I Want The World to Know TV

ou read yesterday that many companies in the United States have pension plans that are severely cause you have your office interview tomorrow with United Dynamics. You hadnÕt really thought that much about the pension plan of your potential fu- ture employer, in part because your current employer has a defined contribution 401K plan, for which funding is not a concern. However, United Dynamics which funding is the employerÕs responsibility. prepare for your interview, you obtained a copy of United DynamicsÕ financial statements. Unfortunately, the financial statements themselves are of little 200720062005 Current service costs$43$47$42 Interest cost on projected benefit obligation178164152 20072006 Projected benefit obligation at beginning of year$2,194$2,121 Service cost4347 Interest cost178164 Actuarial (gain) loss319(40) Benefits paid(106)(98) Projected benefit obligation at end of year$2,628$2,194 THE NATURE OF PENSION PLANS Over 60 million American workers are covered by pension plans. The United StatesÕpension funds tripled in size during the previous two decades and now are roughly the size of JapanÕs gross national product. This powerful investment base now controls about one-fourth of the By the time you finish this chapter, you should be able to respond appropriately to the questions posed in this case. Compare your esponse to the solution provided at the end of the chapter. at December 31, 2007, and 7.73% and 4.7%, respectively, at December 31, 2006. The expected long-term rate 20072006 enhance productivity, educe turnover, satisfy perhaps loyalty that might enhance productivity and reduce turnover. Motivation to sponsor When established according to tight guidelines, a pension plan gains important tax ad- vantages. Such arrangements are called able tax treatment. In a qualified plan, the employer is permitted an immediate tax ees, on the other hand, are not taxed at the time employer contributions are madeÑ Defined contribution pension plans promise fixed annual contributions to a pension fund (say,5% of the employeesÕpay). Employees choose (from designated options) Defined benefit pension plans ADDITIONALCONSIDERATION pension plans are SECTION 3Financial Instruments and Liabilities The two categories of pension plans are depicted in Graphic 17Ð1. Both types of plans have a common goal:to provide income to employees during their re- tirement years. Still,the two types of plans differ regarding who bears the riskÑthe em- AND/OR EMPLOYEE CONTRIBUTIONS agreement Dependent on success of employer's investments Defined by pension formula ? promise defined commitment regarding One popular way for employer companies to provide contributions is with shares of its own common stock. If so,the arrangements usually are designed to comply with government requirements to be designated an employee stock ownership plan (ESOP). Accounting for these plans is quite easy. Each year,the employer simply records pension xpense equal to the amount of the annual contribution. Suppose a plan promises an annual contribution equal to 3% of an employeeÕs salary. If an employeeÕs salary is $110,000 in a particular year,the employer would simply recognize compensation expense in the amount of the contribution: Pension expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,300 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,300 PlanÑCisco Systems The Company sponsors the Cisco Systems, Inc. 401(k) Plan to pro- Of course,this is not entirely unappealing to the employee. Defined contribution plans allow an employee to select investments promise fixed SECTION 3Financial Instruments and Liabilities accounting to pensions, this Pension Expense Interest Interest and investment ays to Measure the SECTION 3Financial Instruments and Liabilities have been changed periodically since then. Beginning in 1989,benefits must vest (a) fully within five years or (b) 20% within three years with another 20% vesting each subsequent year until fully vested after seven years. Five-year vesting is most common. ERISA also es- tablished the Pension Benefit Guaranty Corporation (PBGC) to impose liens on corporate as- Present value projected pay increases Present value present pay Present value present pay Projected ested benefit obligation Alternative Measures ignores possible pay increases in the future. project future salaries for a group of employees,actuaries usually assume some percentage rate of increase in compensation l upcoming years. Recent estimates of the rate of compensation increase have ranged from 4.5% to 10% with 4.5% being the most com monly reported expectation (AICPA, Accounting Trends and Techniques, If the actuaryÕs estimate of the final salary hasnÕt changed,the PBO a year later at the end of 2006 would be $139,715 as demonstrated in Illustration 17Ð1A. from $119,822 to $139,715 for two reasons: 1.One more service year is included in the pension formula calculation (service cost). Jessica Farrow was hired by Global Communications in 1996. The company has a defined LLUSTRATION more service year. SECTION 3Financial Instruments and Liabilities Each yearÕs service Interest accrues on the PBO each year. amended, credit often service rendered in 1. Service cost. As we just witnessed in the illustration,the PBO increases each year by the amount of that yearÕs service cost. This represents the increase in the projected benefit obligation attributable to employee service performed during the period. As we explain later, it also is the primary component of the annual pension expense. 2. Interest cost. interest cost. Even though the projected benefit obligation is not formally recognized as a liability in the com- can verify the increase in the PBO as being caused by the service cost and interest PBO at the beginning of 2006 (end of 2005)$119,822 1 yr. .1845612,701 ADDITIONALCONSIDERATION Assumed discount rates should reflect rates used currently in annuity contracts. Discount rates recently reported have ranged f to 7%,with 6.5% being the most commonly assumed rate (AICPA, Accounting Trends and Techniques, Prior service cost also is created if a defined benefit pension plan is initially adopted by a company that previously did not have one,and can verify the PBO balance by calculating it directly: Present value ( ADDITIONALCONSIDERATION  Ecolab, Inc. SECTION 3Financial Instruments and Liabilities PBO at the beginning of 2007 (end of 2006)$158,341 1 yr. .1956315,258 Revised EstimatePBO 81,6001.7% 935,945$85,680 183,099$982,743 The difference of represents a loss on the PBO because the obligation turned out to be higher than previously expected. Now there would be three elements of the increase in the PBO at the beginning of 2007$158,341 (calculated above)15,258 Interest cost (calculated above)9,500 PBO at the end of 2007$192,254 If a revised estimate causes the PBO to be lower than previously expected,a gain would be indicated. Consider how a few of the other possible estimate changes would affect the A change in the assumed discount rate would affect the present value calculations. A lower rate would increase the estimate of the PBO. A higher rate would decrease the  increased as a result of interest cost. Decreases and increases in estimates periodic reevaluation of uncertainties are called The revised estimate increase. Change in the PBO The Projected Benefits Obligation Changes as a Result of: CauseEffectFrequency Interest cost no obligation exists to accrue interest) Whenever revisions are made in the pension liability The changes in the PBO for Global Communications during 2007 were as follows: (amount assumed)$400 (amount assumed)41 Interest cost: 6%24 (amount assumed)23 LLUSTRATION *Of course, these expanded amounts are not simply the amounts for Jessica Farrow multiplied by 2,000 employees be- SECTION 3Financial Instruments and Liabilities provide the anticipated benefits? To ensure sufficient funding,Global will contribute cash yearÕs service cost plus a portion of the prior service cost. Cash of $48 million was con- LLUSTRATION AICPA, Accounting Trends and Techniques, thePBO exceeds plan REPORTING THE FUNDED STATUS OF THE PENSION PLAN services are performed. A company must report SECTION 3Financial Instruments and Liabilities These are the changes LLUSTRATION Periodic Pension statement is a An alternative to this straight-line approach,called the SECTION 3Financial Instruments and Liabilities Service cost $41 Interest cost24 Prior service cost at the beginning of 2007$56 Prior service cost at the end of 2007$52 Projected Benefit Loss Gain Gain red by a dominant segment of corporate America that was concerned with the effect of allowing gains and losses to immediately impact reported earnings. In 2006,the FASB de- The Board believes that it appropriate and preferable recognition of gains andlosses, or perhaps [to have].. . gains and losses reported currently in comprehensive However, it concluded that those approaches would be too great a change from past atthepresent time. The Board acknowledges that the delayed recognition current and most relevant SECTION 3Financial Instruments and Liabilities ADDITIONALCONSIDERATION GLOBALPERSPECTIVE Most large companies in Japan sponsor pension plans that are funded through financial institutions. Contributions to pension funds are tax deductible. Because the taxes levied the government are reported as income tax expense on the income statement, most Japanese companies report annual pension expense equal to cash contributions to the pension fund. In other countries, such as France, Belgium, Finland, India, and New Zealand, pension costs are not covered by accounting standards. In still other countries pension accounting is irrelevant because the occurrence of pension plans is rare (Korea, Argentina, and Brazil, forexample). REPORTING ISSUES Recording the Pension Expense Recall from Illustration 17Ð4 that GlobalÕs 2007 pension expense is $43 million. Three of the five components of that expense affect the pension liability. HereÕs why. The expense million interest cost,both of which add to Record Pension Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 . . . . . . . . . . . . . . . . . . . . . . . . . . 38 . . . . . . . . . . . . . . . . . . . . . 4 Record Funding Pension liability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Pension liability   SECTION 3Financial Instruments and Liabilities Record Gains and Losses as Other Comprehensive Income (OCI) (from change in assumption) Just as we record new losses and gains as they occur, we also will record a change in the prior service cost account for any new prior service cost should it occur. For instance, if Global revised its pension formula again and recalculated its PBO using the more gen- erous formula, causing a $40 million increase in the PBO, the company would record the Record New Prior Service Cost as Other Comprehensive Prior service costÐOCI (increase in PBO due to plan amendment). . . . 40 Pension liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 rather than increases the PBO, the would reduce both the prior service cost and pension liability. Comprehensive Income Comprehensive income,as you may recall from Chapter 4,is a more expansive view of in- ADDITIONALCONSIDERATION occur) are reported as in the pension liability. Disclosure of Pension 200420032002 Service cost$ 239$ 248$ 218 Interest cost534531503 areitemized in the disclosure note. 20 Pension liability LLUSTRATION Comprehensive arise, are among the other comprehensive period they occur. LLUSTRATION Comprehensive here are 3 options for reporting other comprehensive created during the reporting period . The statement of comprehensive income can be presented: versi on of the statement Within the statement of shareholders’ equity In a disclosure note Other comprehensive income (a) is reporte as it is created and (b) also is reported as a cumulative accumulated amount of other comprehensive income is reported as a separate item of shareholders’ equity in the *From Illustration 17Ð4 on p. 842 Note: These amounts are shown without considering taxes. Actually each of the elements of comprehensive income SECTION 3Financial Instruments and Liabilities would have reported occurs and also as an Informal RecordsFormal Records SECTION 3Financial Instruments and Liabilities Investors and creditors must be cautious of the nontraditional treatment of pension infor- mation when developing financial ratios as part of an analysis of financial statements. The from the disclosure notes and adjusting the computation of the ratios. Similarly,without ad- justment,profitability ratios and the times interest earned ratio will be distorted because pen- Defined Benefit PlanÑ At December 31,2007,$16 million was contributed to the pension fund and $22 million was SECTION 3Financial Instruments and Liabilities Despite the similarities,though,there are a few differences in the characteristics of the benefits that necessitate differences in accounting treatment. Because accounting for the two DisclosuresÑGeneral be for current employees. Then,as illustrated in Graphic 17Ð14 above,contributions to those medical costs in each year Medicare wo Views of the Health care cost trend rates recently reported have ranged from 5.5% to 14%,with 10% being the most commonly assumed rate. AICPA, Accounting Trends and Techniques, SECTION 3Financial Instruments and Liabilities attribution of the costs to the years the benefits are assumed earned. discuss attribution in the next section. If the plan specifically grants credit only for service from a date after employeeÕs date of hire,the beginning of the attribut considered to be the beginning of that credited service period,rather than the employeeÕs date of hire. Or any beneficiaries and covered dependents. $3,098 represents the 10years of the 35-year The APBO increases interest accrued on theAPBO and (b) the attributed to that year. $3,612 represents the 11years of the 35-year benefits are assumed to be earned by afterthat date. Jessica Farrow was hired by Global Communications at age 22 at the beginning of 1996 and ou probably recognize this as the situation used earlier in the chapter to illustrate pension accounting. Pensio n benefits Other post 100% 0% cost differs, though, difference in the way employees acquire SECTION 3Financial Instruments and Liabilities record losses and comprehensive income of 2007. Before doing so,however,we can anticipate (a) the EPBO to be $11,493 1.06,or $12,182,(b) the APBO to be of that amount,or $4,177,and (c) the 2007 service cost to be of that amount,or $348. In Illustration 17Ð9 we see if our expectations are borne out by Present value earAgeBenefitat 2035 2036625,0004,717 2037635,6004,984 2038646,3005,290 2039653,0002,376 ~~~~ 2054809,5503,156 20558110,3003,212 19962007 203020352055 LLUSTRATION SECTION 3Financial Instruments and Liabilities When they analyze financial statements,investors and creditors should be wary of the nonstan- Estimates of the obligations (PBO,ABO,vested benefit obligation,EPBO,and APBO). The discount rates,the assumed rate of compensation increases used to measure the Estimated benefit payments presented separately for the next five years and in the aggregate for years 6Ð10. Estimate of expected contributions to fund the plan for the next year. Disclosures related to the modifications SFAS 158 introduced,including (a) any changes Other information to make it possible for interested analysts to reconstruct the financial Present value ( GLOBALPERSPECTIVE SECTION 3Financial Instruments and Liabilities 1.Why is underfunding not a concern in your present employment? (p. 831) contribution plan, the employer is not obliged to provide benefits beyond the annual contri- Pension plans are arrangements designed to provide income to individuals during their re- tirement years. Defined contribution plans promise fixed annual contributions to a pen- ÒEmployersÕAccounting for Pensions,Ó Statement of Financial Accounting Standards No. 87 (Stamford,Conn.:FASB,1985),par. 26. SECTION 3Financial Instruments and Liabilities Employees Still EmployedFraction of TotalPriorAmount ear(assumed for the illustration)Service YearsService CostAmortized 20062,000 20072,000 20081,850 20091,700 20101,550 ÑÑÑÑÑ 2031400 2032250 2033100 otals30,000 otal numberTotal amount of service yearsamortized What is a pension plan? What motivates a corporation to offer a pension plan for its employees? Qualified pension plans offer important tax benefits. What is the special tax treatment and what qualifies a pension plan for these benefits? Lamont Corporation has a pension plan in which the corporation makes all contributions and employees re- When accounting for pension costs,how should the payment into the pension fund be recorded? TFC,Inc. revises its estimate of future salary levels,causing its PBO estimate to increase by $3 million. How is the $3 reflected in TFCÕs financial statements? A pension plan is underfunded when the employerÕs obligation (PBO) exceeds the resources available to sat- projected benefit projected benefit projected benefit projected benefit SECTION 3Financial Instruments and Liabilities ____ 1.Interest cost. ____ 2.Amortization of prior service cost. ____ 3.A decrease in the average life expectancy of employees. ____ 4.An increase in the average life expectancy of employees. Recording pension Recording pension available with McGraw-HillÕs Homework Manager www.mhhe.com/spiceland4e ____ 1.Interest cost. ____2. Amortization of prior service cost. Projected benefit obligation, January 1, 2007$360 Projected benefit obligation, December 31, 2007465 Accumulated benefit obligation, January 1, 2007300 Accumulated benefit obligation, December 31, 2007415 Cash contributions to pension fund, December 31, 2007150 Recording pension SECTION 3Financial Instruments and Liabilities Pension data for Fahy Transportation,Inc. include the following: Discount rate, 7% Service cost, 2007$112 Projected benefit obligation, January 1, 2007850 Projected Benefit Obligation Balance, January 1$120 Service cost20 Interest cost12 Benefits paid(9) Balance, December 31$143 Discount rate, 7% Case 1Case 2Case 3 Informal RecordsFormal Records ( )s indicate credits; calculations; present SECTION 3Financial Instruments and Liabilities Prior service cost0 Service cost $224 Interest cost150 List AList B LO2 through LO8 Effect of pension Beale Management has a noncontributory,defined benefit pension plan. On December 31,2007 (the end of BealeÕs fiscal year),the following pension-related data were available: Projected Benefit Obligation Balance, January 1, 2007$480 Service cost82 Interest cost, discount rate, 5%24 Gain due to changes in actuarial assumptions in 2007(10) Pension benefits paid(40) Balance, December 31, 2007$536 A.Change in principle B.Change in estimate C.Correction of an error D.Neither an accounting change nor an error changes and errors Multiple choice; CPA Record pension SECTION 3Financial Instruments and Liabilities ____ 1.Change in actuarial assumptions for a defined benefit pension plan. Service cost$124 Required: Prior service costÑoriginated in 2002$50 SECTION 3Financial Instruments and Liabilities c. Benefits are utilized. d. Benefits are paid. The following questions dealing with pensions are adapted from questions that previously appeared on Cer- tified Management Accountant (CMA) examinations. The CMA designation sponsored by the Institute of Management Accountants ( available with McGraw-HillÕs Homework Manager www.mhhe.com/spiceland4e 4.If no estimates are changed in the meantime,what will be the accumulated benefit obligation at the end of 2010 (three years later) when DavenportÕs salary is $100,000? expense; present value Service cost, interest, present value concepts present value concepts SECTION 3Financial Instruments and Liabilities Stanley-Morgan Industries adopted a defined benefit pension plan on April 12,2007. The provisions of the Informal RecordsFormal Records ( )s indicate credits: LO3 through LO8 LO3 through LO8 SECTION 3Financial Instruments and Liabilities The funded status of Hilton Paneling,Inc.Õs defined benefit pension plan and the balances in prior service 20072007 Beginning BalancesEnding Balances Projected benefit obligation$2,300$2,501 Jan. 1Dec. 31 Projected benefit obligation$4,100$4,380 Accumulated benefit obligation3,7153,950 ComprehensiveÑ LO3 through LO8 ComprehensiveÑ LO3 through LO8 Integrating ProblemÑ Deferred tax effects of SECTION 3Financial Instruments and Liabilities Required: 20072007 BalancesBalances LO9 through LO11 LO9 through LO11 ABC D ars to Future Value LO2 through LO8 benefits are based on employee service years and the employeeÕs compensation during the last two eral tax code. Plan contributions provide for benefits expected to be earned in the future as well as those earned to date. The following reconciles the planÕs funded status and amount recognized in the SECTION 3Financial Instruments and Liabilities his new employerÕs obligation under the plan. In part,the pension footnote reads as follows: 20072006 Projected benefit obligation at beginning of year$3,786$3,715 Service cost10394 Interest cost287284 Actuarial (gain) loss302(23) Benefits paid(324)(284) Projected benefit obligation at end of year$4,154$3,786 20072006 20072006 200720062005 Service cost$ 103$ 94$ 112 Interest cost287284263 International Case17Ð5 Case17Ð4 BarlowÕs wife; SECTION 3Financial Instruments and Liabilities Required: 1.What is Mr. MaxwellÕs apparent motivation for the change in the way contributions are handled? 5.Repeat steps 2 through 4 for a second firm. Compare and contrast the types of pension plans offered. Are actuarial assumptions the same for defined benefit plans? Refer to the financial statements and related disclosure notes of edEx Corporation in Appendix B at the end of the book. FedEx sponsors pension plans covering substantially all employees. The largest plan cov- ers U.S. domestic employees age 21 and over,with at least one year of service,and provides benefits based on average earnings and years of service. The plans are described in Note 12. Required: 1.Are FedExÕs pension plans overfunded or underfunded? 2.FedEx reports three actuarial assumptions used in its pension calculations. Did the reported changes in those assumptions from 2003 to 2004 increase or decrease the projected benefit obligation? Why? Charles Rubin is a 30-year employee of . Charles was pleased with recent negotiations be- tween his employer and the United Auto Workers. Among other favorable provisions of the new agreement, the pact also includes a 13% increase in pension payments for workers under 62 with 30 years of service Real World Case 17Ð9 Pension disclosures Research Case 17Ð7 Researching pension Required: Demonstrating an understanding of financial reporting effects of various contingencies. Communicating the way to calculate financial ratios related to liabilities and what they attempt to Researching appropriate accounting for the transfer of accounts receivable to a third party. Research Case 17Ð11 Researching the way employee benefits are tested on the CPA CPA SIMULATION 17Ð1 OVERVIEW Employee compensation comes in many forms. Salaries and wages, of course, provide direct and current payment for services provided. However, itÕs common- LO2Distinguish among the vested benefit obligation, the accumulated benefit obligation, and the projected LO3Describe the five events that might change the balance of the PBO. LO5Describe the funded status of pension plans and how that amount is reported. LO6Describe how pension expense is a composite of periodic changes that occur in both the pension LO7Record for pension plans the periodic expense and funding as well as new gains and losses and new prior service cost as they occur. LO8Understand the interrelationships among the elements that constitute a defined benefit pension plan.