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Employers are at risk with defined-contribution plans because they must contribute enough to meet

the cost of benefits that the plan defines. FALSE

Which of the following does the FASB argue indicates a more realistic measure of the employer’s

obligation under the pension plan on a going-concern basis and should be used as the basis for

determining serice cost! PBO

"he interest on the pro#ected benefit obligation component of pension e$pense reflects the rates atwhich pension benefits could be effectively settled.

Which one of the following is not a component of pension e$pense! Amortization of proected

benefit obli!ation.

%f the actual return on plan assets is positie& then it is subtracted from the annual pension e$pense.

"#$E

'rior serice cost is amorti(ed on a years%of%service method or on a strai!ht%line basis over the

avera!e remainin! service life of active employees.

"he unrecogni(ed net gain or loss balance must be amorti(ed when it e$ceeds )*+ of the larger of

the, be!innin! proected benefit obli!ation or be!innin! mar&et%related asset value.

"he pension assetliability is the difference between the, proected benefit obli!ation and the fair

value of plan assets.

Serice cost is the e$pense caused by the increase in pension benefits payable to employees because

of their serices rendered during years prior to the current year. FALSE

%n a defined benefit plan& pension e$pense is eual to the firm’s cash contribution. FALSE

'rior serice costs due to a pension plan amendment are e$pensed in the year the amendment

occurred. FALSE

"he market-related asset alue is used to determine the corridor and to calculate the e$pected return

on plan assets. 'O##()O# *ES+ E,P #E" O- PLA- ASSE"S -O

Pension planPension plan - is an arrangement where by the employerprovides benefits (payments) to retired employees for theservices they provide in their working years.- A pension plan is funded when the employer makes paymentsto a funding agency. That agency accumulates the assets andmakes payments to the recipients

       Qualified pension plans

plans that offer ta benefits. Permit deductibility of theemployer!s contributions to the pension fund and ta-free statusof earnings from pension fund assets.

       "efined #ontribution Plansprovide the employee an opportunity to invest pre-ta moneydeducted on a regular basis in a group of mutual funds and otherinvestments

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       "efined $enefit Plan"efined $enefit Plan - retirement plan that provides theparticipant with a fied benefit upon retirement.- These benefits typically are a function of an employee!s years of

service and of the compensation level in the years approachingretirement.- %mployers are at risk with defined benefit plans because theymust contribute enough to meet the cost of benefits that the plandefines- The epenses recogni&ed every period is not necessarily e'ualto the cash contribution

        Accounting for pensionsn accounting for a company!s pension plan two 'uestions arise*(+) ,hat is the pension obligation that a company should report

in the financial statements() ,hat is the pension epense for the period Attempting toanswer the first 'uestion has produced much controversy.

        /ested benefits /ested benefits are those that the employee is entitled to receiveeven if he or she renders no additional services to the company.0ost pension plans re'uire a certain minimum number of yearsof service to the employer before an employee achieves vested benefits status. #ompanies compute the vested benefit obligationusing only vested benefits at current salary levels.

       accumulated benefit obligation. Accumulated benefit obligation - Another way to measure theobligation uses both vested and nonvested years of service. 1nthis basis the company computes the deferred compensationamount on all years of employees! service2both vested andnonvested2using current salary levels.

       Pro3ected benefit obligation (4A5$ choice)Pro3ected benefit obligation - the present value of vested and

nonvested benefits accrued to date based on employees! futuresalary levels.- Those in favor of the pro3ected benefit obligation contend that apromise by an employer to pay benefits based on a percentage ofthe employees! future salaries is far greater than a promise to pay a percentage of their current salary and such a difference should be reflected in the pension liability and pension epense.

       

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 Alternative 0easures of Pension 6iability The choice between these measures is critical. The choice affectsthe amount of a company!s pension liability and the annualpension epense reported.

        Actuarial present value Actuarial present value - is the amount payable ad3usted toreflect the time value of money and the probability of payment(by means of decrements for events such as death disability withdrawals or retirement) between the present date and theepected date of payment.

       7ecognition of the 8et 4unded 5tatus of the Pension Plan#ompanies must recogni&e on their balance sheet the fulloverfunded or underfunded status of their defined benefitpension plan.

- 7ecogni&e that 9AAP applies to pensions as well as otherpostretirement benefit plans (1P%$s).- The overfunded or underfunded status is measured as thedifference between the fair value of the plan assets and thepro3ected benefit obligation.

       7ecognition of the 8et 4unded 5tatus of the Pension Plan(%ample)To illustrate assume that #oker #ompany has a pro3ected benefitobligation of :;

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>. Amorti&ation of Prior 5ervice #osts?. 9ain or loss

       #omponents of Pension %pense (5ervice #osts)5ervice #ost. 5ervice cost is the epense caused by the increase in

pension benefits payable (the pro3ected benefit obligation) toemployees because of their services rendered during the current year. Actuaries compute service cost as the present value of thenew benefits earned by employees during the year.

       #omponents of Pension %pense (nterest of the liability)nterest 1n the 6iability. $ecause a pension is a deferredcompensation arrangement there is a time value of moneyfactor. As a result companies record the pension liability on adiscounted basis. nterest epense accrues each year on thepro3ected benefit obligation 3ust as it does on any discounted

debt. The actuary helps to select the interest rate referred to asthe settlement rate.

       5ettlement 7ateThe assumed discount rate at which the pension benefits could be @settled.@ "erived from rates in current annuity contracts.

       #omponents of Pension %pense (Actual 7eturn on Plan Assets) Actual 7eturn 1n Plan Assets. The return earned by the

accumulated pension fund assets in a particular year is relevantin measuring the net cost to the employer of sponsoring anemployee pension plan. Therefore a company should ad3ustannual pension epense for interest and dividends thataccumulate within the fund as well as increases and decreases inthe fair value of the fund assets.

       #omponents of Pension %pense (Amorti&ation of Prior 5ervice#osts) Amorti&ation of Prior 5ervice #ost. Pension plan amendments(including initiation of a pension plan) often include provisions

to increase benefits (or in rare situations to decrease benefits)for employee service provided in prior years. A company grantsplan amendments with the epectation that it will reali&eeconomic benefits in future periods. Thus it allocates the cost(prior service cost) of providing these retroactive benefits topension epense in the future specifically to the remainingservice-years of the affected employees.

       

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#omponents of Pension %pense (9ain or loss)9ain or 6oss. /olatility in pension epense can result fromsudden and large changes in the fair value of plan assets and bychanges in the pro3ected benefit obligation (which changes whenactuaries modify assumptions or when actual eperience differs

from epected eperience). Two items comprise this gain or loss*(+) the difference between the actual return and the epectedreturn on plan assets and () amorti&ation of the net gain or lossfrom previous periods. ,e will discuss this comple computationlater in the chapter.

        Actual 7eturn 1n Plan AssetsThe actual return on the plan assets is the increase in pensionfunds from interest dividends and reali&ed and unreali&edchanges in the fair value of the plan assets. #ompanies computethe actual return by ad3usting the change in the plan assets for

the effects of contributions during the year and benefits paid outduring the year. Asset 7eturn (Plan assets ending balance - Plan assets beginning balance) -(#ontribution - $enefits Paid)

        Actual 7eturn 1n Plan Assetsf the actual return on the plan assets is positive (a gain) duringthe period a company subtracts it when computing pensionepense. f the actual return is negative (a loss) during theperiod the company adds it when computing pension epense.

        Amorti&ation of Prior 5ervice #ost (psc) ,hen either initiating (adopting) or amending a defined benefitplan a company often provides benefits to employees for years of service before the date of initiation or amendment. As a result ofthis prior service cost the pro3ected benefit obligation isincreased to recogni&e this additional liability. n many cases theincrease in the pro3ected benefit obligation is substantial.- 4A5$ says not to recogni&e an epense for these prior servicecosts (P5#) at the time it initiates or amends a plan- nstead the employer initially records the prior service cost as

an ad3ustment to other comprehensive income. The employerthen recogni&es the prior service cost as a component of pensionepense over the remaining service lives of the employees whoare epected to benefit from the change in the plan.

        Amorti&ation of Prior 5ervice #ost (psc)

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The cost of the retroactive benefits (including any benefitsprovided to eisting retirees) is the increase in the pro3ected benefit obligation at the date of the amendment.

        Amorti&ation of Prior 5ervice #ost (psc)

The $oard prefers a years-of-service method that is similar to aunits-of-production computation. 4irst the company computesthe total number of service-years to be worked by all of theparticipating employees. 5econd it divides the prior service cost by the total number of service-years to obtain a cost per service- year (the unit cost). Third the company multiplies the number of service-years consumed each year by the cost per service-year toobtain the annual amorti&ation charge.

       #orridor approach-to limit the growth of the accumulated 1# account the 4A5$

-for amorti&ing the account!s accumulated balance when its gettoo large. The 4A5$ set a limit of +

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       #lassification of Pension Asset or Pension 6iability 7ecently the 4A5$ re'uired more etensive disclosures relatedto pension plan assets. At a minimum companies must disclosethe amount of assets allocated to e'uities government and

corporate bonds mortgage-backed securities derivatives andreal estate. Also information on concentrations of risk must beeplained. 4inally fair value disclosures would be re'uiredincluding classification of amounts into levels of the fair valuehierarchy.

       4air /alue Cierarchy The fair value hierarchy provides insight into the priority of valuation techni'ues that are used to determine fair value. Thefair value hierarchy is divided into three broad levels.

4air /alue Cierarchy

6evel +* 1bservable inputs that reflect 'uoted prices for 6east5ub3ectiveidentical assets or liabilities in active markets.

6evel * nputs other than 'uoted prices included in 6evel + thatare observable for the asset or liability either directly or throughcorroboration with observable data.

6evel ;* Dnobservable inputs (for eample a company!s own

data or assumptions). 0ost 5ub3ective As indicated 6evel + is themost reliable because it is based on 'uoted prices like a closingstock price in the ,all 5treet Eournal. 6evel is the net mostreliable and would rely on evaluating similar assets or liabilitiesin active markets. At the least-reliable level 6evel ; much 3udgmentis needed based on the best information available to arrive at arelevant and reliable fair value measurement.

        Aggregation of Pension PlansThe $oard takes the position that all overfunded plans should be

combined and shown as a pension asset on the balance sheet.5imilarly if the company has two or more underfunded plansthe underfunded plans are combined and shown as one amounton the balance sheet.- The 4A5$ re3ected the alternative of combining all plans andrepresenting the net amount as a single net asset or net liability.The rationale* A company does not have the ability to offsetecess assets of one plan against underfunded obligations of

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another plan. 4urthermore netting all plans is inappropriate because offsetting assets and liabilities is not permitted under9AAP unless a right of offset eists.

        Actuarial 9ains and 6ossesFprior 5ervice #ost

 Actuarial gains and losses not recogni&ed as part of pensionepense are recogni&ed as increases and decreases in othercomprehensive income. The same type of accounting is also usedfor prior service cost. The $oard re'uires that the prior servicecost arising in the year of the amendment (which increases thepro3ected benefit obligation) be recogni&ed by an offsetting debitto other comprehensive income.

       Postretirement $enefits Accounting ProvisionsCealthcare and other postretirement benefits for current andfuture retirees and their dependents are forms of deferred

compensation. They are earned through employee service andare sub3ect to accrual during the years an employee is working.

       attribution periodThe period of time over which the postretirement benefit costaccrues is called the attribution period. t is the period of serviceduring which the employee earns the benefits under the terms ofthe plan.

       1bligations Dnder Postretirement $enefits

n defining the obligation for postretirement benefits the 4A5$maintained many concepts similar to pension accounting. t alsodesigned some new and modified terms specifically forpostretirement benefits. Two of the most important of thesespeciali&ed terms are (a) epected postretirement benefitobligation and (b) accumulated postretirement benefitobligation.

       %pected postretirement benefit obligation (%P$1)The epected postretirement benefit obligation (%P$1) is theactuarial present value as of a particular date of all benefits a

company epects to pay after retirement to employees and theirdependents. #ompanies do not record the %P$1 in the financialstatements but they do use it in measuring periodic epense.

        Accumulated postretirement benefit obligation (AP$1)The accumulated postretirement benefit obligation (AP$1) is theactuarial present value of future benefits attributed to employees!services rendered to a particular date. The AP$1 is e'ual to the

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%P$1 for retirees and active employees fully eligible for benefits.$efore the date an employee achieves full eligibility the AP$1 isonly a portion of the %P$1. 1r stated another way the difference between the AP$1 and the %P$1 is the future service costs ofactive employees who are not yet fully eli

       Postretirement epensePostretirement epense is the employer!s annual epense forpostretirement benefits. Also called net periodic postretirement benefit cost this epense consists of many of the familiarcomponents used to compute annual pension epense. Thecomponents of net periodic postretirement benefit cost are asfollows.