a Defined Benefit Plan
To understand the accounting for a defined benefit pension plan, it is useful to think of the plan as a single entity
made up of two basic components which comprise the net pension asset or liability reported in the employers
balance sheet:
i. the pension plan assets, available to provide benefits to the employees in accordance with the terms of
the plan
ii. the pension plan liability, representing the employers obligation to its employees under the terms of the
plan
In addition to these basic balance sheet accounts, there may be other valuation accounts which serve to modify
the reported value of the pension asset and/or liability.
The periodic costs of the plan, representing certain changes in the components of the net pension asset
(liability), are reported in the income statement as the net pension cost (expense).
Plan Assets
(at Fair Value)
Employer
Contribution
ROI of plan
assets
Settlement to
retired
employees
Pension Liability
(PBO)
Settlement to
retired
employees
Service cost

Interest cost
Pension Plan
Balance
Sheet
Net Pension
Cost/Benefit
Service cost

Interest cost
ROI of plan
assets
Pension Plan
Income
Statement
(1) Capitalization Approach: Supports the substance over legal form of a pension plan (
Capitalize, i.e., recognize the assets and liabilities held by the pension plan).
(2) Noncapitalization Approach: Looks at the form of a pension plan (i.e., it is a separate
legal entity). That is, assets and liabilities held by a pension trust are separate from the
employer's assets and liabilities ( Pension assets and liabilities held by a pension trust
are not recognized).

3) FASBs position (SFAS No. 87 & SFAS No. 158):
The FASB favored the capitalization approach because it is more sound conceptually.
However, the capitalization approach was strongly opposed by many companies (Why?). Its
adoption would have forced them to recognize a huge amount of pension liability that had
not been reported before.
SFAS No. 87 and the amendment in SFAS No. 158 represent a compromise that combines
some of the features of capitalization with some of the features of noncapitalization. Only the
net pension plan asset or liability is recorded (i.e., net funded status). The plans assets
and liabilities are not reported as being those of the firm.

Conceptual Approaches to Pension Accounting
Components of Pension Expense
+ Service Cost
+ Interest Cost
Actual Return on Plan Assets
+ Amortization of PSC
Amortization of Gain (Loss)
Pension Expense xxx
Cash xxx
Pension Asset/Liability* xxx

* Company funding difference
Amortization of
Prior Service Costs - OCI
A plan initiation or amendment granting retroactive
benefits to employees for services rendered
previously results in an immediate increase in the
projected benefit obligation and a deferred cost to be
amortized. Prior service cost (OCI) is amortized over
the future service-years of employees.
Amortization of
Net Gain or Loss - OCI
Amortization of the combination of (a) the current
year's asset gains and losses and liability gains and
losses and (b) the accumulated net gain or loss from
previous years. This may decrease or increase
pension expense.
Actual Return
on Plan Assets
The actual return on plan assets during the year
determined based on the fair value of plan assets.
This reduces pension expenseit represents the
investment return for the year on assets previously
set aside to satisfy plan obligations.
Interest Cost
The assumed discount rate multiplied by the
beginning of year plan obligation measured as the
projected benefit obligation. This indicates the
increase in plan liabilities during a year due to the
passage of timein effect, interest expense for the
year on an existing liability.
Service Cost
The actuarial present value of benefits earned by
employees for the current year of service, measured
by the actuary using the benefit formula and
discounted to present value using the assumed
discount (settlement) rate.
Cash versus accrual basis: Pension costs should be accounted for on an accrual
basis and not on a cash basis.
Expense incurred by the increase in pension benefit obligations as employees
provide services during the current year.
PV of the new benefits are recognized (actuaries compute this PV based on
various actuarial assumptions about mortality, longevity, turnover, etc.).
Example: At 12/31, the actuary of Iris Co. estimates the PV of benefits earned
by the employees to be $450,000 for the year.
[Conceptual Entry] 12/31:
Pension Expense 450,000
PBO 450,000
This is not an actual entry made by the company because PBO is not a formal
B/S account. However, this conceptual entry will be very useful in recording
pension expense and preparing the B/S.
Components (1): Service Cost
Interest on the pension liability.
Since the pension liability is the PV (discounted value) of future compensation, it
has a cost related to the time value of money (i.e., interest).
Interest expense accrues each year.
Interest cost = Beginning balance of PBO x interest rate.
Interest rate selected by the actuary is called settlement rate.
Example: At 1/1, Iris Co. has a $2,500,000 PBO. The settlement rate given by the
actuary is 10%.
[Conceptual Entry] 12/31:
Pension Expense 250,000
PBO 250,000
Components (2): Interest Cost
Pension plan assets are increased by (i) employer contributions and (ii) actual
returns on the assets.
Plan assets are decreased by benefits paid to retired employees.
The actual return on the pension plan assets reduces the employers cost of
providing pension benefits, i.e., the higher the actual return, the less the employer
has to contribute eventually and thus the less pension expense.
Actual return on plan assets reduces pension expense for a given period (as long as
the return is positive).
Note that contributions to the plan assets and benefits paid out do not affect
pension expense.
Example: The actual return on the pension plan assets for Iris Co. is $300,000.
[Conceptual Entry] 12/31:
Plan Assets 300,000
Pension Expense 300,000
Plan Assets is an off-B/S account.
Components (3): Actual Return on Plan Assets
The Pension Work Sheet
Pension
Asset/
Liability
Pension Asset/Liability................
When a pension plan is initiated or amended, credit is often given to employees for the service
years they provided prior to the initiation or amendment.
As a result of prior service credits, the pension benefit obligation is increased (substantially in
many cases). The increased obligation is not fully recognized as a pension expense for the year in
which the plan is initiated or amended.
Because offering the prior service credit will generate economic benefit to the employer in the
future (in the form of increased loyalty, productivity, and reduced turnover), this economic benefit
to the employer company extends over the remaining service periods of the affected employees
(appropriate matching).
The PSC is initially recorded as an adjustment to other comprehensive income (OCI), and
subsequently amortized over the service periods of the affected employees. The amortization of PSC
will increase the periodic pension expense.
Example: Iris Co.s defined benefit pension plan covers 200 employees. In its negotiation with its
employees, Iris amends its plan on 1/1/2003 to augment pension benefits. The prior service credit
creates $98,000 of PSC for Iris Co.
[Conceptual Entry] 1/1/03:
Prior Service Cost OCI 98,000
PBO 98,000
Components (4): Prior Service Cost
Amortization of Prior Service Costs (1)
Example (continued): (i) Years-of-service method
Amortization of Prior Service Costs (2)
Example (continued):





[Conceptual Entry] 12/31/03:
Pension Expense 28,000
Prior Service Cost OCI 28,000
(ii) Straight-line method
Amortize at an equal rate over the average remaining service life of the employees.
Average remaining service life = Total service years # of employees = 700 200 = 3.5
yrs
For 2003 through 2005: Amortization = $98,000 3.5 = $28,000 each year
For 2006: Amortization = $ 14,000 (remainder) = $28,000 x 0.5
A. Actuarial assumptions (about mortality, turnover, longevity, salary levels, etc.)
are often modified in light of actual realizations to make the assumptions more
reliable.
Changes in actuarial assumptions result in changes in the PBO (i.e., loss =
increase in PBO due to changes in actuarial assumptions; gain = decrease in
PBO).
Since these gains and losses are associated with a liability (i.e., PBO), they are
called liability gains and losses.
B. Actual return on plan assets reduces pension expense.
Sudden and large changes in the market value of plan assets (return on plan
assets) can cause pension expense to fluctuate substantially.
Large swings in pension expense and net income due to changes in actuarial
assumptions and actual returns on plan assets are viewed by some as harmful to
the employer company.
As a result, some smoothing techniques that dampen the swings in (A) and (B)
were adopted by the FASB.
Components (5): Gain or Loss
In general, do not include unexpected liability gain or loss in pension expense.
These gains and losses are recorded in a Net Gain or Loss account, which belongs to
other comprehensive income (OCI).
Liability gains and losses are combined with asset gains and losses in the same account.
Example: At 12/31, the actuary of Iris Co. has changed some actuarial assumptions.
This results in an increase in the PBO of $350,000.
[Conceptual Entry] 12/31:
Net Gain or Loss OCI 350,000
PBO 350,000
Smoothing Gains & Losses on Pension Liability
An expected rate of return on plan assets is included as a component of pension expense (rather than
the actual rate of return on plan assets).
An expected rate of return is one that actuaries determine in developing a funding pattern to pay
benefits in the future.
Use of an expected rate of return reduces the variability of pension expense over time.
Amount included in pension expense calculation = Expected rate of return x Market-related asset
value (= FMV of plan assets in many cases) at the beginning of the year.
Loss = Actual return - Expected return < 0
Gain = Actual return - Expected return > 0
These gains and losses are called asset gains and losses, and are recorded in a Net Gain or Loss
account, which is part of other comprehensive income (OCI).
Example: Iris Co. has an actual return on plan assets of $300,000 when the expected return is
$200,000 (i.e., asset gain of $100,000).
[Conceptual Entry] 12/31:
Plan Assets 300,000
Pension Expense 300,000 (actual return)
Pension Expense 100,000
Net Gain or Loss OCI 100,000
Putting the two entries together, the expected return ($200,000), not the actual return, is included as
a component of pension expense for the current period.
Smoothing Gains & Losses on Plan Assets