To cut down on cumbersome paperwork and lessen their exposure to the risk posed by defined benefit plans, many companies are providing defined contribution plans instead. When a plan is terminated, GAAP requires a gain or loss to be reported at that time.29 For instance, Melville Corporation described the termination of its pension plan in the following disclosure note:
Companies sometimes terminate defined benefit plans to reduce costs and lessen risk.
Gain on the Termination of a Defined Benefit Plan—Melville Corporation
Real World Financials
Retirement Plans (in part)
… As a result of the termination of the defined benefit plans, and after the settlement of the liability to plan participants through the purchase of nonparticipating annuity contracts or lump-sum rollovers into the new 401(k) Profit Sharing Plan, the Company recorded a nonrecurring gain of approximately $4,000,000 which was the amount of plan assets that reverted to the Company. This was accounted for in accordance with Statement of Financial Accounting Standards No. 88, “Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits.” [FASB ASC 715–30–35]
Allied Services, Inc., has a noncontributory, defined benefit pension plan. Pension plan assets had a fair market value of $900 million at December 31, 2010.
On January 3, 2011, Allied amended the pension formula to increase benefits for each service year. By making the amendment retroactive to prior years, Allied incurred a prior service cost of $75 million, adding to the previous projected benefit obligation of $875 million. The prior service cost is to be amortized (expensed) over 15 years. The service cost is $31 million for 2011. Both the actuary's discount rate and the expected rate of return on plan assets were 8%. The actual rate of return on plan assets was 10%.
At December 31, 2011, $16 million was contributed to the pension fund and $22 million was paid to retired employees. Also, at that time, the actuary revised a previous assumption, increasing the PBO estimate by $10 million. The net loss AOCI at the beginning of the year was $13 million.
Determine each of the following amounts as of December 31, 2011, the fiscal year-end for Allied: (1) projected benefit obligation; (2) plan assets; and (3) pension expense.
Note: The $18 million gain on plan assets ($90 − 72 million) is not recognized yet; it is carried forward to be combined with previous and future gains and losses, which will be recognized only if the net gain or net loss exceeds 10% of the higher of the PBO or plan assets.
*Since the plan was amended at the beginning of the year, the prior service cost increased the PBO at that time.
†Since the net loss ($13) does not exceed 10% of $900 (higher than $875), no amortization is required for 2011.
We get a glimpse of the future, perhaps, from an Exposure Draft of a new postemployment benefit standard from the IASB. The document, issued in late 2009, indicates the direction of International Financial Reporting Standards for pensions and other postretirement plans. It proposes changes that “leapfrog” existing U.S. GAAP, and because the FASB and IASB are working together on a standard scheduled for completion by June 2011, this document may provide an indication of where both U.S. GAAP and IFRS are headed.
The FASB and IASB are working together on a joint postretirement benefit standard.
The major change proposed is that we would report all changes in the obligation and the value of plan assets in net income. The changes would be separated into (a) the cost of service (employment cost), (b) the cost of financing the deferred settlement of that cost, and (c) gains or losses from occasional remeasurement of the employment cost as assumptions change:
Employment cost includes:
Past service costs (if any).
Finance cost includes:
Remeasurements of the defined benefit obligation (called projected benefit obligation under U.S. GAAP) caused by changes in the discount rate return on plan assets.
Remeasurement cost includes:
Remeasurements of service costs (in the DBO) caused by changes in assumptions other than the discount rate (i.e., assumptions like salary expectations, length of service, length of retirement, etc.).
Even though these three components of the total cost are reported in the income statement, we distinguish among them because the components are believed to have different predictive values. For instance, a decline in profit caused by an increase in pension cost due to rising employment costs might provide information of a different predictive value from an equivalent decline in profit arising from changes in the fair value of investments or interest rate changes. Investors' ability to make predictions is enhanced if income statement items with different predictive implications are reported as separate line items in the income statement.
Classifying the Components of the Total Pension Cost
Using the amounts from our Global Communications illustration, the changes would be classified as follows:
We would report separately the three costs of having a defined benefit plan:
We would report the three components of the total pension cost in the income statement as follows:
Recording the Pension Costs
We would report the costs of service—employment, financing, remeasurement—in net income as a component of net periodic pension cost. Remember, each component is a change in either plan assets (the return on assets) or the defined benefit obligation (all others), so as we record each component we also would record its effect on plan assets and the defined benefit obligation, as follows:
When Global adds its annual cash investment to its plan assets, the value of those plan assets increases by $48 million:
In our illustration, Global's retired employees were paid benefits of $38 million in 2011. Paying those benefits of course reduces the obligation to pay benefits (the DBO), and since the payments are made from the plan assets, that balance is reduced as well:
29FASB ASC 715–30–35: Compensation–Retirement Benefits–Defined Benefit Plans–Pension–Subsequent Measurement (previously “Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” Statement of Financial Accounting Standards No. 88 (Stamford, Conn.: FASB, 1985)).