Ch 20.1 (Fundamentals of Pension Plan Accounting)

Question 1

Reasons for the shift from traditional pension plans

Answer 1

1. Competition
2. Cost
3. Insurance
4. Accounting

Question 2

What affects how the public views retirement?

Answer 2

• The general economic conditions
• Medicare Programs
• Social Security Programs

Question 3

Pension Plan

Answer 3

An arrangement whereby an employer provides benefits (payments) to retired employees for services they provided in their working years.

Accounting for the employer,

Accounting for the pension fund,

Question 4

When is a pension plan funded?

Answer 4

It is funded when the employer makes payments to a funding agency.

That agency accumulates the assets of the pension fund and makes payments to the recipients as the benefits come due.

Question 5

Contributory pension plans

Answer 5

Employees bear part of the cost of the stated benefits or voluntarily make payments to increase their benefits.

Question 6

Noncontributory pension plans

Answer 6

The employer bears the entire cost.

Question 7

Qualified pension plans

Answer 7

Plans that offer tax benefits.

They permit deductibility of the employer’s contributions to the pension fund and tax-free status of earnings from pension fund assets.

Question 8

Two most common types of pension plans

Answer 8

1. Defined contribution plans

2. Defined benefit plans

Question 9

Defined contribution plan

Answer 9

The employer agrees to contribute to a pension trust a certain sum each period, based on a formula.

E.g. 401k plan

Question 10

Accounting for a defined contribution plan

Answer 10

Employee gets the benefit of gain (or the risk of loss) from the assets contributed to the pension plan.

Employer’s pension expense or Employer’s pension liability or Employer’s pension asset

Employer must disclose info about the pension plan

Question 11

Defined benefit plan

Answer 11

Outlines the benefits that employees will receive when they retire.

These benefits typically are a function of an employee’s years of service and of the compensation level in the years approaching retirement.

Employees are the beneficiaries of a defined contribution trust, but the employer is the beneficiary of a defined benefit trust.

Employers are at risk with defined benefit plans because they must contribute enough to meet the cost of benefits that the plan defines.

Question 12

How are pension plans in other parts of the world?

Answer 12

Private pension plans are less common because many other nations rely on government-sponsored pension plans.

Question 13

Actuaries

Answer 13

Individuals trained through a long and rigorous certification program to assign probabilities to future events and their financial effects.

Accounting for defined benefit pension plans relies heavily upon information and measurements provided by actuaries.

Question 14

Questions that come up in accounting for a company’s pension plan

Answer 14

1. What is the pension obligation that a company should report in the financial statements?
2. What is the pension expense for the period?

Question 15

Pension obligation

Answer 15

Most agree that an employer’s pension obligation is the deferred compensation obligation it has to its employees for their service under the terms of the pension plan.

Question 16

Different ways to measure the pension obligation

Answer 16

1. Vested benefits (vested benefit obligation using current salary levels)
2. Accumulated benefit obligation (vested and nonvested using current salary levels)
3. Projected benefit obligation (vested and nonvested using future salaries)

The choice affects the amount of a com­pany’s pension liability and the annual pension expense reported.

Question 17

Which of the three ways to measure pension obligations do most professions favor and why?

Answer 17

The profession adopted the projected benefit obligation—the present value of vested and nonvested benefits accrued to date, based on employees’ future salary levels.

Those in favor of the projected benefit obligation contend that a promise by an employer to pay benefits based on a percentage of the employees’ future salaries is far greater than a promise to pay a percentage of their current salary.

Question 18

Recognition of the Net Funded Status of the Pension Plan

Answer 18

Companies must recognize on their balance sheet the full overfunded or underfunded status of their defined benefit pension plan.

Overfunded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation.

Question 19

Pension expense is a function of the following (Components of pension expense)

Answer 19

1. Service Cost
2. Interest on the liability
3. Actual return on plan assets
4. Amortization of prior service cost
5. Gain or loss

Question 20

Service cost

Answer 20

Actuarial present value of benefits attributed by the pension benefit formula to employee service during the period.

FASB indicates that the projected benefit obligation provides a more realistic measure of the employer’s obligation under the plan on a going concern basis and, therefore, companies should use it as the basis for determining service cost.

Question 21

Interest on the liability (interest expense)

Answer 21

A company defers paying the liability until maturity, the company records it on a discounted basis. The liability then accrues interest over the life of the employee.

The interest component is the interest for the period on the projected benefit obligation outstanding during the period.

Question 22

Settlement rates (How do companies determine the interest rate to apply to the pension liability?)

Answer 22

Assumed discount rate should reflect the rates at which companies can effectively settle pension benefits.

Companies should look to rates of return on high-quality fixed-income investments currently available, whose cash flows match the timing and amount of the expected benefit payments.

Question 23

Actual return on plan asset

Answer 23

The increase in pension funds from interest, dividends, and realized and unrealized changes in the fair value of the plan assets.

Pension plan assets are usually investments in stocks, bonds, other securities, and real estate that a company holds to earn a reasonable return, generally at minimum risk.

Actual return earned on these assets increases the fund balance and correspondingly reduces the employer’s net cost of providing employees’ pension benefits.

Question 24

Actual return (function)

Answer 24

(Plan assets ending balance - Plan assets beginning balance) - (Contributions - Benefits paid)

Actual return on plan assets is the difference between the fair value of the plan assets at the beginning of the period and at the end of the period, adjusted for contributions and benefit payments.

gain => subtract from pension expense

loss => subtract from pension expense