Financial Accounting and Reporting Seminar
Financial Accounting and Reporting Seminar ACCT 592
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Case 057 Ace Company Exhibit The Offering QampA Note only information relevant to the case has been excerpted from the original prospectus What are MEDS Equity Units The MEDS Equity Unit will consist of a purchase contract issued by us and a note in the amount of 50 due December 23 2005 The note component of each MEDS will be owned by the holder of the MEDS but will be pledged as collateral to secure the holder39s obligation to purchase our common stock under the related purchase contract If the notes which are components of the MEDS are successfully remarketed on or prior to the ninth business day preceding June 23 2005 the 39purchase contract settlement date39 as described in this prospectus supplement the applicable ownership interest in a Treasury portfolio of zerocoupon US Treasury securities as further described herein will replace the notes as a component of each MEDS and will be pledged to the collateral agent to secure the holder39s obligations under the related purchase contracts The notes will not trade separately from the MEDS unless and until Treasury securities are substituted for the notes as discussed below or the notes are remarketed Each holder of a MEDS Equity Unit may elect at any time to withdraw the pledged note creating stripped units To create stripped units the holder must substitute as pledged securities specifically identified Treasury securities that will pay 50 on the stock purchase date the amount due on such date under the purchase contract The pledged notes will then be released from the pledge agreement and delivered to the holder What is a purchase contract Each purchase contract underlying a MEDS Equity Unit obligates the holder of the purchase contract to purchase and obligates us to sell on June 23 2005 for 50 in cash a number of newly issued shares of our common stock equal to the 39settlement rate The settlement rate will be calculated subject to adjustment as described under 39Description of the Purchase Contracts AntiDilution Adjustments as follows If the applicable market value of our common stock is equal to or greater than 4800 the settlement rate will be 10417 shares 1f the applicable market value of our common stock is less than 4800 but greater than 4000 the settlement rate will be equal to 50 divided by the applicable market value of our common stock39 and If the applicable market value of our common stock is less than or equal to 4000 the settlement rate will be 125 shares Applicable market value of our common stock means the average of the closing price per share of our common stock on the 20 consecutive trading days ending on the third trading day immediately preceding June 23 2005 The last reported sale price of our common stock on the NYSE was 4000 What is remarketing The notes of MEDS holders will be remarketed on the third business day immediately preceding March 23 2005 which we refer to as the initial remarketing date The remarketing agent will use its commercially reasonable best efforts to remarket the notes bearing the reset rate described below and to obtain a price for the notes of at least 10025 of the purchase price for the Treasury portfolio as defined Copyright 2004 Deloitte Development LLC All Rights Reserved Case 057 Ace Company Exhibit Page 2 below A portion of the proceeds from the remarketing equal to the Treasury portfolio purchase price will be applied to purchase the Treasury portfolio The Treasury portfolio will be substituted for the notes and will be pledged to the collateral agent to secure the MEDS holders39 obligations to purchase our common stock under the purchase contracts When paid at maturity proceeds from the Treasury portfolio in an amount equal to the principal amount of the notes will automatically be applied to satisfy in full the MEDS holders39 obligations to purchase our common stock under the related purchase contracts on the purchase contract settlement date and proceeds from the Treasury portfolio in an amount equal to the interest payment that would have been due on the notes on the purchase contract settlement date assuming the interest rate was not reset will be paid to the holders The remarketing agent will deduct as a remarketing fee an amount not exceeding 25 basis points 025 of the Treasury portfolio purchase price from any amount of the proceeds from the rem arketing of the notes in excess of the Treasury portfolio purchase price The remarketing agent will then remit the remaining portion of the proceeds from the remarketing of the notes if any for the benefit of the holders When will the interest rate on the notes be reset The interest rate on the notes will be reset on the date of a successful rem arketing and such reset rate will become effective three business days following such date or if no successful remarketing occurs on June 23 2005 What is the reset rate In the case of a successful remarketing on or prior to the ninth business day immediately preceding June 23 2005 the reset rate will be the rate subject to the last sentence of this paragraph that the notes should bear in order for the notes included in MEDS to have an approximate aggregate market value of approximately 10025 of the applicable Treasury portfolio purchase price In the case of a successful remarketing on the third business day immediately preceding June 23 2005 the reset rate will be the rate subject to the last sentence of this paragraph that the notes should bear in order for each note to have an approximate market value of approximately 10025 but not less than 100 of the principal amount of that note If a successful remarketing does not occur on or prior to the third business day immediately preceding June 23 2005 the reset rate will be set on such date as described in this prospectus supplement based on a spread over the applicable twoyear Treasury benchmark rate such spread to be determined based on the rating of the notes Any reset rate may not be less than the original interest rate on the notes and may not exceed the maximum rate if any permitted by applicable law What payments am I entitled to as a holder of MEDS A holder of a MEDS you will be entitled to receive cash payments payable quarterly in arrears consisting of I Interest on the related note or cash distributions on the applicable ownership interest of the Treasury portfolio as applicable at the rate of 490 of 50 per year and I Contract adjustment payments at the rate of 385 of the stated amount per year Copyright 2004 Deloitte Development LLC All Rights Reserved Page 1 FASB 52 Foreign Currency T quot A cinclu T 39 quot Also referred to as Temporal Method Current Method Criteria for use Used when accounting records are not kept in the functional currency and for highly 39 quot v functional currencies Used when accounting records are kept in the functional currency as long as that currency is not 391 A highly in ationary Description No attempt is made to preserve relationships that exist in foreign unit s financial statements The object is to remeasure nonmonetary assets at historical currency exchange rates The end result may bear little relationship to the foreign currency statements used by local Foreign entity is viewed as a separate business The only factual financial statements are those denominated in the foreign currency The translation process should maintain the relationship among variables eg current ratio debt to equity International useage Temporal method or the monetarynonmonetary method is used by nearly 50 of countries No major countries use the currentnoncurrent method Used by nearly 50 of countries including almost all of Western Europe and Japan US UK and Canada are the only 3 countries that use both the current rate and the temporal method depending on circumstances Translation gains and losses Reported in net income and closed to retained earnings Included in comprehensive income and accumulated in owners equity as accumulated other comprehensive income General procedures Uses historical rates for all nonmonetary items Uses current rates for all balance sheet items except owners equity Monetary Current rate Current rate assetsliabilities Nonmonetary Historical rate Current rate assetsliabilities Stock common preferred additional paid in capital etc Historical rate Historical rate Sales Average rate for year Average rate for year Expenses Average rate for year Average rate for year Cost of goods sold Average for purchases historical for beginning and ending inventory Average rate for year Depreciation amorti ation Historical Average rate for year ForCurrTransd0c Created by T Gordon 071310 Page 2 Translation of Financial Statements Denominated in a Foreign Currency Conceptual issues 1 Which exchange rate to use a Does the exchange rate selected for a specific account result in a meaningful dollar amount b Does the exchange rate selected for a specific account change the basis of accounting in translation c When a change in the exchange rate has occurred do the translated results re ect the true economic impact of the change 2 How to report the effect of changes in exchange rates a Do the reported effects relate to daytoday operations b Do the reported effects impact cash ows c Are the reported effects realized or unrealized in nature The economic impact of an exchange rate change depends on a The causes of the exchange rate change ie foreign in ation domestic in ation nonin ationary factors b The nature of the foreign unit s assets ie the extent to which the assets are monetary versus nonmonetary c The extent of debt financing relative to equity financing Effects of Exchange Rate Changes Pahler amp Mori 1997 Translation method Possible relevant Foreign currency Domestic currency used financial position has strengthened has strengthened with respect to with respect to the domestic currency 2 foreign currency Temporal Net monetary asset Favorable Unfavorable Temporal Net moneta liability Unfavorable Favorable Current rate Assets exceed Favorable Unfavorable liabilities Current rate Liabilities exceed Unfavorable Favorable assets In all situations the eifect is favorable on assets and unfavorable on liabilities In all situations the effect is unfavorable on assets and favorable on liabilities ForCurrTransdoc Created by T Gordon 071310 Page 3 The Disappearing Plant Problem Many countries suffer from high in ation sometimes exceeding 1000 per year Using the current rate method in such situations causes meaningless fixed asset situations For example assume the parent spent 2000000 in 1974 to build a plant in Argentina when 2000000 purchased 10000000 pesos December 31 1974 December 31 1995 Amount Rate Amount Rate Amount pesos Plant 10000000 20 2000000 00000001 010 To make this work out to a sensible number you would have to use pricelevel adjusted statements instead of historical cost statements for the foreign unit but this is not permitted under US GAAP History Between 1930 and 1975 FASB 8 US companies generally used the currentnoncurrent method In other words current accounts were translated using current exchange rates and noncurrent accounts were translated using historical exchange rates This method has very short term focus 7 as though the Us company might need to take the working capital out of the foreign operations at any time In 1975 FASB issued SFAS 8 which required the temporal method Industry was furious over the variability in earnings caused by this method and put FASB under tremendous pressure to nd a politically acceptable improvement to FASB 8 Floating exchange rates were new when SFAS 8 came out In 1981 FASB issued SFAS 52 which allowed the current rate method to be used in many cases and let most exchange rate gains and losses bypass the income statement FASB also invented the functional currency notion but the guidelines are vague enough that companies can pretty much choose whether to use current rate method or the temporal method FASB 52 has been more acceptable primarily because domestic in ation has not been high relative to foreign in ation since 1981 If domestic in ation returned to the 19781981 levels the current rate method would have industry again clamoring for change In other words both FASB 8 and FASB 52 are awed because FASB did not properly diagnose the causes for exchange rate changes Pahler amp Mori 1997 p 713 Function currency idea The functional currency idea is based on the contention that economic exposure is different for autonomous foreign units as compared to nonautonomous foreign units Pahler and Mori 1997 p 678 argue that the idea is artificial irrelevant and misguided ForCurrTransd0c Created by T Gordon 071310 Foreign Currency T IA39 Page 4 Domestic currency unit of measurement approaches Foreign currency unit of measurement approach Current value approach Variations Currentnoncurrent method Current rate approach Purchasing Power Parity method Monetarynonmonetary method general rule under FASB 52 PPP Temporal method FASB 8 FASB terminology Remeasurement Tran Iminn Description No attempt is made to preserve Foreign entity is Viewed as a Focus on net asset position relationships that exist in foreign unit s nancial statements The object is to remeasure nonmonetary assets at historical currency exchange rates The end result may bear little relationship to the foreign currency statements used by local separate business The only factual nancial statements are those denominated in the foreign currency The translation process should maintain the relationship among variables eg current ratio debt to equity assumes all the foreign unit s assets and liabilities are exposed to the risk of exchange rate changes Similar to current rate approach in that one exchange rate is used but foreign in ation is first taken into consideration Matches economic reality Works fairly well for highly in ationary foreign currencies Properly deals with non in ationary causes of exchange rate uctuations Best portrayal of economic reality Disappearing plant If domestic in ation rate is higher If foreign in ation rate is higher The method eliminates the problem than foreign in ation rate over a than domestic in ation rate over a problem because changes in period of time foreign plant period of time foreign plant relative in ation rates are taken values shrink to unrealistically values shrink to unrealistically into account small numbers small numbers Useage Temporal method or the Used by nearly 50 of countries None monetarynonmonetary method is used by nearly 50 of countries No major countries use the currentnoncurrent method including almost all of Western Europe and Japan US UK and Canada are the only 3 countries that use both the current rate and the temporal method depending on circumstances ForCurrTransd0c Created by T Gordon 071310 Page 5 Reporting Results for Speci c Causes of Exchange Rate Chan e Based on Illustration 208 in Pahler amp Mori 1997 Advanced Accounting 61 edition Achieves general compatibility with the Re ects the true economic effect of the Assumed sole cause of rate domestic in ation no gt ForCurrTransdoc Created by T Gordon 071310 CHAPTER 20 Accounting for Pensions and Postretirement Benefits ASSIGNMENT CLASSIFICATION TABLE BY TOPIC Topics Brief Questions Exercises 1 9 10 Basic definitions and concepts related to pension plans Worksheet preparation Income statement recognition computation of pension expense Balance sheet recognition computation of pension expense Corridor calculation Prior service cost Gains and losses Disclosure issues Special Issues Postretirement benefits 1234 56 7 8 912 24 3 91011 14 13 16 17 1520 2 2223 18 7 121320 5891O 142122 79 23 1O 25 2627 1112 2829 This material is dealt with in an Appendix to the chapter 201 Exercises 16 3 4 7 1015 1 2 36 111314 151617 2021 3 9 11 12 1314 81416 17 1235 91112 1314 8 9 13 14 1617 91112 181920 Problems 10 Concepts for Analysis 1 2 3 4 5 7 ASSIGNMENT CLASSIFICATION TABLE BY LEARNING OBJECTIVE Brief Learning Objectives quot 39 quot Problems 1 Distinguish between accounting for the employer s pension plan and accounting for the pension fund 2 Identify types of pension plans and their characteristics 3 Explain alternative measures for valuing the pension obligation 4 List the components of pension expense 1 2 4 1 2 6 11 12 13 15 5 Use a worksheet for employer s pension plan 3 3 4 7 10 1 2 4 entries 1114 789 6 Describe the amortization of prior service costs 5 1 2 5 7 1 2 3 4 12 13 6 7 8 9 7 Explain the accounting for unexpected gains and 9 12 13 1 2 3 4 5 losses 6 7 8 9 8 Explain the corridor approach to amortizing gains 7 8 12 13 3 4 5 6 and losses 16 17 7 8 9 Describe the requirements for reporting pension 6 8 9 1O 9 10 11 1 2 3 4 8 plans in financial statements 12 13 10 Identify the differences between pensions and 11 12 18 19 2O 1O postretirement healthcare benefits 11 Contrast accounting for pensions to accounting 11 12 18 1920 10 for other postretirement benefits 202 ASSIGNMENT CHARACTERISTICS TABLE Level of Time Item Description DW E201 Pension expense journal entries Simple 5 10 E202 Computation of pension expense Simple 10 15 E203 Preparation of pension worksheet Moderate 15 25 E204 Basic pension worksheet Simple 10 1 5 E205 Application of yearsofservice method Moderate 15 25 E206 Computation of actual return Simple 10 15 E207 Basic pension worksheet Moderate 15 25 E208 Application of the corridor approach Moderate 20 25 E209 Disclosures Pension expense and other comprehensive income Moderate 25 35 E201O Pension worksheet Moderate 20 25 E2011 Pension expense journal entries statement presentation Moderate 20 30 E2012 Pension expense journal entries statement presentation Moderate 20 30 E2013 Computation of actual return gains and losses corridor test Complex 35 45 prior service cost pension expense E2014 Worksheet for E2013 Complex 40 50 E2015 Pension expense journal entries Moderate 15 20 E2016 Amortization of accumulated OCl GL corridor approach Moderate 25 35 pension expense computation E2017 Amortization of accumulated OCl balances Moderate 30 40 E2018 Postretirement benefit expense computation Simple 10 12 E2019 Postretirement benefit expense computation Simple 10 12 E2020 Postretirement benefit worksheet Moderate 15 20 P201 Twoyear worksheet Moderate 40 50 P202 Threeyear worksheet journal entries and reporting Complex 45 55 P203 Pension expense journal entries amortization of loss Complex 40 50 P204 Pension expense journal entries for 2 years Moderate 30 40 P205 Computation of pension expense amortization of net gain or Complex 45 55 loss corridor approach journal entries for 3 years P206 Computation of prior service cost amortization pension Complex 45 60 expense journal entries and net gain or loss P207 Pension worksheet Moderate 35 45 P208 Comprehensive 2year worksheet Complex 45 60 P209 Comprehensive 2year worksheet Moderate 40 45 P201O Postretirement benefit worksheet reporting Moderate 30 35 203 ASSIGNMENT CHARACTERISTICS TABLE Continued Level of Time Item Description Difficulty gminutes CA201 Pension terminology and theory Moderate 30 35 CA202 Pension terminology Moderate 25 30 CA203 Basic terminology Simple 20 25 CA204 Major pension concepts Moderate 30 35 CA205 Implications of FASB Statement No 87 Complex 50 60 CA206 Gains and losses corridor amortization Moderate 30 40 CA207 Nonvested employees an ethical dilemma Moderate 20 30 204 ANSWERS TO QUESTIONS A private pension plan is an arrangement whereby a company undertakes to provide its retired employees with benefits that can be determined or estimated in advance from the provisions of a document or from the company s practices In a contributory pension plan the employees bear part of the cost of the stated benefits whereas in a noncontributory plan the employer bears the entire cost A defined contribution plan specifies the employer s contribution to the plan usually based on a formula which may consider such factors as age length of service employer s profit or compen sation levels A defined benefit plan specifies a determinable pension benefit that the employee will receive at a time in the future The employer must determine the amount that should be contributed now to provide for the future promised benefits In a defined contribution plan the employer s obligation is simply to make a contribution to the plan each year based on the plan formula The benefit of gain or risk of loss from assets con tributed to the plan is borne by the employee In a defined benefit plan the employer s obligation is to make sufficient contributions each year to provide for the promised future benefits Therefore the employer is at risk to the extent that contributions will not be adequate to meet the promised benefits The employer is the organization sponsoring the pension plan The employer incurs the costs and makes contributions to the pension fund Accounting for the employer involves 1 allocating the cost of the pension plan to the proper accounting periods 2 measuring the amount of pension obligation resulting from the plan and 3 disclosing the status and effects of the plan in the financial statements The pension fund or plan is the entity which receives the contributions from the employer adminis ters the pension assets and makes the benefit payments to the pension recipients Accounting for the fund involves identifying receipts as contributions from the employer sponsor income from fund investments and computing the amounts due to individual pension recipients Accounting for the pension costs and obligations of the employer is the topic of this chapter accounting for the pension fund is not When the term fund is used as a noun it refers to assets accumulated in the hands of a funding agency for the purpose of meeting pension benefits when they become due When the term fund is used as a verb it means to pay over to a funding agency as to fund future pension benefits or to fund pension cost An actuary s role is to ensure that the company has established an appropriate funding pattern to meet its pension obligations to make predictions and assumptions about future events and conditions that affect pension costs and to assist the accountant in measuring facets of the pension plan that must be reported costs liabilities and assets In order to determine the company s pension obligation the actuary must first determine the expected benefits that will be paid in the future To accomplish this requires the actuary to make actuarial assumptions which are estimates of the occurrence of future events affecting pension costs such as mortality withdrawals disable ment and retirement changes in compensation and changes in discount rates to reflect the time value of money In measuring the amount of pension benefits under a defined benefit pension plan an actuary must consider such factors as mortality rates employee turnover interest and earnings rates early retirement frequency and future salaries 205 Questions Chapter 20 Continued 7 One measure of the pension obligation is the vested benefit obligation This measure uses only current salary levels and includes only vested benefits that is benefits the employee is already entitled to receive even if the employee renders no additional services under the plan A company s accumulated benefit obligation is the actuarial present value of benefits attributed by the pension benefit formula to service before a specified date and is based on employee service and compensation prior to that date The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation levels The projected benefit obligation is based on vested and nonvested services using future salaries Cashbasis accounting recognizes pension cost as being equal to the amount of cash paid by the employer to the pension fund in any period pension funding serves as the basis for expense recognition under the cash basis Accrualbasis accounting recognizes pension cost as it is incurred and attempts to recognize pension cost in the same period in which the company receives benefits from the services of its employees Not infrequently the amount which an employer must fund for pension purposes during a particular period is unrelated to the economic benefits derived from the pension plan in that period Cash basis accounting recognizes the amount funded as periodic pension cost and the amount funded may be discretionary and vary widely from year to year Funding is a matter of financial management based on working capital availability tax considerations and other matters unrelated to accounting considerations The five components of pension expense are 1 Service cost component the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period 2 Interest cost component the increase in the projected benefit obligation as a result of the passage of time 3 Actual return on plan assets component the reduction in pension cost for actual invest ment income from plan assets and the change in the market value of plan assets 4 Amortization of prior service cost the cost of retroactive benefits granted in a plan amendment including initiation of a plan 5 Gains and losses a change in the value of either the projected benefit obligation or the plan assets resulting from experience different from that assumed or expected or from a change in an actuarial assumption Note to instructor Regarding return on plan assets the final component is expected rate of return We are assuming above that an adjustment is made to the actual return to determine expected return The service cost component of net periodic pension expense is determined as the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period The plan s benefit formula provides a measure of how much benefit is earned and therefore how much cost is incurred in each individual period The FASB concluded that future compensation levels had to be considered in measuring the present obligation and periodic pension expense if the plan benefit formula incorporated them The interest component is the interest for the period on the projected benefit obligation outstanding during the period The assumed discount rate should reflect the rates at which pension benefits could be effectively settled settlement rates Companies should look to rates of return on high quality fixedincome investments currently available whose cash flows match the timing and amount of the expected benefit payments 206 Questions Chapter 20 Continued 12 Service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period Actuaries compute service cost at the present value of the new benefits earned by employees during the year Prior service cost is the cost of retroactive benefits granted in a plan amendment or initiation of a pension plan The cost of the retroactive benefits is the increase in the projected benefit obligation at the date of the amendment When a defined benefit plan is either initiated or amended credit is often given to employees for years of service provided before the date of initiation or amendment The cost of these retroactive benefits are referred to as prior service costs Employers grant retroactive benefits because they expect to receive benefits in the future As a result prior service cost should not be recognized as pension expense entirely in the year of amendment or initiation It is recognized as an adjustment to other comprehensive income It should be recognized during the service periods of those employees who are expected to receive benefits under the plan Consequently prior service cost is amortized over the service life of employees who will receive benefits and is a component of net periodic pension expense each period Liability gains and losses are unexpected gains or losses from changes in the projected benefit obligation Liability gains resulting from unexpected decreases and liability losses resulting from r 39 39 are a 39 39 in other r 39 39 income The accumulated gains and losses are then amortized subject to complex amortization guidelines in other comprehensive Income lf pension expense recognized in a period exceeds the current amount funded a liability account referred to as Pension AssetLiability arises the account would be reported either as a current or longterm liability depending on the ultimate date of payment If the current amount funded exceeds the amount recognized as pension expense an asset account referred to as Pension AssetLiability arises the account would be reported as a noncurrent asset Because these assets are used to fund the pension obligation noncurrent classification is appropriate Computation of actual return on plan assets Fair value of plan assets at end of period 10150000 Deduct Fair value of plan assets at beginning of period 9 200 000 Increase in fair value of assets 950000 Deduct Contributions to plan during the period 1000000 Less benefits paid during the period 1 400 000 400 000 Actual return on plan assets i 1 350 000 An asset gain occurs when the actual return on the plan assets is greater than the expected return on plan assets while an asset loss occurs when the actual return is less than the expected return on the plan assets A liability gain results from unexpected decreases in the pension obligation and a liability loss results from unexpected increases in the pension obligation Corridor amortization occurs when the accumulated OCI GL balance gets too large The gain or loss is too large when it exceeds the arbitrarily selected FASB criterion of 10 of the larger of the beginning balances of the projected benefit obligation or the marketrelated value of the plan assets The excess gain or loss balance may be amortized using any systematic method but the amortization cannot be less than the amount computed using the straightline method over the average remaining servicelife of active employees expected to receive benefits Questions Chapter 20 Continued 19 20 21 22 23 24 The amount of the pension assetliability to be reported on the company s balance sheet is as follows Projected benefit obligation 400000 Pension plant assets 300 000 Pension assetliability 1100 000 In the financial statements the company will report a pension liability of 100000 This amount is also referred to as the funded status of the plan The prior service cost arising in the year of the amendment which increases the projected benefit obligation is recognized by an offsetting debit to Other Comprehensive Income PSC In subsequent periods the 9150000 will be amortized into periodic pension expense over the remaining service lives of the employees This approach is consistent with the treatment for actuarial gains and losses Actuarial gains or losses arise from 1 asset gains or losses when the expected return is different than the actual return on plan assets and 2 a liability gain or loss when actuarial assumptions do not coincide with actual expenses related to computation of the projected benefit obligation In the period that they arise these gains and losses are not recognized as part of pension expense but are recognized as increases or decreases in other comprehensive income In subsequent periods these amounts are amortized into periodic pension expense over the remaining service lives of the employees using corridor amortization a Other Comprehensive Income for 2009 is as follows Actuarial liability gain 10000 Asset loss 13 000 Other comprehensive loss 3 000 b The computation of comprehensive income for 2009 is as follows Net income 25000 Other comprehensive loss 3 000 Comprehensive income 22 000 Multiple plans may be combined and shown as one amount on the balance sheet only if they are in the same under or overfunded position For example if the company has two or more under funded overfunded plans the underfunded overfunded plans are combined and shown as one amount as a liability asset on the balance sheet The FASB rejected the alternative of combining all plans and representing the net amount as a single net asset or net liability The rationale A company does not have the ability to offset the excess of one plan against underfunded obligations of another plan Furthermore netting all plans is inappropriate because offsetting assets and liabilities is not permitted under GAAP unless a right of offset exists a A contributory plan is a pension plan under which employees contribute part of the cost In some contributory plans employees wishing to be covered must contribute in other contributory plans employee contributions result in increased benefits Vested benefits are benefits for which the employee s right to receive a present or future pension benefit is no longer contingent on remaining in the service of the employer Retroactive benefits are benefits granted in a plan amendment or initiation that are attributed by the pension benefit formula to employee services rendered in periods prior to the amendment The yearsofservice method is used to allocate prior service cost to the remaining years of service of the affected employees Each year receives a fraction of the original cost with the fraction depicting the number of serviceyears received out of the total serviceyears to be worked by the affected employees 208 b C d Questions Chapter 20 Continued 25 The accounting issue that arises from these terminations is whether a gain should be recognized by the corporation when these assets revert often called asset reversion transactions to the company The profession requires that these gains or losses be reported immediately in most situations 26 Postretirement benefits other than pensions include healthcare and other welfare benefits provided to retirees their spouses dependents and beneficiaries The other welfare benefits include life insurance offered outside a pension plan dental care as well as medical care eye care legal and tax services tuition assistance day care and housing activities 27 The FASB did not cover both pensions and healthcare benefits in the earlier pension accounting statement No 87 because of the significant differences between the two types of postretirement benefits These differences are listed in the following schedule Differences between Postretirement HealthCare Benefits and Pensions ltem Pensions HealthCare Benefits Funding Generally funded Generally NOT funded Benefit Welldefined and level dollar amount Generally uncapped and great variability Beneficiary Retiree maybe some benefit to Retiree spouse and other surviving spouse dependents Benefit Payable Monthly As needed and used Predictability Variables are reasonably predictable Utilization difficult to predict Level of cost varies geographically and fluctuates over time 28 The major differences between pension benefits and postretirement benefits are listed below Differences between Postretirement HealthCare Benefits and Pensions ltem Pensions HealthCare Benefits Funding Generally funded Generally NOT funded Benefit Welldefined and level dollar amount Generally uncapped and great variability Beneficiary Retiree maybe some benefit to Retiree spouse and other surviving spouse dependents Benefit Payable Monthly As needed and used Predictability Variables are reasonably predictable Utilization difficult to predict Level of cost varies geographically and fluctuates over time Additionally although health care benefits are generally covered by the fiduciary and reporting standards for employee benefit funds under ERISA the stringent minimum vesting participation and funding standards that apply to pensions do not apply to healthcare benefits 29 EPBO expected postretirement benefit obligation is the actuary s present value of all benefits expected to be paid after retirement while APBO accumulated postretirement benefit obligation is the actuarial present value of future benefits attributed to employees services rendered to a particular date The components of postretirement expense are service cost interest cost expected return on plan assets amortization of prior service cost and gains and losses SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 201 Service cost 358000000 Interest on PBO 567000000 Return on plan assets 569000000 Amortization of prior service cost 14000000 Amortization of net loss 58000000 Pension expense g 428000000 BRIEF EXERCISE 202 Ending plan assets 2000000 Beginning plan assets 1680000 Increase in plan assets 320000 Deduct Contributions 120000 Less Benefits paid 200000 80000 Actual return on plan assets g 400000 BRIEF EXERCISE 203 UDDIN COMPANY General Journal Entries Memo Record Projected Pension Pension Benefit Plan Items Expense Cash AssetLiability Obligation Assets 1l1l11 250000 Cr 250000 Dr Service cost 27500 Dr 27500 Cr Interest cost 25000 Dr 25000 Cr Actual return 25000 Cr 25000 Dr Contributions 20000 Cr 20000 Dr Benefits 17500 Dr 17500 Cr Journal entry 27500 Dr 20000 Cr 7500 Cr 123111 7500 Cr 285000 Cr 277500 Dr Note We show actual return on the worksheet to ensure that plan assets are properly reported If expected and actual return differ then an additional adjustment is made to compute the proper amount of pension expense 2010 BRIEF EXERCISE 204 43000000 22000000 Pension Expense Pension AssetLiability Cash BRIEF EXERCISE 205 Cost per service year 120000l2000 60 2011 amortization 350 X 60 21000 BRIEF EXERCISE 206 Project benefit obligation Plan assets at fair value Pension assetlliability BRIEF EXERCISE 207 Net loss in accumulated OCI Corridor 10 X 3300000 Excess Average remaining service life Minimum amortization BRIEF EXERCISE 208 Projected benefit obligation Fair value of plan assets Pension liability classified shortterm or longterm depending on when due 65000000 510000 322000 311 88000 475000 330000 145000 75 8 19333 2800000 2000000 i 800000 Prior service cost is reported as a component of accumulated other compre hensive income in the stockholders equity 2011 BRIEF EXERCISE 209 a Other Comprehensive Loss for 2009 is as follows Actuarial liability loss 25000 Asset gain 18000 Other comprehensive loss g 7000 b The computation of comprehensive income for 2009 is as follows Net income 26000 Other comprehensive loss 7000 Comprehensive income 19000 BRIEF EXERCISE 2010 Pension Assets Projected Benefits Pension Assetl At fair value Obligation Liability Plan X 600000 500000 100000 asset Plan Y 900000 720000 180000 asset Plan Z 550000 700000 150000 liability Depp reports a pension asset of 280000 100000 180000 and a pension liability of 150000 BRIEF EXERCISE 2011 Service cost 40000 lnterest cost 52400 Expected return on plan assets 26900 Postretirement expense 65500 BRIEF EXERCISE 2012 Postretirement Expense 240900 Cash 160000 Postretirement AssetLiability 80900 2012 SOLUTIONS TO EXERCISES EXERCISE 201 5 1 0 minutes a Computation of pension expense Service cost 60000 Interest cost 500000 X 10 50000 Expected return on plan assets 12000 Prior service cost amortization 8000 Pension expense for 2010 106000 b Pension Expense 106000 Cash 95000 Pension AssetLiability 11000 EXERCISE 202 10 15 minutes Computation of pension expense Service cost 90000 Interest cost 800000 X 10 80000 Expected return on plan assets 64000 Prior service cost amortization 10000 Pension expense for 2011 g1 16000 2013 20 14 Items Balance January 1 2011 Service cost Interest cost Actual return Amortization of PSC Contributions Benefits Journal entry for 2011 Accumulated OCI Dec 31 2010 Balance Dec 31 2011 80000 800000 X 10 Rebekah Company Pension Worksheet 2011 General Journal Entries Annual Pension Expense 90000 Dr 80000 Dr 64000 Cr 10000 Dr 116000 Dr OCI Prior Service Cash Cost 10000 Cr 105000 Cr 105000 Cr 10000 Cr 150000 Dr 140000 Dr Pension AssetlLiabIlity 160000 Cr 1000 Cr 161000 Cr Memo Record Projected Benefit 0in ation 800000 Cr 90000 Cr 80000 Cr 40000 Dr 930000 Cr Plan Assets 640000 Dr 64000 Dr 105000 Dr 40000 Cr 769000 Dr Note We show actual return on the worksheet to ensure that plan assets are properly reported lf expected and actual return differ then an add ional adjustment is made to compute the proper amount of pension expense Pension Expense Other Comprehensive lncome PSC Cash Pension AssetLiability 116000 10000 105000 1000 EXERCISE 203 15 25 minutes 2015 Trudy Borke Inc Pension Worksheet 2011 General Journal Entries Memo Record Annual Pension Projected Pension Asset Benefit Plan ltems Expense Cash Liability Obligation Assets Balance January 1 2011 490000 Cr 490000 Dr Service cost 40000 Dr 40000 Cr lnterest cost 41650 Dr 41650 Cr Actual return 49700 Cr 49700 Dr Contributions 30000 Cr 30000 Dr Benefits 33400 Dr 33400 Cr Journal entry December 31 31 950 Dr 30000 Cr 1950 Cr Balance December 31 2011 1950 Cr 538250 Cr 536300 Dr 41650 490000 X 085 Note We show actual return on the worksheet to ensure that plan assets are properly reported lf expected and actual return differ then an additional adjustment is made to compute the proper amount of pension expense EXERCISE 204 10 15 minutes EXERCISE 205 15 25 minutes Computation of ServiceYears 2011 2012 2013 2014 2015 2016 Cost per serviceyear 60000 25 2400 Computation of Annual Prior Service Cost Amortization Total Cost Per Annual Year ServiceYears ServiceYear Amortization 2011 5 2400 12000 2012 5 2400 12000 2013 5 2400 12000 2014 4 2400 9600 2015 3 2400 7200 2016 3 2400 7200 60000 EXERCISE 206 10 15 minutes Computation of Actual Return on Plan Assets Fair value of plan assets at 12l31l11 2725000 Fair value of plan assets at 1l1l11 2300000 Increase in fair value of plan assets 425000 Deduct Contributions to plan during 2011 250000 Less benefits paid during 2011 350000 100000 Actual return on plan assets for 2011 g 525000 2016 2017 Doreen Corp Pension Worksheet 2011 General Journal Entries Annual OCl Prior Pension Service Items Expense Cash Cost Balance Dec 31 2010 0 Prior service cost 100000 Dr Balance Jan 1 2011 Service cost lnterest cost Actual return Amortization of PSC Contributions Benefits Journal entry for 2011 82120 Dr 55000 Cr 83000 Dr Accumulated OCI Dec 31 2010 0 Balance Dec 31 2011 83000 Dr 58000 Dr 59400 Dr 52280 Cr 17000 Dr 17000 Cr 55000 Cr 59400 660000 X 09 Pension 13800 Cr 110120 Cr 123920 Cr Memo Record Projected Benefit 40000 Dr 737400 Cr 0in ation 560000 Cr 100 000 Cr 660000 Cr 58000 Cr 59400 Cr Plan Assets 546200 Dr 546200 Dr 52280 Dr 55000 Dr 40000 Cr 613480 Dr Note We show actual return on the worksheet to ensure that plan assets are properly reported lf expected and actual return differ then an additional adjustment is made to compute the proper amount of pension expense EXERCISE 207 15 25 minutes EXERCISE 208 20 25 minutes Corridor and Minimum Loss Amortization Projected Minimum Benefit Plan Asset 10 Accumulated Amortization Year Obligation a Value a Corridor OCI GL a of Loss 2009 2000000 1 900000 200000 0 0 2010 2400000 2500000 250000 280000 3000 b 2011 2900000 2600000 290000 367000 c 6417 d 2012 3600000 3000000 360000 370583 e 882 f a As of the beginning of the year b 280000 250000 10 years 3000 c 280000 3000 90000 367000 d 367000 290000 12 years 6417 e 367000 6417 10000 370583 f 370583 360000 12 years 882 EXERCISE 209 25 35 minutes a Note to financial statements disclosing components of 2011 pension expense Note X Net pension expense for 2011 is composed of the following components of pension cost Service cost Interest cost Expected return on plan assets Prior service cost amortization Pension expense b Comprehensive income 2011 Amortization of prior service cost Actuarial loss Other comprehensive loss Comprehensive income 2011 Net income Other comprehensive loss Comprehensive income 2018 94000 253000 175680 45000 216320 45000 45680 3 680 35000 680 3 34320 EXERCISE 209 25 35 minutes Continued c Accumulated OCI at December 31 2011 is 250680 this amount is comprised of the following PSC GainLoss Balance Jan 12011 250000 Dr 0 Amortization of PSC 45000 Cr Actuarial loss 45680 Dr Balance Dec 31 2011 205000 Dr 45680 Dr 2019 2020 a Items Balance Jan 1 2011 Service cost Interest cost Actual return Unexpected gain Amortization of PSC Liability increase Contributions Benefits Journal entry for 2011 Accumulated OCI Dec 31 2011 Balance December 31 2011 56250 625000 X 09 Expected return 52000 Annual Pension Expense 90000 Dr 56250 Dr 57000 Cr 5000 Dr 19000 Dr 113250 Dr Buhl Corp Pension Worksheet General Journal Entries Cash 99000 Cr 99000 Cr OCI Prior Service OCI Cost GainLoss 5000 Cr 19000 Cr 76000 Dr 19000 Cr 71000 Dr 100000 Dr 0 81000 Dr 71000 Dr Unexpected gain Actual return minus expected return 5000 57000 52000 b Journal Entry Pension vaense Other I 39 r Paeh Other Comprehensive Income PSC Pension Assetl iah Income Gll 113250 71000 99000 19000 66250 Pension Asset Liability 145000 Cr 66250 Cr 211 250 Cr Memo Record Projected Benefit Oblination 625000 Cr 90000 Cr 56250 Cr 76000 Cr 85000 Dr 762250 Cr Plan assets 480000 Dr 57000 Dr 99000 Dr 85000 Cr 551 000 Dr EXERCISE 2010 20 25 minutes EXERCISE 2011 20 30 minutes a Pension expense for 2010 composed of the following b Ba Ba V Service cost Interest on projected benefit obligation 9 X 1000000 Expected return on plan assets Amortization of prior service cost Pension expense Pension Expense Pension AssetLiability Cash Other Comprehensive Income PSC Income Statement Pension expense Balance Sheet Liabilities Pension liability Plan Assets January 1 2010 600000 Service cost Interest on PBO Actual return 54000 Contribution 145000 December 312010 799000 Projected benefit obligation 1 146000 Plan assets 799000 Pension liability g 347000 Stockholders equity Accumulated OCI PSC Jan 1 2010 400000 Amortization of prior service cost 40000 Accumulated OCI PSC Dec 31 2010 360000 2021 56000 90000 54000 40000 3132000 132000 53000 145000 40000 1 32000 347000 Projected Benefit Obligation 1000000 56000 90000 1146000 EXERCISE 2012 20 30 minutes a Pension expense for 2010 composed of the following Service cost 77000 Interest on projected benefit obligation 200000 10 X 2000000 Expected return on plan assets 80000 10 X 800000 Amortization of prior service cost 115000 Pension expense 312000 b Pension Expense 312000 Pension AssetLiability 253000 Cash 250000 Other Comprehensive Income PSC 115000 Other Comprehensive Income GIL 200000 To record pension expense and employer s contribution c Income Statement Pension expense g 312000 Balance Sheet Liabilities Pension liability g 947000 Stockholders Equity Accumulated OCI PSC 1085000 Accumulated OCI GIL 200000 Projected benefit obligation Dec 31 2010 2077000 Plan assets Dec 312010 1130000 Pension liability g 947000 1200000 115000 2022 2023 Note to instructor To prove the amounts reported a worksheet might be prepared as follows General Journal Entries Memo Record Annual Projected Pension OCl Prior OCI Pension Benefit ltems Ex ense Cash Service Cost GainLoss AssetLia 0in ation Plan assets Balance Jan 1 2010 1200000 Cr 2000000 Cr 800000 Dr Service cost 77000 Cr lnterest cost 200000 Cr Actual return Amortization of PSC Liability gain Contributions Journal entry for 2010 Accumulated OCI Dec 31 2009 Balance Dec 31 2010 77000 Dr 200000 Dr 80000 Cr 115000 Dr 80000 Dr 115000 Cr 200000 Cr 200000 Dr 250000 Cr 312000 Dr 250000 Cr 115000 Cr 200000 Cr 1200000 Dr 0 1085000 Dr 200000 Cr 947000 Cr 2077000 Cr 1130000 Dr 250000 Dr 253000 Dr This number is a plug as the problem states there is no unrecognized gain or loss Note We show actual return on the worksheet to ensure that plan assets are properly reported lf expected and actual return differ then an additional adjustment is made to compute the proper amount of pension expense EXERCISE 2012 Continued EXERCISE 2013 35 45 minutes a Actual Return Ending Beginning Contributions Benefits Fair value of plan assets December 31 2011 2620 Deduct Fair value of plan assets January 1 2011 1700 Increase in fair value of plan assets 920 Deduct Contributions 800 Less benefits paid E 600 Actual return on plan assets in 2011 320 b Computation of pension liability gains and losses and pension asset gains and losses 1 Difference between 123111 actuarially computed PBO and 12l31l11 recorded projected benefit obligation PBO PBO at end of year 3645 PBO per memo records 1l1l11 PBO 2800 Add interest 10 280 Add service cost 400 Less benefits paid 200 3280 Liability loss 365 2 Difference between actual fair value of plan assets and expected fair value 12l31l11 actual fair value of plan assets 2620 Expected fair value 1l1l11 fair value of plan assets 1700 Add expected return 1700 X 10 170 Add contributions 800 Less benefits paid 200 2470 Asset gain Net gain or loss E c Because no net gain or loss existed at the beginning of the period no amortization occurs Therefore the corridor calculation is not needed An example of how the corridor would have been computed is illustrated on the next page assuming a net loss of 240 at the beginning of the year 2024 EXERCISE 2013 Continued BeginningoftheYear Plan 10 Accumulated Loss Year PBO Assets FV Corridor OCI GIL Amortization 2011 2800 1700 280 240 0 d Pension expense for 2011 Service cost 400 Interest cost 2800 X 10 280 Actual return on plan assets from a 320 Unexpected gain from b 2 150 Pension expense for 2011 510 2025 20 26 Linda Berstler Company Pension Worksheet 2011 Items Balance Jan 1 2011 Service cost Interest cost Actual return b Unexpected gain Contributions Benefits Lia ty increase Journal entry for 2011 Accumulated OCI Dec 31 2011 Balance Dec 31 2011 a 2800 x 10 General Journal Entries Memo Record Entries Annual Pension Expense b 320 2620 1700 800 200 c Actual return Expected return 1700 X 10 Asset gain d 365 3645 2800 400 280 200 Cash 800 O 0 00 Cr OCI GainLoss 150 Cr 1100 Cr 75 Dr 1025 Cr Obligation 2800 Cr 200 Dr 365 Cr 3645 Cr Plan Assets 1700 Dr 320 Dr 800 Dr 200 Cr 2620 Dr EXERCISE 2014 40 50 minutes EXERCISE 2014 Continued Journal entries 123111 1 Other Comprehensive Income GIL 215 Pension Expense 510 Pension AssetLiability 75 Cash 800 Balance Sheet at December 31 2011 Liabilities Pension liability g1025 Stockholders equity Accumulated other comprehensive loss GIL 215 EXERCISE 2015 15 20 minutes a Computation of pension expense Service cost 90000 Interest cost 700000 X 10 70000 Expected return on plan assets 15000 Pension expense for 2010 145000 Pension Expense 145000 Pension AssetLiability 5000 Cash 150000 b Income Statement Pension expense 145000 Balance Sheet Liabilities Pension liability g 20000 25000 5000 2027 EXERCISE 2016 25 35 minutes The excess of the cumulative net gain or loss over the corridor amount is amortized by dividing the excess by the average remaining service period of employees The average remaining service period is computed as follows Expected future years of service Number of employees Average remaining service life per employee 5600 400 39 Amortization of Net Gain or Loss Gain or Loss For the Year Average remaining service life per employee 14 Ended December 31 Amount 201 0 300000 201 1 480000 2012 210000 2013 290000 Projected Minimum Benefit Plan Accumulated Amortization Year 0in ation a Assets 3 Corridor b OCI GIL a of Gain Loss 2010 4000000 2400000 400000 0 0 2011 4520000 2200000 452000 300000 0 2012 4980000 2600000 498000 780000 20143 c 2013 4250000 3040000 425000 549857 d 8918 e a As of the beginning of the year b The corridor is 10 percent of the greater of projected benefit obligation or plan assets c 780000 498000 282000 28200014 20143 d 780000 20143 210000 549857 e 549857 425000 124857 12485714 8918 2028 EXERCISE 2017 30 40 minutes a Prior Service Cost Year Amortized 2010 110000 1155000 105 years 2011 110000 1155000 105 years b The excess of the accumulated OCI GIL over the corridor amount is amortized by dividing the excess by the average remaining service life per employee The average service life is 105 years Amortization of Net Gain or Loss Gain or Loss For the Year Ended December 31 Amount 2010 1 01 000 201 1 24000 Projected 10 Minimum Benefit Plan Corridor Accumulated Amortization Year Obligation a Assets 3 b OCI GIL a of Gain Loss 2010 2800000 1700000 280000 0 0 2011 3650000 2900000 365000 101000 0 c a As of the beginning of the year b The corridor is 10 percent of the greater of the projected benefit obligation or plan assets c 365000 is greater than 101000 therefore no amortization c Pension expense for 2010 composed of the following Service cost 400000 Interest on projected benefit obligation 308000 2800000 X 11 Expected return on plan assets 170000 1700000 X 10 Amortization of net gain or loss 0 Amortization of prior service cost 110000 Pension expense g 648000 2029 EXERCISE 2017 30 40 minutes Continued Pension expense for 2011 composed of the following Service cost Interest on projected benefit obligation 3650000 X 8 Expected return on plan assets 2900000 X 10 Amortization of prior service cost Pension expense EXERCISE 2018 10 12 minutes Service cost Interest on accumulated postretirement benefit obligation 10 X 810000 Expected return on plan assets Amortization of prior service cost Postretirement expense EXERCISE 2019 10 12 minutes Service cost Interest on accumulated postretirement benefit obligation 9 X 810000 Expected return on plan assets Amortization of prior service cost Postretirement expense EXERCISE 2020 15 20 minutes See worksheet on next page 2030 475000 292000 290000 110000 587000 8 88000 81000 34000 21000 156000 8 90000 72900 62000 3000 103900 Marvelous Marvin Co Postretirement Benefits Worksheet 2011 2031 General Journal Entries Memo Record Annual postretirement OCl Prior Postretirement plan ltems Expense Cash serVice COSt AssetLiability APBO Assets Balance Jan 1 2011 100000 Cr 810000 Cr 710000 Dr Service cost 90000 Dr 90000 Cr lnterest cost 72900 Dr 72900 Cr Actual return 62000 Cr 62000 Dr Contributions 16000 Cr 16000 Dr Benefits 40000 Dr 40000 Cr Amortization Of PSC 3000 Dr 3 000 Cr Journal entry for 2011 103900 Dr 16000 Cr 3000 Cr 84900 Cr Accumulated OCI Dec 31 2010 100 000 Dr Balance Dec 31 2011 97000 Dr 184900 Cr 932900 Cr 748000 Dr 810000 x 9 EXERCISE 2020 15 20 minutes TIME AND PURPOSE OF PROBLEMS Problem 201 Time 40 50 minutes Purpose to provide a problem that requires preparation of a pension worksheet for two separate years pension transactions Included in the problem are an unexpected loss and prior service cost amortization Problem 202 Time 45 55 minutes Purpose to provide a problem that requires preparation of a pension worksheet for three separate years pension transactions three years of general journal entries for the pension plan and reporting in financial statements for the third year Problem 203 Time 40 50 minutes Purpose to provide a problem that requires computation of the annual pension expense preparation of the pension journal entries measurement of gains and losses and their amortization and presentation in financial statements Problem 204 Time 30 40 minutes Purpose to provide a problem that requires computation of pension expense and preparation of the pension journal entries Problem 205 Time 45 55 minutes Purpose to provide a problem that requires computation of the pension expense for three separate years and the preparation of the pension journal entries for three years Problem 206 Time 45 60 minutes Purpose to provide a problem that requires computation and amortization of prior service cost computation of pension expense and preparation of pension journal entries Problem 207 Time 35 45 minutes Purpose to provide a problem that requires preparation of a worksheet Problem 208 Time 45 60 minutes Purpose to provide a problem that requires preparation of a comprehensive worksheet for two years covering all facets of pension accounting Problem 209 Time 40 45 minutes Purpose to provide a problem that requires preparation of a worksheet for two years journal entries and indicating financial statement presentation Problem 2010 Time 30 35 minutes Purpose to provide a problem that requires preparation of a worksheet and entries for postretirement benefit expense 2032 2033 a Diana Peter Company Pension Worksheet 2011 and 2012 General Journal Entries Memo Record Annual OCl Prior Projected Pension Service OCl Gain Pension Benefit Plan ltems Expense Cash Cost Loss Assetl iahility Oblination Assets Balance Jan 1 2011 4200000 Cr 4200000 Dr Service cost 150000 Dr 150000 Cr lnterest cost 420000 Dr 420000 Cr Actual return 252000 Cr 252000 Dr Contributions 140000 Cr 140000 Dr Benefits 200000 Dr 200000 Cr Journal entry for 2011 318000 Dr 140000 Cr 0 0 178000 Cr Accumulated OCI Dec 31 2010 Balance Dec 31 2011 178000 Cr 4570000 Cr 4392000 Dr Additional PSC 112012 500000 Dr 500000 Cr Balance Jan 1 2012 5070000 Cr Service cost 180000 Dr 180000 Cr lnterest cost 507000 Dr 507000 Cr Actual return 260000 Cr 260000 Dr Unexpected loss 91360 Cr 91360 Dr Amortization of PSC 90000 Dr 90000 Cr Contributions 185000 Cr 185000 Dr Benefits 280000 Dr 280000 Cr Journal entry for 2012 425640 Dr 185000 Cr 410000 Dr 91360 Dr 742000 Cr Accumulated OCI Dec 31 2011 0 0 Balance Dec 31 2012 410000 Dr 91360 Dr 920000 Cr 5477000 Cr 4557000 Dr 420000 4200000 x 10 507000 5070000 x 10 91360 4392000 x 08 260000 Pension Expense 425640 Other Comprehens ve lncome PSC 410000 Other f r 39 39 lncome Gll 91360 Pash 185000 Pension AssetLiability 742000 SOLUTIONS TO PROBLEMS PROBLEM 201 20 34 a Annual Pension Ex ense Balance Jan 1 2011 Service cost Interest cost Actual return Unexpected loss b Contributions Benefits Journal entry for 2011 Accumulated OCI Dec 31 2010 Balance Dec 31 2011 Additional PSC 112012 Balance Jan 1 2012 Service cost lnterest cost Actual return d Amortization of PSC Contributions Benefits Journal entry for 2012 Accumulated OCI Dec 31 2011 Balance Dec 31 2012 Service cost lnterest cost e Actual return Unexpected lossquot Amortization of PSC Contributions Benefits liability loss Journal entry for 2013 Accumulated OCI Dec 31 2012 Balance Dec 31 2013 16000 Dr 20000 Dr 17000 Cr 3000 Cr 16000 Dr 19000 Dr 38200 Dr 21 900 Cr 54400 Dr 89700 Dr 26000 Dr 42280 Dr 24000 Cr 2450 Cr 41600 Dr 83430 Dr Katie Day Company Pension Worksheet 201 1 2012 2013 General Journal Entries OCl Prior Service Cash Cost 16000 Cr 16000 Cr 160000 Dr 54400 Cr 40000 Cr 40000 Cr 105600 Dr 0 105600 Dr 41600 Cr 48000 Cr 48000 Cr 41600 Cr 105600 Dr 64000 Dr OCI GainLoss 3000 Dr 3000 Dr 0 3000 Dr 0 3000 Dr 3000 Dr 2450 Dr 49920 Dr 52370 Dr 3000 Dr 55370 Dr Pension AssetLiabilit 3000 Cr 3000 Cr 155300 Cr 158300 Cr 46200 Cr 204500 Cr Memo Record Projected Benefit Obli ation 200000 Cr 16000 Cr 20000 Cr 14000 Dr 222000 Cr 160000 Cr 382000 Cr 19000 Cr 38200 Cr 16400 Dr 422800 Cr 26000 Cr 42280 Cr 21000 Dr 49920 Cr 520000 Cr Plan Assets 200000 Dr 17000 Dr 16000 Dr 14000 Cr 219000 Dr 21900 Dr 40000 Dr 16400 Cr 264500 Dr 24000 Dr 48000 Dr 21 000 Cr 315500 Dr PROBLEM 202 PROBLEM 202 Continued Worksheet computations a b C d e 0 20000 200000 X 10 3000 200000 X 10 17000 expected return exceeds actual return 38200 382000 X 10 Expected return and actual return are the same 42280 422800 X 10 2450 264500 X 10 24000 expected return exceeds actual return Note to instructor Because the amount of net gain or loss does not exceed 10 of the larger of the projected benefit obligation or the fair value of the plan assets at the beginning of any of the years no amortization is recorded b Journal entries c V 2011 Other Comprehensive lncome GIL 3000 Pension Expense 16000 Cash Pension AssetLiability 2012 Other Comprehensive income PSC 105600 Pension Expense 89700 Cash Pension AssetLiability 2013 Pension Expense 83430 Other Comprehensive lncome GIL 52370 Other Comprehensive lncome PSC Cash Pension AssetLiability Financial Statements 2013 Income Statement Pension expense Balance Sheet Liabilities Pension liability Stockholders equity Accumulated other comprehensive loss PSC Accumulated other comprehensive loss GIL 2035 16000 3000 40000 155300 41600 48000 46200 i 83430 204500 64000 55370 PROBLEM 203 a Pension expense for 2010 comprises the following b 0 Service cost Interest on projected benefit obligation 10 X 350000 Actual return on plan assets Unexpected loss Amortization of gain or loss in 2010 Amortization of prior service cost 150000 105 years Pension expense 10 X 200000 11000 Amortization 150000 105 years 14286 Journal Entries 2010 Other Comprehensive lncome GIL Pension Expense Cash Pension AssetLiability Other Comprehensive lncome PSC 2010 IncreaseDecrease in GainsLosses 1 123110 new actuarially computed PBO Less Projected benefit obligation per memo record 1l1l10 PBO 350000 Add interest 10 X 350000 35000 Add service cost given 52000 Less benefit payments 0 Liability loss 2036 24000 81286 452000 437000 52000 35000 11000 9000 0 14286 81286 65000 26000 14286 15000 PROBLEM 203 Continued 2 12I31I10 fair value of plan assets 276000 Less Expected fair value 1I1I10 fair value of plan assets 200000 Add expected return 20000 10 X 200000 Add pension plan contribution 65000 Less benefit payments 0 285000 Asset loss 9000 Net loss at 123110 24000 The 24000 net loss in the accumulated OCI GIL account becomes the beginning balance in 2011 The corridor at 1I1I11 is 10 of the greater of 452000 PBO or 276000 marketrelated asset value Since the corridor of 45200 is greater than the balance in the accumulated OCI GIL account of 24000 there will be no gainIloss amortization in 2011 It follows that no amortization occurs in 2010 because no balance existed in the accumulated OCI GIL account at the beginning of 2010 d Financial Statements 2010 Income Statement Pension expense g 81286 Balance Sheet Liabilities Pension asset Iliability 176000 Stockholders equity Accumulated other comprehensive loss PSC 135714 Accumulated other comprehensive loss 24000 350000 200000 2000 150000 14286 2037 PROBLEM 204 a Computation of pension expense 2010 2011 Service cost 60000 90000 Interest cost 600000 X 09 and 700000 X 09 54000 63000 Expected return on plan assets 24000 30000 Amortization of prior service cost 10000 12000 Pension expense 100000 135000 b 2010 Pension AssetLiability 34000 Pension Expense 100000 Other Comprehensive Income PSC 10000 Other Comprehensive Income GIL 14000 Cash 110000 2011 Pension Expense 135000 Cash 120000 Pension AssetLiability 3000 Other Comprehensive Income PSC 12000 Note to instructors Although not required students could be encouraged to prepare a 2year pension worksheet as shown on the following page 2038 20 39 General Journal Entries Memo Record Annual OCl Prior Projected Pension Service OCI Pension Benefit Plan Expense Cash Cost GainLoss Assetl iahility Oblination Assets Balance Jan 1 2010 40000 Cr 600000 Cr 560000 Dr Service cost 60000 Dr 60000 Cr lnterest cost 54000 Dr 54000 Cr Actual return 24000 Cr 24000 Dr Unexpected loss Amortization of PSC 10000 Dr 10000 Cr Contributions 110000 Cr 110000 Dr Increase in PBO 14000 Cr 14000 Dr Journal entry for 2010 100000 Dr 110000 Cr 10000 Cr 14000 Cr 34000 Dr Accumulated OCI Jan 1 2010 250000 Dr 0 Balance Dec 31 2010 240000 Dr 14000 Cr 6000 Cr 700000 Cr 694000 Dr Service cost 90000 Dr 90000 Cr lnterest cost 63000 Dr 63000 Cr Actual return 30000 Cr 30000 Dr Unexpected gain Amortization of PSC 12000 Dr 12000 Cr Amortization of loss Contributions 120000 Cr 120000 Dr Journal entry for 2011 135000 Dr 120000 Cr 12000 Cr 0 3000 Cr Accumulated OCI Dec 31 2010 240000 Dr 14000 Cr Balance Dec 31 2011 228000 Dr 14000 Cr 9000 Cr 853000 Cr 844000 Dr PROBLEM 204 Continued PROBLEM 205 a Pension expense for 2010 consisted only of the service cost component amounting to 55000 There were no prior service cost net gain or loss pension assets or projected benefit obligation as of January 1 2010 Pension expense for 2011 comprised the following Service cost 85000 Interest on projected benefit obligation 6050 55000 X 11 Expected return on plan assets 5000 50000 X 10 Amortization of net gain or loss 0 Amortization of prior service cost 0 Pension expense 86050 Pension expense for 2012 comprised the following Service cost 119000 Interest on projected benefit obligation 16000 200000 X 8 Expected return on plan assets 8500 85000 X 10 Amortization of net gain or loss 1 5329 Amortization of prior service cost 0 Pension expense 131829 2040 PROBLEM 205 Continued 1 Projected Minimum Benefit Plan Assets Corridor Accumulated Amortization Year Obligation a a b OCI GIL a of Gain Loss 2010 0 0 0 0 0 2011 55000 50000 5500 0 0 2012 200000 85000 20000 83950 5329 c a As of the beginning of the year b The corridor is 10 percent of the greater of the projected benefit obligation or plan assets c 83950 20000 63950 6395012 5329 b W Pension Expense Cash Pension AssetLiability Journal Entries 2011 Pension Expense Other Comprehensive Income GIL Cash Pension AssetLiability Journal Entries 2012 Pension Expense Other Comprehensive Income GIL Cash Pension AssetLiability 55000 86050 83950 131829 2171 50000 5000 60000 110000 95000 39000 Note The debit to Other Comprehensive Income GIL is a plug figure It equals the corridor amortization credit 5329 netted against an additional loss in 2012 of 7500 Note to instructors Although not required students could be encouraged to prepare a 3year worksheet as presented on the following page 2041 20 42 Balance Jan 1 2010 Service cost Interest cost Expected return Contributions Journal entry for 2010 Accumulated OCI Dec 31 2009 Balance Dec 31 2010 Service cost Interest cost Actual return Contributions Increase in liability Benefits Journal entry for 2011 Accumulated OCI Dec 31 2010 Balance Dec 31 2011 Service cost Interest cost Expected return Amortization of loss Contributions Benefits Liability loss Journal entry for 2012 Accumulated OCI Dec 31 2011 Balance Dec 31 2012 General Journal Entries Memo Record Annual Pension Expense 55000 Dr 55000 Dr 85000 Dr 6050 Dr 5000 Cr 86050 Dr 119000 Dr 16000 Dr 8500 Cr 5329 Dr 131829 Dr Cash 50000 Cr 50000 Cr 60000 Cr 60000 Cr 95000 Cr 95000 Cr OCI Pension GainLoss Assetl iahility 83950 Dr 83950 Dr 0 83950 Dr 5329 Cr 7500 Dr 2171 Dr 83950 Dr 86121 Dr 5000 Cr 5000 Cr 110000 Cr 115000 Cr 39000 Cr 154000 Cr Projected Benefit Oblination 55000 Cr 55000 Cr 85000 Cr 6050 Cr 83950 Cr 30000 Dr 200000 Cr 119000 Cr 16000 Cr 18500 Dr 7500 Cr 324000 Cr Plan Assets 50000 Dr 50000 Dr 5000 Dr 60000 Dr 30000 Cr 85000 Dr 8500 Dr 95000 Dr 18500 Cr 170000 Dr PROBLEM 205 Continued PROBLEM 206 a Prior Service Cost Amortization 2010 13 2011 1 13 2012 1 13 b Pension expense for 2010 comprised the following V Service cost 200000 Interest on projected benefit obligation 500000 Actual return on plan assets 325000 Unexpected gain 25000 Amortization of prior service cost 153846 Pension expense 553846 5000000 X 10 500000 3900000 3000000 575000 0 Expected return of 300000 actual return of 325000 25000 unexpected gain Pension liability beginning of year 2000000 Pension liability end of year 850000 Decrease in liability 1150000 4750000 3900000 Journal Entries 2010 Pension Expense 553846 Pension AssetLiability 1150000 Other Comprehensive lncome GIL 975000 Other Comprehensive lncome PSC 153846 Cash 575000 2043 PROBLEM 206 Continued d 123110 Fair value of plan assets 3900000 Less Expected fair value of assets 1l1l10 fair value of plan assets 3000000 Add expected return 300000 10 X 3000000 Add contributions to the plan 575000 Less benefits 0 3875000 Asset gain 25000 12l31l10 Actuarially computed PBO 4750000 Less 1l1l10 PBO 5000000 Add interest 500000 10 X 5000000 Add service cost 200000 Less benefits 0 5700000 Liability gain 950000 Net gain 12l31l10 g 975000 Amortization in 2010 None because there was no beginning balance Amortization in 2011 corridor approach 38462 Projected Benefit Fair Value Accumulated Year Obligation of Plan Assets Corridor OCI GL Amortization 2010 5000000 3000000 500000 0 0 2011 4750000 3900000 475000 975000 38462 975000 475000 500000 500000 13 38462 2044 2045 Farber Corp Pension Worksheet 201 2 Items Balance Jan 1 2012 Service cost Interest cost Actual return Unexpected loss Amortization of PSC Amortization of loss Contributions Benefits Journal entry for 2012 Accumulated OCI Dec 31 2011 Balance Dec 31 2012 65250 725000 X 09 General Journal Entries Memo Record Annual Pension Expense Service Cash Cost 108000 Dr 65250 Dr 48000 Cr 4000 Cr 25000 Dr 1850 Dr 138000 Cr 148100 Dr 138000 Cr 25000 Cr 81000 Dr 56000 Dr 4000 520000 x 10 48000 1l1 Projected Benefit Year Obligation 2012 725000 Value of 1l1 10 Plan Assets 520000 91000 72500 18500 18500 10 1850 OCI Prior 25000 Cr Corridor 72500 OCI Penison GainLoss AssetLiability Obligation 725000 Cr 520000 Dr 205000 Cr 4000 Dr 1850 Cr 2150 Dr 91000 Dr 93150 Dr 12750 Dr 192250 Cr Accumulated OCI GIL 1l1 91000 Projected Benefit Plan Assets 108000 Cr 62250 Cr 48000 Dr 138000 Dr 85000 Cr 85000 Dr 813250 Cr 621000 Dr Minimum Amortization of Loss for 2012 1 850 PROBLEM 207 2046 a Glesen Company Pension Worksheet 2011 and 2012 Items Balance Jan 1 2011 Service cost Interest cost Actual return Unexpected Ioss b Amortization of PSC Contributions Benefits Increase in PBO Journal entry for 2011 Accumulated OCI Dec 31 2010 Balance Dec 31 2011 Service cost Interest cost Actual return Unexpected gain Amortization of PSC Amortization of Loss e Contributions Benefits Journal entry for 2012 Accumulated OCI Dec 31 2011 Balance Dec 31 2012 General Journal Entries Memo Record Annual Pension Expense 40000 Dr 65000 Dr 36000 Cr 5000 Cr 70000 Dr 134000 Dr 59000 Dr 81050 Dr 61 000 Cr 12350 Dr 55000 Dr 548 Dr 146948 Dr Cash 72000 Cr 72000 Cr 81 000 Cr 81 000 Cr OCI Prior Service Cost 70000 Cr 70000 Cr 160000 Dr 90000 Dr 55000 Cr 55000 Cr 90000 Dr 35000 Dr OCI GainLoss 5000 Dr 87000 Dr 92000 Dr 0 92000 Dr 12350 Cr 548 Cr 12898 Cr 92000 Dr 79102 Dr Pension Projected Asset Benefit Lia 39 ty Obligation 240000 Cr 650000 Cr 40000 Cr 65000 Cr 31500 Dr 87000 Cr 84000 Cr 324000 Cr 810500 Cr 59000 Cr 81050 Cr 54000 Dr 1950 Dr 322050 Cr 896550 Cr Plan Assets 410000 Dr 36000 Dr 72000 Dr 31 500 Cr 486500 Dr 61000 Dr 81000 Dr 54000 Cr 574500 Dr PROBLEM 208 PROBLEM 208 Continued Worksheet computations a b C d e b c V 65000 650000 X 10 5000 410000 X 10 36000 expected return exceeds actual return 81050 810500 X 10 12350 486500 X 10 61000 actual return exceeds expected return 2012 Corridor Test Accumulated net gain or loss at beginning of year 10 of larger of PBO or fair value of plan assets Amortizable amount 2012 amortization 10950 20 years 2011 Pension Expense 134000 Other Comprehensive lncome GIL 92000 Cash Pension AssetLiability Other Comprehensive lncome PSC 2012 Pension AssetLiability 1950 Pension Expense 146948 Cash Other Comprehensive lncome PSC Other Comprehensive lncome GIL Financial Statements 2012 Income Statement Pension expense Balance Sheet Liabilities Pension liability Stockholders equity Accumulated other comprehensive loss PSC Accumulated other comprehensive loss GIL 2047 92000 81050 10950 F b 00 72000 84000 70000 81000 55000 12898 146948 322050 35000 79102 a b C d PROBLEM 209 See worksheet on next page December 31 2009 Other Comprehensive Income GIL Pension Expense Cash Pension AssetLiability See worksheet on next page The entry is below December 31 2010 Other Comprehensive Income PSC Other Comprehensive Income GIL Pension Expense Cash Pension AssetLiability Financial Statements 2010 Income Statement Pension expense Balance Sheet Liabilities Pension liability Stockholders equity 18000 330000 510000 124560 433440 Accumulated other comprehensive loss PSC Accumulated other comprehensive loss GIL 2048 150000 198000 184658 883342 g 433440 981342 510000 142560 20 49 a Mount Company Pension Worksheet 2009 and 2010 General Journal Entries Memo Record Annual Pension Items Expense Balance Jan 1 2009 Service cost lnterest cost Actual return Unexpected loss b Contributions Benefits Journal entry for 2009 Accumulated OCI Dec 31 2008 Balance Dec 31 2009 Additional PSC 112010 Balance Jan 12010 Service cost lnterest cost Actual return Unexpected loss d Amortization of PSC Contributions Benefits Journal entry for 2010 Accumulated OCI Dec 31 2009 Balance Dec 31 2010 a 450000 4500000 x 10 b 18000 4500000 x 6 252000 c 548000 4880000 600000 x 10 d 124560 4682000 x 08 250000 150000 Dr 450000 Dr 252000 Cr 18000 Cr 330000 Dr 170000 Dr 548000 Dr 250000 Cr 124560 Cr 90000 Dr 433440 Dr Cash 150000 Cr 150000 Cr 184658 Cr 184658 Cr OCI Prior Service Cost 600000 Dr 90000 Cr 510000 Dr 0 510000 Dr OCI GainLoss 18000 Dr 18000 Dr 0 18000 Dr 124560 Dr 124560 Dr 18000 Dr 142560 Dr Pension Projected Benefit AssetLiability Obligation 198000 Cr 198000 Cr 883342 Cr 1081342 Cr 4500000 Cr 150000 Cr 450000 Cr 220000 Dr 4880000 Cr 600000 Cr 5480000 Cr 170000 Cr 548000 Cr 280000 Dr 5918000 Cr Plan Assets 4500000 Dr 252000 Dr 150000 Dr 220000 Cr 4682000 Dr 250000 Dr 184658 Dr 280000 Cr 4836658 Dr PROBLEM 209 Continued 2050 a Items Dusty Hass Foods Inc Benefits quot 39 39 Annual Postretirement Expense Balance Jan 1 2011 Service cost Interest cost Actual return Unexpected gain 70000 Dr 18000 Dr 15000 Cr 6000 Dr Contributions Benefits Journal entry for 2011 79000 Dr Accumulated OCI Dec 31 2010 Balance Dec 31 2011 200000 x 09 18000 15000 9000 6000 b Journal Entry Postretirement Expense Other Comprehensive lncome GIL Postretirement AssetLiability General Journal Entries Cash 60000 Cr 60000 Cr 2011 Memo Record OCl Gainl Postretirement Loss 6000 Cr 6000 Cr 0 6000 Cr Cash Financial Statements Income Statement Postretirement expense Balance Sheet Liabi es Postretirement assetliability Stockholders Equity Accumulated other comprehensive income AssetLiab y APBO 200000 Cr 70000 Cr 18000 Cr 44000 Dr 13000 Cr 13000 Cr 244000 Cr 79000 6000 13000 60000 79000 13000 g 6000 Plan Assets 200000 Dr 15000 Dr 60000 Dr 44000 Cr 231000 Dr PROBLEM 2010 TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 201 Time 30 35 minutes Purpose to provide the student with the opportunity to discuss some of the more traditional issues related to pension reporting Specifically the student is asked to de ne a pension plan distinguish between a funded and unfunded plan differentiate between accounting for the employer and the pension fund In addition justification for accrual accounting must be developed as well as a determination of the relative objectivity of the accrual versus the cash basis CA 202 Time 25 30 minutes Purpose to provide the student with the opportunity to discuss the terminology employed in FASB standards CA 203 Time 20 25 minutes Purpose to provide the student with the opportunity to discuss the reasons why accrual accounting is followed for pension reporting In addition certain terms are required to be explained and the proper footnote disclosures identified CA 204 Time 30 35 minutes Purpose to provide the student with the opportunity to study some of the implications of FASB Statement No 87 The student is required to identify the five components of pension expense the major differences between the accumulated benefit obligation and the projected benefit obligation and how to report actuarial gains and losses CA 205 Time 50 60 minutes Purpose to provide the student with the opportunity to discuss the implications of FASB Statement No 87 given a number of different factual situations This case is quite thoughtprovoking and should stimulate a great deal of class discussion CA 206 Time 30 40 minutes Purpose to provide the student with the opportunity to explain gains and losses including the use of corridor amortization CA 207 Time 20 30 minutes Purpose to provide the student with the opportunity to consider the ethical implications of the impact of pension benefits and their impact on financial statements 2051 SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 201 a b C d A private pension plan is an arrangement whereby a company undertakes to provide its retired employees with benefits that can be determined or estimated in advance from the provisions of a document or from the company s practices In a contributory pension plan the employees bear part of the cost of the stated benefits whereas in a noncontributory plan the employer bears the entire cost The employer is the organization sponsoring the pension plan The employer incurs the costs and makes contributions to the pension fund Accounting for the employer involves 1 allocating the cost of the pension plan to the proper accounting periods 2 measuring the amount of pension obligation resulting from the plan and 3 disclosing the status and effects of the plan in the financial statements The pension fund or plan is the entity which receives the contributions from the employer administers the pension assets and makes the benefit payments to the pension recipients Accounting for the fund involves identifying receipts as contributions from the employer sponsor and as income from fund investments and computing the amounts due to individual pension recipients 1 Relative to the pension fund the term funded refers to the relationship between pension fund assets and the present value of expected future pension benefit payments thus the pension fund may be fully funded or underfunded Relative to the employer the term funded refers to the relationship of the contributions made by the employer to the pension fund and the pension expense accrued by the employer if the employer contributes annually to the pension fund an amount equal to the pension expense the employer is fully funded a liability could still appear due to the recognition of a minimum liability 2 Relative to the pension fund the pension liability is an actuarial concept representing an economic liability under the pension plan for future cash payments to retirees From the viewpoint of the employer the pension liability is an accounting credit that results from an excess of amounts expensed over amounts contributed funded to the pension fund 1 The theoretical justification for accrual recognition of pension costs is based on the matching concept Pension costs are incurred during the period over which an employee renders services to the enterprise these costs may be paid upon the employee s retirement over a period of time after retirement as incurred through funding or insurance plans or through some combination of any or all of these methods 2 Although cash payasyougo accounting is highly objective for the final determination of actual pension costs it provides no measurement of annual pension costs as they are incurred Accrual accounting provides greater objectivity in the annual measurement of pension costs than does cash accounting if actuarial funding methods are applied to actuarial valuations to determine the provision for pension costs While cash accounting provides a more precise determination of the final cost accrual accounting provides a more objective measure of the annual cost 2052 CA 201 Continued 6 Terms and their definitions as they apply to accounting for pension plans follow 1 Service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during that period The service cost component is a portion of the projected benefit obligation and is unaffected by the funded status of the plan 2 Prior service costs are the retroactive benefits granted in a plan amendment or initiation Retroactive benefits are benefits granted in a plan amendment or initiation that are attributed by the pension benefit formula to employee services rendered in periods prior to the amendment 3 Vested benefits are benefits that are not contingent on the employee continuing in the service of the employer In some plans the payment of the benefits will begin only when the employee reaches the normal retirement date in other plans the payment of the benefits will begin when the employee retires which may be before or after the normal retirement date The actuarially computed value of vested benefits represents the present value a the benefits expected to become payable to former employees who have retired or who have terminated service with vested rights at the date of determination and b the benefits based on service rendered prior to the date of determination expected to become payable at future dates to present employees taking into account the probable time that employees will retire CA 202 Pension assetliability in the asset section is the excess of the fair value of pension plan assets over the projected benefit obligation Pension assetliability in the liability section is the excess of the projected benefit obligation over the fair value of the pension plan assets Accumulated OCl PSC arises when an additional liability is recognized in the P80 due to prior service cost This account should be reported in the stockholders equity section as a component of accumulated other comprehensive income In addition it should be shown as part of other comprehensive income Net periodic pension expense is the amount recognized in an employer s financial statements as the expense for a pension plan for the period Components of net periodic pension expense are service cost interest cost expected return on plan assets amortization of gain or loss and amortization of prior service cost It should be noted that FASB Statement No 87 uses the term net periodic pension cost instead of net periodic pension expense because part of the cost recognized in a period may be capitalized along with other costs as part of an asset such as inventory 2053 CA 203 a b C 1 The theoretical justification for accrual recognition of pension costs is based on the matching concept Pension costs are incurred during the period over which an employee renders services to the enterprise these costs may be paid upon the employee s retirement over a period of time after retirement as incurred through funding or insurance plans or through some combination of any or all of these methods 2 Although cash payasyougo accounting is highly objective for the final determination of actual pension costs it provides no measurement of annual pension costs as they are incurred Accrual accounting provides greater objectivity in the annual measurement of pension costs than does cash accounting Terms and their definitions as they apply to accounting for pensions follow 1 Marketrelated asset value when based on a calculated value is a moving average of pension plan asset values over a period of time Considerable flexibility is permitted in computing this amount In many cases companies will undoubtedly use the actuarial asset value employed by the actuary as their marketrelated asset value for purposes of applying this concept to pension reporting 2 The projected benefit obligation is the present value of vested and nonvested employee benefits accrued to date based on employees future salary levels This is the pension liability adopted by the FASB in Statement No 87 3 The corridor approach was developed by the FASB as the method for determining when to amortize the balance in the Accumulated OCI GL account The net gain or loss balance is amortized when it exceeds the arbitrarily selected FASB criterion of 10 of the larger of the beginningoftheyear balances of the projected benefit obligation or the marketrelated value of the plan assets The following disclosures about a company s pension plans should be made in financial statements or their notes 1 A description of the plan including employee groups covered type of benefit formula funding policy types of assets held and the nature and effect of significant matters affecting comparability of information for all periods presented 2 The components of net periodic pension expense for the period 3 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 4 Pensionrelated amounts recorded In Accumulated OCI and the impact of amortization of these items on pension expense in the current and next year 5 A table is required indicating the allocation of pension plan assets by category equity securities debt securities real estate and other assets and showing the percentage of the fair value to total plan assets In addition a narrative description of investment policies and strategies including the target allocation percentages if used by the company must be disclosed 6 The company must disclose 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 based on the same assumptions used to measure the company s benefit obligation at the end of the year Also required is disclosure of a company s best estimate of expected contributions to be paid to the plan during the next year 2054 CA 204 a b C Pension benefits are part of the compensation received by employees for their services The actual payment of these benefits is deferred until after retirement The net periodic pension expense measures this compensation and consists of the following five elements 1 The service cost component is the present value of the benefits earned by the employees during the current period 2 Since a pension represents a deferred compensation agreement a liability is created when the plan is adopted The interest cost component is the increase in that liability the projected benefit obligation due to the passage of time 3 In order to discharge the pension liability an employer contributes to a pension fund The return on the fund assets serves to reduce the interest element of the pension expense Specifically the expected return reduces pension expense Expected return is the expected rate of return times the marketrelated value of plan assets 4 When a pension plan is adopted or amended credit is often given for employee service rendered in prior years This retroactive credit or prior service cost is charged to other comprehensive income PSC in the year the plan is adopted or amended and then is recognized as pension expense over the time that the employees who benefited from this credit worked 5 The gains and losses component arises from a change in the amount of either the projected benefit obligation or the plan assets This component is amortized via corridor amortization The major similarity between the accumulated benefit obligation and the projected benefit obli gation is that they both represent the present value of the benefit attributed by the pension benefit formula to employee service rendered prior to a specific date All things being equal when an employee is about to retire the accumulated benefit obligation and the projected benefit obligation would be the same The major difference between the accumulated benefit obligation and the projected benefit obligation is that the former is based on present salary levels and the latter is based on estimated future salary levels Assuming salary increases over time the projected benefit obligation should be higher than the accumulated benefit obligation 1 Pension gains and losses sometimes called actuarial gains and losses result from changes in the value of the projected benefit obligation or the fair value of the plan assets These changes arise from the deviations between the estimated conditions and the actual experience and from changes in assumptions The volatility of these gains and losses may reflect an unavoidable inability to predict compensation levels length of employee service mortality retirement ages and other relevant events accurately for a period or several periods Therefore fully recognizing the gains or losses on the income statement may result in volatility that does not reflect actual changes in the funded status of the plan in that period 2 In order to decrease the volatility of the reporting of the pension gains or losses the FASB had adopted what is referred to as the corridor approach This approach achieves the objective by amortization of the accumulated OCI GL in excess of 10 of the greater of the projected benefit obligation or the marketrelated asset value of the plan assets 2055 CA 205 1 This situation can exist because companies vary as to whether they are using an implicit or explicit set of assumptions when interest rates are disclosed In the implicit approach two or more assumptions do not individually represent the best estimate of the plan s future experience with respect to these assumptions but the aggregate effect of their combined use is presumed to be approximately the same as that of an explicit approach In the explicit approach each significant assumption reflecting the best estimate of the plan s future experience solely with respect to that assumption must be stated As a result some companies are presently using an implicit approach others an explicit approach FASB Statement No 158 requires yet more consistency in discount rates It requires companies to use rates on high quality fixed income investments currently available whose cash flows match the timing and amount of the expected benefit payments As a result this large variance in interest rates will probably disappear to some extent However it should be noted that companies will have some leeway in establishing settlement rates In addition the expected return on assets will also be different among companies This situation will occur because the net funded position of the plan is required to be reported That is companies are required to report as a liability the excess of their projected benefit obligation over the fair value of plan assets In the past the basic liability companies reported was the excess of the amount expensed over the amount funded This statement is questionable If a financial measure purports to represent a phenomenon that is volatile the measure must show that volatility or it will not be representationally faithful Neverthe less many argue that volatility is inappropriate when dealing with such longterm measures as pensions A good example of where dampening might be useful is the recognition of gains and losses lf assumptions prove to be accurate estimates of experience over a number of years gains or losses in one year will be offset by losses or gains in subsequent periods and amortization of gains and losses would be unnecessary The main point is that volatility per se should not be considered undesirable when establishing accounting principles Although some managements may consider volatility bad this belief should not influence standardsetting However it is clear from some of the compromises made in FASB Statement No 87 that certain procedures were provided to dampen the volatility effect a In a defined contribution plan the amount contributed is the amount expensed No significant reporting problems exist here On the other hand defined benefit plans involve many difficult reporting issues which may lead to additional expense and liability recognition Significant amendments will generally increase prior service cost which may lead to significant adjustments to pension expense in the future b Plan participants are of importance because the expected future years of service com putation can have an impact on the amortization of the prior service cost and gains and losses c If the plan is underfunded pension expense will generally increase all other factors constant If the plan is overfunded pension expense will generally decrease all other factors constant The reason is that the expected return on plan assets will be less if the plan is underfunded and vice versa d If the company is using an actuarial funding method different than the one prescribed in FASB Statement No 87 benefitsyearsofservice approach some changes in the computation of pension expense will occur for the company The corridor method is an approach which requires that only gains and losses in excess of 10 of the greater of the projected benefit obligation or market related plan asset value be allocated This excess is then amortized over the average remaining service period of current employees expected to participate in the plan The corridor s purpose is to only recognize gains and losses above a certain amount on the theory that gains and losses within the corridor will offset one another over time 2056 CA 206 To Rachel Avery Accounting Clerk From Good Student Manager of Accounting Date January 3 2011 Subject Amortization of gains and losses in pension expense Pension expense includes several components one occasionally included is the amortization of 39 39 g 39 39 se g 39 quot occur for two reasons First the plan assets may provide a return that is either greater or less than what was expected Second changes in actuarial assumptions may create increases or decreases in the pension liability If these gainslosses are small in relation to the projected benefit obligation PBO or the market related value of the Plan Assets PA then do not include them in annual pension expense If in any given year the gains or losses become too great then at least a portion must be included in pension expense so as not to understate or overstate the annual obligation This is done through a process called amortization To decide whether or not you should include gainslosses in annual pension expense calculate 10 percent of either the P80 or the PA whichever is greater as a corridor Amortize the amount of any gain or loss falling outside the corridor over the average remaining service life of the active employees m these gainslosses must exist at the beginning of the year for which amortization takes place see a on the schedule below Thus in the attached schedule no amortization of the 280000 loss in 2007 was required because the balance in the gainloss account at the beginning of that year was zero However at the beginning of 2008 the balance in that account was 280000 The 10 percent corridor is 260000 so the loss exceeds this corridor by 20000 Since the remaining service life of employees is 10 years you derive the amortized portion by dividing 10 into 20000 2000 see b on the schedule below Note that the unamortized portion of the gainloss from the previous year is combined with the current gainloss Check this new sum against a newly calculated 10 percent corridor If the sum exceeds this corridor then amortize the excess In the attached schedule the unamortized loss from 2008 278000 was added to the 2008 loss of 90000 resulting in a cumulative loss of 368000 see c below This amount exceeds the new corridor 290000 by 78000 However the remaining service life has been changed to 12 years resulting in annual amortization of only 6500 see d below Finally if the losses from 2009 are added to the unamortized portion of the loss from prior years the sum falls within the 2010 corridor and does not need to be amortized at all Corridor and Minimum Loss Amortization Schedule Minimum Projected Benefit Plan Asset Accumulated Amortization Year Obligation a Value a 10 Corridor OCI GL a of Loss 2007 2200000 1900000 220000 0 0 2008 2400000 2600000 260000 280000 2000 b 2009 2900000 2600000 290000 368000 c 6500 d 2010 3900000 3000000 390000 373500 e 0 2057 CA 206 Continued a As of the beginning of the year b 280000 260000 10 years 2000 c 280000 2000 90000 368000 d 368000 290000 12 years 6500 e 368000 6500 12000 373500 CA 207 While Selma may be correct in assuming that the termination of nonvested employees would decrease its pensionrelated liabilities and associated expenses she is callous to suggest that firing employees is a reasonable approach to correcting the underfunding of College Electronix s pension plan Arbitrarily dismiss ing productive employees on the basis of being vested or not vested in the pension plan in order to avoid capitalizing a liability and recognizing expenses is a capricious and unsound business decision Richard Nye should discuss the ethical legal and financial implications of the alternatives available as well as the accounting requirements relating to this situation This obligation and its effect on the financial statements should have been known to Cardinal Technology when it performed its due diligence audit of CE at the time of merger negotiations Cardinal Technology should capitalize the pension obligations of CE as required by GAAP 2058 FINANCIAL REPORTING PROBLEM a b C d PampG offers various postretirement benefits to its employees The most prevalent employee benefit plans offered are defined contribution plans which cover substantially all employees in the US Under the defined contribution plans the company generally makes contributions to par ticipants based on individual base salaries and years of service The company maintains the Procter amp Gamble Profit Sharing Trust and Employee Stock Ownership Plan ESOP to provide a portion of the funding for the US defined contribution plan as well as other retiree benefits Certain other employees primarily outside the US are covered by local defined benefit plans 2004 Pension expense 239000000 2003 Pension expense 192000000 2002 Pension expense 151000000 In 2004 PampG reports a 1401000000 Accrued Pension Cost on its balance sheet It reports 239000000 as pension expense on its income statement It also reports a postretirement liability of 160000000 PampG provides the following disclosure of its asset allocations for the pension fund and the fund for Other Retiree Benefits Plan Assets The Company s target asset allocation for the year ending June 30 2005 and actual asset allocation by asset category as of June 30 2004 are as follows Target Allocation Pension Benefits Other Retiree Benefits Asset Category 2005 2005 Equity securities 64 99 Debt secu rities 32 1 Real estate 4 Total 100 100 2059 FINANCIAL REPORTING PROBLEM Continued Plan Asset Allocation at June 30 Pension Benefits Other Retiree Benefits Asset Category 2004 2004 Equity securities 64 99 Debt secu rities 32 1 Real estate 4 Total 100 100 These allocations appear inline with the expected return assumptions for these two funds 2004 Assumptions used to determine net periodic cost Pensions Other Retiree Expected return on plan assets 74 95 As indicated almost all of the assets in the Other Retiree Benefit fund are equity investments which should earn higher if not also riskier returns than debt investments The differences are consistent with the higher expected return assumption for Other Retiree Benefit funds Thus this information is useful to users of the financial statements in evaluating the pension plan s exposure to market risk and possible cash flow demands on the company In addition it will help users to better understand and assess the reasonableness of the company s expected rate of return assumption 2060 FINANCIAL STATEMENT ANALYSIS CASE a b The components of postretirement expense are service cost interest cost return on plan assets amortization of prior service cost and gains and losses The expense for these plans is reporting in income from operations Similar to pensions the net pension asset for the postemployment benefit plan will be reported in Peake s balance sheet depending on whether there is a net debit or credit balance in the memorandum accounts related to the plan The accounting for defined benefit plans and OPEBs is very similar For example the measures of the obligation are similar and the components of expense and their calculation are the same with similar smoothing mechanisms employed for both types of plans with respect to gains and losses There are however a number of differences between Postretirement HealthCare Benefits and Pensions ltem Pensions HealthCare Benefits Funding Generally funded Generally NOT funded Benefit Welldefined and level Generally uncapped and dollar amount great variability Beneficiary Retiree maybe some Retiree spouse and benefit to surviving other dependents spouse Benefit Payable Monthly As needed and used Predictability Variables are reasonably Utilization difficult to predictable predict Level of cost varies geographically and fluctuates over time Additionally although healthcare benefits are generally covered by the fiduciary and reporting standards for employee benefit funds under ERISA the stringent minimum vesting participation and funding standards that apply to pensions do not apply to healthcare benefits The lack of required funding is particularly relevant for OPEB plans compared to pensions Generally this results in a much higher unfunded OPEB obligation reported in the balance sheet In addition with fewer assets in OPEB plan there is a lower credit associated with the returnonasset component of OPEB expense 2061 COMPARATIVE ANALYSIS CASE a CocaCola sponsors andlor contributes to pension plans covering b c d V V V substantially all US employees and certain employees in international locations CocaCola also sponsors nonqualified unfunded defined benefit plans for certain officers and other employees PepsiCo sponsors noncontributory defined benefit pension plans cover ing substantially all fulltime US employees and certain international employees CocaCola reported net periodic benefit cost of 122 million in 2004 PepsiCo reported pension expense of 245 million in 2004 for US plans 2004 Funded Status millions Pensions OPEB CocaCola 403 791 PepsiCo 930 1319 Relevant rates used to compute pension information CocaCola PepsiCo Discount rate expense 60 61 Rate of increase in compensation levels 425 44 Expected longterm rate of return on plan 775 78 assets 2062 COMPARATIVE ANALYSIS CASE Continued e CocaCola and PepsiCo provide the following disclosures on expected contributions and benefit payments amounts in milions CocaCola Cash Flows Information about the expected cash flow for our pension and other postretirement benefit plans is as follows Pension Benefits Other Benefits Expected employer contributions 2005 114 9 Expected benefit payments 5 130 30 2006 121 32 2007 126 35 2008 128 37 2009 129 40 2010 2014 706 236 PepsiCo Future Benefit Payments Our estimated future benefit payments to beneficiaries are as follows 2005 2006 2007 2008 2009 2010 2014 Pension 215 220 235 255 280 1855 Retiree medical 85 80 85 90 95 515 These benefit payments to beneficiaries include payments made from both funded and unfunded pension plans The above payments exclude any discretionary contributions we may make We expect such contri butions to be approximately 400 million in 2005 PepsiCo appears to have a much higher cash claim related to its post retirement benefit plans with expected benefit payments than Coca Cola s Thus these disclosures provide information related to the cash outflows of the company With this information financial statement users can better understand the potential cash outflows related to the pension plan As a result users can better assess the liquidity and solvency of the company which helps in assessing the company s overall financial flexibility 2063 INTERNATIONAL REPORTING CASE a The key differences arise from the use of shorter amortization periods b c V for 1 unrecognized prior service costs and 2 unrecognized actuarial differences These latter items likely reflect unrecognized gains and losses and would include asset gains and losses Under US GAAP amortization periods are based on remaining service lives of employees which is probably longer than five or ten years One other difference that students might note are the relatively low discount rate and expected return assumptions used by this Japanese company For example Procter and Gamble and many US companies use rates up to three times as high as the rates used by this Japanese company It should be noted that there are several similarities Under Japanese GAAP the pension obligation is measured based on the projected benefit obligation and amount recognized is based on an amount net of the liability and plan assets There is smoothing of gains and losses Also the components of pension expense are similar Shorter amortization periods will result in higher pension expense with respect to prior service costs Depending on whether the company has unrealized gains or losses the shorter amortization period for the actuarial differences may result in either higher or lower reported income On the balance sheet there will be less nonrecognition of the prior service costs and gains and losses So the net pension asset or liability will be measured closer to the net of the liability and fund assets The reported amounts on Japanese balance sheets will be more volatile since the smoothing period is shorter As indicated above income and equity likely will be lower due to higher pension expense and lower net income If there are significant asset gains which is possible given the low expected return assumptions then income could be higher as the gains are amortized into income more quickly The lower discount rate used to measure the pension obligation will result in lower interest cost in income but gives a higher measure of the projected benefit obligation 2064 RESEARCH CASES CASE 1 Students answers will vary based on the companies selected CASE 2 a b V 0 Companies record a credit to pension expense by applying an expected rate of return to the fair value of the pension assets When the market does well the value of the plan assets increase and the pension credit is larger The higher returns also factor into the expected return resulting in a higher return lower expense and higher income In the short term managers and directors get more benefits and possibly higher salaries to the extent that pension credits increase earnings related bonuses However in the wake of a bear market the pension surpluses will dissipate and the company may not have the resources to fund its benefit obligations andor have competitive benefit packages to attract highquality employees Because it can be costly to withdraw excess pension assets from over funded pension plans companies could choose to use the excesses to 1 provide additional pension benefits for current employees 2 provide additional other postretirement benefits healthcare life insurance etc 3 increase pension benefits to current retirees or 4 maintain the pension surplus by changing to cashbalance or similar plans which reduce the overall benefit obligation The article indicates that many companies are letting the surplus ride in order to reap continued pension expense credits The major disadvantage of overfunding is the loss of flexibility for uses of the monies invested in the pension fund Excess funds can only be used on employeerelated costs and companies may have to pay an excise tax if they contribute too much 2065 RESEARCH CASES Continued d The ethical issue relates to the fairness of reducing or holding steady benefits to current via switches to cash balance plans and retired employees while at the same time protecting or increasing benefits to top management The use of socalled top hat benefit plans for top management could increase management s welfare at the expense of employees and shareholders 2066 PROFESSIONAL RESEARCH FINANCIAL ACCOUNTING AND REPORTING Search Strings environment pension cos components of net pension cost recognition of liabilities and assets asset gains and losses recognition of gains and losses pension cost a FAS 87 Par 31 Asset gains and losses are differences between the actual return on assets during a period and the expected return on assets for that period Asset gains and losses include both a changes re ected in the marketrelated value of assets and b changes not yet re ected in the marketrelated value that is the difference between the fair value of assets and the marketrelated value Asset gains and losses not yet reflected in marketrelated value are not required to be amortized under paragraphs 32 and 33 FAS 87 Par 32 As a minimum amortization of an unrecognized net gain or loss excluding asset gains and losses not yet reflected in marketrelated value shall be included as a component of net pension cost for a year if as of the beginning of the year that unrecognized net gain or loss exceeds 10 percent of the greater of the projected benefit obligation or the marketrelated value of plan assets lf amortization is required the minimum amortization shall be that excess divided by the average remaining service period of active employees expected to receive benefits under the plan If all or almost all of a plan s participants are inactive the average remaining life expectancy of the inactive participants shall be used instead of average remaining service b FAS 87 Par 29 Gains and losses are changes in the amount of either the projected benefit obligation or plan assets resulting from experience different from that assumed and from changes in assumptions This Statement does not distinguish between those sources of gains and losses Gains and losses include amounts that have been realized for example by sale of a security as well as amounts that are unrealized Because gains and losses may reflect refinements in estimates as well as real changes in economic values and because some gains in one period may be offset by losses in another or vice versa this Statement does not require recognition of gains and losses as components of net pension cost of the period in which they arise c FAS 87 Par 4 After 1966 the importance of information about pensions grew with increases in the number of plans and amounts of pension assets and obligations There were significant changes in both the legal environment for example the enactment of ERISA and the economic environment for example higher inflation and interest rates Critics of prior accounting require ments including users of financial statements became aware that reported pension cost was not comparable from one company to another and often was not consistent from period to period for the same company They also became aware that significant pensionrelated obligations and assets were not recognized in financial statements 2067 2068 Measurement a Annual Pension OCI Prior Formula L9 9 391 L9 N9 Formula Pension Formula 311 1 Projected Benefit PROFESSIONAL SIMULATION PROFESSIONAL SIMULATION Continued b Simply change the formula in cell B11 to multiply by 07 change the formula in cell B12 to multiply 10 times N9 1 Journal Entry Other Comprehensive Income GainILoss 71000 Pension Expense 113250 Pension AssetLiability 66250 Cash 99000 Other Comprehensive lncome PSC 19000 Disclosure Financial Statements Income Statement Pension expense 113250 Balance Sheet Liabilities Pension liability 211250 Stockholders Equity Accumulated other comprehensive loss 152000 81000 71000 2069 FASB UpDate FIN 46R FIN No 46 Consolidation of Variable Interest Entities Revised Dec 2003 Special purpose entities SPEs typically are partnerships orjoint ventures that are often used by companies to move debt off their balance sheet Many have legitimate uses but others are structured specifically with the intent of concealing debt from investors They came into the spotlight after the collapse of energy trader Enron which used sophisticated partnerships it controlled to move debt off its balance sheet The murky deals were instrumental in Enron39s demise and the company is accused of using them to fool investors about the true state of its finances From Tougher Rules on Enrontype Deals Approved By Deepa Babington 01152003 Reuters English News Service accessed 32803 at httpwwwsternnyueduNewsnews2003januaryO l15reutershtm VARIABLE INHRESTENYYHES Variable interest entity refers to an entity subject to consolidation according to the provisions of Interpretation No 46 There are two conditions either one of which if met would cause a particular entity to be consolidated within the nancial statements of the primary beneficiary The term includes special purpose entities but FASB decided that SPE was too narrow a term and these rules should apply to a broader group of entities Variable interest entities are subject to consolidation if by design m of the following three conditions a b or c apply a The total equity investment at risk is not suf cient to permit the entity to nance its activities without additional subordinated nancial support from other parties That is the equity investment at risk is not greater than the expected losses of the entity See de nition of total equity investment at risk 7 below b As a group the holders of the equity investment at risk lack one of the following three characteristics of a controlling nancial interest 1 The direct or indirect ability to make decisions about an entity s activities through voting rights or similar rights 2 The obligation to absorb the expected losses of the entity if they occur The investor or investors do not have that obligation if they are directly or indirectly protected from the expected losses or are guaranteed a return by the entity itself or by other parties involved with the entity 3 The right to receive the expected residnal returns of the entity if they occur The investors do not have that right if their return is capped by the entity s governing documents or arrangements with other variable interest holders or with the entity The equity investors as a group also are considered to lack characteristic bl if i the hVeUxE7eo6doc Created 32204 by T Gordon voting rights of some investors are not proportional to their obligations to absorb the expected losses of the entity to receive the expected residual returns of the entity or both and ii substantially all of the entity s activities for example providing financing or buying assets either involve or are conducted on behalf of an investor that has disproportionately few voting rights c The equity investors as a group lack characteristic of b1 if 1 The voting rights of some investors are not proportional to their obligations to absorb expected losses their rights to receive expected residual returns or the entity or both 2 Substantially all the entity s activities either involve or are conducted on behalf of an investor that has disproportionately few voting rights Note that this thirdpravisian is one of the revisions am Dec 2003 Determination ofsta tus The initial determination of whether an entity is a variable interest entity is made on the date at which an enterprise becomes involved with the entity Involvement with an entity is defined to be ownership contractual or other pecuniary interests that may be determined to be variable interests Status as a variable interest entity is reconsidered only if one or more of the following occur a The entity s governing documents or the contractual arrangements among the parties involved change b The equity investment or some part thereof is returned to the investors and other parties become exposed to expected losses c The entity undertakes additional activities or acquires additional assets that increase the entity s expected losses d The entity receives additional equity investment that is at risk or the entity curtails or modifies its activities in a way that decreases its expected losses NOT CLASSIFIED AS VIE The following are SOME of the exceptions to the scope of FIN46 l I t f r 39 fit 39 39 and entities unless they are used by business enterprises in an attempt to circumvent the provisions of this Interpretation 2 Employee benefit plans subject to specific accounting requirements in existing FASB Statements 3 Registered investment companies are not required to consolidate a variable interest entity unless the variable interest entity is a registered investment company 4 Separate accounts of life insurance enterprises as described in AICPA Auditing and Accounting Guide Life and Health Insurance Entities 5 Transferors to qualifying specialpurpose entities and quotgrandfatheredquot qualifying special purpose entities subject to the reporting requirements of FASB Statement No 140 Accounting for Transfers and Servicing of Financial Assets and Extinguishm ents of Liabilities Do not consolidate those entities 6 No other enterprise consolidates a qualifying specialpurpose entity or a quotgrandfatheredquot qualifying specialpurpose entity unless the enterprise has the unilateral ability to cause the entity to liquidate or to change the entity in such a way that it no longer meets the requirements to be a qualifying specialpurpose entity or quotgrandfatheredquot qualifying special purpose entity 7 An entity deemed to be a business see definition Appendix C need not be evaluated as a potential VIE unless one or more of the following conditions exist a Reporting enterprise and its related parties all participated significantly in the design or redesign of the entity unless the entity is an operating joint venture under joint control and one more independent parties or a franchisee b The entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting enterprise and its related parties c The reporting enterprise and its related parties provide more than half of the equity subordinate debt and other forms of subordinated financial support e The activities of the enterprise are prim arily related to securitizations or other forms of assetbacked financings or singlelessee leasing arrangements Note that this nal scope exception is one of the revisions from Dec 2003 Note that development stage enterprises SHOULD BE examined as possible VIEs per para 1 I DEFINI TONS OF TERMS By design This phrase refers to entities that meet the conditions for treatment as a variable interest entity because of the way they are structured For example an enterprise under the control of its equity investors that originally was not a variable interest entity does not become one because of operating losses Entity refers to any legal structure used to conduct activities or to hold assets Some examples of such structures are corporations partnerships limited liability companies grantor trusts and other trusts Portions of entities or aggregations of assets within an entity shall not be treated as separate entities for purposes of applying this Interpretation unless the entire entity is a variable interest entity Some examples are divisions departments branches and pools of assets subject to liabilities that give the creditor no recourse to other assets of the entity Majorityowned subsidiaries are entities separate from their parents that are subject to this Interpretation and may be variable interest entities Equity investments in an entity are interests that are required to be reported as equity in that entity s nancial statements Expected losses and expected residual returns refer to amounts derived from discounted expected cash ows using a creditadjusted riskfree rate Expected variability is the sum of the absolute values of the expected residual return and the expected loss All three concepts are illustrated in Appendix A Primary bene ciary refers to an enterprise that consolidates a variable interest entity under the provisions of this Interpretation Interests held by an entity s related parties para 16 are considered to be held by the entity itself So which one gets to consolidate the VIE It will be the entity of the group that is most closely associated with the VIE as described in para l7 Subordinated financial support refers to variable interests that will absorb some or all of an entity s expected losses ifthey occur Total equity investment at risk for the purpose of applying FIN 46 1 Includes only equity investments in the entity that participate significantly in profits and losses even if those investments do not carry voting rights 2 Does not include equity interests that the entity issued in exchange for subordinated interests in other variable interest entities 3 Does not include amounts provided to the equity investor directly or indirectly by the entity or by other parties involved with the entity for example by fees charitable contributions or other payments unless the provider is a parent subsidiary or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor 4 Does not include amounts financed for the equity investor for example by loans or guarantees of loans directly by the entity or by other parties involved with the entity unless that party is a parent subsidiary or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor Variable interests in a variable interest entity are contractual ownership or other pecuniary interests in an entity that change with changes in the entity s net asset value Equity interests with or without voting rights are considered variable interests if the entity is a variable interest entity FIN 46R Paragraph 1213 explains how to determine whether a variable interest in specified assets of an entity is a variable interest in the entity Appendix B in FIN 46R describes various types of variable interests and explains in general how they affect the determination of the primary beneficiary of a variable interest entity April 2006 FSP FIN 46R6 Variability of VIE is based on the DESIGN of the entity using the following steps 1 Analyze the nature of the risks in the entity see para 6 amp 7 in the FSP 2 Determine the purpose for which the entity was created and determine the variability created by the risks identified in Step 1 the entity is designed to create and pass along to its interest holders para 814 of the FSP Risks to be considered in Step 1 Credit risk Interest rate risk including prepayment risk Foreign currency exchange risk Commodity price risk Equity price risk Operations risk There is an Appendix A to FSP FIN46R 6 that provides a series of examples that will help you understand the nature of VIEs and why they might be established The solutions use the two step process to explain the risks and which risks the entity was designed to pass along to its variable interest holders Case 08 1 Go With the Flow Inc Go With the Flow Incorporated Company designs manufactures and sells a broad range of mobile network products and systems and communication devices including mobile cordless and corded telephones The Company39s primary sources of liquidity are internally generated cash ows the Company39s debt and revolving credit facilities and the sale of trade accounts receivables The Company s liquidity and capital requirements are primarily a function of its working capital needs capital expenditures and debt service requirements The Company has the following transactions that need to be analyzed under FASB Statement No 95 Statement of Cash Flows 1 Insurance Settlement Proceeds The Company reached a settlement with its insurance carrier related to a claim from a tornado that destroyed one of the Company s manufacturing facilities During the year the Company received proceeds of 20 million from its insurance carrier in connection with its claim for reimbursement for the destroyed building The Company plans to use the insurance proceeds to fund its definedbene t pension plan rather than to rebuild the destroyed facility 2 Sale of Accounts Receivable The Company sells undivided interests in designated pools of qualified accounts receivable to a securitization vehicle a qualifying special purpose entity The Company utilizes securitization as a financing technique e g to reduce more expensive bank debt 7 the interest rates the company obtains on notes issued by the qualifying special purpose entity are lower than the company could get on its own bank debt The Company services administers and collects the receivables on behalf of the purchaser The agreement includes certain covenants and provides for various events of termination The agreement also requires that proceeds from securitization be used to pay down Company debt During the current year 11 million of receivables generated from sales of the Company s inventory were sold under the agreement and therefore are not re ected in the accounts receivable balance in the Company s balance sheet 3 Acquisition of Property Plant and Equipment on Account In December the Company incurred 12 million of capital expenditures related to the acquisition of manufacturing equipment and machinery The terms of the invoice are 2 15 net 45 The amounts were unpaid as of yearend ie included in the accounts payable balance The Company intends to pay the invoice in early January in accordance with the terms of the invoice Required Determine the appropriate cash ow statement treatment 7 classification eg operating investing financing and timing if applicable 7 for the above transactions Copyright 2006 Deloitte Development LLC All Rights Reserved 15 July 2006 No 06721 The lnterpretatron39s Scope Recognrtron and Derecognrtron Measurement Changed Evaluatrons Lrabrlrtles and Therr Classrfrcatron Deferred Taxes lnterest and Penaltres Drsclosures Effectrve Date and Transrtron Staff Posrtron on Leveraged Leases emotions KPMG LLP the u 8 member rm of KPMG lnterrE oFE a Swrss cooperanve KPMG and the KPMG logo are regrstered tradermrks of KPMG lnternanonal a Swrss cooperanve All rlghts reserved 23590 Photo GettylrragesStoneRyan McVay zoommsrom AUDIT TAX 391 AVISORV mmbebwmmmg Accounting for Income Tax Uncertainties New FASB Interpretation 48 which defines the threshold for recognizing the benefits of m return positions in the financial statements as morelikely than not to be sustained by the taxing authority will affect many companies reported results and their disclosures of uncer tain tax positions1 The FASB also released a Staff Position that requires lessors to apply the Interpretation 48 model in determining the timing and amount of expected tax cash ows in leveragedlease calculations2 Uncertainty in income taxes as used in the title of the new Interpretatiorg refers to uncer tainty about how some transactions will be treated under the tax law This uncertainty leads to questions about whether tax positions taken or to be taken on tax returns should be re ected in the financial smtements before they are finally resolved with the taxing authorities Earlier authoritative literature provided no specific guidance Some companies historically recognized tax positions only if they were probable of being ultimately realized guided by views expressed by the SEC staff and consistent with the definition of an asset in FASB Concepts Statement No 63 However research by the FASB staff and comments on the FASB s Exposure Dra suggested there was diversity in practice with respect to the recognition and measurement principles used and the scope of transactions to which such principles were applied The new Interpretation should result in more consistent application The Interpretation39s Scope Interpretation 48 applies to all tax positions accounted for under Statement 109 including tax positions acquired in a business combination4A tax position for this purpose includes a current or future reduction in mxable income reported or expected to be reported on a tax l EASB lnterpretatron No 48 Accountrng for Uncertarnty rn lncomeTaxes June 2006 avarlable at vvvvwfas org 2 EASB Staff Posrtron No EAS l372 Accountrng for a Change or Projected Change tn the Trmrng of Cash Elovvs Relatrng to lncome Taxes Generated by a Leveraged Lease Transactron July 2006 avarlable at 3 SEC Staff Speech by Randolph P Green at theThrrtyrErrstAlCPA Natronal Conference on Current SEC Developments December ll 2003 avarlable at vyvyvvsec gov EASB Statement of ElnancralAccountrng Concepts No 6 Elements of Ernancral Statements December l985 avarlable at vvwwfasb org 4 EASB Statement No l09 Accountrng for lncomeTaxes Eebruary l992 avallable at vvvvvvfasb org return the decision not to report a transaction in a tax return and an assertion that a company is not subject to taxation Because of the way a tax position is defined the Interpretation applies to notforprofit organizations real estate investment trusts regulated investment companies and other entities that are poten tially subject to income taxes if conditions specified by the tax law are not met The Interpretation s recognition and principles also apply to evaluating the poten tial treatment of tax planning strategies used to support the realizability of deferred m assets Interpretation 48 applies to all tax positions regardless of their level of uncertainty or the nature of the position However the Interpretation s recognition and measurement requirements are likely to have the most impact on positions for which current or future deductions may be disallowed or reduced in a tax examination The Interpretation applies to situations where the uncertainty is about the timing of the deduction the amount of the deduction or the validity of the deduction The following tax positions are among those subject to the Interpretation 0 A deduction taken on the tax return for a current expenditure that the taxing author ity may assert should be capitalized and amortized over future periods I A decision that certain income is nontax able under the tax law a The determination of the amount of tax able income to report on intercompany transfers between subsidiaries in different tax jurisdictions The calculation of the amount of a research and experimentation credit o The determination as to whether a spinoff transaction is taxable or nontaxable o The determination as to whether an entity qualifies as a real estate investment trust or regulated investment company 2001wmnuvzw me Lu warm muml i luwh 2 I The determination as to whether an entity is subject to tax in a particular jurisdiction Tax benefits associated with positions that are highly certain and not likely to be ques tioned by the taxing authorities such as deductions for ordinary salaries paid to employees are unlikely to be affected by the Interpretation quot39 39 39 and l Interpretation 48 supplements Statement 109 by defining the confidence level that a tax position must meet in order to be recognized in the financial statements The Interpretation requires that the tax effects of a position be recognized only if it is morelikelythan not to be sustained based solely on its technical merits as of the reporting date In making this assessment a company must assume that the taxing authority will examine the posi tion and have full knowledge of all relevant information The term morelikely than not means a likelihood of more than 50 percent Each tax position is to be considered on its own regardless of whether the related benefit is expected to be negotiated with the taxing authority as part of a broader settlement involving multiple tax positions The morelikelythan not threshold represents a positive assertion by management that a company is entitled to the economic benefits of a tax position If a m position is not con sidered morelikelythannot to be sustained based solely on its technical merits no bene fits of the position are to be recognized Moreover the morelikelythan not threshold must continue to be met in each reporting period to support continued recognition of a benefit If the threshold ceases to be met the previously recorded benefit must be derecognizedithat is reversed The benefit of a tax position that initially fails to meet the morelikelythannot threshold should be recognized in a subsequent period if changing New L le i39masuv d i an1 wi facts and circumstances enable the position to meet the threshold the matter is ultimately settled through negotiation or litigation with the xing authority or the statute of limita tions has expired The Interpretation does not prescribe the type of evidence required to support meeting the morelikelythannot threshold stating that it depends on the individual facts and circumstances A company s position may be supported in whole or in part by unambiguous tax law prior experience with the xing authority and analysis that considers all rele vant facts circumstances and regulations including widely understood administrative practices and precedents of the mxing authority Tax positions supported by administrative practices and precedents are those positions which are accepted by the taxing authorities even though the treatment may not be speci fied by the tax law or the positions may be considered technical violations of the tax law In an example from the Interpretation the m law in a particular jurisdiction may not establish a capitalization threshold below which fixedasset expenditures may be con sidered deductions in the period of acquisi tion but management may be able to conclude based on previous experience that the taxing authority has not historically disallowed cur rent deductions for individual fixedasset purchases below a specific dollar amount The Interpretation permits such conclusions for what is expected to be a small number of tax positions that re ect widely known and consistently applied practices of the taxing authority Another example in the Interpretation illustrates how administrative practices may affect evaluations of whether an entity may be subject to tax in a jurisdiction In some cases it may be unclear how a tax position should be defined The unit of account for determining what constitutes an individual tax position is a matter of judgment that should consider the manner in which a company prepares and supports its income tax returns and the approach expected to be taken by the taxing authority during an examination The determination of the unit of account can significantly a ect the amount of tax benefits recognized particularly if a deduction or other benefit involves multiple issues that vary widely in their degree of uncertainty For instance a company may claim a research and experimentation credit for a qualifying research project that conmins both expenditures that are highly certain to result in a benefit and expenditures that could be disallowed If the unit of account is the research project the company may not be able to conclude that the recognition thresh old has been met because some of the benefit associated with the position is likely to be disallowed Alternatively if the unit of account is the individual expenditure management may be able to conclude that the position associated with the highly certain expendi tures meets the recognition threshold We believe that because of this sensitivity it may be appropriate in some cases to define the unit of account at the lowest level necessary to ensure that significant benefits with widely varying levels of uncertainty are not included in the same unit of account M eas u re m e nt The benefit recognized for a tax position meeting the morelikelythannot criterion is measured based on the largest benefit that is more than 50 percent likely to be realized The measurement of the related benefit is determined by considering the probabilities of the amounts that could be realized upon ultimate settlement assuming the taxing authority has full knowledge of all relevant facts and including expected negotiated set tlements with the taxing authority The Interpretation does not prescribe how to ana lyze the probabilities of individual outcomes In measuring the benefit a company could first consider the amount and probability of sustaining the largest possible benefit that is the benefit claimed or expected to be claimed on the m return If the largest pos sible benefit is greater than 50 percent likely to be realized the company would recognize that amount If not the company could determine whether the next largest benefit is greater than 50 percent likely to be realized including the probability that a larger benefit could be realized If the 50 percent threshold has not been reached the company could continue to evaluate other outcomes in a similar manner until it identifies the largest amount of benefit that is greater than 50 per cent likely to be realized The measurement process is applied only to tax positions that meet the morelikelythan not recognition threshold According to the Interpretation a tax position that does not meet the recognition threshold is measured at zero even if some part of the benefit associated with the position is more than 50 percent likely of being realized Changed Evaluations New information about a tax position should trigger a reevaluation The reevaluation could lead a company to derecognize a previously recognized tax position because new infor mation indicates that it is no longer more likelythannot to be sustained recognize a previously unrecognized tax position because it has become morelikelythannot that the position would be sustained or remeasure a previously recognized tax position The effect of a changed evaluation related to a tax position taken in a prior annual period is 5 APB Opinion No 28 interim Financial Reporting iia i973 and FASB interpretation No i8 Accounting for income Taxes in interim Periods iiarcii i977 available at wwwias org reizuuiunifiuiiziii are tic iiiaimi hi iiJii iiii iiiTv39i39i i2 V New L iiiwiimasmad beaniiiii accounted for as a change in estimate and is recognized entirely in the interim period in which the change occurs Changes in evalua tions related to tax positions taken in prior interim periods within the same fiscal year are accounted for under Opinion 28 and Interpretation 18 as an adjustment to the estimated annual effective tax rate beginning in the period of the changed evaluation5 Only information that is available at the reporting date that is the date of the com pany s most recent statement of financial position should be considered in recognizing and measuring a tax position A change in available facts subsequent to a company s reporting date but prior to issuance of the financial statements should be recognized in the period in which the change in facts occurs even if that new information provides a bet ter estimate of the ultimate outcome of an uncertainty Nevertheless companies should make appropriate disclosures in the notes to the financial statements if the impact of sub sequent facts is considered material Liabilities and Their Classification Recognizing a benefit from a tax position in the financial statements that is smaller than the m etTect of the related deduction reported in the company s tax return creates a tax lia bility or reduces the amount of a net operating loss carryforward or amount reftmdable from the xing authority Companies that present a classified statement of financial position should classify the liability as current or noncurrent depending on the anticipated timing of settlement Amounts expected to be settled within one year of the balance sheet date would therefore be classified as current liabilities Interpretation 48 does not change the classification guidance for deferred taxes Example Applying Interpretation 48 Compahy ABC rs evaluatrhg currehtiperrod rhterest cost assocrated wrth rts comertrble debt ahd rs plahmhg to take ah rhterest deduct10h 0h rts tax returh ahd thereby reduce rts rhcome taxes payable by 100 for the year The Compahy drscusses the tax positron With its tax advrsors ahalyzes srmri lar deduct10hs specrtrcally challehged ahd accepted by the taxrhg authority in prevrous examrhatIOhs ahd cOhcludes that the cost dualrtres as a valrd rhterest deduct10h ahd rs therefore moreilrkelyithahihot to be susi tarhed 1h ah examrhatIOh CompahyABC therefore cOhcludes the rhterest deduct10h meets lhterpretatron 48 s recoghrtron crrtei r10h ahd the related tax behetrt should be measured for trhahcral reportth It the deduct10h rs subsequehtly examrhed by the taxrhg authorrty several outcomes are possrble because It rs uhcertarh whether ahy deductroh wrll be allowed ahd because of the judgmeht rhvolved 1h determrhrhg the approprrate market rate of rhterest r e the amouht of the rhterest deduct10h to be allowed Oh the tax returh Based 0h rts pref vrous experrehce 1h hegotratrhg srmrlar deduct10hs wrth the taxrhg authorrty Compahy ABC39s mahagemeht belreves there rs 0th a 30 perceht lrkelrhood that the ehtrre behetrt of 100 would be allowed 1h ah examination However mahagemeht belreves there rs a 60 perceht lrkelrhood that at least ah 80 behetrtwould be sustarhed r e a 60 perceht probabrlrty that a maxri mum of 20 would be drsallowed Mahagemeht also belreves there rs a 40 per ceht lrkelrhood that a taxrhg authorrty examri hat10h would dehy the compahy ahy behetrt tor the posrt10h lhterpretatIOh 48 requrres Compahy ABC to record ah 80 behetrt 1h rts trhahcral state mehts because there rs a 60 perceht probai brlrty that a behetrt of 80 or more would ultrmately be realrzed Compahy ABC cahhot report the full 100 behetrt clarmed 0h rts tax returh 1h rts trhahcral statemehts because there rs 0th a 30 perceht probabrli rty that the ehtrre behetrt would be allowed If examrhed by the taxrhg authorrty A 20 tax exposure lrabrlrty should be recorded as ah rhcrease to rhcome taxes payable repree sehtrhg the drtterehce betweeh the behetrt recoghrzed uhder lhterpretatIOh 48 of 80 ahd the behetrt clarmed Oh the tax returh of 100 Thrs rhcome tax lrabrlrty would be clasi srtred as hOhcurreht rt Compahy ABC does hot expect to settle the amouht wrth the taxi rhg authorrty wrthrh Ohe year of the balahcei sheet date lhterest must be accrued Oh the 2011abrlrty begrhmhg 1h the rst perrod rhterest would begrh to accrue uhder the tax law Deferred Taxes Interpretation 48 will directly affect the cal culation of income taxes payable and may also affect the measurement of deferred taxes Deferred tax assets and deferred tax liabili ties should be calculated based on the differ ence between the carrying values of assets and liabilities for financialreporting purposes and the m basis of those assets and liabilities as calculated using Interpretation 48 For example assume a company incurs costs of 100 to repair equipment in its manufac turing plant recognizing the expenditure as a currentyear expense in the financial state ments and a deduction in its currentyear tax return Management believes it is highly cer tain that the 100 will ultimately be deductible However management also believes it is morelikely than not that the taxing author ity will require the costs to be capitalized and amortized over four years In this case u are we merrer hr rrJIHIl the company must recognize an increase in income taxes payable for the tax effects of the 75 deduction that management believes the taxing authority will disallow in the cur rent year ie the 100 deduction claimed less one year or 25 of amortization In addition a deferred tax asset for the tax effect of the 75 deduction that is expected to be allowed over the next three years should be recognized because there is no correspon ding asset for financial reporting purposes Interest and Penalties Interest that the tax law requires to be paid on the underpayment of taxes should be accrued on the difference between the amount claimed or expected to be claimed on the m return and the tax benefit recog nized in the financial smtements The accrual for financial reporting should begin in the period inwhich accrual would begin under the tax law An expense must be recognized mopsrarwe L le r 1ew9d AGES u for the amount of a statutory penalty in the period for which the tax position has been taken or is expected to be taken on the tax return if a tax position does not meet the minimum statutory threshold to avoid the penalty Classifying interest and penalties on the income statement is an accounting policy decision that should be consistently applied D i so Ios u re s Interpretation 48 requires significant new armual disclosures in the notes to the finan cial statements A significant additional requirement is a table disclosing the begin ning and ending balances of unrecognized tax benefits The following items must be separately presented in the table which is required at the end of each armual period 0 The gross amounts of the increases and decreases in unrecognized tax benefits as a result of tax positions taken during a prior period o The gross amounts of the increases and decreases inunrecognized tax benefits as a result of tax positions taken during the current period c The amount of decreases in unrecognized tax benefits relating to settlements with taxing authorities a Reductions to unrecognized tax benefits as a result of lapse of the applicable statute of limitations The table is required for unrecognized tax benefits on an aggregate worldwide basis No disaggregated information for individual tax positions or jurisdictions is required Companies must also disclose the amount of unrecognized tax benefits that if recognized would change the effective rate For exam ple recognition of an unrecognized tax bene fit that corresponds to a recognized deferred tax asset because the deduction was expected to be available for tax purposes at a future date may not change the company s effective tax rate The Interpretation also requires qualitative and quantimtive disclosures related to estimates of unrecognized tax benefits if it is reason ably possible the estimate will significantly change in the 12 months after the balance sheet date This disclosure must include the nature of the uncertainty the nature of the events that could cause the change and an estimate of the range of reasonably possible changes or a statement that an estimate of the changes cannot be made Other provisions of the Interpretation require companies to disclose the classification of interest and penalties the amount of interest and penal ties included in the income statement each period and the amount of interest and penal ties accrued in the statement of financial position A description of open tax years by major jurisdiction is also required Effective Date and Transition Interpretation 48 is effective as of the begin ning of the first fiscal year beginning a er December 15 2006 January 1 2007 for calendaryear companies with early applica tion permitted if no interim financial smtements have been issued At adoption companies must adjust their financial statements to reflect only those tax positions that are more likely thannot to be sustained as of the adoption date Positions that meet this crite rion should be measured using the largest benefit that is more than 50 percent likely to be realized The necessary adjustment should be recorded directly to the beginning balance of retained earnings in the period of adoption and reported as a change in accounting prin ciple Retrospective application is prohibited Over the coming months companies will need to begin the process of reassessing their historical tax positions in order to successfully apply the new Interpretation Companies with m positions involving complex tax law or significant uncertainty may need assismnce from outside tax experts In many cases we believe companies that have historically used a probable threshold for recognizing uncertain tax positions will find that the reassessment reduces the liability for unrec ognized tax benefits at the date of adoption Disclosures made in the period of adoption should enable financialstatement readers to 5 SEC Staff Accounting Bulletin No 74 Disclosure Oane lmpactTnat Recently lssued Accounting Standards Will Have On The Financial Statements Oane Registrant When Adopted ln a Future Period available at sec 7 FASB Statement No l3 Accounting for Leases November l976 available at vvvvvvfasb org ZUUlL J Jl lv l lll are tie iiiaimi hi iiJllllil lliTv39i39i i2 V New L lliiuli39ia8iv d beaniiiii understand the company s new accounting policies and their etTect on the financial statements In reporting periods prior to adoption including secondquarter 2006 interim reports public companies should discuss the expected effects of adoption in MDampA and in accounting policy footnotes as required by SAB 746 VVV Staff Position on Leveraged Leases The new FASB Staff Position amends Statement 13 by requiring lessors to recalcu late the rate of return and periodic income allocation for leveragedlease transactions when there is a change or projected change in the timing of income tax cash ows related to the lease7 The Staff Position requires lessors to use the model in Interpretation 48 to determine the timing and amount of expected tax cash flows in leveragedlease calculations and recalculations The StatT Position applies to all leveraged leases but was issued primarily in response to IRS challenges to tax positions in Lease InLease Out and Sale InLease Out transac tions Changes in the expected timing of tax cash flows can result in significant changes in the lessor s expected rate of return and timing of income recognition for two reasons First income related to a leveraged lease is required to be recognized by the lessor using a constant rate of return in periods in which the lessor s net investment balance in the lease is positive Second the tax benefits of accelerated tax depreciation together with interest expense deductions related to the This is a publication of KPlVlG39s Department of Professional Practice Audit 212 9095600 Contributing authors Kimber K Bascom Darryl S Briley Angela B Storm Brian W Fields Earlier editions are available at WWW aro kpmg com Defining lssues is a registered traderrErk of KPMG LLP 20017 m 2006 KPMG up the u s ember rm 0mm lnteinanonal a Swisscooperanv u v r r r interest on nonrecourse debt o en exceed rental income from the lease inthe early years of the transaction affording the lessor the temporary use of funds through deferred m balances The Staff Position clarifies that the assumed timing of income tax cash flows is an impor tant assumption as that term is used in paragraph 46 of Statement 13 and must be included in leveragedlease accounting calculations Lease income must be recalculated under paragraph 46 for changes or projected changes in the timing of income tax cash flows related to a lever aged lease However recalculation is required only for changes or projected changes in the timing of income tax cash flows that are directly related to the leveragedleasing transaction for example changes related to interpretations of tax law or the expected outcome of tax audit Changes in the anticipatedtiming of tax benefits related solely to the effect of the lessor s alternative rriinimum tax credits or projected tax losses generally do not trigger a required recalculation of a leveraged lease In addition a change in the projected timing of income tax cash flows does not trigger a reassessment of lease classification The Staff Position provides additional guidance on how recalculations should be performed Any projected interest and penalties relating to settlement or potential settlement of a tax position related to the lease should not be included in the calculation of cash flows from a leveraged lease Similarly advance payments and deposits to taxing authorities toward poten tial settlement of a leveragedlease tax position are not considered cash flows to be included in the leveragedlease recalculation Finally all important assumptions in a leveraged lease must be updated based upon current information When a recalculation is performed under paragraph 46 of Statement 13 The Staff Position is effective in the same period as Interpremtion 48 At the date of adoption the lessor is required to reassess projected income tax cash flows related to leveraged leases using the Interpretation48 model for recognition and measurement If this results in a change in the expected timing or amount of leveragedlease income tax cash flows the rate of return on the leveraged leases should be recalculated and the net investment in the leases adjusted as prescribed by Statement 13 Revisions to the net investment in a leveraged lease required when the Staff Position is adopted should be recorded as a direct adjustment to the beginning balance of retained earnings in the period of adoption and reported as a change in accounting principle Consistent With the transition provisions of Interpretation 48 retrospective applica tion of the Staff Position is not permitted SAB 74 requires the expected effects of adopting the smr Position to be disclosed in financialreporting periods prior to adoption including secondquarter 2006 interim reports e marks of KPMG lnternanonal a Swiss cooperative All rights reserved AZSEBONYO The descriptive and summary statements in this presentation are not intended to substitute for the texts of any tax legislation FASB pronouncements or SEC regulations Companies should apply the texts of the relevant laws regulations and accounting requirements cone sider their particular circumstances and consult their accounting tax and legal adVisors Case 05 7 Ace Company In June 2002 Ace Company a US SEC registrant was in the process of raising 100 million of capital and is considering an offering of MEDS Equity Units with a targeted issue date of June 23 The CFO of Ace Company tells you that each MEDS Equity Unit consists of o A forward stock purchase agreement where the investor is obligated to purchase common stock of Ace Company in three years for 50 The number of shares to be purchased depends on the market price of Ace Company common stock at the time of settlement The holder of the forward stock purchase agreement receives periodic contract adjustment payments A note payable by Ace Company with a maturity of three years and siX months The interest rate payable is fixed for the first three years and it is reset and the note is remarketed to other investors at the end of three years The note is pledged as collateral under the forward stock purchase agreement The CFO provides you with a copy of the prospectus summary attached as Exhibit 1 and informs you that the investment bankers have confirmed that the interest rate on the note payable is equal to Ace Company s market rate ie if Ace Company issued the notes payable separately there would be no premium or discount The investment bankers also assert that the likelihood of a failed remarketing of the notes is remote The last reported sales price of Ace Company s common stock on the NYSE was 4000 Requirement In deciding how to account for the issuance of the MEDS Equity Units address the following issues 0 Should the components of an equity unit be accounted for separately If so how should the proceeds be allocated between the components of the units Should the unit if accounted for as a unit or the components if accounted for separately be accounted for as a derivative or should any embedded derivatives be accounted for separately Copyright 2004 Deloitte Development LLC All Rights Reserved Case 08 8 Gainey Auto Inc Albert Gator the controller of Gainey Auto Inc Gainey has requested a meeting with the engagement team and the chief nancial officer of Gainey to discuss implementation issues associated with the adoption of FASB Statements No 157 Fair Value Measurements and No 159 The Fair Value Option for Financial Assets and Financial Liabilities Gainey hasjust led its September 30 2007 Form 10Q and is interested in understanding the implications of the adoption of the fair value option FVO for certain assets and liabilities Gainey understands that in order to apply the FVO to the selected items for fiscal 2008 the company must make and document its elections by January 1 2008 but Gainey is unclear as to all of the implications Albeit indicated that Gainey is considering electing the fair value option for certain investments in debt securities that are accounted for as availableforsale AFS an investment in a joint venture forward commodity contracts an issuance of longterm debt and a warranty obligation Albeit has provided the following details about these assets and liabilities Assets include AFS debt securities which are traded on exchanges that are considered active markets A 50 percent limited partnership ownership interest in a joint venture called Tebow The Tebow investment is accounted for under the equity method of accounting Tebow owns and operates a tire manufacturing plant in Jacksonville Florida Gainey also funded the Tebow joint venture startup activities through an advance that is recorded as a loan receivable on Gainey s balance sheet at a carrying value of 195 million as of October 1 2007 Ninetyday forward commodity contracts to purchase steel used in production of its vehicles These contracts do not meet the definition of a derivative under FASB Statement No 133 Accounting for Derivative Instruments and Hedging Activities and are not currently reported on the balance sheet except for periodic contract settlement balances Liabilities include 2 billion of fixed rate public debt that is actively traded on an exchange This debt is fully hedged with an interest rate swap notional equals face value of debt that meets the hedging criteria in Statement 133 and is appropriately accounted for as a fair value hedge Unamortized debt issuance costs associated with this debt instrument are 4 million as of October 1 2007 Copyright 2008 Deloitte Development LLC All Rights Reserved Case 088 Gainey Auto Inc Page 2 o A warranty program providing replacement parts including any related service e g installation for defective products for up to five years Under the program Gainey may only settle the warranty by providing replacement parts and services ie Gainey cannot settle a claim in cash or pay a third party to perform under the warranty In preparation for implementing Statement 159 on January 1 2008 including having all of the required documentation in place Gainey performed a mock implementation as of October 1 2007 Before the meeting Albert gave the engagement team an analysis of the carrying value and estimated fair value of the assets and liabilities as of October 1 2007 the hypothetical date of adoption as presented below Albert and the CFO would like the engagement team to review the analysis and discuss whether management s analysis is reasonable and appropriate Albert and the CFO are planning to present this information to the Board of Directors later in the month Copyright 2008 Deloitte Development LLC All Rights Reserved Case 088 Gainey Auto Inc Page 3 Mock Implementation Gainey Analysis as of October 1 2007 October 1 2007 Type of Instrument Preelection Fair Value Pretax C331 Men 111211 DrCr Adoption Assets in 000 s AFS securities See note A 35000 33000 2000 Investment in Tebow 45000 47000 Commodity contracts 600000 600000 Liabilities Public fixedrate debt 1975000 2100000 125000 See note B Interest rate swap 25000 25000 Warranty obligation 1400000 1300000 100000 Notes A Because Gainey holds a substantial position in certain AFS securities Gainey s management believes the company would probably receive less than the quoted market price if it were to liquidate the entire position at once Therefore Gainey reduced the quoted market value of these securities by 2 million to arrive at the fair value ie Gainey incorporated a block discount B Unamortized debt issuance costs were 4 million as of October 1 2007 Copyright 2008 Deloitte Development LLC All Rights Reserved Case 088 Gainey Auto Inc Page 4 Required Answer the following questions documenting any issues identi ed and all professional literature used to support recommendations and conclusions for resolving these issues Issue 1 Is the election of the FVO and the measurement under Statement 157 of the items listed below appropriate accurate and complete If not what observations caused the engagement team concern Instruments Is the election of the FVO and the measurement of the item under Statement 157 appropriate accurate and complete If not describe the team s observations include references to applicable guidance AFS securities Investment in Tebow Commodity contracts Public xedrate debt including interest rate swap Warranty obligation Issue 2 Gainey has historically reported interest income generated from its trading securities as a separate line item in the income statement After electing the FVO for its AFS securities would Gainey be required to report interest income from these securities Copyright 2008 Deloitte Development LLC All Rights Reserved Accounting for Income Taxes Intraperiod tax allocation Involves WHERE we present income tax expense during a single year The quotnet of taxquot items are generally the same items for which we present an EPS number plus any prior period adjustments Interperiod tax allocation Related to temporary differences between accounting and taxable income Deferral approach to tax allocation APB Opinion 11 Income tax expense amount of taxes that would be paid if income statement numbers appeared on the current year39s tax return Deferred taxes was the plug gure difference between taxes payable and tax expense The effect of subsequent changes in tax rates on deferred tax account were essentially ignored Liability approach to tax allocation FASB 96 109 Income tax expense taxes currently payable plus change in deferred taxes If tax rates change the effect on deferred tax amounts affect income tax expense in the year the change is enacted If there are no changes in tax rates income tax expense should be approximately the same as under APB Opinion 11 Permanent Differences Permanent differences affect both the computation of taxable income and income tax expense as reported on the income statement Examples Interest revenue on Municipal Bonds Life insurance premiums and proceeds when coporation is bene ciary Fines and penalties Dividend exclusion Statutory depletion Tempora Differences Temporary differences occur when an item appears on financial statements in one year and on the tax return in a different year Taxable temporary differences give rise to deferred tax liabilities Deductible temporary differences give rise to deferred tax assets wd6Rr5daYldoc created by T Gordon 71310 Page 1 TEMPORARY DIFFERENCES Examples Taxable temporary differences Revenues or gains that are taxable after they are recognized on books Installment method for tax returns accrual method for nancial accounting purposes Completed contract method for tax returns percentage of completion method for nancial accounting purposes now uncommon Expenses or losses that are deductible before they are recognized on books Accelerated depreciation for tax returns straightline for financial accounting purposes Goodwill deductable on tax return but not an expense for GAAP However impairment of goodwill if it occurs would cause the writedown of goodwill and a loss on GAAP financial statements Impairment is NOT deductible for tax purposes Business combinations if assigned values of identifiable assets are higher than their tax basis the difference is a taxable temporary difference and the related deferred tax liability would increase the goodwill to be recorded A reduction in the tax basis of depreciable assets because of tax credits under 1982 law it was possible to get a larger investment tax credit if the depreciable basis of the assets were reduced similar result ifwe capitalize interest for book purposes but deduct it on tax return as aid Deductible tempo ram differences Expenses or losses that are deductible after they are recognized on books Warranty expenses accrued in year of sale according to GAAP deductible on tax return only when paid Unrealized losses gains on marketable securities FASB 115 deductible on tax return only when the securities are actually sold affects trading securities on income statement and available for sale securities on statement of comprehensive income Losses related to contingent liabilities compensated absenses lawsuits etc are deductible on tax return only when actually paid Revenues or gains that are taxable before they are recognized on books Subscription revenue recognized when earned per GAAP but taxable when collected Rent revenue received in advance deferred revenue under GAAP is taxable when received Investment tax credits accounted for by the deferral method An increase in the tax basis of assets because of indexing whenever the local currency is the functional currency wd6Rr5daYldoc created by T Gordon 71310 Page 2 Net operating cargybacks and cargyforwards Under current laws a net operating loss in a particular year can be carried back for two years or forward for 20 years The NOL would be handled as a deduction on the tax return of the year it is carried to If you carry back an NOL record quotincome tax refund receivablequot using the tax rate in effect the year you are carrying to If you elect to carryforward you would use the current tax rate or enacted future tax rate and record a quotdeferred tax assetquot Unused Tax credits may also be carried forward and would affect the amounts in the deferred tax accounts Other temporary differences Unremitted earnings of subsidiaries We report share of subsidiary s reported net income on parent company39s books this is not a taxable item currently However if we collect dividends they are probably partially taxable assuming 80 exclusion is in effect Valuation Allowance for Deferred Tax Assets Deferred tax assets must be reduced by a valuation allowance contra asset account if it is more likely than not 50 probability that they will not be realized CLASSIFICATION OF DEFERRED TAXES Deferred tax assets and liabilities are classi ed as current or noncurrent as follows If the amount is associated with a balance sheet account the deferred taxes are classi ed the same way For example differences in depreciation methods would give rise to noncurrent deferred tax liability because accumulated depreciation is noncurrent account If the amount is not associated with a balance sheet account the deferred taxes are classi ed on the basis of when the difference is expected to reverse if they reverse during next year classify as current otherwise as noncurrent For each taxing jurisdiction current temporary differences are combined and presented as either current asset net debit balance or current liability net credit balance The same procedure is used for noncurrent temporary differences Therefore there will be at most two lines on the balance sheet for deferred income tax assets or liabilities for each taxing authority state federal etc RECENT CHANGES FIN48 June 2006 clari es the accounting for uncertainty in income taxes recognized by prescribing a recognition threshold and measurement attribute for the nancial statement recognition and measurement of a tax position taken or expected to be taken in a tax return The Interpretation also provides guidance on derecognition classifrcation interest and penalties wd6Rr5daYldoc created by T Gordon 71310 Page 3 accounting in interim periods disclosure and transition Detailed notes are contained in the PowerPoint lecture slides The key points in the Interpretation are 7 A tax bene t may be re ected in the nancial statements only if it is more likely than not that the company will be able to sustain the tax return position based on its technical merits 7 A tax bene t should be measured as the largest amount of bene t that is cumulatively greater than 50percent likely to be realized lntraperiod Tax Allocation Income Statement Income tax expense or bene t for the year shall be allocated among continuing operations discontinued operations extraordinary items other comprehensive income and items charged or credited directly to shareholders39 equity paragraph 36 FASlO9 Par 35 Balance Sheet Owners Equity 01 Statement of Retained Earnings a Wd6Rr5daYldoc created by T Gordon 71310 Adjustments of the opening balance of retained earnings for certain changes in accounting principles or a correction of an error Gains and losses included in comprehensive income but excluded from net income for example translation adjustments under Statement 52 and changes in the unrealized holding gains and losses of securities classi ed as availableforsale under FASB Statement No 115 Accounting for Certain Investments in Debt and Equity Securities An increase or decrease in contributed capital for example deductible expenditures reported as a reduction of the proceeds from issuing capital stock An increase in the tax basis of assets acquired in a taxable business combination accounted for as a pooling of interests and for Which a tax benefit is recognized at the date of the business combination Expenses for employee stock options recognized differently for nancial reporting and tax purposes refer to paragraphs 5863 of FASB Statement No 123 revised 2004 ShareBased Payment Dividends that are paid on unallocated shares held by an ESOP and that are charged to retained earnings r 39 quot 39 39 r differ nch A existed at the date of a quasi reorganization except as set forth in paragraph FASlO9 Par 36 Page 4 Starr One Inc Starr One Inc was incorporated in 2007 Information related to its first five years of operation are shown below Deferred Tax Problem The company39s products carry a oneyear warranty The company policy is to always carryback net operating losses before opting for a carryforward Compute income tax expense and the deferred tax liabilityasset for each year Prepare journal entries 2007 2008 2009 2010 2011 Pretax accounting income 100000 120000 125000 200000 225000 Depreciation schedule Machinery with 5 year life no salvage Acquired 112007 for 1000000 2007 2008 2009 2010 2011 Total Straightline method book 200000 200000 200000 200000 200000 1000000 MACRS method tax 250000 380000 300000 70000 1000000 Difference 50000 180000 100000 130000 200000 Accounting income includes Life insurance premiums on officers 2300 2300 2500 2500 2800 Rent revenue accrual basis 50000 50000 Book depreciation 200000 200000 200000 200000 200000 Warranty expense accrual 20000 30000 35000 40000 42000 Taxable income includes MACRS depreciation 250000 380000 300000 70000 Rent revenue cash basis 100000 Warranty costs paid 10000 21000 31000 38000 39000 Income tax rates 2007 2008 2009 2010 2011 No changes anticipated 30 30 New law passed in early 2009 with phased in increases in tax rate for 2010 and beyond 32 34 34 Wd6Rr5daYldoc created by T Gordon 71310 Page 5 Deferred Tax Problems worksheet Permanent Differences Temporary Differences Inventory of TDs Net ending balance deferred tax Wd6Rr5daYldoc created by T Gordon 71310 Page 6 Deferred Tax Problems worksheet Permanent Differences Temporary Differences Inventory of TDs Net ending balance deferred tax Wd6Rr5daYldoc created by T Gordon 71310 Page 7 Deferred Tax Problems worksheet Permanent Differences Temporary Differences Inventory of TDs Net ending balance deferred tax Wd6Rr5daYldoc created by T Gordon 71310 Page 8
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