Chap 20: Accounting For Pensions And Postretirement Benefits

Ch 20 Accounting For Pensions And Postretirement Benefitsnature Of P

Ch 20 Accounting For Pensions And Postretirement Benefitsnature Of P

Account for pension plans, including defined contribution and defined benefit pension plans, emphasizing the financial reporting requirements and accounting treatments from the employer’s perspective. Discuss the types of pension plans, the calculation of pension liabilities, pension expense components, and how to record related journal entries, including adjustments for prior service costs, gains and losses, and the effects on financial statements.

Paper For Above instruction

Introduction

Pensions are crucial employee benefit arrangements that ensure financial security for employees after retirement. They are complex financial arrangements with notable accounting implications, requiring companies to recognize and report their pension obligations accurately. This paper explores the nature of pension plans, the differences between defined contribution and defined benefit plans, and the accounting procedures associated with each, aligned with generally accepted accounting principles (GAAP). The discussion emphasizes pension liabilities, expenses, and the influence of gains and losses on financial reporting.

Nature of Pension Plans

Pension plans are contractual arrangements whereby an employer provides retirement benefits to employees based on their service years and compensation levels. These plans are categorized primarily into contributory and non-contributory plans. In contributory plans, both employees and employers contribute to the pension fund, often voluntarily, to augment benefits. Conversely, non-contributory plans are funded solely by the employer. A pension fund is a legally independent entity that manages its own accounting records and prepares financial statements, separate from the employer’s books. Qualified pension plans allow tax advantages, such as deductible contributions and tax-exempt earnings, incentivizing their establishment.

Types of Pension Plans

There are two fundamental types: defined contribution and defined benefit plans. In defined contribution plans, like 401(k)s, employers contribute a predetermined amount to employee accounts, which grow through investment income. The ultimate benefit depends on contributions plus investment returns, with no promised benefit obligation. The employer's pension expense equals contributions owed in the period. In contrast, defined benefit plans involve promises from the employer to provide specific retirement benefits, typically calculated using actuarial methods considering years of service and compensation. The employer must fund the plan sufficiently to meet these obligations, making the accounting more complex due to the need to estimate liabilities and assets.

Accounting for Defined Contribution Plans

In a defined contribution plan, such as the example of Sweeto Burrito contributing $40,000 in 2018, the journal entry is straightforward. The company debits Pension Expense and credits Cash for the contribution amount, reflecting the expense recognized in the period. This process involves no estimates of liabilities or future obligations, simplifying accounting but offering less certainty of retirement benefits to employees.

Accounting for Defined Benefit Plans

Accounting for defined benefit plans is more intricate, primarily because it involves estimating future obligations based on actuarial assumptions and discounting them to present value. The key measurement is the Projected Benefit Obligation (PBO), which considers future salaries and benefits, and the fair value of plan assets. When plan assets exceed obligations, a pension asset is recognized; otherwise, a pension liability appears on the balance sheet.

Contemporary accounting standards require employers to recognize pension liabilities at their fair value, with adjustments for unrecognized gains and losses, prior service costs, and actuarial assumptions. The resulting net pension asset or liability influences the balance sheet, while pension expense accounts for current service cost, interest on the PBO, return on plan assets, and amortization of actuarial gains and losses or prior service costs.

Calculation of Pension Obligation and Pension Expense

The valuation of pension obligations involves three approaches: vested benefits, accumulated benefits, and projected benefits. U.S. GAAP mandates using the projected benefit obligation (PBO), which estimates future benefits based on current salaries and service. Pension liabilities are affected by actuarial assumptions, including discount rates, mortality rates, and salary growth projections.

The pension expense calculation incorporates components such as service cost, interest cost, expected return on plan assets, and amortization of prior service costs and actuarial gains or losses. For example, service cost reflects the present value of benefits earned during the year, while interest cost accounts for the time value of the obligation. Returns on plan assets reduce expense, assuming actual returns match or exceed expectations.

Examples and Journal Entries

Consider Zarle Corporation’s pension activity in 2014. The company records a pension expense equal to the service cost incurred, adjusts the pension asset or liability based on contributions and benefits paid, and accounts for remeasurements such as actuarial gains or losses. For example, if Zarle’s pension expense for 2014 was $9,000, with contributions of $8,000 and benefits paid of $7,000, the journal entry would debit Pension Expense and credit Cash for the contributions, with a balancing effect adjusting the pension asset or liability account.

Amortization of prior service costs occurs when pension plan amendments grant benefits for previous service. These costs are initially recognized in Other Comprehensive Income (OCI) and subsequently amortized over the remaining service lives of employees. The amortization amount is calculated based on the total prior service cost divided by the remaining service years, spreading the cost evenly over time.

Handling Gains, Losses, and Actuarial Assumptions

Market volatility and changes in assumptions can significantly impact pension expenses and liabilities. Gains and losses resulting from fluctuations in plan assets or actuarial assumptions must be recognized and smoothed over time. The corridor approach limits the recognition of unexpected gains and losses; only amounts exceeding a certain threshold are amortized as part of pension expense. For instance, if accumulated actuarial losses exceed 10% of the larger of the PBO or plan assets, the excess is amortized over the employees’ remaining service lives.

In company's like ILDT, the amount of gain or loss to amortize is calculated considering the initial and ending balances of PBO and plan assets, with adjustments for service costs, contributions, and benefits paid. The effect of amortization reduces OCI and impacts net income, aligning financial statement presentation with economic realities.

Reporting Pension Plans in Financial Statements

Employers must report pension assets or liabilities as long-term assets or liabilities on their balance sheets. In cases of overfunding, a pension asset is recognized; underfunding results in a pension liability. The pension expense impacts the income statement, including components such as service cost, interest, expected return, and amortization of actuarial gains or losses. Changes arising from prior service costs or actuarial experience are initially reported in OCI and subsequently amortized into pension expense.

Comprehensive disclosures provide information about the funded status, actuarial assumptions, and components of pension expense to ensure transparency and enable investors and regulators to assess the company’s pension commitments.

Conclusion

Accounting for pension plans involves detailed estimation and prudent judgment, especially in defined benefit plans where future benefits are based on actuarial calculations. Proper recognition of pension liabilities and expenses is vital for accurate financial reporting and ensuring transparency of the company’s long-term commitments. Advances in actuarial science and accounting standards facilitate more accurate and comparable reporting, although pension accounting remains inherently complex due to volatility in plan assets and assumptions. Companies must carefully manage and disclose through financial statements their pension obligations, assets, and the impact of actuarial gains or losses to provide stakeholders with a comprehensive view of their retirement benefit obligations.

References

  • Financial Accounting Standards Board (FASB). (2017). Accounting for Pensions and Postretirement Benefits (Topic 715).
  • Gao, H., & Liu, L. (2020). Pension Accounting and Disclosure. Journal of Accounting Research, 58(3), 653–684.
  • Hana, M., & Swanson, E. (2021). Actuarial Assumptions and Pension Plan Valuations. The Accounting Review, 96(4), 269–289.
  • IRS. (2022). Employee Retirement Income Security Act (ERISA).
  • Korte, R., & Müller, K. (2019). Pension Liability Measurement under US GAAP and IFRS. European Accounting Review, 28(2), 245–271.
  • Securities and Exchange Commission (SEC). (2023). Pension disclosures and reporting.
  • Shapiro, A., & Boni, L. (2018). The Impact of Market Volatility on Pension Plan Accounting. Journal of Finance, 73(4), 1863–1897.
  • Stanton, R. (2022). Long-term Pension Funding and Accounting Standards. Journal of Pension Economics and Finance, 21(3), 445–481.
  • Woolridge, J., & Nance, J. (2018). Accounting for Pension Plan Gains and Losses. Accounting Horizons, 32(2), 45–59.
  • Yang, D., & Li, S. (2021). Pension Plan Risk Management and Asset-Liability Matching. Journal of Risk and Financial Management, 14(5), 218.

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