Chapter 20 Textbook Outline
Chapter 20 Textbook Outline Acc 302
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This 3 page Class Notes was uploaded by Lauren95 on Thursday March 31, 2016. The Class Notes belongs to Acc 302 at Pace University taught by Reisig in Spring 2016. Since its upload, it has received 7 views. For similar materials see Intermediate Accounting II in Accounting at Pace University.
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Date Created: 03/31/16
Chapter 20 – Pensions: A pension plan is an arrangement whereby an employer provides benefits (payments) to retired employees for services they provided in their working years. Pension accounting may be divided and separately treated as accounting for the employer and accounting for the pension fund. The company or employer is the organization sponsoring the pension plan. It incurs the cost and makes contributions to the pension fund. The fund or plan is the entity that receives the contributions from the employer, administers the pension assets, and makes the benefit payments to the retired employees (pension recipients). A pension plan is funded when the employer makes payments to a funding agency. o That agency accumulates the assets of the pension fund and makes payments to the recipients as the benefits come due. Some pension plans are contributory. o The employees bear part of the cost of the stated benefits or voluntarily make payments to increase their benefits. Other plans are noncontributory. o The employer bears the entire cost. Companies generally design their pension plans so as to take advantage of federal income tax benefits. Plans that offer tax benefits are called qualified pension plans. The two most common types of pension plans are defined contribution plans and defined benefit plans: Defined contribution plan o The employer agrees to contribute to a pension trust a certain sum each period, based on a formula. o This formula may consider such factors as age, length of employee service, employer’s profits, and compensation level. o The plan defines only the employer’s contribution. o It makes no promise regarding the ultimate benefits paid out to the employees. A common form of this plan is a 401(k) plan. A defined benefit plan outlines the benefits that employees will receive when they retire. These benefits typically are a function of an employee’s years of service and of the compensation level in the years approaching retirement. o The employees are the beneficiaries of a defined contribution trust, but the employer is the beneficiary of a defined benefit trust. o The trust’s primary purpose is to safeguard and invest assets so that there will be enough to pay the employer’s obligation to the employees. o In form, the trust is a separate entity. o In substance, the trust assets and liabilities belong to the employer. o As long as the plan continues, the employer is responsible for the payment of the defined benefits (without regard to what happens in the trust ). Companies engage actuaries to ensure that a pension plan is appropriate for the employee group covered. Actuaries are individuals trained through a long and rigorous certification program to assign probabilities to future events and their financial effects. The insurance industry employs actuaries to assess risks and to advise on the setting of premiums and other aspects of insurance policies. Employers rely heavily on actuaries for assistance in developing, implementing, and funding pension funds. Actuaries make predictions (called actuarial assumptions ) of mortality rates, employee turnover, interest and earnings rates, early retirement frequency, future salaries, and any other factors necessary to operate a pension plan. They also compute the various pension measures that affect the financial statements, such as the pension obligation, the annual cost of servicing the plan, and the cost of amendments to the plan. Pension obligation is the deferred compensation obligation it has to its employees for their service under the terms of the pension plan. Vested benefits are those that the employee is entitled to receive even if he or she renders no additional services to the company. o Most pension plans require a certain minimum number of years of service to the employer before an employee achieves vested benefits status. o Companies compute the vested benefit obligation using only vested benefits, at current salary levels. The company computes the deferred compensation amount on all years of employees’ service— both vested and nonvested —using current salary levels. o This measurement of the pension obligation is called the accumulated benefit obligation. A third measure bases the deferred compensation amount on both vested and nonvested service using future salaries. o This measurement of the pension obligation is called the projected benefit obligation. o Because future salaries are expected to be higher than current salaries, this approach results in the largest measurement of the pension obligation. o The profession adopted the projected benefit obligation—the present value of vested and nonvested benefits accrued to date, based on employees’ future salary levels. The profession recognizes that accounting for pension plans requires measurement of the cost and its identification with the appropriate time periods. 1. Service cost. o Service cost is the expense caused by the increase in pension beneﬁts payable (the projected beneﬁt obligation ) to employees because of their services rendered during the current year. o Actuaries compute service cost as the present value of the new beneﬁts earned by employees during the year. 2. Interest on the liability. o Because a pension is a deferred compensation arrangement, there is a time value of money factor. o As a result, companies record the pension liability on a discounted basis. o Interest expense accrues each year on the projected beneﬁt obligation just as it does on any discounted debt. o The actuary helps to select the interest rate, referred to as the settlement rate . 3. Actual return on plan assets. o The return earned by the accumulated pension fund assets in a particular year is relevant in measuring the net cost to the employer of sponsoring an employee pension plan. o Therefore, a company should adjust annual pension expense for interest and dividends that accumulate within the fund, as well as increases and decreases in the fair value of the fund assets. 4. Amortization of prior service cost. o Pension plan amendments (including initiation of a pension plan) often include provisions to increase beneﬁts (or in rare situations, to decrease beneﬁts) for employee service provided in prior years. o A company grants plan amendments with the expectation that it will realize economic beneﬁts in future periods. o Thus, it allocates the cost ( prior service cost ) of providing these retroactive beneﬁts to pension expense in the future , speciﬁcally to the remaining service-years of the affected employees. 5. Gain or loss. o Volatility in pension expense can result from sudden and large changes in the fair value of plan assets and by changes in the projected beneﬁt obligation (which changes when actuaries modify assumptions or when actual experience differs from expected experience). o Two items comprise this gain or loss: (1) the difference between the actual return and the expected return on plan assets, and (2) amortization of the net gain or loss from previous periods. Years-of-service method that is similar to a units-of-production computation. o First, the company computes the total number of service-years to be worked by all of the participating employees. o Second, it divides the prior service cost by the total number of service-years, to obtain a cost per service-year (the unit cost). o Third, the company multiplies the number of service-years consumed each year by the cost per service- year, to obtain the annual amortization charge. Corridor approach for amortizing the account’s accumulated balance when it gets too large.