Post-Employment

Benefits
GSBA 510:
Financial Accounting - Session 23
Who is this??
 Agenda
• Accounting for contingent liabilities
• Basic economic concepts for post-
employment benefits
• Differences between accounting and
economic values
• The role of accounting discretion

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 Contingent Liabilities

• A contingent liability is an obligation that is

contingent on future events.
– Contingencies present a problem for financial
reporting – we know they could cost something in
the future, but we do not know how much and
when.
– E.g., lawsuits, environmental costs, frequent-flyer
miles, warranties, post-employment benefits.

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 Contingent Liabilities
• Accounting treatment for contingent liabilities:
– Probable and reasonably estimable  accrue, i.e.
recognize as an estimated loss and a related liability.
– Reasonably possible  disclose in a footnote.
– Remote  no need to disclose.
– Terminology:
• Probable: the future event is likely to occur.
• Possible: the chance of the future event occurring
is more than remote but less than likely.
• Remote: the chance of the event occurring is slight .

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 Pensions
• A pension plan is an agreement by the firm to provide a series
of payments to employees when they retire.
• The firm makes periodic contributions to a pension trust.
• The pension trust then makes periodic benefit payments to
retired employees.

Firm Pension Retired

Contributions Trust Benefit Employee
payments

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 Defined Contribution Pension Plans
• Specify the amount of cash the employer puts into
the plan.
• No explicit promise is made about the size of the
periodic payments the employee will receive on
retirement – retirement benefits depend on
investment performance.
• There is no liability beyond the periodic contribution.

DR Pension Expense xxx

CR Cash xxx

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 Defined Benefit Pension Plans
• Specify the formula for determining the amount that will be paid out to
the employee after retirement.

• Retirement benefits do not depend on investment performance. The

employer bears the risk of whether or not the pension funds cover the
obligation for future pension payments.

• Determining the pension obligation, how much should be charged to

pension expense each year and how much cash must be contributed to
the fund is complex. the following factors must be estimated:

1. Proportion of workforce that will remain long enough to qualify for benefits
(vesting).
2. Rate at which employee salaries will rise until they leave the company.
3. Life expectancy of employees after retirement. And it's going up...
4. Rate of return that will be earned on pension investments.
5. Discount rate to reflect the PV of future benefits earned by employees in the
current period

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Rising U.S. Life Spans Spell Likely
Pain for Pension Funds, WSJ
 Defined Benefit Pension Plans
Basic Economic Concepts
Plan Assets (PA): Measured at fair value.

Plan Obligation: Measured in two ways:

• Accumulated Benefit Obligation (ABO): PV of benefits earned
based on service to date and salary levels earned to date.

• Projected Benefit Obligation (PBO): PV of benefits earned to date

based on service to date and salary levels projected to exist when
the employee retires or leaves the company.
– PBO is the measure required by FASB.
– Requires the following assumptions: life expectancy, employee
turnover, future salary increases and discount rate.

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 Defined Benefit Pension Plans
Basic Economic Concepts

• PA > PBO  Pension plan is over-funded.

• PA < PBO  Pension plan is under-funded.
•  (PBO – PA) over a period reflects:
1. Service cost – the increase in the discounted present value of
the pension benefits due to an additional year’s employment,
i.e., benefits earned this period.
2. Interest cost – the growth in the pension liability that arises
from the passage of time.
3. Return on plan assets
4. Changes in assumptions (e.g., interest rate, turnover) and plan
amendments (e.g., salary increases, change in formula)
5. Funding

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 Defined benefit pension plans:
Six components of pension expense
Service cost (+) The increase in the discounted present value of the pension
benefits due to an additional year’s employment.

Measures the growth in the pension liability that arises from

Interest cost (+)
the passage of time.

Expected return Dollar return management believes will be earned on

on pension assets (-) pension investments.

Recognized gains Smoothing device that adjusts for the difference between
or losses (- or +) the expected and actual return on pension assets.

Amortization of
Smoothing device that adjusts for the initial SFAS No. 87
unrecognized transition
disparity between pension assets and liabilities.
asset or obligation (- or +)

Recognized prior Smoothing device that adjusts for the costs of retroactive
service cost (- or +) changes in plan benefits.

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 Pensions – Journal Entries
TRUST BOOKS

Pension Assets Pension Obligation

BB BB
Contributions Service Cost
Actual Return Interest Cost

Pension Payments Pension

Payments
Plan Amendments, Changes
EB EB

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 Accounting for Defined Benefit
Plans: A Brief History
• In the beginning there was cash basis accounting.
– Wait until employees retire.
– Expense benefit payments to retired employees.
• What’s the problem?
– On the balance sheet?
– On the income statement?

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Accounting for Defined Benefit
Plans: A Brief History
• FAS 87 (issued 1985).
– Modified accrual basis accounting.
– Record smoothed pension expense in year
employee provides services.
– Highly contentious standard.
• FAS 106 on postretirement benefits
• delayed until 1990.
• Institutionalized delayed recognition.

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Accounting for Defined Benefit Plans: A Brief History

…just as American businesses have managed to dig out

from under the debt loads of the 1980s, they will be forced
to reflect a massive new burden on their balance sheets --
estimated at a staggering $400 billion or more nationwide
-- all because they have promised to pay retirees' medical
insurance. … some companies … are likely to have FASB
106 liabilities in excess of their net worth, even though
their positions have not changed….The future
competitiveness of American business -- and the future
health and well-being of millions of retirees -- should not
be determined on the basis of a mere bookkeeping rule.
(Wall Street Journal, Dec 28, 1992. pg. A10)

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 Corporate Pension Crisis
• Who pays pension benefits when a company
goes bankrupt?
– Pension Benefit Guarantee Corp. (PBGC)
– 2020 Annual Report 
• Companies are starting to rethink pensions

PBGC Annual Report 2009

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 PBGC Annual Report 2009

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 PBGC Annual Report 2009

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 Accounting for Defined Benefit Pension
Plans
• On the I/S, the company recognizes
Net (accounting) Pension Expense = Service Cost + Interest Cost
- Expected (not Actual) Return on Plan Assets
 Amortization of Smoothing Items (Deferrals)
• Amortization of Smoothing Items (Deferrals) result from
– Prior service cost resulting from plan amendments
– Actual return on plan assets different from expectations
– Changes in assumptions (e.g., discount rate)

• Net Pension Expense may not equal  (PBO – PA). For two reasons:
1. Expected vs. Actual Returns are recorded
2. Amortization of Items vs. Actual Items

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 Defined benefit pension plans:
Excerpts from GE’s pension footnotes

Volatile
actual returns

Smooth
expected
returns

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 Defined benefit pension plans:
Actual and expected return at GE

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 GE’s Pension year-to-year…
“Expected” vs. “Actual” Returns on Plan Assets

10,000
7,500
5,000
2,500
0
($) Million

-2,500
-5,000
-7,500
-10,000
-12,500
-15,000
-17,500
-20,000
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20

Actual Assumed

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 GE’s Cumulative Return
on Plan Assets

Cumulative effect over time

80,000
70,000
60,000
50,000
($) Million

40,000
30,000
20,000
10,000
0
88 989 990 991 992 993 994 995 996 997 998 999 000 001 002 003 004 005 006 007 008
19 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2

Actual Assumed

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 Pensions – Journal Entries
COMPANY F/S

(+) Net Pension Expense (I/S) (-) (-) Net Pension Liability (B/S) ( + )
BB
Service Cost Service Cost
Interest Cost Expected Return Interest Cost
Contributions
Expected Return
Other Stuff (amortization) Other Stuff (amortization)
Net Pension Exp. EB

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 Accounting for Defined Benefit
Pension Plans
• In the footnotes, the company discloses
– Plan assets (PA) and obligations (PBO)
– Components of Net Pension Expense on the I/S
– Assumptions used (expected rate of return on plan assets,
discount rate, etc.)

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 Next Session

• Case Assignment: General Mills, Inc.

– DO NOT DO QUESTION #7
• Basic concepts of pension accounting.
• Differences between accounting and
economic values of post-employment
benefits.
• The effect of accounting discretion.

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