Pensions and Other Postretirement BenefitsOverview

Employee compensation comes in many forms. Salaries and wages, of course, provide direct and current payment for services provided. However, it’s commonplace for compensation also to include benefits payable after retirement. We discuss pension benefits and other postretirement benefits in this chapter. Accounting for pension benefits recognizes that they represent deferred compensation for current service. Accordingly, the cost of these benefits is recognized on an accrual basis during the years that employees earn the benefits.

Learning ObjectivesAfter studying this chapter, you should be able to:LO17-1 Explain the fundamental differences between a defined contribution pension plan and a

defined benefit pension plan.LO17-2 Distinguish among the accumulated benefit obligation, the vested benefit obligation, and

the projected benefit obligation.LO17-3 Describe the five events that might change the balance of the PBO.LO17-4 Explain how plan assets accumulate to provide retiree benefits and understand the role of

the trustee in administering the fund.LO17-5 Describe the funded status of pension and other postretirement benefit plans and how that

amount is reported. LO17-6 Describe how pension expense is a composite of periodic changes that occur in both the

pension obligation and the plan assets.LO17-7 Record for pension plans the periodic expense and funding as well as new gains and losses

and new prior service cost as they occur. LO17-8 Understand the interrelationships among the elements that constitute a defined benefit

pension plan.LO17-9 Describe the nature of postretirement benefit plans other than pensions and identify the

similarities and differences in accounting for those plans and pensions.LO17-10 Explain how the obligation for postretirement benefits is measured and how the obligation

changes.LO17-11 Determine the components of postretirement benefit expense.LO17-12 Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting

for postretirement benefit plans.

Lecture OutlinePart A – The Nature of Pension Plans

I. Nature of Pension PlansA. Pension plans provide income to employees during their retirement years. B. Employers set aside funds during an employee’s working years so that at retirement, the

accumulated funds plus earnings from investing those funds are available to replace wages.

C. Defined contribution pension plans and defined benefit pension plans have the common objective of providing income to employees during their retirement years. However, they differ regarding who bears the risk of ensuring that the objective is achieved. (T17-1)

II. Types of Pension PlansA. Defined contribution pension plans promise fixed annual contributions to a pension fund

(4% of employees' pay, for example). 1. Employees choose where funds are invested, within set options. 2. The employees’ retirement pay depends on the accumulated balance of the invested

funds at retirement.3. As a result, the employee bears the risk of uncertain investment returns. The

employer is free of any further obligation. 4. Defined contribution pension plans have several variations, but the most common

are 401(k) plans – named after the Tax Code section which specifies the conditions for the favorable tax treatment of these plans. Such plans permit voluntary contributions by employees, which often are matched by employers (dollar for dollar, 1 for 2, etc.).

5. The employer simply records pension expense equal to the cash contribution. B. Defined benefit pension plans promise fixed retirement benefits that are “defined” by a

pension formula. 1. The employer is accountable for ensuring that sufficient funds are available to

provide the promised benefits.2. A typical pension formula specifies that a retiree will receive annual retirement

benefits based on the employee’s years of service and annual pay at retirement. (T17-2)

III. Defined Benefit Pension Plans A. The fundamental components of a defined benefit pension plan are:

1. The employer’s obligation to pay retirement benefits in the future. 2. The plan assets set aside by the employer from which to pay the retirement benefits

in the future. 3. The periodic expense of having a pension plan.

B. The employer’s obligation and plan assets are not individually reported in a company’s primary financial statements, but the difference between the two, the funded status, is reported as a pension liability if underfunded or as a pension asset if overfunded.

C. The third component, pension expense, is reported in the income statement. The pension expense is comprised of several elements that include changes in the employer’s obligation and plan assets, so we discuss those first before looking at the components of pension expense.

Part B: The Pension Obligation and Plan Assets

I. The Pension Obligation A. There are three different ways to measure the pension obligation: (T17-3)

1. Accumulated Benefit Obligation (ABO) – present value of estimated retirement benefits earned so far by employees, estimated by plugging existing compensation levels into the pension formula.

2. Vested Benefit Obligation (VBO) - vested portion of the accumulated benefit obligation – part that plan participants are entitled to receive regardless of their continued employment.

3. Projected Benefit Obligation (PBO) – present value of estimated retirement benefits earned so far by employees, estimated by plugging projected compensation levels into the pension formula. A company usually hires an actuary to make these estimates. (T17-4) (T17-5)

B. The PBO can change due to: 1. Service cost - the increase in the PBO attributable to employee service this year.

(T17-6) (T17-7)2. Interest cost - the accrual of interest as time passes (beginning PBO x discount rate).3. Prior service cost - the cost of making plan amendments retroactive to prior years

(T17-8) 4. Loss (gain) on PBO - the periodic adjustments to PBO when estimates change.

(T17-9)5. Retiree benefits paid - the benefits actually paid to retired employees. (T17-10)

II. The Plan Assets A. To pay the pension obligation companies accumulate funds known as the plan assets. B. A trustee usually is hired who:

1. Accepts employer contributions.2. Invests the contributions.3. Accumulates the earnings on the investments. 4. Pays benefits from the plan assets to retired employees or their beneficiaries.

C. The balance in pension plan assets is not formally recognized on the balance sheet, but is actively monitored in the employer’s informal records.

D. The plan assets can change due to: (T17-11)1. Return on plan assets - dividends, interest, market price appreciation.2. Cash contributions - employer contributions.3. Retiree benefits paid - benefits actually paid to retired employees.

Part C: Determining Pension Expense

I. Composition of Pension Expense A. Employees receive pension benefits long after they earn those benefits. However, the

employer’s cost of providing those benefits is allocated to the periods the services are performed.

B. The periodic pension expense is a composite of periodic changes in both the pension obligation and the plan assets. (T17-12) (T17-13)1. The service cost is the increase in the PBO attributable to employee service and is

the primary component of pension expense. 2. The interest and return-on-assets components are “financial items” created only

because the compensation is delayed and the obligation is funded currently. a. The actual return on assets is increased by the loss on plan assets so that

effectively the expected return is the component of pension expense. b. This is due to the desire to achieve income smoothing by delaying the

recognition of both the loss (gain) on the PBO and the loss (gain) on plan assets.

c. If gains and losses were immediately recognized in pension expense, the annual pension expense, and therefore earnings, would rise and fall frequently with each difference between results and expectations.

C. Prior service cost is recognized over the average remaining service life of the active employee group. (T17-14)

D. Delaying the recognition in expense of both the loss (gain) on the PBO and the loss (gain) on plan assets means these amounts are set aside for possible future recognition. (T17-15)a. When a net gain or net loss gets “too large,” a portion of the excess is

included in pension expense. b. The FASB defines too large as being greater than 10% of either plan assets or

the PBO (at the beginning of the year), whichever is larger. c. The amount amortized is the excess divided by the average remaining service

life of the active employee group. (T17-16)

Part D – Reporting Issues

I. Reporting the Funded Status of the Pension PlanA. The PBO is not reported among liabilities in the balance sheet nor are plan assets

reported among assets in the balance sheet. B. However, the net difference between those two amounts, referred to as the “funded

status” of the plan is reported as a pension liability if underfunded or as a pension asset if overfunded. (T17-17)

II. Recording Gains and LossesA. 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, instead, reported as other comprehensive income in the statement of comprehensive income as a gain–other comprehensive income or a loss–other comprehensive income in the reporting period they occur.

B. Gains and losses increase or decrease either the PBO or plan assets. a. Actuarial gains decrease the PBO and losses increase the PBO. Similarly, gains

from the return on assets being higher than expected increase plan assets while losses decrease plan assets. (T17-18)

b. Because the pension liability (or asset) is the difference between the PBO and plan assets, that difference changes when either the PBO or plan assets change.

C. Gains and losses become part of either a net loss–AOCI or a net gain–AOCI account, which is a component of accumulated other comprehensive income, a shareholders’ equity account.

III. Recording the Periodic Expense and Periodic FundingA. The pension expense includes the service cost, the interest cost, and a reduction for the

expected return on plan assets. The service cost and interest cost add to the PBO, and the return on plan assets adds to the plan assets.

B. The pension expense also might include amortization of prior service cost–AOCI or amortization of either a net loss–AOCI or a net gain–AOCI. But unlike the other three components, these amortization amounts affect neither the PBO nor the plan assets. (T17-19)a. Amortization reduces the prior service cost–AOCI and the net loss–AOCI or net

gain–AOCI. b. These are shareholders’ equity accounts, components of accumulated other

comprehensive income.C. When the cash investment is added to plan assets that account is increased. (T17-20)

IV. A Pension SpreadsheetA. A pension spreadsheet can be useful to see how each element relates to the others. (T17-

21) B. It also serves as a check that all changes tie together.

V. International Financial Reporting StandardsA. Under both U.S. GAAP and IFRS we report gains and losses among OCI items in the

statement of comprehensive income, thus 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 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 high grade corporate bonds) for both the interest cost on the defined benefit obligation and the interest revenue on the plan assets. In fact, under IFRS, we multiply that rate times the net difference between the DBO and plan assets and report the net interest cost/income. (T17-22)

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. (T17-23)

C. Under IFRS the various components of pension expense are not reported as a single net amount. We separately report service cost (including past service cost) net interest cost/income, and amortization of remeasurement gains and losses. Service cost and net interest cost/income are reported within the income statement. Remeasurement gains and losses are reported as other comprehensive income in the statement of comprehensive income. Under U.S. GAAP, all components of pension expense are reported as a single net amount in the operating profit (loss) section of the income statement.

. (T17-24)

Part E: Postretirement Benefits Other Than Pensions

I. Nature of Postretirement Benefit PlansA. Postretirement benefits include all retiree health and welfare benefits other than pensions

and can include:1. Medical coverage.2. Dental coverage.3. Life insurance.4. Group legal services.5. Other benefits.

B. The most common is health care benefits. C. Eligibility usually is based on age and/or years of service.

II. Accounting for Postretirement Benefits A. Accounting for postretirement benefits is, to the extent possible, the same as for pension

benefits. B. Any differences are due to fundamental differences between pensions and other

postretirement benefits. C. There are more similarities than differences. D. The main difference from an accounting perspective is that postretirement health care

benefits usually are “all-or-nothing” plans in which a certain level of coverage is promised upon retirement, and the coverage is independent of the length of service beyond the eligibility date. Cost is unrelated to service and is “attributed” to the years from the employee’s date of hire to the “full eligibility date.”

III. The Postretirement Benefit ObligationA. An actuary estimates what the net cost of postretirement benefits will be for current

employees (and dependents) in each year of their expected retirement. B. The discounted present value of those costs is the company’s liability.

1. The actuary's estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants is the Expected Postretirement Benefit Obligation (EPBO).

2. The portion of the EPBO attributed to employee service to date is the Accumulated Postretirement Benefit Obligation (APBO). (T17-25)

IV. The Accumulated Postretirement Benefit Obligation A. The APBO changes for much the same reasons as the PBO in pension accounting. (T17-

26)1. Prior service cost - Cost of making plan amendments retroactive to prior years.2. Service cost - Portion of the EPBO attributed to the current period. 3. Interest cost - Accrual of interest as time passes (beginning APBO x discount rate).4. Loss (gain) on APBO - Periodic adjustments to APBO when estimates change.5. Less: Retiree benefits paid - Benefits actually paid to retired employees.

B. The attribution period for service cost spans each year of service from the employee’s date of hire to the employee’s “full eligibility date.”(T17-27)

V. The Plan Assets

A. Many postretirement benefit plans are not funded, so no plan assets are specifically set aside to pay benefits when they come due.

B. Funded plans often are significantly underfunded. C. When postretirement benefit plans are funded, the plan assets change for the same

reasons they do with pension plans. 1. Return on plan assets - Dividends, interest, market price appreciation.2. Cash contributions - Employer contributions.3. Less: Retiree benefits paid - Benefits actually paid to retired employees.

VI. The Postretirement Benefit Expense A. Postretirement benefit expense includes essentially the same components as does pension

expense. (T17-28) B. It is a composite of periodic changes in both the APBO and the plan assets (if any):

1. Service cost - Increase in the APBO attributed to employee service this year.2. Interest cost - Accrual of interest as time passes (beginning APBO x discount rate).3. Expected return on the plan assets - Dividends, interest, price appreciation

a. Actual return minus any gain - when actual exceeds expected return.b. Actual return plus any loss - when expected exceeds actual return.c. It is subtracted in the calculation of postretirement benefit expense.

4. Amortization of prior service cost. (T17-29)5. Amortization of the net loss or net gain.

PowerPoint SlidesA PowerPoint presentation of the chapter is available at the textbook website.

An alternate version of the PowerPoint presentation also is available.

Teaching Transparency MastersThe following can be reproduced on transparency film as they appear here, or

you can use the disk version of this manual and first modify them to suit your particular needs or preferences.

PENSION PLANSPension plans are designed to provide income to individuals during their retirement years. This is accomplished by setting aside funds during an employee’s working years so that at retirement, the accumulated funds plus earnings from investing those funds are available to replace wages.

TYPES OF PENSION PLANS

Defined contribution pension plans promise fixed annual contributions to a pension fund (say, 10% of the employees' pay). The employee chooses (from designated options) where funds are invested – usually stocks or fixed-income securities. Retirement pay depends on the size of the fund at retirement.

Defined benefit pension plans promise fixed retirement benefits “defined” by a designated formula. Typically, the pension formula bases retirement pay on the employees' (a) years of service, (b) annual compensation [often final pay or an average for the last few years], and sometimes (c) age. Employers are responsible for ensuring that sufficient funds are available to provide promised benefits.

T17-1

DEFINED BENEFIT PENSION PLANS

A pension formula might define annual retirement benefits as:

1 1/2 % x Years of service x Final year’s salary

By this formula, the annual benefits to an employee who retires after 40 years of service, with a final salary of $100,000, would be:

1 1/2 % x 40 years x $100,000 = $60,000

T17-2

PENSION OBLIGATIONThree different ways to measure the pension obligation have

meaning in pension accounting:

Accumulated benefit obligation (ABO) – The actuary's estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula to existing compensation levels.

Vested benefit obligation (VBO) - The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment.

Projected benefit obligation (PBO) – The actuary's estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula to estimated future compensation levels. [If the pension formula does not include future compensation levels, the PBO and the ABO are the same.]

T17-3

PROJECTED BENEFIT OBLIGATION

Jessica Farrow was hired by Global Communications in 2002. The company has a defined benefit pension plan that specifies annual retirement benefits equal to:

1.5% x service years x final year’s salary

Farrow is expected to retire in 2041 after 40 years service. Her retirement period is expected to be 20 years. At the end of 2011, 10 years after being hired, her salary is $100,000. The interest rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement.

What is the company’s projected benefit obligation with respect to Jessica Farrow?

Steps to calculate the projected benefit obligation:

1. Use the pension formula (including a projection of future salary levels) to determine the retirement benefits.

2. Find the present value of the retirement benefits as of the retirement date.

3. Find the present value of retirement benefits as of the current date.

T17-4

PBO IN 2011

present value [n=30, i=6%] actuary estimates employee has of retirement benefits at 2011 is earned (as of 2011) retirement benefits of

$688,195 x .17411 = 1.5% x 10 years x $400,000 =

$119,822 $60,000 per year 2002 2011 2041 2061_______________________________________________

10 years 30 years 20 yearsService period Retirement

present value [n=20, i=6%] of the

retirement annuity at the retirement date is $60,000 x 11.46992 =

$688,195

T17-4 (continued)

PBO IN 2012If the actuary’s estimate of the final salary hasn’t changed, the

PBO at the end of 2012 would be $139,715:

present value [n=29, i=6%] actuary estimates employee has of retirement benefits at 2012 is earned (as of 2012) retirement benefits of

$757,015 x .18456 = 1.5 x 11 years x $400,000 =

$139,715 $66,000 per year2002 2012 2041 2061_______________________________________________

11 years 29 years 20 yearsService period Retirement

present value [n=20, i=6%] of the

retirement annuity at the retirement date is $66,000 x 11.46992 =

$757,015

Notice that the PBO increased during 2012 from $119,822 to $139,715 for two reasons:

1. One more service year is included in the pension formula calculation.

2. The employee is one year closer to retirement, causing the present value of benefits to increase due to the time value of future benefits.

T17-5

CHANGES IN THE PBO

1 – SERVICE COSTThe PBO increases each year by the amount of that year’s

service cost. This represents the increase in the projected benefit obligation attributable to employee service performed during the period.

2 – INTEREST COSTThe second reason the PBO increased is called the interest cost.

Even though the projected benefit obligation is not formally recognized as a liability in the company’s balance sheet, it is a liability nevertheless. And, as with other liabilities, interest accrues on its balance as time passes. The amount can be calculated directly as the assumed discount rate multiplied by the projected benefit obligation at the beginning of the year.

T17-6

HOW THE PBO CHANGED IN 2012

PBO at the beginning of 2012 (end of 2011) $119,822

Service cost: (1.5 x 1 yr. x $400,000) x 11.46992 x .18456 12,701annual retirement benefits to discount to discount

from 2012 service to 2041 * to 2012 **

Interest cost: $119,822 x 6% 7,189

PBO at the end of 2012 $139,712***

* present value of an ordinary annuity of $1: n=20, i=6%** present value of $1: n=29, i=6%***differs from $139,715 due to rounding

T17-7

3 – Prior Service Cost

Assume the formula’s salary percentage is increased in 2012 from 1.5% to 1.7%:

1.7% x Service years x Final year’s salary[Revised Pension Formula]

The increase in the PBO attributable to making a plan amendment retroactive is referred to as prior service cost.

PBO Without Amendment PBO With Amendment

1.5 x 10 years x $400,000 = $60,000 1.7 x 10 years x $400,000 = $68,000

$60,000 x 11.46992 = $688,195 $68,000 x 11.46992 = $779,955

$688,195 x .17411 = $119,822 $779,955 x .17411 = $135,798

$15,976 Prior service cost

T17-8

4 – GAIN OR LOSS ON THE PBO

A number of estimates are necessary to derive the PBO. When one or more of these estimates requires revision, the estimate of the PBO also will require revision. The resulting decrease or increase in the PBO is referred to as a gain or loss, respectively.

Assume the estimate of Farrow’s final salary should be increased by 5% to $420,000. This would affect the estimate of the PBO as follows:

PBO Without PBO With Revised Estimate Revised Estimate

1.7 x 12 years x $400,000 = $81,600 1.7 x 12 years x $420,000 = $85,680

$81,600 x 11.46992 = $935,945 $85,680 x 11.46992 = $982,743

$935,945 x .19563 = $183,099 $982,743 x .19563 = $192,254

$9,155 Loss on PBO

5 – PAYMENT OF RETIREMENT BENEFITS

Another change in the PBO occurs when the obligation is reduced as benefits actually are paid to retired employees.

T17-9

ILLUSTRATION EXPANDED TO THE ENTIRE EMPLOYEE POOL

($ in millions)

PBO at the beginning of 2013 (amount assumed) $400

Service cost, 2013 (amount assumed) 41

Interest cost: $400 x 6% 24

Loss (gain) on PBO (amount assumed) 23

Less: Retiree benefits paid (amount assumed) (38 )

PBO at the end of 2013 $450

T17-10

PENSION PLAN ASSETSGlobal Communications funds its defined benefit pension plan by contributing each year the year’s service cost plus a portion of the prior service cost. Cash of $48 million was contributed to the pension fund in 2013.

Plan assets at the beginning of 2013 were valued at $300 million. The expected rate of return on the investment of those assets was 9%, but the actual return in 2013 was 10%. Retirement benefits of $38 million were paid at the end of 2013 to retired employees.

What is the value of the company’s pension plan assets at the end of 2013?

($ in millions)

Plan assets at the beginning of 2013 $300

Return on plan assets (10% x $300) 30

Cash contributions 48

Less: Retiree benefits paid (38 )

Plan assets at the end of 2013 $340

T17-11

PENSION EXPENSECHANGES IN THE PENSION LIABILITY AND

PENSION PLAN ASSETS AFFECT PENSION EXPENSE

CHANGES IN THE PBO:Included currently:

Service cost – increase in the employer’s obligation attributed to employee service during the period

Interest – interest accrued on the obligation during the period (balance at the beginning of the period multiplied by the interest rate)

Delayed recognition (recognized in pension expense over time):Losses or (gains) on the PBO – increases or (decreases) in the estimate of the

PBO from revisions in underlying assumptions Prior service cost – increase in the employer’s obligation due to giving credit to

employees for years of service provided before the pension plan is amended (or initiated)

CHANGES IN PLAN ASSETS:Included currently:

Return on the plan assets – increase in the value of plan assets during the period, adjusted for employer contributions and benefits paid to retireesActual return adjusted for: Losses or (gains) on the plan assets

Delayed Recognition in Income (recognized in pension expense over time):

Losses or (gains) on the plan assets – return on plan assets lower or (higher) than expected

T17-12

PENSION EXPENSEReports from the actuary and the trustee of plan assets:

PLAN ($ in millions) PBO ASSETS Beginning of 2013 $400 Beginning of 2013 $300

Service cost 41 Return on plan assets,Interest cost, 6% 24 10% (9% expected) 30Loss (gain) on PBO 23 Cash contributions 48Less: Retiree benefits (38 ) Less: Retiree benefits (38 )

End of 2013 $450 End of 2013 $340A prior service cost was incurred at the beginning of the previous year of $60 million due to a plan amendment increasing the PBO at that time. At the beginning of 2013 Global had a net loss-AOCI of $55 million. The average remaining service life of the active employee group is 15 years. Global’s 2013 pension expense is determined as follows:Service cost $41 Interest cost 24Expected return on the plan assets ($30 actual, less $3 gain) (27)Amortization of prior service cost 4Amortization of net loss 1 Pension expense $43

T17-13

AMORTIZATION OF PRIOR SERVICE COST

By the straight-line method, prior service cost is recognized over the average remaining service life of the active employee group.

($ in millions)Service cost $41 Interest cost 24Expected return on the plan assets ($30 actual, less $3 gain) (27)Amortization of prior service cost–AOCI ($60 million ÷ 15 years) 4

Amortization of net loss–AOCI 1 Pension expense $43

T17-14

GAINS AND LOSSES

Projected Benefits Return on Obligation Plan Assets________________________

HigherThan LossGain

Expected________________________

LowerThan GainLoss

Expected________________________

T17-15

AMORTIZATION OF NET LOSS–PENSIONS

We assume a net loss–AOCI of $55 million at the beginning of 2013. The PBO and plan assets are $400 million and $300 million, respectively, at that time.

($ in millions)

Net loss–pensions (previous losses exceeded previous gains) $5510% of $400 ($400 is greater than $300) 40 Excess at the beginning of the year $15Average remaining service period ÷ 15 yrsAmount amortized to 2013 pension expense $ 1

T17-16

REPORTING THE FUNDED STATUS OF THE PENSION PLAN

A company must report in its balance sheets a liability for the underfunded (or asset for the overfunded) status of its postretirement plans.

($in millions) 2012 2013Projected benefit obligation (PBO) $400 $450Fair value of plan assets 300 340 Underfunded status $100 $110

Because the plan is underfunded, Global reports a pension liability of $100 million in its 2012 balance sheet and $110 million in 2013. If the plan becomes overfunded in the future, Global will report a pension asset instead.

T17-17

Recording Gains and Losses($ in millions)

Loss–OCI (from change in assumption) 23PBO.............................. . 23

Plan assets................................. . . 3Gain–OCI (from actual return exceeding expected return) 3

Gains and losses are deferred and not immediately included in

pension expense and net income.

Instead, we report gains and losses as other comprehensive income

in the statement of comprehensive income.

Global records a loss–other comprehensive income for the $23

million loss when it revised its estimate of future salary levels

causing its PBO estimate to increase

Global records a $3 million gain–other comprehensive income

when the $30 million actual return on plan assets exceeds the $27

million expected return.

The gain and loss becomes part of the net loss–AOCI which is a

component of accumulated other comprehensive income, a

shareholders’ equity account.

T17-18

RECORD PENSION EXPENSE

($ in millions)

Pension expense (total)....................................... 43Plan assets (expected return on plan assets)................. 27

PBO ($41 service cost + $24 interest cost).................. 65Prior service cost–AOCI............................. 4Net loss–AOCI............................................ 1

Service cost and interest cost add to Global’s PBO

The return on plan assets adds to the plan assets.

Amortization reduces the prior service cost–AOCI by $4 million

and the net loss–AOCI by $1 million.

T17-19

RECORD PENSION FUNDING AND RETIREE BENEFITS

When Global adds its annual cash investment to its plan assets, the value of those plan assets increases by $48 million:

($ in millions) Plan assets........................................ 48

Cash (contribution to plan assets)....... 48

PBO................................................. 38 Plan assets (retiree benefits)............ 38

T17-20

PENSION SPREADSHEET

($ in millions)Note:  ( )s indicate credits; debits

otherwise PBOPlan

Assets

Prior Service

CostNet Loss

Pension Expense Cash

Net Pension (Liability) /

Asset

Balance, Jan. 1, 2013 (400)

300 56 55 (100)

Service cost (41) 41 (41) Interest cost, 6% (24) 24 (24) Expected return on assets 27 (27) 27 Gain on assets 3 (3) 3 Amortization of: Prior service cost (4) 4 Net loss (1) 1

Loss on PBO (23) 23 (23)

Contributions to fund 48 (48)

48

Retiree benefits paid 38 (38)Balance, Dec. 31, 2013 (45

0)340 52 74 43 (110)

T17-21

INTERNATIONAL FINANCIAL REPORTING STANDARDS

Actuarial Gains and Losses. Under both U.S. GAAP and IFRS we report gains and losses among OCI items in the statement of comprehensive income, thus 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).

The gain or loss on plan assets under 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 high grade corporate bonds) for both the interest cost on the defined benefit obligation and the interest revenue on the plan assets. In fact, under IFRS, we multiply that rate times the net difference between the DBO and plan assets and report the net interest cost/income.

T17-22

INTERNATIONAL FINANCIAL REPORTING STANDARDS

Prior Service Cost. 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.

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.

T17-23

INTERNATIONAL FINANCIAL REPORTING STANDARDSUnder IFRS the various components of pension

expense are not reported as a single net amount. We separately report service cost (including past service cost) net interest cost/income, and amortization of remeasurement gains and losses.

Service cost and net interest cost/income would be reported within the income statement.

Remeasurement gains and losses would be reported as other comprehensive income in the statement of comprehensive income.

Under U.S. GAAP, all components of pension expense are reported as a single net amount in the operating profit (loss) section of the income statement.

..

OTHER POSTRETIREMENT BENEFITS

There are two related obligation amounts: one measures the total obligation and the other refers to a specific portion of the total.

Expected Postretirement Benefit Obligation (EPBO) – The actuary's estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants.

Accumulated Postretirement Benefit Obligation (APBO) – The portion of the EPBO attributed to employee service to date.

T17-25

POSTRETIREMENT BENEFIT OBLIGATION

Assume the actuary estimates the net cost of providing health care benefits to a particular employee during her retirement years to have a present value of $10,842 as of the end of 2011. This is the EPBO. If the benefits (and therefore the costs) relate to an estimated 35 years of service and 10 of those years have been completed, the APBO would be:

2011 $10,842 x 10/35 = $3,098EPBO fraction APBO

attributedx 1.06

2012 $11,492 x 11/35 = $3,612EPBO fraction APBO

attributed

HOW THE APBO CHANGED

APBO at the beginning of the year $3,098

Interest cost: $3,098 x 6% 186

Service cost: ($11,492 x 1/35) 328portion of EPBO

attributed to the year

APBO at the end of the year $3,612

T17-26

ATTRIBUTIONJessica Farrow was hired by Global Communications at age 22 at the beginning of 2002 and is expected to retire at the end of 2041 at age 61. The retirement period is estimated to be 20 years.

Global’s employees are eligible for postretirement health care benefits after both reaching age 56 while in service and having worked 20 years.

Since Farrow becomes fully eligible at age 56 (the end of 2036) retiree benefits are attributed to the 35-year period from her date of hire through that date. Graphically, the situation can be described as follows:

Attribution Period Retirement Period35 years 20 years

Age Age Age Age22 56 61 81

2002 2036 2041 2061

Retirement

Date Full-eligibilityhired date

T17-27

100 %

0 %

ACCOUNTING FOR POSTRETIREMENT BENEFIT PLANS OTHER THAN PENSIONS It’s necessary to attribute a portion of the accumulated

postretirement benefit obligation to each year as the service cost for

that year rather than measuring the actual benefits employees earn

during the year as for pension plans.

Employees are ineligible for benefits until specific eligibility criteria

are met, at which time they become 100% eligible. This contrasts

with pension plans under which employees earn additional benefits

each year until they retire.

Pension benefits Other postretirement benefits

Employees earn benefits gradually No benefits until full eligibility

The way we measure service cost is the primary difference between

accounting for pensions and for other postretirement benefits.

Otherwise, though, accounting for the two is virtually identical.

T17-28

PRIOR SERVICE COST

Prior service cost is attributed to the service of active employees from the date of the amendment to the full eligibility date, not the expected retirement date.

Like for pensions, the pattern of attribution can follow the service method or the straight-line approach.

T17-29

Suggestions for Class Activities1. Real World ScenarioA Financial Times.com article reported the following:

Pension funds may act over inflated returnsBy Julie Earle in New York US pension funds are considering a crackdown on companies that inflate their earnings by using too high pension fund return assumptions.Calpers, the number one pension fund, and its sister fund Calstrs, are weighing up whether to assess high-return assumptions on other companies' pension funds, as part of their investing strategy.Companies like Weyerhaeuser, the forest products group, Delta Airlines, General Motors and Ford have stuck with their high pension fund return assumptions, in spite of the sinking stock market.If companies do not make their assumed pension fund returns, they would then need to make up the difference. Any earnings revisions are likely to harm companies' share prices."In many corporations in America, pension income has been a substantial part of revenue growth in the past three years," said Kathleen Connell, California's state controller and a board member of Calpers and Calstrs."If you subtract pension earnings, you end up with an entirely different value for share prices. These are phantom earnings," she said.A 2002 study of 50 of the largest pension plans by Millima USA, a Seattle-based actuarial firm, shows the average rate of return on assets for 2001 was 9.3 per cent, producing an expected return of $54bn. The actual returns, however, were a negative $36bn, a loss of more than $90bn.Ms Connell wants Calpers and Calstrs to assess too high pension fund return assumptions as part of their investing strategy. Both funds have said they will discuss the issue, but the process is likely to be a lengthy one.The funds are already assessing an overhaul of stock option accounting and whether to ban investing in companies that relocate to offshore tax havens.Ms Connell said pension fund investors, hit hard by losses on accounting scandals like WorldCom and Enron, did not need any more pain.In some cases, companies' pension income accounted for more than 50 per cent of corporate net income, she said. General Motors and IBM both assume they can earn 10 per cent a year on their pension reserves. In GM's case, 60 per cent of the pension fund is invested in equities.Warren Buffet, the investment guru, has warned for some time that fund managers' long-term return assumptions for equities are "delusional".Ms Connell said pension fund return earnings would not be reason alone for investing or divesting in a company's stock, but part of the funds' due diligence in reviewing companies.

Suggestions:Ask students to discuss how companies “inflate their earnings by using too high pension fund return assumptions.”

Points to note:Normally, a company’s net periodic pension cost represents an expense and therefore 

 decreases earnings. Often, though, circumstances cause this element of the income statement to 

 actually increase reported earnings. This occurs when the “expected return on assets,” a negative  component of pension expense is higher than the combined total of the other components.

2. Internet Activity

Ask students to use the internet to locate the financial statements of a firm with a defined benefit plan. The company's corporate website and EDGAR (www.sec.gov) are good sources. Older, established companies are probably the best possibilities because newer companies are more likely to have defined contribution plans.

Suggestions:

From information in the financial statements and disclosure notes have students:1. Determine the amount of the projected benefit obligation.2. Determine the change in the projected benefit obligation.3. Speculate on the reasons for the change.

Points to note:

The PBO will not be reported in the balance sheet, but its balance and the change in the balance will be reported in the pension note. It's possible, but improbable, that students will encounter a company that amended its plan in the most recent year. More likely, then, there will be no originating prior service cost, so the four changes in the PBO will be service cost, interest cost, payments to retirees, and maybe a gain and/or loss. The service cost and interest cost will be disclosed. Payment to retirees and gains/losses will not. However, sources of some gains or losses will be evident. For instance, if the discount rate or estimated rate of change in compensation levels (both disclosed) changed from the previous year, a gain or loss is indicated.

3. Real World Scenario

Following is a portion of Disclosure Note 7 from the 2004 annual report of Walgreens:

Employee Benefits (in part)The company provides certain health insurance benefits for retired employees who meet eligibility requirements, including age, years of service and date of hire. The costs of these benefits are accrued over the period earned. The company's postretirement health benefit plans currently are not funded.

Funded status (In Millions): 2004 2003 Funded status $(392.5) $(349.6)Net loss 220.1 197.0Prior service cost (32.1) (6.2)

Suggestions: Ask students to consider the following:

1. The funded status of Walgreen’s postretirement benefit plan is $(392.5) at the end of 2004. What does that mean?

2. What are its plan assets?

Points to consider: The funded status of Walgreen’s postretirement benefit plan being $(392.5) at the end of 2004

means that its postretirement benefit obligation exceeds its plan assets. Walgreen’s plan is not funded. If it were, plan assets would be included in the schedule. Thus there are no plan assets. So, its postretirement benefit obligation must also be $392.5 million. This is not unusual. A majority of postretirement benefit plans are not funded.

4. Professional Skills Development Activities

The following are suggested assignments from the end-of-chapter material that will help your students develop their communication, research, analysis, and judgment skills.

Communication Skills. In addition to Communication Cases 17-2 and 17-4, Real World Case 17-5 can be modified to ask students to write a short report. Judgment Case 17-1 does well as a group assignment. Exercise 17-13, Problem 17-8, Judgment Case 17-3 and Real World Case 17-10 are suitable for student presentation(s). Problem 17-12 can be adapted to ask students to assume the role of a new accountant with Hilton Paneling, Inc. and write a short memo to a superior explaining the amounts requested in the requirement. Communication Case 17-4 requires group interaction. In addition, Ethics Case 17-6 does well as a group assignment. Questions 17-11, 14, and 19 create good class discussions.

Research Skills. In their professional lives, our graduates will be required to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. Research Cases 17-7 and 17-11 provide excellent opportunities to help students develop this skill. In addition, Real World Case 17-9 can be adapted to require students to research the authoritative literature on accounting for pension amendments.

Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct students to gather, assemble, organize, process, or interpret date to provide options for making business and investment decisions. In addition to Analysis Cases 17-10 and 17-12, Communication Case 17-2 and Real World Case 17-8 also provide opportunities to develop analysis skills.

Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require students to critically analyze issues to apply concepts learned to business situations in order to evaluate options for decision-making and provide an appropriate conclusion. In addition to Judgment Cases 17-1 and 17-3, Ethics Case 17-6 also requires students to exercise judgment.

5. Ethical Dilemma

The chapter includes the following ethical dilemma.

ETHICAL DILEMMA Earlier this year, you were elected to the Board of Directors of Champion International, Inc.

Champion has offered its employees postretirement health care benefits for 35 years. The practice of extending health care benefits to retirees began modestly. Most employees retired after age 65, when most benefits were covered by Medicare. Costs also were lower because life expectancies were shorter and medical care was less expensive. Because costs were so low, little attention was paid to accounting for these benefits. The company simply recorded an expense when benefits were provided to retirees. SFAS 106 changed all that. Now, the obligation for these benefits must be anticipated and reported in the annual report. Worse yet, the magnitude of the obligation has grown enormously, almost unnoticed. Health care costs have soared in recent years. Medical technology and other factors have extended life expectancies. Of course, the value to employees of this benefit has grown parallel to the growth of the burden to the company.

Without being required to anticipate future costs, many within Champion’s management were caught by surprise at the enormity of the company’s obligation. Equally disconcerting was the fact that such a huge liability now must be exposed to public view. Now you find that several Board members are urging the dismantling of the postretirement plan altogether.

What do you think?

You may wish to discuss this in class. If so, discussion should include these elements.

Step 1 - The Facts:Some members of the board of directors of champion International, Inc. are considering

discontinuing postretirement health care benefits because SFAS 106 now requires companies to record an obligation (debt) for these benefits on their financial statements. No longer can Champion record the health care benefits as an expense when services are provided to retirees. The fact that medical costs and life expectancies are increasing makes potential obligations even higher. Postretirement benefits are important to employees as a form of deferred compensation earned during employment.

Step 2 - The Ethical Issue and the Stakeholders:The ethical issue or dilemma is whether the obligation to reduce the company’s debt and

employment expenses is greater than the obligation to employees to provide post-retirement health benefits as a part of deferred compensation.

Stakeholders include you as a director, other members of the board of directors, company management, present and future employees, current and future creditors, and current and future investors.

Step 3 - Values: Values include integrity, objectivity, loyalty to employees, loyalty to the company, and

responsibility to users of financial statements.

Step 4 - Alternatives:1. Dismantle the postretirement health care benefits plan.2. Maintain the current postretirement benefit plan.3. Pay employees higher wages and ask them to invest in their own health care plans.

Step 5 - Evaluation of Alternatives in Terms of Values:1. Alternative 1 illustrates loyalty to protecting the company’s financial statement position and

protecting the interests of current investors. 2. Alternative 2 reflects values of integrity and responsibility to employees.3. Alternative 3 reflects both loyalty to the company and its employees.

Step 6 - Consequences:

Alternative 1

Positive consequences: The company would reflect a stronger financial position and higher net income without the health care expense. Creditors may be more willing to loan the firm money in the future and possible shareholders may be more willing to invest. Current shareholders may benefit financially, at least in the short run.

Negative consequences: Current employees would lose postretirement benefits. Some may quit their jobs in order to seek higher wages and postretirement benefits elsewhere. The company may experience difficulty in hiring new employees if other companies provide these benefits.

Alternative 2

Positive consequences: Current employees would retain benefits and perhaps be more satisfied with their current employment. Future employees may be more willing to work for the company. Management and board members may gain respect and gratitude from their employees.

Negative consequences: The company would be forced to reflect a substantial debt obligation on its balance sheet and postretirement benefit expense on the income statement. The company may have future difficulty obtaining loans or may have current debt called in if a weakened financial position violates any current debt covenants. Investors may withdraw their support and future shareholders may invest in other companies. The company may be forced into bankruptcy causing current employees to lose their jobs as well as their postretirement benefits.

Alternative 3

Positive consequences: The company would reflect a stronger financial position and possible higher net income without the health care expense. Wage expense would increase. The improved financial condition may mean that creditors may be more willing to loan the firm money in the future and stockholders may be more willing to invest. Employees may be more satisfied with their current employment and the company may experience as easier time hiring future employees. Management and board members may gain respect and gratitude from their employees

Negative consequences: The increased wages would decrease net income and may cause investors to withdraw their support. Future shareholders may invest in other companies. Some employees may be dissatisfied, resign, and go to work for other companies. Some employees may use the increased wages for current living expenses without investing the funds in their own postretirement health care plans.

Step 7 - Decision: Student(s) must decide their course of action.