Accounting for PensionsAccounting for Pensions
Measurement of pension liability
Capitalization, non-capitalization, partial capitalization
Measurement of pension expense
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 employer’s 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
There are two kinds of pension plans: defined contribution
plans and defined benefit plans.
*
© 1999 by Robert F. Halsey
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 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 company’s 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 company’s income statement?
We will consider each of these questions in turn.
*
© 1999 by Robert F. Halsey
Measurement of Net Pension Liability
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.
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.
*
Overview - Pension Liability
Fair Market Value
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 plan’s 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.
*
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
*
Service cost
+ Interest cost
Pension expense
Overview - Pension Expense
This is the increase in the pension liability resulting from employees working another year for the company
*
© 1999 by Robert F. Halsey
The following is an example of the computation of pension cost form Hasbro’s annual report:
Don’t worry about
a little later
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
Cash (B/S) 75
*
© 1999 by Robert F. Halsey
Let’s look at an example of the computation of pension expense, the net pension liability and the required journal entry:
*
© 1999 by Robert F. Halsey
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.
*
Prior Service Costs
Increases in the PBO arising from adoption of a new plan or amendment of a plan are called Prior Service Costs.
*
© 1999 by Robert F. Halsey
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.
*
*
© 1999 by Robert F. Halsey
Let’s look at an example of unexpected gains on plan assets when we relax the assumption that actual returns and expected returns are equal.
*
© 1999 by Robert F. Halsey
*
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.
*
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 stockholder’s equity is reduced accordingly.
*
© 1999 by Robert F. Halsey
*
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 End