Chapter 19 Pensions_STUDENT

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CHAPTER 19 Accounting for Pensions and Postretirement Benefits LO1: Discuss the fundamentals of pension plan accounting.  RETIREMENT ACCOUNT A pension plan is said to be funded when the employer sets funds aside for future pension benefits by making payments to a funding agency that is responsible for accumulating the assets of the pension fund and for making payment to the recipients as the benefits come due. In an insured plan, the funding agency is an insurance company; in a trust fund plan, the funding agency is a trustee. What Types of Pensions Plans Are There? i) contributory plan (employees pay part) / noncontributory plan (employer pays all) ii) qualified (offers tax benefits 1,2 to employers) / non-qualified. (1) Employer contributions are tax-deductible. (2) Earnings from pension fund assets are not taxed. iii) defined contribution plan (example: 401(k) plan) The employer agrees to contribute to a pension trust a certain sum each period based on a formula. This formula may consider such factors as age, length of employee service, employer’s profits, and compensation level. Only the employer’s contribution is defined; no promise is made regarding the ultimate benefits paid out to the employees. The employer’s annual cost is the amount it is obligated to contribute to the pension trust. If the contribution is made in full each year, no pension asset or liability is reported on the employer’s balance sheet. FACTS Murphy Company sponsors a defined contribution plan for all of its full-time employees that is administered by Fidelity. Under the terms of the plan, Murphy contributes at least 1.25% 1

of its pretax operating income to the plan each year. On December 31, 2025, Murphy reported pretax operating income of $2,480,000, therefore, Murphy made a contribution to the plan of $31,000. QUESTIONS (a) What entry would you make to record pension expense for Murphy’s defined contribution plan at December 31, 2025? (b) Does Murphy have a liability on its balance sheet related to the plan? Explain. SOLUTION a) Pension expense 31,000 Cash 31,000 b) NO, because it is a define contribution plan. (2,480,000 * 1.025 = 31,000) iv) defined benefit plan These plans define the benefits that the employee will receive at the time of retirement. The formula typically provides for the benefits to be a function of the employee’s years of service and the compensation level when he or she nears retirement. • The accounting for a defined benefit plan is complex. Because the benefits are defined in terms of uncertain future variables, an appropriate funding pattern must be established to ensure that enough money will be available at retirement to meet the benefits promised. This funding level depends on a number of factors such as turnover, mortality, length of employee service, compensation levels, and interest earnings. Actuaries are individuals trained through a long and rigorous certification program to assign probabilities to future events and their financial effects. Measures of the Liability In accounting for a company’s defined benefit pension plan, two questions arise: 1. What is the pension obligation that a company should report in the financial statements? Most accountants agree that an employer’s pension obligation is the deferred compensation obligation it has to its employees for their services under the terms of the pension plan. 2

However, there are three ways to measure this liability. (Regardless of the approach used, the estimated future benefits to be paid are discounted to present value.) Companies must recognize on their balance sheet the full overfunded or underfunded status of their defined benefit pension plan. The overfunded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation. https://equable.org/unfunded-liabilities-for-state-pension-plans-2022/ 3 EXAMPLE – Funded Status of a Pension Plan FACTS Coker Company has a projected benefit obligation (PBO) of $300,000. The fair value of its plan assets is $210,000. QUESTION What is the funded status of Coker’s pension plan? Plan Assets = 210,000 PBO Liability = 300,000 Underfunded by 90,000  Net Liability on the balance

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2. What is the pension expense for the period? Pension cost should be accounted for on the accrual basis . Accounting for pension plans requires measurement of the cost and its identification with the appropriate time periods. The determination of pension cost is very complicated because it is a function of a number of factors. These factors are identified and described below: Actual Return on Plan Assets. Annual expense is adjusted for interest and dividends that accumulate within the fund as well as increases and decreases in the market value of the fund assets. Computation of the actual return on plan assets is illustrated by the following schedule: Fair value of plan assets at end of the period $2,500,000 Deduct: Fair value of plan assets at beginning of period 1,800,000 Increase/decrease in fair value of plan assets 700,000 Deduct: Contributions to plan during period $275,000 less benefits paid during the period (120,000) 155,000 Actual return on plan assets $ 545,000 If the actual return on the plan assets is positive (a gain) during the period, it is subtracted in the computation of pension expense. If the actual return is negative (a loss) during the period, it is added in the computation of pension expense. 4

Gain or Loss. Two items comprise gain or loss: (1) the difference between the actual return and the expected return on plan assets, and (2) amortization of the unrecognized net gain or loss from previous periods BE19.1 (LO 1) AMR Corporation (parent company of American Airlines) reported the following (in millions). Service cost $366 add Interest on P.B.O. 737 add Return on plan assets 593 less Amortization of prior service cost 13 add Amortization of net loss 154 less Compute AMR’s pension expense. Formula: Service cost + Interest on P.B.O - Return on plan assets + Amortization of prior service cost - Amortization of net loss = PENSION EXPENSE 366 + 737 – 593 + 13 -154 = Pension expense = 677 millions BE19.2 (LO 1) For Warren Corporation, year-end plan assets were $2,000,000. At the beginning of the year, plan assets were $1,780,000. During the year, contributions to the pension fund were $120,000, and benefits paid were $200,000. Compute Warren’s actual return on plan assets. Fair value of plan assets at end of the period $2,000,000 Deduct: Fair value of plan assets at beginning of period 1,780,000 Increase/decrease in fair value of plan assets 220,000 Deduct: Contributions to plan during period $120,000 **Less benefits paid during the period (200,000) (80,000) Actual return on plan assets $ 300,000 **Remember law of signs matter in here because of the explicit less Formula: (Fair value of plan assets at end of the period) – [(Contributions to plan during period) – (benefits paid during the period)] = Actual return on plan assets 5

FACTS Mayhew Inc. has the following information for its defined benefit pension plan in 2025. INSTRUCTIONS Determine the following for Mayhew's pension plan in 2025. a. Actual return on pension assets. b. Pension expense. c. Funded status of the pension plan. a) Fair value of plan assets at end of the period $2,725,000 Deduct: Fair value of plan assets at beginning of period 2,400,000 Increase/decrease in fair value of plan assets 325,000 Deduct: Contributions to plan during period $280,000 Less benefits paid during the period (350,000) (70,000) Actual return on plan assets $ 395,000 b) Serv cost +194,000 Interest PBO +253,000 Return Assets -395,000 = Pension expense 52,000 6

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LO2: Use a worksheet for employer’s pension plan entries • The “General Journal Entries” columns determine the entries to record in the formal general ledger accounts. • The “Memo Record” columns maintain balances in the projected benefit obligation and the plan assets. • The difference between the projected benefit obligation and the fair value of the plan assets is the pension asset/liability , which is reported in the balance sheet. Remember the following two items. 1. If the pension benefit obligation is greater then plan assets → Pension liability. 2. If the pension benefit obligation is less than plan assets → Pension asset. 7

FACTS On January 1, 2025, Zarle Company provides the following information related to its pension plan for the year 2025. • Plan assets, January 1, 2025, are $100,000. • Projected benefit obligation, January 1, 2025, is $ 100,000. • Annual service cost is $9,000. • Settlement rate is 10%. • Actual return on plan assets is $10,000. • Funding contributions are $8,000. • Benefits paid to retirees during the year are $7,000. QUESTION What is the pension worksheet you would prepare for Zarle? Continuing with Example 19.4, Zarle makes the following journal on December 31, which records the pension expense in 2025, as follows. Pension Reconciliation Schedule-December 31, 2025 In the previous example, the credit to Pension Asset/ Liability for $1,000 represents the difference between the 2025 pension expense of $9,000 and the amount funded of $8,000. 8 Projected benefit obligation (Credit) $(112,000) Plan assets at fair value (Debit) 111,000 Pension asset/liability (Credit) $ (1,000)

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BE19.3 (LO 2) At January 1, 2025, Hennein Company had plan assets of $280,000 and a projected benefit obligation of the same amount. During 2025, service cost was $27,500, the settlement rate was 10%, actual and expected return on plan assets were $25,000, contributions were $20,000, and benefits paid were $17,500. Prepare a pension worksheet for Hennein for 2025. 10 E19.1 (LO1, 2) Pension Expense, Journal Entries Actual and expected rate of return on plan assets 15,000 $ Benefits paid to retirees 40,000 Contributions (funding) 90,000 Interest/discount rate 10% Prior service cost amortization 8,000 $ Projected benefit obligation, January 1, 2020 500,000 Service cost 60,000 Instructions a. Compute pension expense for the year 2025. b. The following information is available for the pension plan of Radcliffe Company for the year 2025. Prepare the journal entry to record pension expense and the employer's contribution to the pension plan in 2025.

LO3. Describe the accounting and amortization of prior service costs. When either initiating (adopting) or amending a defined benefit plan, a company often provides benefits to employees for years of service before the date of initiation or amendment. As a result of this prior service cost, the projected benefit obligation is increased to recognize this additional liability.  The employer initially records the prior service cost as a component of Other Comprehensive Income. DR: Other Comprehensive Income (PSC) CR: Projected Benefit Obligation (PBO)  The employer then charges the prior service cost to pension expense over the remaining service lives of the employees who are expected to benefit from the change in the plan.  The cost of the retroactive benefits (including any benefits provided to existing retirees) is the increase in the projected benefit obligation at the date of the amendment. To amortize the PSC, FASB prefers the years-of-service method (as follows). See Example 19.5 11

E19.5 (LO 3) (Application of Years-of-Service Method) Andrews Company has five employees participating in its defined benefit pension plan. Expected years of future service for these employees at the beginning of 2025 are as follows. Employee Future Years of Service Jim 3 Paul 4 Nancy 5 Dave 6 Katy 6 On January 1, 2025, the company amended its pension plan, increasing its projected benefit obligation by $72,000. Instructions: Compute the amount of prior service cost amortization for the years 2025 through 2030 using the years-of-service method, setting up appropriate schedules. Jim Paul Nancy Dave Katy Total Cost * Annual Charge 2025 1 1 1 1 1 5 3,000 15,000 2026 1 1 1 1 1 5 3,000 15,000 2027 1 1 1 1 1 5 3,000 15,000 2028 1 1 1 1 4 3,000 12,000 2029 1 1 1 3 3,000 9,000 2030 1 1 2 3,000 6,000 24 sv years 72,000 / 24 = 3,000 per service year 12

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BE19.5 (LO 3) Mancuso Corporation amended its pension plan on January 1, 2025, and granted $160,000 of prior service costs to its employees. The employees are expected to provide 2,000 service years in the future, with 350 service years in 2025. Compute prior service cost amortization for 2025. 160,000 / 2,000 = 80 80 * 350 = 28,000 To illustrate the use of a worksheet with prior service costs (PSC), the following facts apply to Oehler Company for the year 2026: Present value of prior service benefits granted January 1, 2026…. $42,000 Annual service cost for 2026 28,000 Settlement rate for 2026 7% Actual return on plan assets for 2026 31,000 Contributions (funding) in 2026 29,000 Benefits paid retirees in 2026 24,000 Amortization of prior service costs 17,500 At the point that the plan is amended in 2026, the prior service cost increases the PBO and is charged to Other Comprehensive Income – PSC (and is reported in Accumulated Other Comprehensive Income – PSC in the equity section of the balance sheet). It is then amortized to Pension Expense over the remaining service lives of the affected employees. The journal entry to record pension expense, including the amortization of PSC, for 2026 is as follows: Pension Expense 51,845 Other Comprehensive Income (PSC) 24,500 Cash 29,000 Pension Asset/Liability 47,345 The worksheet would be completed as follows: 13

*$533,500 X .07 The balance of the Pension Asset/Liability account ($43,845) is equal to the net of the balances in the memo accounts. The pension reconciliation schedule is as follows: Projected benefit obligation (Credit) ................................ $(574,845) Plan assets at fair value (Debit) ....................................... 531,000 Pension asset/liability (Credit) ......................................... $ (43,845 ) BE19.6 (LO 3) At December 31, 2025, Besler Corporation had a projected benefit obligation of $560,000, plan assets of $322,000, and prior service cost of $127,000 in accumulated other comprehensive income. Determine the pension asset/liability at December 31, 2025. 14 Oehler Company Pension Worksheet—2026 Items General Journal Entries Memo Record Annual Pension Expense Cash OCI-Prior Service Cost Pension Asset/ Liability Projected Benefit Obligation Plan Assets Balance, Dec. 31, 2025 3,500 Dr. 491,500 Cr. 495,000 Dr. (a) Prior service cost 42,000 Dr. 42,000 Cr. Balance, Jan. 1, 2026 533,500 Cr. 495,000 Dr (b) Service cost 28,000 Dr. 28,000 Cr. (c) Interest cost *37,345 Dr. 37,345 Cr. (d) Actual return 31,000 Cr. 31,000 Dr. (e) Amortization of PSC 17,500 Dr. 17,500 Cr. (f) Contributions 29,000 Cr. 29,000 Dr. (g) Benefits 24,000 Dr. 24,000 Cr. Journal entry for 2026 51,845 Dr. 29,000 Cr. 24,500 Dr. 47,345 Cr. Accumulated OCI, Dec. 31, 2025 0 Balance, Dec. 31, 2026 24,500 Dr. 43,845 Cr. 574,845 Cr. 531,000 Dr.

E19.7 (LO1, 2, 3) Basic Pension Worksheet The following defined pension data of Rydell Corp. apply to the year 2025. Projected benefit obligation, 1/1/25 (before amendment) 560,000 $ Plan assets, 1/1/25 546,200 Pension liability 13,800 On January 1, 2025, Rydell Corp., through plan amendment, grants prior service benefits having this present value 120,000 Settlement rate 9% Service cost 58,000 $ Contributions (funding) 65,000 Actual (expected) return on plan assets 52,280 Benefits paid to retirees 40,000 Prior service cost amortization for 2025 17,000 Instructions For 2025, prepare a pension worksheet for Rydell Corp. that shows the journal entry for pension expense and the year-end balances in the related pension accounts. 15

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LO4. Explain the accounting and amortization for unexpected gains and losses. Because of the concern to companies that pension plans would have uncontrollable and unexpected swings in pension expense, the profession decided to reduce the volatility by using smoothing techniques. Asset gains and asset losses are:  recorded in an Other Comprehensive Income (G/L) account and  combined with unrecognized gains and losses accumulated in prior years (Accumulated OCI). EXAMPLE In 2027, Zarle Company has an actual return on plan assets of $12,000. The expected rate of return is 10%, and the fair value of the plan assets at the beginning of 2027 is $134,100. QUESTION What is the unexpected gain or loss (if any)? The expected return is: $134,100 * .10 = $13,410 Actual return: $12,000 < $13,410 (expected return) by $1,410: this difference is an asset loss DR: Other Comprehensive Income (loss) 13,410 CR: Pension Expense 13,410 Liability gains (resulting from unexpected decreases in the PBO liability balance) and liability losses (resulting from unexpected increases) are deferred and combined in the same Other Comprehensive Income (G/L) account used for asset gain or losses. Corridor Amortization Approach The Accumulated Other Comprehensive Income (G/L) account can continue to grow if asset gains and losses are not offset by liability gains and losses. To limit this potential growth, the FASB requires the corridor approach for amortizing the balance in Accumulated OCI when it gets too large. 16 UNEXPECTED GAIN/LOSS Actual Return > Expected Return  Asset GAIN Actual Return < Expected Return  Asset LOSS

 The Accumulated OCI account balance is considered too large and must be amortized when it exceeds 10% of the larger of the beginning balance of the projected benefit obligation or the market-related value of plan assets.  Any systematic method of amortizing the excess may be used, but it cannot be less than the amount computed using straight-line amortization over the average remaining service-life of all active employees.  Amortization of the excess unrecognized net gain or loss should be included as a component of pension expense, only if, as of the beginning of the year, the unrecognized net gain or loss exceeds the corridor. BE19.7.1 Given the following information for Tyler Company’s pension plan at the beginning of the year, calculate the corridor, excess net loss (gain), and amortized net loss (gain). Assume an average remaining service life of 15 years. Cumulative net loss $ 25,000 Projected benefit obligation: actual 220,000 Fair value of pension plan assets 200,000 Corredor: 220,000 * 0.10 = 22,000 Excess net loss = 25,000 – 22,000 = 3,000 LOSS Amortizaiton = 3,000 / 15 years = 200 per year BE19.7 (LO 4) Shin Corporation had a projected benefit obligation of $3,100,000 and plan assets of $3,300,000 at January 1, 2025. Shin also had a net actuarial loss of $465,000 in accumulated OCI at January 1, 2025. The average remaining service period of Shin’s employees is 7.5 years. Compute Shin’s minimum amortization of the actuarial loss. 17 CORRIDOR AMORTIZATION OF NET GAIN/LOSS Step 1. Calculate net gain/loss at the beginning of the year. Step 2. The corridor is defined as 10% of the greater of the beginning of the year projected benefit obligation or the beginning of the year fair value of the plan assets. Step 3. If the net gain/loss > corridor, the amount in excess of the corridor is amortized over the remaining service life of active employees. The company adds any amortization of a net loss to pension expense and subtracts a net gain.

Cumulative net loss $ 465,000 Projected benefit obligation: actual 3,100,000 Fair value of pension plan assets 3,300,000 Corridor: 3,300,000 * 0.10 = 330,000 Excess net loss = 465,000 – 330,000 = 135,000 LOSS Amortization = 135,000 / 7.5 years = 18,000 per year 18

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LO5. Describe the requirements for reporting pension plans in financial statements. Assets and Liabilities a. Companies must recognize on their balance sheet the overfunded (pension asset) or underfunded (pension liability) status of their defined benefit pension plan. The overfunded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation. b. If the fair value of plan assets exceeds the projected benefit obligation (the plan is overfunded), companies will report a net pension asset. However, no portion of a pension asset is reported as a current asset. Net Income Pension expense includes multiple components (service cost, interest cost, return on assets, and amortization of various amounts such as prior service cost and gains and losses) deferred from prior periods. The FASB requires presentation of the components of pension expense as follows: 1. Service cost component is reported as pension expense in income from operations (often as part of compensation expense). 2. Other components of pension expense are generally reported as one net amount in the “Other expenses and losses” section below income from operations. Comprehensive Income  In addition to the pension expense reported on the income statement, companies are also required to recognize actuarial gains and losses and prior service costs that originate in the current period in other comprehensive income.  Actuarial gains and losses not recognized as part of pension expense are recognized as increases and decreases in other comprehensive income. The same type of accounting is also used for prior service cost.  By recognizing both actuarial gains and losses and prior service cost as part of other comprehensive income, the Board believes that the usefulness of financial statements is enhanced. Within the Notes to the Financial Statements  A schedule showing all the major components of pension expense.  A reconciliation showing how the projected benefit obligation and the fair value of the plan assets changed from the beginning to the end of the period.  A disclosure of the rates used in measuring the benefit amounts.  A table indicating the allocation of pension plan assets by category and a narrative description of investment policies and strategies.  The expected benefit payments to be paid to current plan participants for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter.  The nature and amount of changes in plan assets and benefit obligations recognized in net income and in other comprehensive income of each period. 19

 The accumulated amount of changes in plan assets and benefit obligations that have been recognized in other comprehensive income and that will be recycled into net income in future periods. Pension Reform Act The Pension Reform Act of 1974 (ERISA) set out specific requirements for companies providing a pension plan for their employees. These requirements are designed to safeguard employees’ pension rights, specifically in the areas of funding, participation, and vesting. The Act also created the Pension Benefit Guaranty Corporation (PBGC) to administer terminated plans and to impose liens on the corporate assets for certain unfunded pension liabilities. Pension Terminations eRISA prevents companies from recapturing excess assets (pension plan assets in excess of projected benefit obligations) unless they pay participants what is owed to them and then terminate the plan. The accounting issue that arises from these terminations is whether a gain should be recognized by the corporation when these assets revert back to the company. The FASB requires recognition in earnings of a gain or loss when the employer settles a pension obligation either by lump-sum cash payments or by purchasing annuity contracts. 20

Chapter 19 Pensions_STUDENT

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