Question

Review the authoritative literature regarding accounting changes and relate it to the discount rate and rate of return changes for pensions and other postretirement benefits. Under what circumstances are changes in estimates justifiable?

Answer 1

Ans) ACCOUNTING FOR PENSIONS AND POSTRETIREMENT BENEFITS

NATURE OF PENSION PLANS	ACCOUNTING FOR PENSIONS	USING A PENSION WORKSHEET	REPORTING PENSION PLANS IN FINANCIAL STATEMENTS
		2010 entries and worksheet	Within the financial statements
Defined-contribution plan	Alternative measures of liability	Amortization of prior service cost	Within the notes to the financial statements
Defined-benefit plan	Recognition of net funded status	2011 entries and worksheet	Pension note disclosure
Role of actuaries	Components of pension expense	Gain or loss	2013 entries and worksheet— a comprehensive example
		2012 entries and worksheet	Special issues

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.

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. In these, the employees bear part of the cost of the stated benefits or voluntarily make payments to increase their benefits. Other plans are noncontributory. In these plans, 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. They permit deductibility of the employer’s contributions to the pension fund and tax-free status of earnings from pension fund assets.

The Role of Actuaries in Pension Accounting

The problems associated with pension plans involve complicated mathematical considerations. Therefore, 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. In summary, accounting for defined-benefit pension plans relies heavily upon information and measurements provided by actuaries.

Components of Pension Expense

There is broad agreement that companies should account for pension cost on the accrual basis. The profession recognizes that accounting for pension plans requires measurement of the cost and its identification with the appropriate time periods. The determination of pension cost, however, is extremely complicated because it is a function of the following components.

1. Service Cost. 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. Actuaries compute service cost as the present value of the new benefits earned by employees during the year.

2. Interest on the Liability. Because a pension is a deferred compensation arrangement, there is a time value of money factor. As a result, companies record the pension liability on a discounted basis. Interest expense accrues each year on the projected benefit obligation just as it does on any discounted debt. The actuary helps to select the interest rate, referred to as the settlement rate.

3. Actual Return on Plan Assets. 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. 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 market value of the fund assets.

4. Amortization of Prior Service Cost. Pension plan amendments (including initiation of a pension plan) often include provisions to increase benefits (or in rare situations, to decrease benefits) for employee service provided in prior years. A company grants plan amendments with the expectation that it will realize economic benefits in future periods. 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. Volatility in pension expense can result from sudden and large changes in the market 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). 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.

Service Cost The service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. That is, the actuary predicts the additional benefits that an employer must pay under the plan’s benefit formula as a result of the employees’ current year’s service, and then discounts the cost of those future benefits back to their present value. The Board concluded that companies must consider future compensation levels in measuring the present obligation and periodic pension expense if the plan benefit formula incorporates them. In other words, the present obligation resulting from a promise to pay a benefit of 1 percent of an employee’s final pay differs from the promise to pay 1 percent of current pay. To overlook this fact is to ignore an important aspect of pension expense. Thus, the FASB adopts the benefits/years-of-service actuarial method, which determines pension expense based on future salary levels

Interest on the Liability

The second component of pension expense is interest on the liability, or interest expense. Because a company defers paying the liability until maturity, the company records it on a discounted basis. The liability then accrues interest over the life of the employee. The interest component is the interest for the period on the projected benefit obligation outstanding during the period. The FASB did not address the question of how often to compound the interest cost. To simplify our illustrations and problem materials, we use a simple-interest computation, applying it to the beginning-of-the-year balance of the projected benefit liability.

How do companies determine the interest rate to apply to the pension liability?

The Board states that the assumed discount rate should reflect the rates at which companies can effectively settle pension benefits. In determining these settlement rates, companies should look to rates of return on high-quality fixed-income investments currently available, whose cash flows match the timing and amount of the expected benefit payments. The objective of selecting the assumed discount rates is to measure a single amount that, if invested in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the pension benefits when due. Actual Return on Plan Assets Pension plan assets are usually investments in stocks, bonds, other securities, and real estate that a company holds to earn a reasonable return, generally at minimum risk. Employer contributions and actual returns on pension plan assets increase pension plan assets. Benefits paid to retired employees decrease them. As we indicated, the actual return earned on these assets increases the fund balance and correspondingly reduces the employer’s net cost of providing employees’ pension benefits. That is, the higher the actual return on the pension plan assets, the less the employer has to contribute eventually and, therefore, the less pension expense that it needs to report. The actual return on the plan assets is the increase in pension funds from interest, dividends, and realized and unrealized changes in the fair-market value of the plan assets. Companies compute the actual return by adjusting the change in the plan assets for the effects of contributions during the year and benefits paid out during the year.

If the actual return on the plan assets is positive (a gain) during the period, a company subtracts it when computing pension expense. If the actual return is negative (a loss) during the period, the company adds it when computing pension expense.

Companies often use a worksheet to record pension-related information.

As its name suggests, the worksheet is a working tool. A worksheet is not a permanent accounting record: it is neither a journal nor part of the general ledger. The worksheet is merely a device to make it easier to prepare entries and the financial statements.

The “General Journal Entries” columns of the worksheet (near the left side) determine the entries to record in the formal general ledger accounts. The “Memo Record” columns (on the right side) maintain balances in the projected benefit obligation and the plan assets. The difference between the projected benefit obligation and the fair value of the plan assets is the pension asset/liability, which is shown in the balance sheet. If the projected benefit obligation is greater than the plan assets, a pension liability occurs. If the projected benefit obligation is less than the plan assets, a pension asset occurs. On the first line of the worksheet, a company records the beginning balances (if any). It then records subsequent transactions and events related to the pension plan using debits and credits, using both sets of columns as if they were one. For each transaction or event, the debits must equal the credits. The ending balance in the Pension Asset/Liability column should equal the net balance in the memo record.

Amortization of Prior Service Cost (PSC)

When either initiating (adopting) or amending a defined-benefit plan, a company often provides benefits to employees for years of service before the date of initiation or amendment. As a result of this prior service cost, the projected benefit obligation is increased to recognize this additional liability. In many cases, the increase in the projected benefit obligation is substantial.

The FASB says no. The Board’s rationale is that the employer would not provide credit for past years of service unless it expects to receive benefits in the future. As a result, a company should not recognize the retroactive benefits as pension expense in the year of amendment. Instead, the employer initially records the prior service cost as an adjustment to other comprehensive income. The employer then recognizes the prior service cost as a component of pension expense over the remaining service lives of the employees who are expected to benefit from the change in the plan.

Smoothing Unexpected Gains and Losses on Plan Assets

One component of pension expense, actual return on plan assets, reduces pension expense (assuming the actual return is positive). A large change in the actual return can substantially affect pension expense for a year. Assume a company has a 40 percent return in the stock market for the year. Should this substantial, and perhaps one-time, event affect current pension expense? Actuaries ignore current fluctuations when they develop a funding pattern to pay expected benefits in the future. They develop an expected rate of return and multiply it by an asset value weighted over a reasonable period of time to arrive at an expected return on plan assets. They then use this return to determine a company’s funding pattern.

PENSIONS COSTS UPS AND DOWN

For some companies, pension plans generated real profits in the late 1990s. The plans not only paid for themselves but also increased earnings. This happens when the expected return on pension assets exceed the company’s annual costs. At Norfolk Southern, pension income amounted to 12 percent of operating profit. It tallied 11 percent of operating profit at Lucent Technologies, Coastal Corp., and Unisys Corp. The issue is important because in these cases management is not driving the operating income—pension income is. And as a result, income can change quickly. Unfortunately, when the stock market stops booming, pension expense substantially increases for many companies. The reason: Expected return on a smaller asset base no longer offsets pension service costs and interest on the projected benefit obligation. As a result, many companies find it difficult to meet their earnings targets, and at a time when meeting such targets is crucial to maintaining the stock price.

Corridor Amortization

The asset gains and losses and the liability gains and losses can offset each other. As a result, the Accumulated OCI account related to gains and losses may not grow very large. But, it is possible that no offsetting will occur and that the balance in the Accumulated OCI account related to gains and losses will continue to grow.

Special Issues

The Pension Reform Act of 1974 The Employee Retirement Income Security Act of 1974—ERISA—affects virtually every private retirement plan in the United States. It attempts to safeguard employees’ pension rights by mandating many pension plan requirements, including minimum funding, participation, and vesting. These requirements can influence the employers’ cash flows significantly. Under this legislation, annual funding is no longer discretionary. An employer now must fund the plan in accordance with an actuarial funding method that over time will be sufficient to pay for all pension obligations. If companies do not fund their plans in a reasonable manner, they may be subject to fines and/or loss of tax deductions.

POSTRETIREMENT BENEFITS ACCOUNTING PROVISIONS

Healthcare and other postretirement benefits for current and future retirees and their dependents are forms of deferred compensation. They are earned through employee service and are subject to accrual during the years an employee is working. The period of time over which the postretirement benefit cost accrues is called the attribution period. It is the period of service during which the employee earns the benefits under the terms of the plan.

Discount Rate

Over the past few years, we have provided insights into approaches used to support discount rates for defined benefit plans (e.g., hypothetical bond portfolio, yield curve, index-based discount rate), as well as considerations related to how the discount rates should be applied when an entity measures its benefit obligation. Recently, one of the most discussed emerging issues related to discount rates for defined benefit plans has been the use of a more granular approach to measure components of benefit cost. Considerations related to an entity’s discount rate selection method, its use of a yield curve, and its measurement of components of benefit cost are addressed below.

Discount Rate Selection Method

ASC 715-30-35-43 requires the discount rate to reflect rates at which the defined benefit obligation could be effectively settled. In the estimation of those rates, it would be appropriate for an entity to use information about rates implicit in current prices of annuity contracts that could be used to settle the obligation. Alternatively, employers may look to rates of return on high-quality fixed-income investments that are currently available and expected to be available during the benefits’ period to maturity.

One acceptable method of deriving the discount rate would be to use a model that reflects rates of zero-coupon, high-quality corporate bonds with maturity dates and amounts that match the timing and amount of the expected future benefit payments. Since there are a limited number of zero-coupon corporate bonds in the market, models are constructed with coupon-paying bonds whose yields are adjusted to approximate results that would have been obtained through the use of the zero-coupon bonds. Constructing a hypothetical portfolio of high-quality instruments with maturities that mirror the benefit obligation is one method that can be used to achieve this objective. Other methods that can be expected to produce results that are not materially different would also be acceptable — for example, use of a yield curve constructed by a third party such as an actuarial firm. The use of indexes may also be acceptable.

Entity’s Use of a Yield Curve Developed by a Third Party to Support Its Discount Rate

To support its discount rate, an entity may elect to use a yield curve constructed by an actuarial firm or other third party. Many yield curves constructed by actuarial firms or other third parties are supported by a white paper or other documentation that discusses how the yield curves are constructed. Management should understand how the yield curve it has used to develop its discount rate was constructed as well as the universe of bonds included in the analysis. If applicable, management should also evaluate and reach conclusions about the reasonableness of the approach the third party applied to adjust the bond universe used to develop the yield curve.

Other Postretirement Benefit Plans —

Discount Rate and Health Care Cost Trend Rate ASC 715-60-20 defines “health care cost trend rate” as an “assumption about the annual rates of change in the cost of health care benefits currently provided by the postretirement benefit plan . . . . The health care cost trend rates implicitly consider estimates of health care inflation, changes in health care utilization or delivery patterns, technological advances, and changes in the health status of the plan participants.” The health care cost trend rate is used to project the change in the cost of health care over the period for which the plan provides benefits to its participants. Many plans use trend rate assumptions that include

(1) a rate for the year after the measurement date that reflects the recent trend of health care cost increases,

(2) gradually decreasing trend rates for each of the next several years,

(3) an ultimate trend rate that is used for all remaining years.

Historically, the ultimate health care cost trend rate had been less than the discount rate. While discount rates have started to recover from their record lows in recent years, the discount rate for some plans is below the ultimate health care cost trend rate. Some parties have raised concerns regarding this phenomenon, since expectations of long-term inflation rates are assumed to be implicit in both the health care cost trend rate and the discount rate. In such situations, entities should consider all the facts and circumstances of their plan(s) to determine whether the assumptions used (e.g., ultimate health care cost trend rate of 5 percent and discount rate of 4 percent) are reasonable

Mortality Assumption

Many entities rely on their actuarial firms for advice or recommendations related to demographic assumptions, such as the mortality assumption. Frequently, actuaries recommend published tables that reflect broad-based studies of mortality. Under ASC 715-30 and ASC 715-60, each assumption should represent the “best estimate” for that assumption as of the current measurement date. The mortality tables used and adjustments made (e.g., for longevity improvements) should be appropriate for the employee base covered under the plan. Last year, the Retirement Plans Experience Committee of the Society of Actuaries (SOA) released a new set of mortality tables (RP-2014) and a new companion mortality improvement scale (MP-2014)

Expected Long-Term Rate of Return

The expected long-term rate of return on plan assets3 is a component of an entity’s net periodic benefit cost and should represent the average rate of earnings expected over the long term on the funds invested to provide future benefits (existing plan assets and contributions expected during the current year). The long-term rate of return is set as of the beginning of an entity’s fiscal year (e.g., January 1, 2015, for a calendar-year-end entity). If the target allocation of plan assets to different investment categories has changed from the prior year, an entity should consider whether adjusting its assumption about the long-term rate of return is warranted. Some entities engage an external investment adviser to actively manage their portfolios of plan assets. In calculating the expected long-term rate of return, such entities may include an adjustment (“alpha” adjustment) to increase the rate of return to reflect their expectations that actively managed portfolios will generate higher returns than portfolios that are not actively managed. If an entity adjusts for “alpha,” management should support its assumption that returns will exceed overall market performance plus management fees. Such support would most likely include a robust analysis of the historical performance of the plan assets.