Chapter 17 Flashcards
Pension plans often enhance productivity, reduce turnover, satisfy union demands, and allow employers to compete in the labor market. true or false?
true. 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
A pension formula typically defines retirement pay based on the employees’ years of service, annual compensation, and sometimes age. True or False?
True
Define an Actuary
A professional trained in a particular branch of statistics and mathematics, to assess the various uncertainties (employee turnover, salary levels, mortality, etc.) and to estimate the company’s obligation to employees in connection with its pension plan.
Unions typically oppose pension plans. true or false?
False - Motivation to sponsor a plan sometimes comes from union demands and often relates to being competitive in the labor market. Other factors include providing employees with a degree of retirement security. This security also can induce a degree of job satisfaction and perhaps loyalty that might enhance productivity and reduce turnover
Difference between Defined Contribution and Defined Benefit plans
Defined Contribution: promise fixed annual contributions to a pension fund (say, 5% of the employees’ pay). Employees choose (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: 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.
Today, approximately three-fourths of workers covered by pension plans are covered by defined benefit plans. True or False?
False: Today, approximately three-fourths of workers covered by pension plans are covered by defined contribution plans, roughly one-fourth by defined benefit plans.
Uncertainties complicate determining how much to set aside each year to ensure that sufficient funds are available to provide promised benefits. in defined contribution plans.
False - this is a characteristic of Defined Benefit Plans. This is particularly true when pension benefits are defined by a pension formula, as usually is the case. A typical formula might specify that a retiree will receive annual retirement benefits based on the employee’s years of service and annual pay at retirement (say, pay level in the final year, highest pay achieved, or average pay in the last two or more years).
For defined contribution plans, the employee would bear the risk of uncertain investment returns. True or False?
True. The employee would bear the risk of uncertain investment returns and, potentially, settle for far less at retirement than at first expected. Risk is reversed in a defined benefit plan. Because specific benefits are promised at retirement, the employer would be responsible for making up the difference when investment performance is less than expected.
Defined contribution plans promise defined periodic contributions to a pension fund, without further commitment regarding benefit amounts at retirement. True or false?
True
Since actuarial estimates are inherently subjective, estimates invariably deviate from the actual outcome to one degree or another For instance, the return on assets can turn out to be more or less than expected. These deviations are referred to as gains and losses. True or False?
True. Pension gains and losses occur when the pension obligation is LOWER (gain) or HIGHER (loss) than expected. Pension gains and losses occur when the return on plan assets is higher or lower than expected.
The key elements of a defined benefit pension plan are:
- 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. The first two of these elements are not reported individually in the employer’s financial statements. This may seem confusing at first because it is inconsistent with the way you’re accustomed to treating assets and liabilities. Even though they are not separately reported, it’s critical that you understand the composition of both the pension obligation and the plan assets because (a) they are reported as a net amount in the balance sheet, and (b) their balances are reported in disclosure notes.
Why are virtually all new pension plans are defined contribution plans.
1.Government regulations make defined benefit plans cumbersome and costly to administer. 2.Employers are increasingly unwilling to bear the risk of defined benefit plans; with defined contribution plans, the company’s obligation ends when contributions are made. 3.There has been a shift among many employers from trying to “buy long-term loyalty” (with defined benefit plans) to trying to attract new talent (with more mobile defined contribution plans).
True or False - the ABO is the portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment.
False. That is the Vested Benefit Obligation (VBO). ABO is The actuary’s estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels.
True or False? If the pension formula does not include future compensation levels, the PBO and the ABO are the same
true
What is the Projected Benefit Obligation?
Projected benefit obligation (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.)
Difference between the PBO and ABO?
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 using existing compensation levels. Projected benefit obligation (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.)
. The amount can be calculated directly as the assumed discount rate multiplied by the projected benefit obligation at the beginning of the year.
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 passe
This represents the increase in the projected benefit obligation attributable to employee service performed during the period.
Service Cost
When the ABO is estimated, the most recent salary is included in the pension formula to estimate future benefits. True or false?
True. When the ABO is estimated, the most recent salary is included in the pension formula to estimate future benefits, even if the pension formula specifies the final year’s salary. No attempt is made to forecast what that salary would be the year before retirement.
True or False - A prior service cost arises when the pension plan itself is amended to revise the way benefits are determined
True - When a pension plan is amended, credit often is given for employee service rendered in prior years. The cost of doing so is called prior service cost. Applied retroactively so employees won’t get upset.
Most VBO’s are vested in five years. True or false?
True - Today, benefits must vest (a) fully within five years or (b) 20% within three years with another 20% vesting each subsequent year until fully vested after seven years. Five-year vesting is most common.
Define a Gain or Loss on PBO
Decreases and increases in estimates of the PBO because of periodic re-evaluation of uncertainties are called gains and losses. 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.
Pension Plan Assets must be recorded in the disclosure notes as well
Its separate balance, too, must be reported in the disclosure notes to the financial statements (as does the separate PBO balance
Define Pension Plan Assets
employer contributions and accumulated earnings on the investment of those contributions to be used to pay retirement benefits to retired employees. . Like the PBO, the pension plan assets are not reported separately in the employer’s balance sheet but are netted together with the PBO to report either a net pension asset (debit balance) or a net pension liability (credit balance).
Payment of retirement benefits increases the PBO. True or false?
False - Reduces PBO
A trustee accepts employer contributions, invests the contributions, accumulates the earnings on the investments, and pays benefits from the plan assets. True or False?
True
BO at the end of 2013 is $450 million. Because the plan assets are only $340 million, the pension plan is said to be underfunded/overfunded?
Underfunded. An underfunded pension plan means the PBO exceeds plan assets. It is not unusual for pension plans today to be underfunded. An overfunded pension plan means plan assets exceed the PBO.
Estimated long-term return on invested assets. are also known as:
Expected return on plan assets. When an employer estimates how much it must set aside each year to accumulate sufficient funds to pay retirement benefits as they come due, it’s necessary to estimate the return those investments will produce. The higher the return, the less the employer must actually contribute. On the other hand, a relatively low return means the difference must be made up by higher contributions.
The assets of a pension fund must be held by a trustee. True or false?
True. A trustee accepts employer contributions, invests the contributions, accumulates the earnings on the investments, and pays benefits from the plan assets to retired employees or their beneficiaries. The trustee can be an individual, a bank, or a trust company. Plan assets are invested in stocks, bonds, and other income-producing assets.
Example of Pension Expense
Figure 17-12
Like wages, salaries, commissions, and other forms of pay, pension expense is part of a company’s compensation for employee services each year. But what is different about Pension Expense?
the fact that this form of compensation actually is paid to employees many years after the service is performed means that other elements in addition to the annual service cost will affect the ultimate pension cost. See slide 27
Overfunding and Underfunding are examples of Funded Status. Define the Funded Status
Though firms don’t report PBO or Plan assets seperately on the balance sheet, they do report the difference betweed these two amounts. this is the “Funded Status”. PBO - Fair Value of Plan Assets (if pbo larger) = Underfunded Status. Fair Value of Plan Assets - PBO = Overfunded Status
Low interest rates hurt plans’ funded status. True or false?
True. . Low interest rates hurt plans’ funded status because the pension obligation is a present value calculation that increases with a lower discount rate. Even small interest rate changes have big effects on funded status.
Is the Expected or Actual return included in the calculation of Pension Expense?
Expected! FASB concluded that the actual return should first be adjusted by any difference between that return and what the return had been expected to be. So, it’s actually the expected return that is included in the calculation of pension expense. difference between the actual and expected return is considered a loss or gain on plan assets. Any loss or gain is not included in pension expense right away
Interest cost is the discount rate times the PBO balance at the beginning of the year for Pension Expense. True or False?
True.
When Calculating Pension Expense, an Amortization of Prior Service Cost may be a component. Why is Prior Service Cost amortized?
Prior service cost is recognized as pension expense over the future service period of the employees whose benefits are recalculated. Amending a pension plan, and especially choosing to make that amendment retroactive, typically is done with the idea that future operations will benefit from those choices. For that reason, the cost is not recognized as pension expense in the year the plan is amended. Instead, it is recognized as pension expense over the time that the employees who benefited from the retroactive amendment will work for the company in the future..
True or False - Service Cost each year is the first component of Pension Expense
True
Prior Service Costs are beneficial in retaining employees. Are they considered assets/liabilities/AOCI?
AOCI. This is a result of the FASB’s disinclination to treat the cost as an expense as it is incurred. The Board, instead, prefers to ascribe it the off-the-income-statement designation as other comprehensive income (OCI) in the same manner as the handful of losses and gains also categorized the same way and not reported among the gains and losses in the traditional income statement.
True or False - Prior service cost is expensed as it is incurred.
False - Prior service cost is not expensed as it is incurred. Instead, it is reported as a component of AOCI to be amortized over time.
What two possible components of Pension Expense are amortized?
Prior Service Costs and Amortization of Net Loss or Gains. We report both components as OCI
Difference between Defined Contribution Plans and Defined Benefit Plans?
See slide 4
Journal Entry for a Defined Contribution Pension Plan
Let’s assume that the annual contribution is to be 3% of an employee’s salary. If an employee earned $110,000 during the year, the company would make the following entry: (slide 6)
Three key elements of a Defined Benefit Pension Plan
See Slide 9
Example of a Defined Benefit Pension Plan
See Slide 8
Differences between three types of Pension Obligations?
See slide 11
Another way of seeing Pension Obligations -
See slide 12
Example of PBO - Jessica Farrow was hired by Global Communications in 2002. Farrow is expected to retire in 2041 after 40 years of 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.
The formula is given by the company. See Slide 14. Pay close attention to amount of years taken up at each step.
Components of Pension Expense
See Slide 10
Five events that chagne PBO?
see Slide 16
EG of PBO calculation
See slide 22
Eg of Plan AssetsCalculation
See slide 24
See Gains and Losses summary
See slide 32
What is journal entry of funding of plan assets When Global adds its annual cash investment of $48 million to its plan assets?
See slikde 39
Eg of Pension Expense
See slikde 36
See journal of Pension Expense (slide 38)
slikde 38
When Global pays $38 million in retirement pension benefits, what does the entry look like?
slikde 40
For 2013, the actual return on plan assets exceeded the expected return by $3 million. In addition, there was a $23 million loss from changes made by the actuary when it revised its estimate of future salary levels causing its PBO estimate to increase. Global would make the following journal entry to record the gain and loss:
See Slide 37. Of course, know opppsite effects as well
Where would the comprehensive income affects be on the balance sheet?
See slide 44
T-Account for a Gains or Losses (include the difference between actual and expected return)
