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Chapter 17

CHAPTER 17
QUESTIONS
1. Five taxes are based on gross payroll. The
costs of these taxes are borne by
employees and employers as follows:

mortality
tables.
The
employer
contribution
is
related
to
the
guaranteed benefits defined in the
plan. A defined contribution pension
plan provides employees pension
benefits that are determined by the
amount in the pension fund. A periodic
contribution amount is agreed to by the
employer, and the contributions and
investment earnings determine the
benefits to be received.
(b) A contributory pension plan is one in
which employees make contributions to
the pension fund in addition to those
made by the employer. Under
noncontributory pension plans, the
employer pays the entire cost of the
plan.
(c) A multiemployer pension plan is one
administered for the benefit of many
employers. Trade associations or
similar
groups
often
sponsor
multiemployer plans. Single-employer
pension plans are tailored to a specific
employer.
Generally,
they
are
administered by an outside trustee, and
the provisions are designed to meet
the
specific
needs
of the employees of the company
involved.

Employee Employer

Federal old-age,
survivors,
and disability............
Federal hospital insurance..........................
Federal unemployment insurance.........
State unemployment
insurance..................
Individual income tax...

X
X
X

2. A compensated absence represents a


liability that must be estimated. A liability
must be recognized for compensated
absences that (a) have been earned
through services already rendered, (b) vest
or can be carried forward to subsequent
years, and (c) are estimable and probable.
The entry to record a liability for
compensated absences would be a debit to
an expense account and a credit to a
payable account for the estimated amount
of
the
obligation.
3. In defining the meaning of bonus
agreements,
difficulties
arise
in
determining the intended meaning of the
word profits. Profits may mean income
before deductions for bonus or income tax,
income after deduction of bonus but before
income tax, or net income after deductions
for both bonus and income tax. To avoid
any misunderstandings, the profit figure on
which the bonus is to be determined should
be clearly defined in the bonus agreement.

5. Vesting occurs when an employee retains


the right to receive pension benefits at
retirement, even though employment with
the employer is terminated. Federal
regulation has reduced significantly the
number of years of service required before
employees are entitled to vested benefits.
6. In measuring future benefits, the actuaries
must consider many variables, including
the average age of current employees,
length of service, expected rate of
turnover, vesting privileges, and life
expectancy.

4. (a) A defined benefit pension plan


guarantees employees a retirement
income based on the plans benefit
formula. Many plans define benefits in
terms of an employees average salary
over a specified number of years. The
amount of the employers periodic
contribution to the pension fund is
affected by such variables as the
interest rate, investment earnings,
employee turnover, and

7. The four basic issues that the FASB


addressed in relation to defined benefit
pension plans were:
(a) the amount of net periodic pension
expense

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Chapter 17

(b) the amount of pension liability or asset


to be reported on the balance sheet

(c) the accounting for pension settlements,


curtailments, and terminations
(d) disclosures needed to supplement the
amounts reported in the financial
statements
8. The principal difference between the
accumulated benefit approach and the
projected benefit approach to determining
pension benefits is the salary level used.
Under the accumulated benefit approach,
the present employee salary level is used
to measure future benefits. Under the
projected benefit approach, expected future
salary levels are used in all computations.
9. Net periodic pension expense includes five
basic components as follows:
Service cost. The present value of
additional future benefits attributable to
services rendered by employees during the
period.
Interest cost. The increase in the projected
benefit obligation that occurs over time.
The interest component is computed on the
beginning balance of the obligation using
the settlement rate.
Actual return on plan assets. The return on
pension fund investments that is deducted
in computing net periodic pension expense.
This component is based on the actual
return on plan assets. Differences between
the actual return and the expected return
are deferred and included with gains and
losses.
Amortization of unrecognized prior service
cost. Costs related to employee service in
years
preceding
the
adoption
or
amendment of a pension plan are referred
to as prior service cost. These costs are
amortized over future expected service
periods of the employees.
Deferral and amortization of gains and
losses. The difference between the
expected value of several variables and
their actual values is included in this
component. The impact of these gains and
losses is spread over several years through
an
amortization method that includes a

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Chapter 17

minimum corridor amount that must be


reached before any gain or loss is
recognized.

13. Even though prior service cost is related to


years of service already rendered, there
has been general agreement in the
accounting profession that this cost should
be charged to future periods. The future
economic benefits accruing to the
employer from the adoption or amendment
of a plan include improved employee
morale, loyalty, and productivity reflected in
future
employee services. The
enhancement of a pension plan through
labor union negotiations is often included in
lieu of additional wage increases. Because
wage increases are related to future
services, so are
enhancements in
pension benefits.

10. (a) When a pension plan is first adopted,


provision must be made to give credit
to current employees for prior services
rendered. Some employees may be
close to retirement but will still receive
full retirement benefits. The cost to the
employer of these future pension
benefits, predicated on years of service
already rendered, is determined by
actuaries, who negotiate with the
employer as to how the additional
benefits will be funded.
(b) When a pension plan is amended to
alter the formula used to compute
retirement benefits, the impact of the
new formula on prior years service
must be determined and the additional
benefits funded as in the case of a
plans
adoption.

14. The FASB specified that a market-related


value of the pension fund may be used to
compute the expected return on the
pension fund and the corridor amount. This
value may be based on average values
over a period not to exceed 5 years, or,
alternatively, it may be the fair value of the
pension fund. A company must use the
same definition of market-related asset
values from year to year. The fair value of
the pension fund is used for all other
pension measurements.

11. According to FASB Statement No. 87, the


service cost portion of net periodic pension
expense is the actuarial present value of
the benefits attributed by the plans benefit
formula to services rendered by employees
during a period. One way to measure this
cost is to compute the present value of the
expected future service benefits at both the
beginning and end of a period using
uniform assumptions about salary levels
and discount rates and take their
difference. The present value of these
expected future benefits is defined as the
projected benefit obligation.

15. The corridor amount provides a buffer to


reduce the volatility of pension costs. The
concept used by the FASB in accounting
for gains and losses permits employers to
spread the impact of fluctuations in key
pension variables across several future
time periods. The corridor established is
one method to help do this.
16. (a) A contra equity account is used when
an additional liability is required for a
pension plan and the amount of the
liability exceeds the unrecognized prior
service cost.
(b) A new minimum liability is computed
each period, and a new determination
of the amounts in the deferred pension
cost account and the contra equity
account is made.
(c) The contra equity account does not
impact net income at all. However, the
year-to-year change in the account is
reported
as
an
element
of
comprehensive income.

12. Pension expense includes the expected


return on plan assets; however, it is not
reported as such directly. The actual return
is reported as a separate component of net
periodic pension expense, and the
difference between the expected return and
the actual return is deferred as part of the
gain and loss components. The deferral
becomes part of the unrecognized gains
and losses that are amortized over the
future service years of the employees to
the extent that they exceed the corridor
amount.

17. The primary function of the pension


disclosure requirement is to provide
information that allows users to better

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Chapter 17

understand the extent and effect of an


employers responsibility
to
provide
employee pension benefits and related
financial arrangements. The disclosure is to
include information about the variables
used in determining the liability and the
reported
value
of
the
plan
assets.
18. A pension settlement occurs when an
employer takes an irrevocable action that
relieves
the
employer
of
primary
responsibility for all or part of the pension
obligation. An example of a settlement
would be a cash buyout of the employees
vested benefits by the employer. A pension
curtailment occurs when there is a
significant reduction in, or elimination of,
defined benefit accruals for present
employees future services. Curtailments
include termination of employees services
earlier than expected (e.g., as a result of a
plant closing) and the termination or
suspension of a pension plan.

(a) Unlike pension plans, postretirement


benefit plans other than pensions are
often informal.
(b) Most postretirement benefit plans other
than pensions are nonfunded, whereas
federal law requires pension plans to
be funded.
(c) Contributions to postretirement benefit
plans other than pensions are not tax
deductible to the extent that they
exceed current period costs for
employee benefits. Most contributions
to pension plans are tax deductible.
(d) Historically, the cost of future health
care has been much more difficult to
estimate than the cost of future
pension benefits.
(e) The level of postretirement benefits
other than pensions is often unrelated
to the level of an employees salary or
length of service (beyond a certain
threshold length of service). Pension
benefits are usually tied to employee
salary and length of service.

19. IFRS 19, Employee Benefits, governs the


accounting for pensions. This standard was
last revised in January 1998.

24. The full eligibility date is the date an


employee becomes eligible to receive the
full benefits from a postretirement plan.
This often occurs several years before
retirement.

20. The two major differences between IFRS


19 and U.S. GAAP are that IFRS 19 does
not include any provision for the
recognition of an additional minimum
liability and that IFRS 19 does not allow the
recognition of a net pension asset under
some circumstances.
21. The ASB in the United Kingdom has
adopted a new approach to accounting for
the items treated as deferred gains and
losses in U.S. pension accounting. The
U.K. standard recognizes these gains and
losses immediately but as a part of
comprehensive income.
22. Postretirement
benefits
include
continuation
of
medical
insurance
programs, life insurance contracts, and
other special corporate privileges, such as
country club dues, special transportation
privileges, or special discounts on items
produced or sold by the employer. The
primary issue in accounting for the costs of
these benefits is whether they should be
accrued as pension costs are or recognized
as the benefits are paid.
23. Some differences between pension plans
and other postretirement benefit plans are
as follows:

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Chapter 17

It is important in accounting for postretirement benefits because the FASB has


recommended that the attribution period
end with the full eligibility date rather than
the retirement date.

eligible for full benefits. The cost of


pension benefits is charged to all the
years of an employees service.
(b) No minimum liability requirement
exists for postretirement benefit plans
other than pensions.
(c) The
disclosure
requirement
for
postretirement benefit plans other than
pensions includes an analysis of how
sensitive the reported amounts are to
changes in the growth rate in health
care costs.

25. The major differences between the


accounting for pensions and for other
postretirement benefits are as follows:
(a) The cost of postretirement benefits
other than pensions is charged to the
years between when an employee is
hired and when the employee becomes

107

PRACTICE EXERCISES
PRACTICE 171

WAGES AND WAGES PAYABLE

1.
December 31
Wages Expense
Wages Payable

15,000
15,000

Wages are $5,000 ($25,000/5 days) per day. Three days (Monday, Tuesday, and
Wednesday) have elapsed during the week.
2.
January 5
Wages Payable
Wages Expense
Cash
PRACTICE 172

15,000
10,000

25,000

ACCOUNTING FOR PAYROLL TAXES

Wages and Salaries Expense


FICA Taxes Payable (7.65%)
Employee Income Taxes Payable
Cash

50,000
3,825
7,000
39,175

Payroll Tax Expense


FICA Taxes Payable (employer portion)
State Unemployment Taxes Payable (5.4%)
Federal Unemployment Taxes Payable (0.8%)
PRACTICE 173

6,925

3,825
2,700
400

COMPENSATED ABSENCES

1.
Average Wage
Per Day
$160
200
250

Employee
1
2
3
Total

2.

Unused
Vacation Days
0
5
15

Wages Expense
Vacation Wages Payable

4,750

Wages Expense
Vacation Wages Payable
Cash ($4,750 + 10% raise)

475
4,750

PRACTICE 174

EARNINGS-BASED BONUS

Accrued Vacation
Wages Payable
$ 0
1,000
3,750
$4,750
4,750

5,225

B = 0.05 ($200,000 B)
B = $10,000 0.05 B
1.05 B = $10,000
B = $9,524
PRACTICE 175

POSTEMPLOYMENT BENEFITS

To record the impairment:


Impairment (or Restructuring) Loss
Accumulated Depreciation
Building
To record postemployment benefits:
Restructuring Loss ($8,800 32)
Postemployment Benefits Payable

900,000
1,300,000

2,200,000

281,600
281,600

Postemployment benefits per employee:


Job training
$ 500
Supplemental health and life3,300
Two months salary
5,000
Total
$8,800
PRACTICE 176

COMPUTING THE ACCUMULATED BENEFIT OBLIGATION (ABO)

1.
Highest salary = $50,000 (future salary increases ignored with ABO)
Annual pension payment = $10,000 (2% 10 years $50,000)
Number of pension payments to be received after retirement = 15
Length of time until retirement = 25 years
Present value of 15 pension payments at retirement date (in 25 years):
PMT = $10,000, N = 15, I = 8% PV = $85,595
Present value of pension payments on January 1, 2005:
FV = $85,595, N = 25, I = 8% PV = $12,498
2.
Present value of 15 pension payments at retirement date (in 25 years):
PMT = $10,000, N = 15, I = 12% PV = $68,109
Present value of pension payments on January 1, 2005:
FV = $68,109, N = 25, I = 12% PV = $4,006

PRACTICE 177

COMPUTING THE PROJECTED BENEFIT OBLIGATION (PBO)

1.
Estimated salary growth rate = 3%
Length of time until retirement = 25 years
Highest salary: PV = $50,000, N = 25, I = 3% FV = $104,689
Annual pension payment = $20,938 (2% 10 years $104,689)
Number of pension payments to be received after retirement = 15
Present value of 15 pension payments at retirement date (in 25 years):
PMT = $20,938, N = 15, I = 8% PV = $179,218
Present value of pension payments on January 1, 2005:
FV = $179,218, N = 25, I = 8% PV = $26,169
2.
Present value of 15 pension payments at retirement date (in 25 years):
PMT = $20,938, N = 15, I = 12% PV = $142,606
Present value of pension payments on January 1, 2005:
FV = $142,606, N = 25, I = 12% PV = $8,389
PRACTICE 178

SIMPLE COMPUTATION OF THE NET PENSION ASSET OR LIABILITY

1.
Projected benefit obligation
Pension fund
Accrued pension liability

$(10,000)
9,200
$
(800)

2.
Projected benefit obligation, January 1 $(10,000)
Service cost
(1,200)
Interest cost ($10,000 0.09)
(900)
Benefits paid to retirees
100
Projected benefit obligation, December 31$(12,000)
3.
Fair value of pension fund, January 1
$ 9,200
Actual return on pension fund
250
Contribution to pension fund
1,050
Benefits paid to retirees
(100)
Fair value of pension fund, December 31 $ 10,400
PRACTICE 179

SIMPLE COMPUTATION OF PENSION EXPENSE

Service cost
$1,200
Interest cost ($10,000 0.09)
900
Expected return on pension fund ($9,200 0.10) (920)
Pension expense
$1,180

PRACTICE 1710 BASIC PENSION JOURNAL ENTRIES


Pension Expense
Accrued Pension Liability

1,180

Accrued Pension Liability


Cash

1,050

1,180
1,050

PRACTICE 1711 SIMPLE PENSION WORK SHEET


Prepaid/

Periodic

Net

Accrued

Pension

Unrecognized

Pension

Pension

Expense

Net Pension

Cost

Items

Expense

Cash

800

Balance January 1

PBO
10,000

a. Service cost

1,200

1,200

b. Interest cost

900

900

c. Actual return

250

d. Benefits paid

(Gain)/Loss

9,200

250
100

e. Deferred loss

FVPF

100

670

670

Summary Journal Entries


1. Annual Pension
Expense Accrual

1,180

1,180

2. Annual Pension
Contribution
Balance December 31

1,050

1,050
930

1,050
12,000

10,400

670

PRACTICE 1712 AMORTIZATION OF UNRECOGNIZED PRIOR SERVICE COST


The total number of employee service years is computed as follows:
[10(10 + 1)/2] 3 = 165 employee service years
Amortization of unrecognized prior service cost for this year: $1,000,000 (30/165) =
$181,818

PRACTICE 1713 DIFFERENCE BETWEEN ACTUAL AND EXPECTED RETURN ON PENSION


FUND
1.

2.

Service cost
Interest cost ($15,000 0.08)
Expected return on pension fund ($17,000 0.10)
Pension expense

$ 1,500
1,200
(1,700)
$ 1,000

Unrecognized net pension gain, beginning of year


Deferred loss for the year:
($1,700 expected $700 actual)
Unrecognized net pension gain, end of year

$(1,100)
1,000
$ (100)

Service cost
Interest cost ($15,000 0.08)
Expected return on pension fund ($17,000 0.12)
Pension expense

$ 1,500
1,200
(2,040)
$ 660

Unrecognized net pension gain, beginning of year


Deferred loss for the year:
($2,040 expected $700 actual)
Unrecognized net pension loss, end of year

$(1,100)
$

1,340
240

PRACTICE 1714 IMPACT OF CHANGES IN ACTUARIAL ESTIMATES


1.
Projected benefit obligation (PBO)
Fair value of pension fund
Net underfunding of PBO
Unrecognized net pension (gain)/loss
Unrecognized prior service cost
Accrued pension liability

$(26,169)
23,000
$ (3,169)
1,100
2,000
$
(69)

2.

From the solution to Practice 177: PBO using 12% is $8,389.

3.

Interest cost for 2005: $8,389 0.12 = $1,007

4.
Projected benefit obligation (PBO)
Fair value of pension fund
Net overfunding of PBO
Unrecognized net pension (gain)/loss
Unrecognized prior service cost
Accrued pension liability
Unrecognized net pension (gain):
Initial loss balance
Unrecognized (gain) from change in discount rate
($26,169 $8,389)

$ (8,389)
23,000
$ 14,611
(16,680)
2,000
$
(69)
$

1,100

(17,780)
$(16,680)
Note that because the large decrease in the PBO is treated as a deferred gain, there is no net change in the accrued
pension liability.
PRACTICE 1715 PENSION WORK SHEET

Prepaid/

Periodic

Unrecognized

Net
Pension
Expense

Cash

Accrued

Pension

Pension

Expense

Cost

Items

Balance January 1

PBO

a. Service cost

1,200

1,200

b. Interest cost

800

800

d. Benefits paid
538

f. Amortization of PSC

400

Service

(Gain)/Loss

Cost

700

2,000

1,550
300

300

e. Deferred gain

Net Pension

9,200

1,550

c. Actual return

Prior

FVPF

10,000

500

Unrecognized

538
400

Summary Journal
Entries
1. Annual Pension
Expense Accrual

1,388

1,388

2. Annual Pension
1,050

Contribution

1,050

Balance December 31

1,050
11,700

162

11,500

1,238

PRACTICE 1716 THE CORRIDOR AMOUNT


The corridor amount is $2,300 = $23,000 (greater of PBO and pension fund) 0.10
Amortization: ($3,100 $2,300)/6 years = $133
PRACTICE 1717 COMPUTATION OF THE MINIMUM PENSION LIABILITY

Case 1
Case 2
Case 3
Case 4

Excess of ABO over


Fair Value of
Pension Fund
$2,000
2,000
less
2,000

Prepaid
Pension
Cost
$ 0
0
500
500

Accrued
Pension
Liability
$500
500
0
0

Existing
Additional
Pension
Liability
$ 0
700
0
0

Necessary New
Additional
Pension
Liability
$1,500
800
no need
2,500

1,600

PRACTICE 1718 RECOGNITION OF ADDITIONAL PENSION LIABILITY


Case 1

Case 2

Deferred Pension Cost


Additional Pension Liability

2,000

Deferred Pension Cost ($3,000 $1,500)


Excess of Additional Pension Liability
over Unrecognized Prior Service Cost
Additional Pension Liability

1,500

2,000

500

2,000

Recall that the account Excess of Additional Pension Liability over Unrecognized Prior Service Cost is reported as
a contra equity account under the Accumulated Other Comprehensive Income heading.
Case 3

Excess of Additional Pension Liability


over Unrecognized Prior Service Cost
Additional Pension Liability
Deferred Pension Cost

2,500

2,000
500

PRACTICE 1719 RECONCILIATION OF BEGINNING AND ENDING PBO BALANCES


Projected benefit obligation, January 1 $(10,000)
Service cost
(1,200)
Interest cost ($10,000 0.08)
(800)
Benefits paid to retirees
300
Projected benefit obligation, December 31$(11,700)
PRACTICE 1720 RECONCILIATION OF BEGINNING AND ENDING PENSION FUND BALANCES
Fair value of pension fund, January 1
$ 9,200
Actual return on pension fund
1,550
Contribution to pension fund
1,050
Benefits paid to retirees
(300)
Fair value of pension fund, December 31 $11,500

EXERCISES
1721.

Wages Expense..................................................................
Employees Income Taxes Payable ($28,348 0.17). .
FICA Taxes Payable ($28,348 0.0765).......................
Union Dues Payable......................................................
Cash...............................................................................
To record weekly payroll.

28,348*

Payroll Tax Expense...........................................................


FICA Taxes Payable......................................................
State Unemployment Taxes Payable
($28,348 0.054)..........................................................
Federal Unemployment Taxes Payable
($28,348 0.008)..........................................................
To record weekly payroll taxes.

3,927

4,819
2,169
160
21,200

2,169
1,531
227

*Let X = Gross wages


X 0.17X 0.0765X $160 = $21,200
0.7535X = $21,360
X = $28,348 (rounded)
1722.

Salaries and Commissions Expense................................


FICA Taxes Payable......................................................
Employees Income Taxes Payable..............................
Cash...............................................................................

33,000*

Payroll Tax Expense...........................................................


FICA Taxes Payable......................................................
Federal Unemployment Taxes Payable.......................
State Unemployment Taxes Payable...........................

4,571

FICA Taxes Payable............................................................


Federal Unemployment Taxes Payable............................
State Unemployment Taxes Payable................................
Employees Income Taxes Payable...................................
Cash...............................................................................

5,050
264
1,782
9,900

COMPUTATIONS:
*Monthly payroll:
Frank 5.0% $120,000 =
$6,000 + $1,000
Sally 5.0
$120,000 =
$6,000 + $1,000
Tina 5.0
$120,000 =
$6,000 + $1,000
Barry 4.0
$120,000 =
$4,800 + $1,000
Mark 2.5
$120,000 =
$3,000 + $1,000
Lisa 1.0
$120,000 =
$1,200 + $1,000
Total salaries and commissions expense

=
=
=
=
=
=

2,525
9,900
20,575
2,525
264
1,782#

16,996

$ 7,000
7,000
7,000
5,800
4,000
2,200
$33,000

1722.

(Concluded)

FICA taxes payable:


Payroll..................................................................
FICA rate...............................................................
FICA taxes payable.............................................

$ 33,000
0.0765
$ 2,525

Employees income taxes payable:


Payroll..................................................................
Income tax rate....................................................
Employees income taxes payable.....................

$ 33,000
0.30
$ 9,900

FUTA taxes payable:


Federal rate..........................................................
State credit...........................................................
Total FUTA tax rate..............................................
Payroll..................................................................
FUTA rate..............................................................
FUTA taxes payable.............................................

0.062
0.054
0.008
$ 33,000
0.008
$
264

State unemployment taxes payable:


Payroll..................................................................
State rate..............................................................
SUTA taxes payable............................................

$ 33,000
0.054
$ 1,782

1723.

Total
Total
Total
Weeks
Weeks
Weeks
Vacation Vacation Vacation Weekly
Employee
Earned
Taken Liability Salary
Andy Hampsten............
14
10
4
$475
Phil Anderson...............
4
2
2
600
Lance Armstrong.........
2
0
2
450
Steve Bauer..................
4
3
1
400
Sean Yates....................
0
0
0
500
Michele Fellows...........
16
14
2
700
Total liability for vacation pay, December 31, 2005.......................

1724.

1.
2.

B = 0.07 $350,000 = $24,500


B=
B=
1.07B =
B=

0.07($350,000 B)
$24,500 0.07B
$24,500
$22,897 (rounded)

Liability
for
Vacation
Pay
$1,900
1,200
900
400
0
1,400
$5,800

1725.

1. As of January 1, 2005, Derrald has put in 12 years of service for


Francisco and, assuming that his 2004 salary of $75,000 is his highest
salary to date, the forecasted amount of Derralds annual pension
payment can be computed as follows:
(0.03 $75,000) 12 years = $27,000
This is the amount Francisco should use in computing the accumulated
benefit obligation as of January 1, 2005.
2. In computing the projected benefit obligation, Francisco must take into
account Derralds expected future salary increases. Derralds expected
future salary in 20 years is computed as follows:
PV = $75,000, N = 20, I = 4% FV = $164,334
Using this amount as an estimate of Derralds highest salary, the
forecasted amount of Derralds annual pension payment can be
computed as follows:
(0.03 $164,334) 12 years = $59,160 (rounded)
This is the amount Francisco should use in computing the projected
benefit obligation as of January 1, 2005.

1726.

Projected benefit obligation, December 31, 2005...................


Projected benefit obligation, January 1, 2005.........................
Increase in projected benefit obligation..................................
Less: Interest cost (0.12 $3,620,000)....................................
Plus: Benefits paid to retired employees................................
Pension service cost for 2005..................................................

1727.
Case 1
Accumulated benefit obligation...................................
Additional amounts related to projected
pay increases.............................................................
Projected benefit obligation.........................................
Fair value of pension assets........................................
Excess of PBO over assets..........................................
Unrecognized prior service cost.................................
Unrecognized net pension gain...................................
Accrued pension liability..............................................

$ (750)
(250)
$ (1,000)
700
$ (300)
310
(70)
$
(60)

$4,150,000
3,620,000
$ 530,000
(434,400)
272,000
$ 367,600

1727.

(Concluded)
Case 2
Accumulated benefit obligation...................................
Additional amounts related to projected
pay increases.............................................................
Projected benefit obligation.........................................
Fair value of pension assets........................................
Excess of assets over PBO..........................................
Unrecognized prior service cost.................................
Unrecognized net pension gain...................................
Prepaid pension cost....................................................
Case 3
Accumulated benefit obligation...................................
Additional amounts related to projected
pay increases.............................................................
Projected benefit obligation.........................................
Fair value of pension assets........................................
Excess of PBO over assets..........................................
Unrecognized prior service cost.................................
Unrecognized net pension gain...................................
Accrued pension liability..............................................

1728.
Using the formula discussed in the text:
N(N 1)

D =Total future years of service

where:
N = Number of years of remaining service
D = Decrease in number of employees working each year
56
2

1 =

15

Amortization amount:

2005:
2006:
2007:
2008:
2009:

5/15 $620,000 = $206,667


4/15 $620,000 = $165,333
3/15 $620,000 = $124,000
2/15 $620,000 = $82,667
1/15 $620,000 = $41,333

$ (800)
(100)
$ (900)
1,300
$ 400
190
(120)
$ 470
$ (850)
(150)
$(1,000)
900
$ (100)
50
(200)
$ (250)

1729.

1.
PV = $3,726,000; N = 10; I = 10% PMT = $606,389 annual contribution
2. Denominator of amortization fraction:
N(N 1)
D = Total future years of service
2
30(31)

10 = 4,650

2005 amortization: 300/4,650 $3,726,000 = $240,387


2007 amortization: 280/4,650 $3,726,000 = $224,361
2012 amortization: 230/4,650 $3,726,000 = $184,297
1730.

1.

N(N 1)

2
15(16)

D
3

=Total future years of service

= 360

Average remaining service life: 360/45 = 8 years


Annual amortization of prior service cost: $1,262,000/8 = $157,750
2. Pension Expense ($460,000 + $157,750).......................... 617,750
Prepaid/Accrued Pension Cost.....................................
617,750
To record net pension expense for the year.
Prepaid/Accrued Pension Cost ........................................ 520,000
Cash ................................................................................
520,000
To record contribution to pension fund.
1731.

Fair value of the pension fundDecember 31, 2005............


Fair value of the pension fundJanuary 1, 2005..................
Increase in fair value of the pension fund2005..................
Pension benefits paid..............................................................
Contributions made to the fund..............................................
Actual return on the pension fund2005..............................

$980,000
875,000
$105,000
62,000
(70,000)
$ 97,000

1732.

Actual return on the pension fund..........................................


Expected return on the pension fund ($1,100,000 0.12)....
Difference between actual and expected return...................

$155,000
132,000
$ 23,000

Because the actual return exceeds the expected return, the $23,000
difference is treated as a deferred gain in the gain or loss component of
pension expense. This amount is added in computing net pension expense
for the period. Because the actual return is included in the return on the
pension fund component, the net effect of combining the actual return and
the
deferred gain or loss is that the expected return is reflected in
pension
expense, and the difference is amortized if necessary over
future years.

1733.

Corridor amount: 10% of $2,050,000*....................


*Higher of PBO or market-related value of the pension fund.
Amortization of gain2005:
Unrecognized gain at beginning of the year.....
Less: Corridor amount........................................
Unrecognized gain in excess of corridor amount
Amortization ($220,000/10).................................
*Deducted in computing net periodic pension expense.

$ 205,000

$425,000
205,000
$ 220,000
$ 22,000*

122

Chapter 17

1734.

Deferral of difference between actual


and expected returndeferred gain
or (loss)....................................................

$20,000

Unrecognized (gain) loss at beginning


of year....................................................... $200,000
Corridor amount.........................................

$(30,000)
$275,000

100,000

150,000

Excess of (gain) or loss over corridor


amount...................................................... $100,000

$125,000

Average service life....................................

10 yrs.

$100,000

$(100,000)

$(75,000)

50,000

175,000

$ (50,000)

5 yrs.

8 yrs.

Amortization of (gain) or loss....................

10,000

25,000

Amount added (deducted) as gain or


loss component of net pension expense

$30,000

$ (5,000)

$(50,000)

12 yrs.
(6,250)
$ 93,750

0
$(50,000)

(Note: Parentheses indicate a deduction in computing net periodic pension expense. In the first line, a deferred gain adds
to current pension expense and a deferred loss reduces current pension expense.)

1735.

1736.

Computation of pension expense:


Service cost.............................................................
Amortization of prior service cost.........................
Interest cost.............................................................
Actual return on the pension fund.........................
Gain or loss:
Deferral of difference between expected
return and actual return in 2005
(deferred loss).....................................................
Amortization of deferred loss from prior years...
Net periodic pension expense..................................

$ 45,000
38,000
52,000
(75,000)

$(20,000)
15,000

Pension Expense............................................................
Prepaid/Accrued Pension Cost.................................
To record pension expense.

55,000

Prepaid/Accrued Pension Cost.....................................


Cash ...........................................................................
To record pension fund contribution.

72,000

(5,000)
$ 55,000
55,000

Computation of pension expense:


Service cost..........................................................
Interest cost..........................................................
Actual return on the pension fund...................... $ (900,000)
Less: Deferred gain..............................................
68,000
Amortization of prior service cost......................
Pension expense..................................................

72,000

$ 750,000
1,000,000
(832,000)
25,000
$ 943,000

124

Chapter 17

1737.
Mascare Company
Pension Work Sheet for 2005
Formal Accounts
Net
Pension
Expense

Cash

Balance, January 1, 2005...................


(a) Service Cost................................
(b) Interest Cost................................
(c) Actual Return on Assets.............
(d) Benefits Paid................................
(e) Deferred Gain...............................
Summary Journal Entries
(1) Annual Pension Expense Accrual
(2) Annual Pension Contribution.....
Balance, December 31, 2005.............

$1,220
$(100)

Prepaid/
Accrued
Pension
Cost
$ 2,000

(1,220)
100
$ 880

Memorandum Accounts
Periodic
Pension Projected
Expense Benefit
Items Obligation
$ (9,000)
$1,200
(1,200)
900
(900)
(1,500)
500
620

$(10,600)

Fair
Value of
Pension
Fund
$11,000

Unrecognized Net
Pension
(Gain)/Loss
$ 0

1,500
(500)
(620)

100
$12,100

$(620)

1738.

Computation of adjustment for additional pension liability:


Accumulated benefit obligation.................................................
$
825,000
Less: Fair value of the pension fund.........................................
790,000
Computed minimum pension liability.......................................
$ 35,000
Plus: Prepaid pension cost........................................................
27,000
Additional pension liability.........................................................
$ 62,000
Required journal entry:
Deferred Pension Cost....................................................
62,000
Additional Pension Liability........................................
62,000
To recognize additional pension liability.
(Note: Because the unrecognized prior service cost exceeds the
adjustment amount, the offsetting charge is to an intangible asset.)

1739.

1.

Accumulated benefit obligation................................................


Fair value of the pension fund..................................................

(in thousands)
$1,380
1,460

Because the fair value of the pension fund exceeds the


ABO, no additional liability is required according to
FASB Statement No. 87.
2. Projected benefit obligation......................................................
Less: Fair value of the pension fund.......................................
Computed minimum pension liability......................................
Less: Accrued pension cost.....................................................
Additional pension liability.......................................................

$1,625
1,460
$ 165
61
$ 104

Deferred Pension Cost....................................................... 104


Additional Pension Liability...........................................
104
To recognize additional pension liability.
(Note: Because the unrecognized prior service cost exceeds the
adjustment amount, the offsetting charge is to an intangible
asset.)
1740.
Projected benefit obligation..........................
Fair value of the pension fund......................
Funding status (underfunded)......................
Unrecognized net (gain) or loss from prior
years .............................................................
Unrecognized prior service cost..................
Adjustment required to recognize
minimum liability..........................................
Prepaid/(accrued) pension cost....................

(in thousands)
Case 1
Case 2 Case 3
$(12,500) $ (6,290) $ (890)
15,300
4,200
650
$ 2,800
$ (2,090) $ (240)
(200)
800
0
$ 3,400

(850)
2,300

100
125

0
(640)

(85)
$ (100)*

*The reported amount of accrued pension cost in Case 3 includes the $15
conventional liability plus the $85 additional minimum liability.

126

Chapter 17

PROBLEMS
1741.
2005
Oct. 31

Office Staff Salaries Expense........................................


Officer Salaries Expense...............................................
Sales Salaries Expense.................................................
Salaries Payable.........................................................
To record accrual of October 31 payroll.

13,250
27,000
22,000
62,250*

*Alternatively, one may credit individual liability accounts


(i.e., FICA, $1,760; Federal Income Tax, $10,100;
State Income Tax, $2,520; Insurance, $1,180; Salaries
Payable, $46,690) for the total.
31

Payroll Tax ExpenseOffice.........................................


788.30*
Payroll Tax ExpenseOfficer.......................................
324.00
Payroll Tax ExpenseSales.......................................... 1,562.20
FICA Taxes Payable....................................................
Federal Unemployment Taxes Payable....................
State Unemployment Taxes Payable........................

1,760.00
118.00#
796.50**

COMPUTATIONS:
Schedule of Employers Payroll Taxes
Total
Office Staff Salaries:
FICA..................................................
FUTA: 0.008 $13,250 0.20..........
SUTA: 0.054 $13,250 0.20..........
Officer Salaries:
FICA..................................................
FUTA (all exempt)............................
SUTA (all exempt)............................
Sales Salaries:
FICA..................................................
FUTA: 0.008 $22,000 0.55..........
SUTA: 0.054 $22,000 0.55..........
Total taxes..............................................

FICA

$ 624.00 $ 624.00
21.20
143.10
$ 788.30*
$ 324.00
0
0
$ 324.00

FUTA

SUTA

$ 21.20
$143.10

324.00

$ 812.00
812.00
96.80
653.40
$1,562.20
$2,674.50 $1,760.00

0
0

96.80
653.40
$118.00#

$796.50**

Chapter 17

127

1742.
Jan. 6

6
6

Salaries and Wages Expense........................................


FICA Taxes Payable..................................................
Employees Income Taxes Payable..........................
Insurance Payable....................................................
Union Dues Payable.................................................
Salaries and Wages Payable....................................

1,758.00*

Salaries and Wages Payable.........................................


Cash
...................................................................

1,201.63

Payroll Tax Expense.......................................................


FICA Taxes Payable..................................................
Federal Unemployment Taxes Payable..................
State Unemployment Taxes Payable......................

243.48

134.49
354.70
61.53
5.65#
1,201.63
1,201.63
134.49
14.06**
94.93

COMPUTATIONS:
*Payroll expense:
Richard......... 50
Denise.......... 40
Dale.............. 40
Bryan............ 30
Albert............ 20

$14.00
$11.50
$9.75
$4.50
$3.65

= $ 700.00
=
460.00
=
390.00
=
135.00
=
73.00
$1,758.00

FICA taxes payable:


Payroll.................................
FICA tax rate.......................

$1,758.00
0.0765
$ 134.49

Employees income taxes payable:


Payroll: $700 0.28........... = $ 196.00
$1,058 0.15........ =
158.70
$ 354.70
(Note: Richard is the only hourly employee with an annual income over $29,500.)

Insurance payable:
Payroll...................................... $1,758.00
Insurance rate.........................
0.035
$ 61.53

Union dues payable:


Dues per employee.................
Number of employees............

$
$

Number of periods..................
Union dues payable................

5.65
4
22.60
4
5.65

128

Chapter 17

1742.

(Continued)

**FUTA taxes payable:


Federal tax rate.......................
State tax credit........................
FUTA tax rate...........................

0.062
0.054
0.008

Payroll...................................... $1,758.00
FUTA tax rate...........................
0.008
$ 14.06

State unemployment taxes payable:


Payroll...................................... $1,758.00
State Tax Rate.........................
0.054
$ 94.93

Jan. 13

13
13

15

Salaries and Wages Expense........................................


FICA Taxes Payable..................................................
Employees Income Taxes Payable..........................
Insurance Payable....................................................
Union Dues Payable.................................................
Salaries and Wages Payable....................................

11,547.59*

Salaries and Wages Payable.........................................


Cash
...................................................................

7,480.44

Payroll Tax Expense.......................................................


FICA Taxes Payable..................................................
Federal Unemployment Taxes Payable..................
State Unemployment Taxes Payable......................

1,599.34

FICA Taxes Payable........................................................


Employees Income Taxes Payable...............................
Insurance Payable..........................................................
Union Dues Payable.......................................................
Federal Unemployment Taxes Payable........................
State Unemployment Taxes Payable............................
Cash
...................................................................

2,035.76
3,246.28
348.06
11.30
106.44
718.50

883.39
2,891.58
286.53
5.65
7,480.44
7,480.44
883.39
92.38
623.57**

6,466.34

COMPUTATIONS:
*Salaried payroll:
Ken............
Tatia...........
Jennifer.....
Robyn........
Kyle............

$91,500/24 =
57,000/24 =
48,750/24 =
23,800/24 =
13,900/24 =

Hourly payroll................................
Total payroll.............................

Salary
$ 3,812.50
2,375.00
2,031.25
991.67
579.17
$ 9,789.59
1,758.00
$11,547.59

Income
Tax Rate

28%

28

28

15

15

=
=
=
=
=

Employees Income
Taxes Payable
$1,067.50
665.00
568.75
148.75
86.88
$2,536.88
354.70
$2,891.58

Chapter 17

1742.

129

(Concluded)

FICA taxes payable:


Payroll........................................................................
FICA tax rate..............................................................

$11,547.59
0.0765
$ 883.39

Insurance payable:
Hourly employees.....................................................
Salaried employees (5 $45)...................................
FUTA taxes payable:
Hourly employees ($1,758.00 0.8%).....................
Salaried employees ($9,789.59 0.8%)...................

**State unemployment taxes payable:


Hourly employees ($1,758.00 5.4%).....................
Salaried employees ($9,789.59 5.4%)...................

$ 61.53
225.00
$286.53
$14.06
78.32
$92.38
$ 94.93
528.64
$623.57

1743.
1.

Liability for compensated absencesDecember 31, 2005


Days
Daily
Accrued
Rate
22
$70
15
76
0

(10)
58
45*
82
6
60
Total accrued........................................
*Policy limits days to 15 per year for 3 years.

Total
Accrued
$1,540
1,140

(580)
3,690
360
$6,150

Sick and Vacation Pay Payable...........................................


Cash and Withholding Liabilities..................................

5,730*

Sick and Vacation Pay Expense........................................


Sick and Vacation Pay Payable.....................................

5,020

Employee
A
B
C
D
E
F

2.

5,730
5,020

130

Chapter 17

1743.

(Concluded)

COMPUTATIONS:
AccrualJan. 1,
2005 (Days
Employee
Daily Rate)
A
20 $68 = $1,360
B
15 $74 = 1,110
C
25 $62 = 1,550
D
5 $56 = (280)
E
40 $78 = 3,120
F

$6,860

Balance in
Absences Taken in Liab. Acct.
2005 (Days Avg.
before
Daily Rate)
Adjustment
13 $69 = $ 897
$ 463 Cr.
15 $75 = 1,125
15 Dr.
32 $64 = 2,048
498 Dr.
20 $57 = 1,140
1,420 Dr.
5 $80 =
400
2,720 Cr.
2 $60 =
120
120 Dr.
$5,730*
$1,130 Cr.

Accrual
at Dec.
31, 2005
[See (1)]
$1,540
1,140

(580)
3,690
360
$6,150

Adjustment
$1,077
1,155
498
840
970
480
$5,020

1744.
1.

2005
Dec. 31 Pension Expense......................................................
Prepaid/Accrued Pension Cost...........................
Prepaid/Accrued Pension Cost...................................
Cash.......................................................................

2006
Dec. 31 Pension Expense.........................................................
Prepaid/Accrued Pension Cost...........................
Prepaid/Accrued Pension Cost...................................
Cash.......................................................................

2007
Dec. 31 Pension Expense.........................................................
Prepaid /Accrued Pension Cost..........................
Prepaid/Accrued Pension Cost...................................
Cash.......................................................................

2008
Dec. 31 Pension Expense.........................................................
Prepaid/Accrued Pension Cost...........................
Prepaid/Accrued Pension Cost...................................
Cash.......................................................................

560,700
560,700
625,000

625,000
725,000

725,000
670,000

670,000
685,000

685,000
620,000

620,000
726,500

726,500
625,000

625,000

(Note: No entries are made on Allieds books for the benefits paid to retirees.
The actual return on the pension fund is included in the computation of the
pension cost accrual.)

Chapter 17

1744.

131

(Concluded)

2. Prepaid/(Accrued) Pension Cost:..................................................


Balance, Jan. 1, 2005..................................................................
2005..............................................................................................
2006..............................................................................................
2007..............................................................................................
2008..............................................................................................
Balance Dec. 31, 2008.................................................................
3. Fair value of the pension fund at Jan. 1, 2005..............................
Add funding, 20052008:
2005......................................................................... $625,000
2006.........................................................................
670,000
2007.........................................................................
620,000
2008.........................................................................
625,000
Add return on the pension fund, 20052008:
2005......................................................................... $350,000
2006.........................................................................
400,000
2007.........................................................................
450,000
2008.........................................................................
525,000
Deduct benefits paid:
2005......................................................................... $300,000
2006.........................................................................
300,000
2007.........................................................................
275,000
2008.........................................................................
400,000
Fair value of the pension fund at Dec. 31, 2008........

Dr. (Cr.)
(25,000)
64,300
(55,000)
(65,000)
(101,500)
$ (182,200)
$

$ 2,600,000

2,540,000

1,725,000

(1,275,000)
$ 5,590,000

1745.
1. PV = $6,290,000; N = 15; I = 10% PMT = $826,970 annual contribution
2. Computation of total future years of service:
N = 225/15 = 15 (Number of remaining years of service)

N(N 1)
D = Total future years of service
2
15(16)
15 = 1,800
2
1,800/225 = 8 years
Annual amortization of prior service cost:
$6,290,000/8 = $786,250

132

Chapter 17

1746.
1. Actual return on the pension fund............................................................
Expected return on the pension fund ($2,600,000 0.11).......................
Difference (deferred loss)..........................................................................

$275,000
286,000
$ (11,000)

2. Unrecognized pension gain at Jan. 1, 2005.............................................


Corridor amount ($3,600,000 0.10).........................................................
Unrecognized pension gain to be amortized...........................................
Number of years for amortization.............................................................
Amortization of unrecognized pension gain2005 ($140,000/10).........

$500,000
360,000
$ 140,000
10 years
$ 14,000

3. Net periodic pension expense, exclusive of gain or loss component


Gain or loss component:
Deferred loss from 2005................................................
$(11,000)
Amortization of unrecognized gain from prior years. .
(14,000)
Net periodic pension expense including gain or loss component.........

$626,000

4. Unrecognized pension gain at beginning of 2005...................................


Deduct deferral of loss...............................................................................
Deduct amortization of unrecognized pension gain...............................
Unrecognized pension gain at end of 2005..............................................

$500,000
(11,000)
(14,000)
$ 475,000

(25,000)
$ 601,000

1747.
1. Computation of net periodic pension expense (in thousands):
Component
Service cost .....................................................
Interest cost .....................................................
Actual return on the pension fund..................
Gain or loss:
Deferral of difference between actual and
expected return on the pension fund.........
Amortization of unrecognized (gain) or
loss above corridor amount........................
Amortization of unrecognized prior service
cost....................................................................
Net periodic pension expense.........................
2.
Pension Expense..............................................
Prepaid/Accrued Pension Cost...................
Prepaid/Accrued Pension Cost.......................
Cash..............................................................

2005
$330
150
(35)

2006
$ 415
170
(50)

$5

$5

(20) (15)

(10) (5)

70
$500

2007
$580
220
(40)
$(10)

90
$ 620

18

90
$858

2005
500
500

2006
2007
620
858
620
858

520

580
520

750
580

750

Chapter 17

1747.

133

(Concluded)

3. BalancePrepaid/(Accrued) Pension CostJanuary 1, 2005 . .


Accruals:
2005............................................................................................. $(500)
2006............................................................................................. (620)
2007............................................................................................. (858)
Contributions:
2005............................................................................................. $ 520
2006.............................................................................................
580
2007.............................................................................................
750
BalancePrepaid/(Accrued) Pension CostDec. 31, 2007........

75

(1,978)

1,850
(53)

1748.
1. Computation of net periodic pension expense, 20052007:

2005
Pension expense exclusive of
prior service cost amortization...............................
Amortization of prior service cost..............................
Net periodic pension expense....................................

2006

2007

$ 1,920 $ 2,410 $ 2,860


420
0
0
$ 2,340 $ 2,410 $ 2,860

2. 2005: Pension Expense...........................................................................


Prepaid/Accrued Pension Cost................................................

2,340

Prepaid/Accrued Pension Cost....................................................


Cash ..........................................................................................

2,970

2006: Pension Expense...........................................................................


Prepaid/Accrued Pension Cost................................................

2,410

Prepaid/Accrued Pension Cost....................................................


Cash ..........................................................................................

2,510

2007: Pension Expense...........................................................................


Prepaid/Accrued Pension Cost................................................

2,860

Prepaid/Accrued Pension Cost....................................................


Cash ..........................................................................................

2,410

2,340
2,970
2,410
2,510
2,860
2,410

3. Computation of additional liability:


Accumulated benefit obligation.............................
37,000
Less: Fair value of the pension fund.....................
Under- (over)fundedminimum liability................
Less: Accrued pension cost...................................
Additional pension liability.....................................
*$985 + ($2,340 $2,970) = $355

$355 + ($2,410 $2,510) = $255

$255 + ($2,860 $2,410) = $705

2005
$23,800

2006
$29,300

24,200
(400)
355*
$
0

27,900
$ 1,400
255
$ 1,145

31,500
$ 5,500
705
$ 4,795

2007

134

Chapter 17

1748.

(Concluded)

4. Balance sheet accounts, December 31, 2007:


Accrued Pension Cost................................................................
Additional Pension Liability.......................................................
Excess of Additional Pension Liability over Unrecognized
Prior Service Cost (contra equity)..........................................

$705 Cr.
$4,795 Cr.
$4,795 Dr.

1749.
1. Computation of additional liability:
Accumulated benefit obligation...................................
Less: Fair value of the pension fund...........................
Minimum liability...........................................................
Prepaid/(accrued) pension cost...................................
Additional pension liability...........................................

2005
$159,100
149,000
$ 10,100
4,200
$ 14,300

2. 2005
Dec. 31 Deferred Pension Cost..............................................
Excess of Additional Pension Liability over
Unrecognized Prior Service Cost............................
Additional Pension Liability..................................
To recognize additional pension liability.
2006
Dec. 31 Additional Pension Liability.......................................
Deferred Pension Cost..........................................
Excess of Additional Pension Liability over
Unrecognized Prior Service Cost........................
To adjust additional pension liability.

2006
$172,900
160,000
$ 12,900
(1,950)
$ 10,950

8,200
6,100
14,300

3,350*

COMPUTATIONS:
*$14,300 $10,950 = $3,350 decrease in additional liability balance

$8,200 $6,300 = $1,900 decrease in unrecognized prior service cost and


deferred pension cost balance

$10,950 $6,300 = $4,650 excess of additional pension liability over


unrecognized prior service cost at 12/31/06;
$6,100 (excess at 12/31/05) $4,650 = $1,450 decrease

1,900
1,450

Chapter 17

135

1750.
Annual amortization of prior service cost = $250,000.
Amount of prior service cost at December 31, 20052007:
2005: $1,000,000 $250,000 = $750,000
2006: $750,000 $250,000 = $500,000
2007: $500,000 $250,000 = $250,000
Journal entries to record adjustment to Additional Pension Liability for the years
20042007:
2004 Deferred Pension Cost.................................................... 100,000
Additional Pension Liability........................................
100,000
To adjust Additional Pension Liability to $800,000.
(Maximum charge to Deferred Pension Cost is
$1,000,000.)
2005 Excess of Additional Pension Liability over
Unrecognized Prior Service Cost................................. 350,000
Deferred Pension Cost................................................
Additional Pension Liability........................................
To adjust Additional Pension Liability to $1,100,000.
(Maximum charge to Deferred Pension Cost is
$750,000.)
2006 Additional Pension Liability............................................ 700,000
Deferred Pension Cost................................................
Excess of Additional Pension Liability over..............
Unrecognized Prior Service Cost ............................
To adjust Additional Pension Liability and
Deferred Pension Cost to $400,000. Contra equity
account is eliminated.
2007 Excess of Additional Pension Liability over
Unrecognized Prior Service Cost................................. 350,000
Deferred Pension Cost................................................
Additional Pension Liability........................................
To adjust Additional Pension Liability to $600,000.
(Maximum charge to Deferred Pension Cost is
$250,000.)

50,000
300,000

350,000
350,000

150,000
200,000

1751.
1. Computation of additional pension liability at December 31, 2005:
Accumulated benefit obligation, December 31, 2005..........................
Less: Fair value of the pension fund, December 31, 2005.................
Computed minimum pension liability...................................................
Plus: Prepaid pension cost...................................................................
Additional pension liability, December 31, 2005..................................

$2,804
2,754
$ 50
15
$ 65

136

1751.

Chapter 17

(Concluded)

Computation of additional pension liability at December 31, 2006:


Accumulated benefit obligation, December 31, 2006..........................
Less: Fair value of the pension fund, December 31, 2006.................
Computed minimum pension liability...................................................
Less: Accrued pension cost..................................................................
Additional pension liability, December 31, 2006..................................
Less: Additional pension liability, December 31, 2005.......................
Adjustment for additional pension liability, December 31, 2006........
2. 2005
Dec. 31 Deferred Pension Cost...................................................
65*
Additional Pension Liability.......................................
*Unrecognized prior service cost on December 31,
2005, is $240. Because this exceeds the amount of
the additional liability, the entire $65 is recorded as an
intangible asset, Deferred Pension Cost.
2006
Dec. 31 Deferred Pension Cost...................................................
150*
Excess of Additional Pension Liability over
Unrecognized Prior Service Cost................................ 130
Additional Pension Liability.....................................
*Maximum deferred pension cost, December 31, 2006.........
Deferred pension cost, December 31, 2006...........................
Adjustment to deferred pension cost, December 31, 2006. .

$2,907
2,532
$ 375
30
$ 345
(65)
$ 280

65

280
$ 215
65
$ 150

1752.
The 2005 pension expense includes the following components (in thousands):
Service cost...........................................................................................
$
875
Interest cost...........................................................................................
1,100
Actual return on the pension fund.......................................................
(1,250)
Deferred loss from return on the pension fund.................................
(60)
Amortization of prior service cost.......................................................
75
Net pension expense............................................................................
$
740
The funded status of the pension plan at December 31, 2005, was as follows:
Accumulated benefit obligation, December 31, 2005........................
$ (9,900)
Effect of projected future compensation increases..........................
(1,850)
Projected benefit obligation, December 31, 2005..............................
$(11,750)
Fair value of the pension fund, December 31, 2005...........................
10,800
Excess of projected benefit obligation over fair value of pension
plan assets (underfunding).................................................................
$ (950)
Unrecognized net pension loss...........................................................
160
Accrued pension cost...........................................................................
$ (790)

Chapter 17

137

1753.
Haan Company
Pension Work Sheet for 2005
(in thousands)
Formal Accounts
Memorandum Accounts
Prepaid/ Periodic
Fair
Unrecognized
Net
Accrued Pension Projected Value of
Prior
Unrecognized
Pension
Pension Expense Benefit
Pension
Service
Net Pension
Expense Cash
Cost
Items Obligation
Fund
Cost
(Gain)/Loss
Balance, January 1, 2005...............
$(350)
$(3,500)
$3,000
$150
$ 0
(a) Service cost..............................
$ 400
(400)
(b) Interest cost..............................
350
(350)
(c) Actual return on pension fund
(130)
130
(d) Benefits paid............................
170
(170)
(e) PSC amortization.....................
40
(40)
(f) Deferred loss............................
(80)
80
Summary Journal Entries:
(1) Annual pension expense
accrual.....................................
(2) Annual pension contribution..
Balance, December 31, 2005.........

$580
$(230)

(580)
230
$(700)

230
$(4,080)

$3,190

$110

$80

138

Chapter 17

1754.
Viewmont Cable Company
Pension Work Sheet for 2005
(in thousands)
Formal Accounts
Memorandum Accounts
Prepaid/ Periodic
Fair
Net
Accrued Pension Projected Value of Unrecognized Unrecognized
Pension
Pension Expense Benefit
Pension Prior Service Net Pension
Expense Cash
Cost
Items Obligation
Fund
Cost
(Gain)/Loss
Balance, January 1, 2005...............
(a) Service cost..............................
(b) Interest cost..............................
(c) Actual return on pension fund
(d) Retirement benefits paid.........
(e) Deferral of gain on pension
fund.........................................
(f) Amortization of prior service
cost..........................................
(g) Amortization of unrecognized
pension (gain) loss................
Summary Journal Entries:
(1) Pension expense accrual........
(2) Contributions to fund..............
Balance, December 31, 2005.........

$(598)
$ 90
456

$(3,800)
(90)
(456)
(220)
185

$2,530

$732

$(60)

220
(185)

10

(10)

61

(61)

0
$397
$(300)

(397)
300
$(695)

300
$(4,161)

$2,865

$671

$(70)

Chapter 17

1754.

139

(Concluded)

COMPUTATIONS:
(a) 2005 service cost:
Projected benefit obligation, Dec. 31, 2005...................................
Less: Projected benefit obligation, Jan. 1, 2005...........................
Increase in projected benefit obligation........................................
Less: Interest cost (0.12 $3,800).................................................
Plus: Benefits paid..........................................................................
Service cost ....................................................................................

$4,161
3,800
$ 361
(456)(b)
185
$ 90

(c) 2005 actual return on the pension fund:


Fair value of the pension fund, Dec. 31, 2005...............................
Less: Fair value of the pension fund, Jan. 1, 2005.......................
Increase in fair value of the pension fund.....................................
Plus: Benefits paid..........................................................................
Less: Contributions to the fund.....................................................
Actual return on the pension fund.................................................

$2,865
2,530
$ 335
185
(300)
$ 220

(e) Expected return: 0.10 $2,100 = $210


$220 $210 = $10 deferred gain
(f) Unrecognized prior service cost........................................................
Number of years for amortization......................................................
Amortization per year..........................................................................
(g) Corridor amount, 0.10 $3,800, or $380
Unrecognized gain$60
Amortization is $0 for 2005

$ 732
12
$ 61

140

Chapter 17

1755.
The following work sheets are not required but may be helpful.
Leffingwell Company
Pension Work Sheet for 2005
Formal Accounts
Prepaid/
Net
Accrued
Pension
Pension
Expense Cash
Cost
Balance, January 1, 2005..............

Periodic
Pension
Expense
Items

3,500

Service cost..............................
Interest cost..............................
Actual return on pension fund
Retirement benefits paid.........
Amortization of prior service
cost..........................................
Deferral of loss on pension
fund..........................................
Amortization of unrecognized
pension (gain) loss.................
Change in PBO assumptions..

Projected
Benefit
Obligation

Memorandum Accounts
Fair
Value of Unrecognized Unrecognized
Pension Prior Service Net Pension
Fund
Cost
(Gain)/Loss

$(1,615,000) $1,513,500
$ 87,000
177,650
(26,350)

$105,000

(87,000)
(177,650)
132,000

26,350
(132,000)

21,000

(21,000)

(125,000)

125,000

0
80,000

(80,000)

Summary Journal Entries:


Pension expense accrual........ $134,300
Contributions to fund..............
Balance, December 31, 2005........

(134,300)
$(120,000)

120,000
$ (10,800)

120,000
$(1,827,650) $1,527,850

$ 84,000

$205,000

Chapter 17

1755.

141

(Continued)
Leffingwell Company
Pension Work Sheet for 2006
Formal Accounts
Prepaid/
Net
Accrued
Pension
Pension
Expense Cash
Cost

Balance, January 1, 2006..............

Periodic
Pension
Expense
Items

$ (10,800)

Service cost..............................
Interest cost..............................
Actual return on pension fund
Retirement benefits paid.........
Amortization of prior service
cost..........................................
Deferral of gain on pension
fund..........................................
Amortization of unrecognized
pension (gain) loss.................

Projected
Benefit
Obligation

Memorandum Accounts
Fair
Value of Unrecognized Unrecognized
Pension Prior Service Net Pension
Fund
Cost
(Gain)/Loss

$(1,827,650) $1,527,850
$ 115,000
201,042
(180,000)

$ 84,000

$205,000

(115,000)
(201,042)
140,000

180,000
(140,000)

18,667

(18,667)

27,215

(27,215)

4,447

(4,447)

Summary Journal Entries:


Pension expense accrual........ $186,371
Contributions to fund..............
Balance, December 31, 2006........

(186,371)
$(125,000)

125,000
$ (72,171)*

*The minimum liability adjustment is not shown in the work sheet.

125,000
$(2,003,692) $1,692,850

$ 65,333

$173,338

142

Chapter 17

1755. (Continued)
1.

Leffingwell Company
Pension Expense Components
For the Year Ended December 31, 2005

Service cost...................................................................................................
Interest cost ($1,615,000 0.11)...................................................................
Actual return on the pension fund...............................................................
Amortization of prior service cost...............................................................
Gain or loss:
Deferral of deficiency of actual return compared to expected return
on the pension fund ($1,513,500 0.10) $26,350 (deferred loss).....
Net pension expense....................................................................................

$ 87,000
177,650
(26,350)
21,000
(125,000)
$ 134,300

Leffingwell Company
Reconciliation of Reported Amount of Prepaid/Accrued Pension Cost
December 31, 2005
Accumulated benefit obligation...................................................................
Effect of projected future compensation....................................................
Projected benefit obligation, December 31, 2005.......................................
Fair value of the pension fund, December 31, 2005...................................
Excess of obligation over assets (underfunding)......................................
Unrecognized net pension loss, December 31, 2005.................................
Unrecognized prior service costs, December 31, 2005.............................
Prepaid/accrued pension cost, December 31, 2005...................................

$ (1,530,000)
(297,650)
$ (1,827,650)
1,527,850
$ (299,800)
205,000
84,000
$
(10,800)

Leffingwell Company
Pension Expense Components
For the Year Ended December 31, 2006
Service cost...................................................................................................
Interest cost ($1,827,650 0.11)...................................................................
Actual return on the pension fund...............................................................
Amortization of prior service cost...............................................................
Gain or loss:
Deferral of excess of actual return over expected return on the
pension fund ($1,527,850 0.10) $180,000 (deferred gain). $27,215
Amortization of prior years deferred net pension loss*.......... 4,447
Net pension expense......................................................................
*[$205,000 ($1,827,650 0.10)]/5 years = $4,447

$ 115,000
201,042
(180,000)
18,667

31,662
$ 186,371

Chapter 17

1755.

143

(Concluded)
Leffingwell Company
Reconciliation of Reported Amount of Prepaid/Accrued Pension Cost
December 31, 2006

Accumulated benefit obligation................................................................


Effect of projected future compensation..................................................
Projected benefit obligation, December 31, 2006....................................
Fair value of the pension fund, December 31, 2006................................
Excess of obligation over assets (underfunding)...................................
Unrecognized net pension loss, December 31, 2006..............................
Unrecognized prior service costs, December 31, 2006..........................
Prepaid/accrued pension cost, December 31, 2006................................
2.

2005
Dec. 31 Pension Expense......................................................
Prepaid/Accrued Pension Cost...........................
Prepaid/Accrued Pension Cost...............................
Cash ...................................................................
2006
Dec. 31 Pension Expense......................................................
Prepaid/Accrued Pension Cost...........................
Prepaid/Accrued Pension Cost...............................
Cash ...................................................................

3.

$ (1,850,000)
(153,692)
$ (2,003,692)
1,692,850
$ (310,842)
173,338
65,333
$
(72,171)

134,300
134,300
120,000
120,000
186,371
186,371
125,000
125,000

2005
Dec. 31 No entry needed.
Minimum liability adjustment not needed:
($1,530,000 $1,527,850) is less than $10,800
2006
Dec. 31 Deferred Pension Cost.............................................
Excess of Additional Pension Liability
over Unrecognized Prior
Service Cost ($84,979 $65,333)...........................
Additional Pension Liability.................................

65,333
19,646
84,979

Additional pension liability*..................................................... $(84,979)


*($1,850,000 $1,692,850) $72,171 = $84,979 minimum liability adjustment.
Unrecognized prior service cost as of December 31, 2006, is $65,333; the
remainder of the additional pension liability is recognized as a contra equity
account.

144

Chapter 17

DISCUSSION CASES
Discussion Case 1756
This case allows students to consider how difficult it is to solve a complex accounting issue that has
broad, pervasive effects on companies. The pressure from various groups on any issue can be intense. It
certainly was so in this case. Even after the Accounting Principles Board issued Opinion No. 8, there was
a general feeling among accountants that this was still only one step in the process of accounting for
pensions. As pension fund assets and liabilities grew in magnitude, the materiality of pensions became
an important issue. The conceptual framework project of the FASB caused Board members to focus on
issues that raised questions concerning the soundness of the accounting standards for pensions. The
Board could not continue to ignore the area, and the pension project was added to its agenda relatively
early in its existence.
Once the project was under way, a resolution was imperative. Some observers believed that the future of
the FASB hinged on how well it resolved this intricate area. To leave pension standards as they were was
not a viable alternative. The discrepancies among companies in their reporting of pension expense and
the almost universal ignoring of pension fund assets and liabilities on the employers financial statements
required new standards. While the final standard can be criticized for many of its features, the Board
should be commended for finally bringing the project to a close. While there were dissents to the final
standard, the process was so long and painful that it is doubtful that the pension standard will be
modified in a major way for many years to come.
Discussion Case 1757
The pension standards provide a fertile field to relate terms used by the FASB in its conceptual
framework project with an accounting issue. The terms selected for discussion in this case are not all
inclusive. Others could have been included. The following discussion indicates some of the relationships
that students could identify in answering the questions posed in this case.
(a)

Representational faithfulness
This concept was included in Concepts Statement No. 2 as a subset of reliability. Much of the
criticism of the earlier pension standards was based on their failure to represent faithfully the true
underlying economic conditions surrounding pension liabilities. While it was obvious that employers
often had significant future obligations for pensions, these obligations were not being reported in the
financial statements. Periodic measures of pension cost were not comparable across companies
because of the wide latitude permitted in the accounting standards. By focusing on this term, Board
members tried to develop a standard that represented more completely the underlying economic
effects of pension plans. Postretirement benefits were recognized only on a cash basis prior to
FASB Statement No. 106. To be representationally faithful, the accrual concept is required.

(b) Substance over form


Accounting standard-setting bodies have emphasized substance over form in establishing many
standards. Accounting for leases, for example, is based largely on the concept that many leases are
in substance purchases rather than rental agreements. Pension accounting under APB Opinion No.
8 and its predecessors assumed a complete separation between an employer and the pension fund.
While legally a separation does exist, the obligation of an employer for defined benefit pension
plans does not end when funds are placed with the trustee. An employers total pension
contributions and obligations are directly related to the management of the pension fund assets.
This differs from the obligation under defined contribution pension plans. Even though these two
types of pension plans are significantly different, the legal form of the entities involved often
appears to be the same. By looking at the true substance of the relationship rather than the form,
different standards of accounting for defined contribution pension plans and defined benefit pension
plans are required.

Chapter 17

(c)

145

Verifiability
Verifiability relates to the ability of different measurers to arrive at the same valuation. The previous
pension standards allowed great variability in determining the amount of pension expense that was
reported on the income statement. An objective of the FASB was to narrow this disparity in an
attempt to increase the verifiability of the reported pension amounts. Pensions are an especially
difficult area of accounting because almost all pertinent variables deal with the future. There is great
uncertainty as to the actual amount of pension benefits that will ultimately be paid. Although FASB
Statement No. 87 narrows the range of some of the variables, there is still considerable variation in
the final result. Thus, verifiability is only partially achieved. FASB Statement No. 106 introduces
other variables that are very difficult to verify.

(d) Usefulness
One of the motivating reasons for adding the pension project to the FASB agenda was to increase
the usefulness of the pension information reported in employers financial statements. Because
most of the relevant information was not included in the financial statements and the note
disclosure often was incomplete, the users did not have the necessary information to evaluate the
status of the employers obligation for pensions. The new standards provide for more extensive note
disclosure and in many cases result in additional information being reported on the balance sheet.
(e)

Present value
The fact that monetary values change over time is recognized in many accounting applications.
Pension accounting is especially dependent on the use of the present values because of the
extended
period between the time benefits are earned and when they are actually paid. The present value
computation is very sensitive to the discount rate used. Previous pension standards also involved
present value techniques; however, FASB Statements No. 87 and No. 106 separate the interest
component of pension expense and require a separate disclosure of that expense.

(f)

Conservatism
Although conservatism was not included as a qualitative characteristic in Concepts Statement No.
2, it was discussed as a pervasive constraint in accounting practice. Conservatism is reflected in
FASB Statement No. 87 through the requirement for recording a minimum liability when pension
plans are underfunded but not recognizing an asset when pension plans are overfunded. FASB
Statement No. 88, however, would not be described as conservative because it provides for an
immediate recognition of gains arising from pension plan settlements and curtailments as opposed
to a deferral of these items. Conservatism, as presently defined in the literature, refers to
accounting for uncertainty and a careful evaluation of how uncertainty should be reflected in the
financial statements.

(g) Adequate disclosure


This principle was considered very carefully by the Board, and the disclosure requirement for
pensions and postretirement benefits has been expanded significantly. The reconciliation of
recorded and unrecorded items and the disclosure of alternative liability measures are intended to
help users obtain a clearer picture of the pension plan and its status. Disclosure, however, involves
the financial statements themselves as well as the notes. The Board compromised on some items
that theoretically could have been reported in the statements themselves, but it decided to include
them only in the notes.

146

Chapter 17

Discussion Case 1758


At retirement, you need enough to be able to withdraw $60,000 per year for 20 years.
I = 8%, N = 20, PMT = $60,000 PV = $589,089
Each year, you must set aside enough so that it will grow to $589,089 by the end of 40 years.
I = 8%, N = 40, FV = $589,089 PMT = $2,274
$2,274/$100,000 = 2.27%
If you start at age 30 (work 35 years), the payment is $3,419.
If you start at age 35 (work 30 years), the payment is $5,200.
If you start at age 40 (work 25 years), the payment is $8,058.
Most people overestimate the amount that they will have to save each year. This exercise illustrates the
power of a small, steady savings program.

Discussion Case 1759


1.

People feel they have more control of their money in a defined contribution plan.
The stock market has been (or had been) solid during the working careers of many people.
A defined contribution plan is mobile. Employees these days are much more likely to change
jobs.

2.

One big reason is the switch in investment risk from the company to the employees.
Easier to manage with todays mobile work force.

Enron impact: Another consequence of the Enron scandal may be a revision in companies defined
contribution pension plans. Many Enron employees lost everything because they had their entire
retirement investment fund invested in Enron shares. Enron management encouraged this. Senator
Barbara Boxer of California has resurrected a proposal that would require employees to hold no
more than 10% of their retirement fund in the form of shares of their own company. To many, this
seems like a prudent measure; one of the fundamental principles of long-term investing is
diversification.
3. Because most defined benefit plans are based on the highest salary, an employee really sees a
disproportionate share of benefit growth in the final years of work when the highest salary usually
occurs. If the transition amount is computed based on current salaries, older employees lose out on
the big benefits that would have accrued to them in their final, high-salary years, and they dont have
many years in which to accrue new benefits under the new defined contribution scheme. It is said
that IBMs plan started to unravel as employees went to the companys Web site and used the
pension benefit calculator intended to explain the consequences of the switch. Older employees
were outraged.

Chapter 17

147

Discussion Case 1760


The purpose of this case is to provide a vehicle for students to explore the reasons for and against the
accrual method in reporting postretirement benefits. A lively debate on how these benefits differ from
other liabilities such as pension costs often occurs.
Pro
The FASBs definition of liabilities states that liabilities include probable future outlays of resources for
past or present services rendered. Postretirement benefit plans usually provide specific guidelines for
how employee benefits after retirement will be handled. If these benefits have been paid to past retirees,
it is probable they will be paid in the future. Attempts to change company policy to reduce or eliminate
these benefits may result in litigation by damaged employees. If a company intends to grant these
benefits, they should accrue the cost over the years of service of the employee and not wait to charge
these costs to expense when there is no offsetting revenue from service rendered. Postretirement benefit
costs are really not much different from pension costs. To be consistent, companies should use similar
methods with postretirement benefits as they do for pension costs.
Con
As George indicated, these postretirement plans are often very informal. If a company decides to modify
the terms of the benefits, there are usually no contractual restrictions in doing so. The definition of
liabilities includes the concept of measurability. Future postretirement benefits, especially health care
costs, are very difficult to measure. Variables such as health care cost trends, illness incidence, medical
technology cost trends, government assistance programs, and so forth, are too uncertain to estimate
many years in advance. Accruing these uncertain costs will result in significant reductions in the income
of corporations unless they pass on the cost in higher prices. This could fuel spiraling inflation and have a
significant negative impact on the economy. Companies have used a pay-as-you-go approach for years,
and it has worked. The tax laws do not recognize as an expense estimates of these future costs. The cost
of implementing such a standard may exceed any benefits that could accrue.
Discussion Case 1761
When deliberating about the proposed standard on postretirement benefits other than pensions, the
FASB received comments suggesting that requiring firms to accrue a liability for such benefits would
increase the probability that governments would mandate that firms provide such benefits. Another
suggested consequence is that governments would restrict firms already providing such benefits from
cutting back or terminating their benefit plans. The reasoning behind these predictions is that reporting
these benefits as liabilities on the balance sheet makes it easier for governments to argue that the
obligation is more than just an informal one.
Another predicted consequence of FASB Statement No. 106 that Seabright should consider is whether
contributions to postretirement benefits funds that exceed amounts necessary to cover current outlays
should be made tax deductible. Currently, such contributions are deductible only to the extent of currentyear outlays. The reasoning is that the tax treatment has followed the historical practice of computing
postretirement benefit expense on a pay-as-you-go basis. Since postretirement benefit expense is now
reported on an accrual basis, the tax treatment might change. Excess contributions to pension funds are
currently tax deductible.
In commenting about the possibility of these consequences, the FASB stated:
Those actions, if taken, are not the direct result of a requirement to accrue postretirement benefits,
but rather, may result from more relevant and useful information on which to base decisions
(Statement No. 106, par. 130).

148

Chapter 17

SOLUTIONS TO STOP & THINK


Stop & Think (p. 1046): Compare the three criteria used in accounting for postemployment benefits with
the FASBs definition of a liability. Does it appear that the definition of a liability as defined in the
conceptual framework influenced Statement No. 43?
Notice that the definition of a liability closely parallels the criteria used in accounting for postemployment
benefits. The benefits are probable future sacrifices of economic benefit resulting from past transactions.
The FASB has used definitions provided in the conceptual framework extensively in addressing complex
accounting issues.
Stop & Think (p. 1049): Many companies are changing their plans from defined benefit to defined
contribution. Why would employers do this?
With a defined benefit plan, the employer bears the majority of the risk. With a defined contribution plan,
the risk shifts to the employee. Companies would prefer that, where possible, employees bear the risk.
Stop & Think (p. 1059): What is the relationship between unrecognized prior service cost and the
measurement of the PBO?
Prior service cost is an amount that is included in the PBO, but the FASB allows those amounts to be
offset and fully included over time. As the amounts are amortized, their full effect is reflected in the net
pension obligation (or asset) reported in the balance sheet.
Stop & Think (p. 1067): How would a company find itself exceeding the corridor amount? If the
company is constantly revising its estimated expected return, how often should the corridor amount
come into play?
A company would exceed the corridor amount only when it was off in its estimates by a significant
amount over a long period of time. Because the corridor amount is 10% of a very large number (either
plan assets or PBO), a company would have to have made a series of bad estimates. Typically, a
company will monitor the amount of its unrealized gains and losses and adjust its estimated return to
compensate.

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SOLUTIONS TO STOP & RESEARCH


Stop & Research (p. 1045): Access the most recent proxy statement for Microsoft and determine
whether the company has an earnings-based bonus plan. (Note: The best way to get a proxy statement is
through the SECs EDGAR system at http://www.sec.gov. A proxy statement is called a DEF 14A filing.)
Microsofts proxy statement filed with the SEC on September 27, 2001, includes mention of an Executive
Bonus Plan. The proxy statements says, Officers also participate in an Executive Bonus Plan. Each
officer is eligible to receive a discretionary bonus of up to 100% of base salary based upon individually
established performance goals. This is not necessarily an earnings-based bonus plan. However, for at
least two employees, the bonus is based on earnings, as indicated in the following: The Compensation
Committee annually reviews and approves the compensation of Steven A. Ballmer, Chief Executive
Officer, and William H. Gates, the Chairman of the Board and Chief Software Architect. Messrs. Ballmer
and Gates participate in an Executive Bonus Plan in which they are eligible to receive up to 100% of
their base salary. Their bonuses are tied to corporate revenue and profit goals. For fiscal 2001, Bill
Gates had a Microsoft salary of $494,992, and his bonus for the year was $171,762. Thus, it appears that
corporate revenue and profits must have fallen short of the goal for the year because Mr. Gates bonus
was substantially less than 100% of his salary.
Stop & Research (p. 1064): General Motors, Ford, IBM, and General Electric have large defined benefit
pension plans. Obtain a copy of the most recent annual report for each company and determine what the
company is assuming about the expected return on its pension fund.
All numbers are for 2001:

General Motors
Ford
IBM
General Electric

Expected Return
on U.S. Pension Funds
10.0%
9.5
10.0
9.5

Expected Return
on Non-U.S. Pension Funds
8.9%
8.7
5.010.0
n/a

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SOLUTIONS TO NET WORK EXERCISES


Net Work Exercise (p. 1041):
1.

The simple, rough estimate is used. With an age of 40 and earnings in the current year of $50,000,
the monthly benefit for a person who retires at age 67 is $1,553. A more accurate estimate can be
generated by inputting your specific wage history.

2.

The extra amount that a person must save each year between now and retirement is $7,245 under
the following assumptions:

Currently age 40
Current income is $50,000
Retire at age 65
Monthly Social Security benefit of $1,553 [as estimated in part (1)]

Net Work Exercise (p. 1047):


According to Northwestern Mutuals Longevity Game, a male who is 45 years old, has reasonable height
and weight, vigorously exercises, doesnt smoke or drink, wears his seat belt, and so forth, can expect to
live to age 95.

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151

SOLUTIONS TO BOXED ITEMS


Pension Plan Settlements (pp. 10701071)
1.

The announcement of a pension plan settlement and excess asset reversion would have no effect
on a firms stock price if the move had already been anticipated by investors. In such a case, the
public announcement would be official confirmation of information already impounded in the firms
stock price. Before 1984, when it was uncertain whether the courts would allow firms to claim
excess pension assets, ownership of those assets was uncertain, and their value was not fully
reflected in firms market values. As the number of successful settlements and asset reversions
increased, market participants revised their expectations and included the value of excess pension
assets in their assessments of firms market values.

2.

If a firm sees that its pension plan is overfunded, it can simply reduce funding levels in subsequent
years. The cash savings from this reduced funding are analogous to the excess assets acquired
when an overfunded plan is settled. Reduction in funding level has the advantage of being less
costly to implement, both in monetary terms (the transaction costs of purchasing annuity contracts
can be avoided) and in terms of lost employee goodwill. However, if the intent is to ease immediate
cash flow problems, a gradual funding reduction may not provide cash fast enough.

Accounting for Postretirement Benefits Other than Pensions: Cost vs. Benefit (pp. 10781079)
1.

Reducing retiree health benefits would reduce the earning impact and the size of the liability to be
reported under FASB Statement No. 106. Without the changes, firms might fear that the adverse
financial statement effects would lower their stock price, reduce their ability to maintain
management bonuses, or make it more difficult to obtain loans. In one sense, the existence of such
consequences is counterintuitive since FASB Statement No. 106 mandates a change in accounting
only for retiree benefit plansplans that have been in existence for years. However, the fact that
firms seem to be willing to change their retiree plans in response to a change in accounting again
supports the belief that the way something is accounted for has real economic consequences.

2.

In a perfect world, one would expect no impact on stock prices or on the ability to get loans. This is
so because the impact of postretirement benefit plans on the financial condition of a company
would have already been taken into account by sophisticated investors and bankers who are known
to use all sorts of data not found in financial statements when doing their financial analyses.
However, the world is not perfect, and it is possible that the financial effects of postretirement
benefit plans either have not been fully factored into investment decisions or the estimates of those
effects have been systematically in error. There is some evidence that firms are finding that they
have been underestimating the cost of their retiree benefit plans. If this is true, FASB Statement No.
106 may impact stock prices and creditworthiness of firms with large retiree benefit plans.

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COMPETENCY ENHANCEMENT OPPORTUNITIES


Deciphering 171 (The Walt Disney Company)
1.

In Note 7 of the financial statements, Disney reports that the ending PBO for 2001 is $2,131 million.

2.

An Unrecognized net gain indicates that Disneys actual return has been greater than what it has
expected over time. Notice also that the amount of the unrecognized net gain decreased from 2000
to 2001, indicating that the actual return in 2001 was less than expected.

3.

Before the adoption of SFAS No. 106, almost all companies, including Disney, accounted for their
postretirement medical benefits programs on a pay-as-you-go basis. With the adoption of SFAS No.
106, companies were required to report the entire estimated cost of these benefits in the financial
statements. For almost all companies (including Disney), this resulted in a substantial increase in
the reported annual expense. Many companies responded to this financial accounting change by
changing their benefit programs. This is a classic example of the economic consequences of
financial accounting rules.

4.

Disneys projected obligation associated with its postretirement benefit plans, i.e., the APBO,
exceeds the fair value of plan assets on September 30, 2001, by $356 million. It is not uncommon
for firms to have underfunded other postretirement benefit plans.

Deciphering 172 (Northrop Grumman)


1.

As of December 31, 2001, the fair value of Northrop Grummans pension fund exceeded its
projected benefit obligation by $1,485 million. Thus, the plan is overfunded.

2.

In 2001, Northrop Grumman suffered an actual loss of $537 million on its pension fund. This is
certainly less than the positive return that is expected on a long-term basis. This is confirmed by the
fact that the unrecognized net gain of $1,802 million at the end of 2000 became an unrecognized
net loss of $765 million by the end of 2001. Not all of this change was caused by a shortfall in the
return on the pension fund, but it is probable that a large portion of it was.

3.

The PBO associated with companies acquired in 2001 was $2,391 million. The fair value of the
pension funds associated with these acquired companies was $3,311 million. Thus, the acquired
plans were overfunded.

4.

Deferred Pension Cost (intangible asset)........................................... 9


Accumulated Other Comprehensive Income (equity)........................ 72
Additional Pension Liability...................................................

81

If the simplifying assumption is not made, then the changes in balances from 2000 suggest that the
following journal entry was made:
Deferred Pension Cost (intangible asset)........................................... 6
Accumulated Other Comprehensive Income (equity)........................ 41
Additional Pension Liability...................................................
5.

47

As of December 31, 2001, the fair value of Northrop Grummans medical and life benefits fund was
less than the projected obligation by $1,325 million. Thus, these plans are underfunded.

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153

Deciphering 173 (Eli Lilly and Company)


1.

You might first think that decreasing the discount rate would decrease pension expense as reported
on the income statement. Why? Because in computing the interest cost component of pension
expense, the PBO is multiplied by this lower discount rate. However, you must remember that
decreasing the discount rate will result in increasing the PBO (because the PBO amount is a
present value). So a larger PBO will be multiplied by a smaller discount rate, perhaps resulting in an
increase in interest costs. Notice that interest cost in 2001 is greater than in 2000. The larger PBO
will also affect the balance sheet by increasing the liability (or decreasing the asset).

2.

Overall, Eli Lillys pension plans are underfunded because the fair value of this pension fund is less
than the PBO by $416.6 million as of December 31, 2001.

3.

During 2000 and 2001, the company increased its PBO by $144.3 and $88.5 million, respectively,
related to actuarial losses. That is, the actuaries revised their estimates of employee life span, time
remaining to retirement, employee retention, and so forth, and determined that the PBO should be
increased by $232.8 million related to these items.

4.

In the late 1990s, the stock market provided annual returns exceeding 20%. However, in 2000 and
2001, market returns were actually negative for most portfolios. For example, the return on Eli Lillys
pension fund in 2001 was negative. However, the expected return on the pension fund is a longterm expectation. Since 1925, the return on a broad-based mutual fund has averaged about 12%
per year. Eli Lilly probably has many of its pension plan assets invested in the stock market. By
reviewing its assumptions regarding long-term rates of return, it appears that Eli Lilly is betting that
the stock market will eventually turn around and provide it with a return that exceeds the return
offered on a standard savings account at a bank.

Deciphering 174 (General Motors)


1.

GMs PBO for all plans (both U.S. and non-U.S.) totals $86,333 million ($76,383 + $9,950). That is
quite an obligation! But GM has accumulated (in the form of contributions and revenues on these
contributions) $73,662 million ($67,322 + $6,340) in an effort to finance this obligation.

2.

GMs obligation relating to postretirement benefits other than pensions totals $52,489 million.
Adding this to its PBO from (1) results in future obligations relating to retirement benefits of
$138,822 million.

3.

GM assumed that health care costs would increase by 6% during 2002 and then decrease to an
annual rate of 5% through 2008. If GM had assumed a 7% rate (instead of the 6% rate), the effect
on the APBO would have been to increase it by $5.4 billion and to increase service and interest
costs by $472 million for the year.

SAMPLE CPA EXAM QUESTIONS


1.

The correct answer is a. Kane will report pension expense equal to service cost of $19,000 +
interest of $38,000 the expected return on plan assets of $22,000 + amortization of unrecognized
prior service cost of $52,000 for a net amount of $87,000. With employer contributions of $40,000,
the unfunded amount is $47,000. The prepaid pension cost of $2,000 at January 1, 2006, will be
eliminated resulting in accrued pension cost of $45,000 at December 31, 2006.

2.

The correct answer is a. Although an employer's obligation for postretirement health benefits is
recognized over the period of the employee's active employment, the obligation must be fully
accrued by the date that the employee is fully eligible for the benefits.

3.

The correct answer is a. The minimum pension liability is the unfounded ABO; or $140,000. The
company already has an accrual for pension cost of $80,000, indicating that an additional liability of
$60,000 must be recorded. The debit would ordinarily be to Deferred Pension Cost, an intangible
asset. If the additional liability, however, exceeds the unrecognized prior service cost, the excess is
reported in a contra-equity account. In this case, the excess is $60,000 $45,000, or $15,000.

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Writing Assignment: Pensions in foreign countries


When students stop and think about pensions, they will realize that pension plans are common in the
United States but not as common around the world. And in those countries where pension plans are in
place, they are not as elaborate, or usually as generous, as the pension plans in the United States. From
a financial reporting standpoint, the thinking in these countries is Why spend a lot of effort developing
accounting standards for an economic transaction that doesn't even exist? In addition, where pension
accounting does exist, it often mirrors the calculations done to compute the correct amount of funding for
the year, i.e., how much should be put in the pension fund.

Research Project: Reviewing actual financial statements and associated notes


The objective of this research project is to get students to review annual reports and realize that the
issues and concepts discussed in class are actually used by companies. A review of note information
relating to pensions and other postretirement benefits will allow students to see that the material covered
in the chapter is sufficient to obtain an understanding of complex note disclosures. In addition, students
will gain an appreciation for the size of these retirement obligations. The postretirement benefit
disclosure for General Motors (contained in Exhibit 1712 in the text) will be used as the basis for sample
answers for the research questions.
1.

GM discloses information about its U.S. and non-U.S. defined benefit pension plans. Both sets of
plans were underfunded as of December 31, 2001.

2.

As of December 31, 2001, GM had recognized a $5.6 billion intangible asset and a $14.3 billion
reduction in equity associated with an additional minimum pension liability.

3.

For the three years presented in Exhibit 17-12, GM assumed a discount rate ranging from 7.3% to
7.8% (for U.S. plans) and an expected long-term return on assets of 10.0% (for U.S. plans). Future
compensation is expected to increase by 5.0% per year.

4.

GM has a very large obligation for other postretirement benefits. This obligation is associated with a
relatively small fund. Contributions to pension funds are primarily dictated by federal law in the
United States. These contributions are also given favorable tax treatment. The laws are different for
non-pension postretirement benefit plans. As a result, these plans typically are substantially
underfunded.

The Debate: The minimum pension liability


This exercise should force students to realize what factors would lead to a firms having to recognize an
additional minimum pension liability. If a firm has a large balance in its deferred gain/loss account and/or
has had significant changes to its pension plan resulting in a large amount of prior service cost, these
factors can distort pension expense issues. The minimum liability computation forces firms to ignore
these other items and focus on the value of the plan assets compared to the ABO.
Students should stop and think, If a firm hasnt set aside enough plan assets to cover its ABO (which
doesnt include future salary increases), then it makes sense that it should be required to disclose a
minimum amount.

Ethical Dilemma: Actuarial assumptions


Accounting involves estimates and it seems as if all of the advanced topics require a lot of estimates.
Deferred taxes, pensions, investment securities, and earnings per share all require management to
estimate or express an intent regarding an issue. In the case of pensions, assumptions regarding
discount rates, rates of return, estimated life of employees, and so forth, all combine to result in the PBO
being a very tenuous number.

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155

But before someone starts to think that he/she can blatantly manipulate these estimates, several things
must be considered. First, auditors will review the estimates to ensure that they are reasonable. Second,
the actuaries themselves provide a control in that they are not paid to provide management with a
favorable estimate but instead with a reasonable estimate. Finally, modifying assumptions may alter the
liability on the books, but does not alter the liability in fact. As employees retire, they will expect their
promised benefits regardless of how the company chose to account for those benefits in the past.
Suggested answers to the five questions are as follows:
1.

The reduction in the discount rate would increase the present value of the postretirement
obligations. The reductions in the estimates of future salary increases and health care cost
increases would both decrease the present value of the postretirement obligations. The increase in
the expected return on the pension fund would not impact the present value of the obligations.

2.

The reductions in the estimates of future salary increases and health care cost increases and the
increase in the expected return on the pension fund would all decrease the net expense reported on
the income statement. The reduction in the discount rate might increase or decrease the reported
expense. As mentioned in (1), the reduction in the discount rate would increase the present value of
the obligations. However, in computing the interest cost component of expense, a smaller interest
rate would be applied to this increased obligation. The net effect on the reported expense depends
on the exact numbers.

3.

Any changes in estimates like these must be confirmed as being reasonable by both the companys
auditor and the companys actuary. In addition, ethical considerations should constrain a company
from manipulating these estimates in order to deceive financial statement users.

4.

Changing the estimates does not change the underlying economic obligation.

5.

A key consideration is whether the changes are being made to better inform or to deceive financial
statement users. As discussed in Chapter 6, deceptive reporting practices are not only unethical, but
they can also prove costly to companies that lose their reporting credibility and subsequently find it
more difficult to attract investors and creditors.

Cumulative Spreadsheet Analysis


See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual.
Internet Search
1.

The mission statement of PBGC is as follows:


The Pension Benefit Guaranty Corporation (PBGC) protects the retirement incomes of about 44
million American workers in more than 35,000 defined benefit pension plans. A defined benefit plan
provides a specified monthly benefit at retirement, often based on a combination of salary and
years of service.
PBGC was created by the Employee Retirement Income Security Act of 1974 to encourage the
continuation and maintenance of defined benefit pension plans, provide timely and uninterrupted
payment of pension benefits, and keep pension insurance premiums at a minimum. Defined benefit
pension plans promise to pay a specified monthly benefit at retirement, commonly based on salary
and years on the job.
PBGC is not funded by general tax revenues. PBGC collects insurance premiums from employers
that sponsor insured pension plans, earns money from investments and receives funds from
pension plans it takes over.
PBGC pays monthly retirement benefits, up to a guaranteed maximum, to nearly 269,000 retirees in
2,975 pension plans that ended. Including those who have not yet retired, PBGC is responsible for
the current and future pensions of about 624,000 people.

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Chapter 17

The maximum pension benefit guaranteed by PBGC is set by law and adjusted yearly. For plans
ended in 2002, workers who retire at age 65 or older can receive up to $3,579.55 a month
($42,954.60 a year). The guarantee is lower for those who retire early or when there is a benefit for
a survivor.
2.

As of October 2002, all PBGC-insured single-employer defined benefit pension plans pay a flat-rate
charge of $19 per participant per plan year. Underfunded single-employer plans pay an additional
variable-rate premium of $9 for every $1,000 (or fraction thereof) of unfunded vested benefits.
The premium rate for PBGC-insured multiemployer plans is $2.60 per participant per plan year.

3.

Accountant positions at PBGC require the following minimum qualifications:

An accounting degree or a degree in a related field (such as business administration, finance, or


public administration) that included or was supplemented by 24 semester hours in accounting.
The 24 semester hours may include up to 6 hours of credit in business law; OR
A combination of education and experience that includes at least 4 years of experience in
accounting or an equivalent combination of accounting experience, college-level education, and
training that provided professional accounting knowledge.

The applicant's background must also include one of the following:

Twenty-four (24) semester hours in accounting or auditing courses, which may include up to 6
hours of business law; OR
A certificate as Certified Public Accountant or a Certified Internal Auditor; OR
Completion of the requirements for a degree that included substantial course work (e.g., at least
15, but less than the 24 semester hours required) in accounting or auditing, provided that:

The applicant has successfully worked at the full performance level in accounting, auditing,
or a related field; AND

A panel of at least two higher level professional accountants or auditors has determined that
the applicant has demonstrated a good knowledge of accounting and of related and
underlying fields that equals in breadth, depth, currency, and level of advancement that
which is normally associated with successful completion of the four-year course of study;
AND

Except for the lack of the required 24 semester hours in accounting or auditing, the
applicant's education, training, and experience fully meet the specified requirements.