Question

CA20-5 WRITING (Implications of GAAP Rules on Pensions) Jill Vogel and Pete Dell have to do a class presentation on GAAP rules for reporting pension information. In developing the class presentation, they decided to provide the class with a series of questions related to pensions and then discuss the answers in class. Given that the class has all read the rules related to pension accounting and reporting, they felt this approach would provide a lively discussion. Here are the questions:

1.In an article in Businessweek prior to new rules related to pensions, it was reported that the discount rates used by the largest 200 companies for pension reporting ranged from 5% to 11%. How can such a situation exist, and does GAAP alleviate this problem?

2.An article indicated that when new GAAP rules were issued related to pensions, it caused an increase in the liability for pensions for approximately 20% of companies. Why might this situation occur?

3.A recent article noted that while “smoothing” is not necessarily an accounting virtue, pension accounting has long been recognized as an exception—an area of accounting in which at least some dampening of market swings is appropriate. This is because pension funds are managed so that their performance is insulated from the extremes of short-term market swings. A pension expense that reflects the volatility of market swings might, for that reason, convey information of little relevance. Are these statements true?

4.Understanding the impact of the changes required in pension reporting requires detailed information about its pension plan(s) and an analysis of the relationship of many factors, particularly the:

(a)Type of plan(s) and any significant amendments.

(b)Plan participants.

(c)Funding status.

(d)Actuarial funding method and assumptions currently used.

What impact does each of these items have on financial statement presentation?

5.An article noted “You also need to decide whether to amortize gains and losses using the corridor method, or to use some other systematic method. Under the corridor approach, only gains and losses in excess of 10% of the greater of the projected benefit obligation or the plan assets would have to be amortized.” What is the corridor method and what is its purpose?

Answer 1

1. Such a 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, and some an explicit approach. GAAP requires even 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 freedom in establishing settlement rates. In addition, the expected return on assets will also be different among companies.

2.This situation will occur because the net funded position of the plan is required to be reported. That is, companies are required to report,the excess of their projected benefit obligation over the fair value of plan assets, as a liability. In the past, the basic liability companies reported was the excess of the amount expensed over the amount funded.

3.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 genuine. None the less, many argue that volatility is inappropriate when dealing with such long-term measures as pensions. A good example of where dampening might be useful is the recognition of gains and losses. If 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 standard-setting. However, it is clear from some of the compromises made in GAAP that certain procedures were provided to dampen the volatility effect.

4(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 computation 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 ( other factors being constant). If the plan is overfunded, pension expense will generally decrease (all factors being 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 GAAP(benefits/years- of-service approach), some changes in the computation of pension expense will occur for the company.

5.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.