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(c) How should Dexter classify the deferred tax consequences of the temporary differences on its balance sheet? CA19-3 (Identify Temporary Differences and Classification Criteria) The asset-liability approach for recording deferred income taxes is an integral part of generally accepted accounting principles. Instructions (a) Indicate whether each of the following independent situations should be treated as a temporary difference or as a permanent difference, and explain why. (1) Estimated warranty costs (covering a 3-year warranty) are expensed for financial reporting pur- poses at the time of sale but deducted for income tax purposes when paid. (2) Depreciation for book and income tax purposes differs because of different bases of carrying the related property, which was acquired in a trade-in. The different bases are a result of different rules used for book and tax purposes to compute the basis of property acquired in a trade-in. (3) A company properly uses the equity method to account for its 30% investment in another com- pany. The investee pays dividends that are about 10% of its annual earnings. (4) A company reports a gain on an involuntary conversion of a nonmonetary asset to a monetary asset. The company elects to replace the property within the statutory period using the total proceeds so the gain is not reported on the current year’s tax return. (b) Discuss the nature of the deferred income tax accounts and possible classifications in a company’s balance sheet. Indicate the manner in which these accounts are to be reported. CA19-4 (Accounting and Classification of Deferred Income Taxes) Part A: This year, Gumowski Company has each of the following items in its income statement. 1. Gross profits on installment sales. 2. Revenues on long-term construction contracts. 3. Estimated costs of product warranty contracts. 4. Premiums on officers’ life insurance policies with Gumowski as beneficiary. Instructions (a) Under what conditions would deferred income taxes need to be reported in the financial statements? (b) Specify when deferred income taxes would need to be recognized for each of the items above, and indicate the rationale for such recognition. Part B: Gumowski Company’s president has heard that deferred income taxes can be classified in different ways in the balance sheet. Instructions Identify the conditions under which deferred income taxes would be classified as a noncurrent item in the balance sheet. What justification exists for such classification? (AICPA adapted) 1172 Chapter 19 Accounting for Income Taxes CA19-5 (Explain Computation of Deferred Tax Liability for Multiple Tax Rates) At December 31, 2014, Higley Corporation has one temporary difference which will reverse and cause taxable amounts in 2015. In 2014, a new tax act set taxes equal to 45% for 2014, 40% for 2015, and 34% for 2016 and years thereafter. Instructions Explain what circumstances would call for Higley to compute its deferred tax liability at the end of 2014 by multiplying the cumulative temporary difference by: (a) 45%. (b) 40%. (c) 34%. CA19-6 (Explain Future Taxable and Deductible Amounts, How Carryback and Carryforward Affects Deferred Taxes) Maria Rodriquez and Lynette Kingston are discussing accounting for income taxes. They are currently studying a schedule of taxable and deductible amounts that will arise in the future as a result of existing temporary differences. The schedule is as follows. Future Years 2014 2015 2016 2017 2018 Taxable income $850,000 Taxable amounts $375,000 $375,000 $375,000 $375,000 Deductible amounts (2,400,000) Enacted tax rate 50% 45% 40% 35% 30% Instructions (a) Explain the concept of future taxable amounts and future deductible amounts as illustrated in the schedule. (b) How do the carryback and carryforward provisions affect the reporting of deferred tax assets and deferred tax liabilities? CA19-7 (Deferred Taxes, Income Effects) Stephanie Delaney, CPA, is the newly hired director of corpo- rate taxation for Acme Incorporated, which is a publicly traded corporation. Ms. Delaney’s first job with

Acme was the review of the company’s accounting practices on deferred income taxes. In doing her review, she noted differences between tax and book depreciation methods that permitted Acme to realize a sizable deferred tax liability on its balance sheet. As a result, Acme paid very little in income taxes at that time. Delaney also discovered that Acme has an explicit policy of selling off plant assets before they reversed in the deferred tax liability account. This policy, coupled with the rapid expansion of its plant asset base, allowed Acme to “defer” all income taxes payable for several years, even though it always has reported positive earnings and an increasing EPS. Delaney checked with the legal department and found the policy to be legal, but she’s uncomfortable with the ethics of it. Instructions Answer the following questions. (a) Why would Acme have an explicit policy of selling plant assets before the temporary differences reversed in the deferred tax liability account? (b) What are the ethical implications of Acme’s “deferral” of income taxes? (c) Who could be harmed by Acme’s ability to “defer” income taxes payable for several years, despite positive earnings? (d) In a situation such as this, what are Ms. Delaney’s professional responsibilities as a CPA? USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Using Your Judgment 1173 Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) What amounts relative to income taxes does P&G report in its: (1) 2011 income statement? (2) June 30, 2011, balance sheet? (3) 2011 statement of cash flows? (b) P&G’s income taxes in 2009, 2010, and 2011 were computed at what effective tax rates? (See the notes to the financial statements.) (c) How much of P&G’s 2011 total income taxes was current tax expense, and how much was deferred tax expense? (d) What did P&G report as the significant components (the details) of its June 30, 2011, deferred tax assets and liabilities? Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What are the amounts of Coca-Cola’s and PepsiCo’s provision for income taxes for the year 2011? Of each company’s 2011 provision for income taxes, what portion is current expense and what portion is deferred expense? (b) What amount of cash was paid in 2011 for income taxes by Coca-Cola and by PepsiCo? (c) What was the U.S. federal statutory tax rate in 2011? What was the effective tax rate in 2011 for Coca-Cola and PepsiCo? Why might their effective tax rates differ? (d) For year-end 2011, what amounts were reported by Coca-Cola and PepsiCo as (1) gross deferred tax assets and (2) gross deferred tax liabilities? (e) Do either Coca-Cola or PepsiCo disclose any net operating loss carrybacks and/or carryforwards at year-end 2011? What are the amounts, and when do the carryforwards expire? Financial Statement Analysis Case Homestake Mining Company Homestake Mining Company is a 120-year-old international gold mining company with substantial gold mining operations and exploration in the United States, Canada, and Australia. At year-end, Homestake reported the following items related to income taxes (thousands of dollars). Total current taxes $ 26,349 Total deferred taxes (39,436) Total income and mining taxes (the provision for taxes per its income statement) (13,087) Deferred tax liabilities $303,050 Deferred tax assets, net of valuation allowance of $207,175 95,275 Net deferred tax liability $207,775 Note 6: The classifi cation of deferred tax assets and liabilities is based on the related asset or liability creating the deferred tax. Deferred taxes not related to a specifi c asset or liability are classifi ed

based on the estimated period of reversal. Tax loss carryforwards (U.S., Canada, Australia, and Chile) $71,151 Tax credit carryforwards $12,007 Instructions (a) What is the significance of Homestake’s disclosure of “Current taxes” of $26,349 and “Deferred taxes” of $(39,436)? (b) Explain the concept behind Homestake’s disclosure of gross deferred tax liabilities (future taxable amounts) and gross deferred tax assets (future deductible amounts). (c) Homestake reported tax loss carryforwards of $71,151 and tax credit carryforwards of $12,007. How do the carryback and carryforward provisions affect the reporting of deferred tax assets and deferred tax liabilities? 1174 Chapter 19 Accounting for Income Taxes Accounting, Analysis, and Principles DeJohn Company, which began operations at the beginning of 2012, produces various products on a con- tract basis. Each contract generates a gross profit of $80,000. Some of DeJohn’s contracts provide for the customer to pay on an installment basis. Under these contracts, DeJohn collects one-fifth of the contract revenue in each of the following four years. For financial reporting purposes, the company recognizes gross profit in the year of completion (accrual basis). For tax purposes, DeJohn recognizes gross profit in the year cash is collected (installment basis). Presented below is information related to DeJohn’s operations for 2014: 1. In 2014, the company completed seven contracts that allow for the customer to pay on an installment basis. DeJohn recognized the related gross profit of $560,000 for financial reporting purposes. It reported only $112,000 of gross profit on installment sales on the 2014 tax return. The company expects future collections on the related installment receivables to result in taxable amounts of $112,000 in each of the next four years. 2. In 2014, nontaxable municipal bond interest revenue was $28,000. 3. During 2014, nondeductible fines and penalties of $26,000 were paid. 4. Pretax financial income for 2014 amounts to $500,000. 5. Tax rates (enacted before the end of 2014) are 50% for 2014 and 40% for 2015 and later. 6. The accounting period is the calendar year. 7. The company is expected to have taxable income in all future years. 8. The company has no deferred tax assets or liabilities at the end of 2013. Accounting Prepare the journal entry to record income taxes for 2014. Analysis Classify deferred income taxes on the balance sheet at December 31, 2014, and indicate, starting with Income before income taxes, how income taxes are reported on the income statement. What is DeJohn’s effective tax rate? Principles Explain how the conceptual framework is used as a basis for determining the proper accounting for deferred income taxes. BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation Kleckner Company started operations in 2010. Although it has grown steadily, the company reported a ccumulated operating losses of $450,000 in its first four years in business. In the most recent year (2014), Kleckner appears to have turned the corner and reported modest taxable income of $30,000. In addition to a deferred tax asset related to its net operating loss, Kleckner has recorded a deferred tax asset related to product warranties and a deferred tax liability related to accelerated depreciation. Given its past operating results, Kleckner has established a full valuation allowance for its deferred tax assets. However, given its improved performance, Kleckner management wonders whether the company can now reduce or eliminate the valuation allowance. They would like you to conduct some research on the accounting for its valuation allowance. Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) Briefly explain to Kleckner management the importance of future taxable income as it relates to the valuation allowance for deferred tax assets. (b) What are the sources of income that may be relied upon to remove the need for a valuation allowance?

(c) What are tax-planning strategies? From the information provided, does it appear that Kleckner could employ a tax-planning strategy to support reducing its valuation allowance? Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS Insights 1175 IFRS INSIGHTS The accounting for income taxes in IFRS is covered in IAS 12 (“Income Taxes”), 12 LEARNING OBJECTIVE which is based on an asset-liability approach to measurement of deferred taxes. Compare the accounting for income taxes under GAAP and IFRS. RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to accounting for taxes. Similarities • Similar to GAAP, IFRS uses the asset and liability approach for recording deferred taxes. Differences • The classifi cation of deferred taxes under IFRS is always non-current. As indicated in the chapter, GAAP classifi es deferred taxes based on the classifi cation of the asset or liability to which it relates. • Under IFRS, an affi rmative judgment approach is used, by which a deferred tax asset is recognized up to the amount that is probable to be realized. GAAP uses an impair- ment approach. In this approach, the deferred tax asset is recognized in full. It is then reduced by a valuation account if it is more likely than not that all or a portion of the deferred tax asset will not be realized. • IFRS uses the enacted tax rate or substantially enacted tax rate. (“Substantially en- acted” means virtually certain.) For GAAP, the enacted tax rate must be used. • The tax effects related to certain items are reported in equity under IFRS. That is not the case under GAAP, which charges or credits the tax effects to income. • GAAP requires companies to assess the likelihood of uncertain tax positions being sustainable upon audit. Potential liabilities must be accrued and disclosed if the posi- tion is “more likely than not” to be disallowed. Under IFRS, all potential liabilities must be recognized. With respect to measurement, IFRS uses an expected-value ap- proach to measure the tax liability, which differs from GAAP. ABOUT THE NUMBERS Deferred Tax Asset (Non-Recognition) Under IFRS, companies recognize a deferred tax asset for all deductible temporary dif- ferences. However, based on available evidence, a company should reduce a deferred tax asset if it is probable that it will not realize some portion or all of the deferred tax asset. “Probable” means a level of likelihood of at least slightly more than 50 percent. Assume that Jensen Co. has a deductible temporary difference of $1,000,000 at the end of its first year of operations. Its tax rate is 40 percent, which means it records a deferred tax asset of $400,000 ($1,000,000 3 40%). Assuming $900,000 of income taxes payable, Jensen records income tax expense, the deferred tax asset, and income taxes payable as follows. Income Tax Expense 500,000 Deferred Tax Asset 400,000 Income Taxes Payable 900,000 1176 Chapter 19 Accounting for Income Taxes After careful review of all available evidence, Jensen determines that it is probable that it will not realize $100,000 of this deferred tax asset. Jensen records this reduction in asset value as follows. Income Tax Expense 100,000 Deferred Tax Asset 100,000 This journal entry increases income tax expense in the current period because Jensen does not expect to realize a favorable tax benefit for a portion of the deductible tempo- rary difference. Jensen simultaneously recognizes a reduction in the carrying amount of the deferred tax asset. Jensen then reports a deferred tax asset of $300,000 in its state- ment of financial position. Jensen evaluates the deferred tax asset account at the end of each accounting period. If, at the end of the next period, it expects to realize $350,000 of this deferred tax asset, Jensen makes the following entry to adjust this account. Deferred Tax Asset ($350,000 2 $300,000) 50,000 Income Tax Expense 50,000 Jensen should consider all available evidence, both positive and negative, to determine

whether, based on the weight of available evidence, it needs to adjust the deferred tax asset. For example, if Jensen has been experiencing a series of loss years, it reasonably assumes that these losses will continue. Therefore, Jensen will lose the benefit of the future deductible amounts. Generally, sufficient taxable income arises from temporary taxable differences that will reverse in the future or from a tax-planning strategy that will generate tax- able income in the future. Illustration IFRS19-1 shows how Ahold describes its report- ing of deferred assets. ILLUSTRATION Ahold IFRS19-1 Deferred Tax Asset Note 11. Significant judgment is required in determining whether deferred tax assets are realizable. Disclosure Ahold determines this on the basis of expected taxable profits arising from recognized deferred tax liabilities and on the basis of budgets, cash flow forecasts, and impairment models. Where utilization is not considered probable, deferred taxes are not recognized. Carryforward (Non-Recognition) To illustrate non-recognition of a loss carryforward, assume that Groh Inc. has tax ben- efits of $110,000 associated with a NOL carryback and a potential deferred tax asset of $80,000 associated with an operating loss carryforward of $200,000, assuming a future tax rate of 40% ($200,000 3 40%). However, if it is probable that Groh will not realize the entire NOL carryforward in future years, it does not recognize this deferred tax a sset. To illustrate, Groh makes the following journal entry in 2014 to record only the tax refund receivable. To recognize benefit of loss carryback Income Tax Refund Receivable 110,000 Benefit Due to Loss Carryback (Income Tax Expense) 110,000 IFRS Insights 1177 Illustration IFRS19-2 shows Groh’s 2014 income statement presentation. ILLUSTRATION GROH INC. IFRS19-2 INCOME STATEMENT (PARTIAL) FOR 2014 Recognition of Benefi t Operating loss before income taxes $(500,000) of Loss Carryback Only Income tax benefit Benefit due to loss carryback 110,000 Net loss $(390,000) In 2015, assuming that Groh has taxable income of $250,000 (before considering the carryforward), subject to a tax rate of 40 percent, it realizes the deferred tax asset. Groh records the following entries. To recognize deferred tax asset and loss carryforward Deferred Tax Asset 80,000 Benefit Due to Loss Carryforward (Income Tax Expense) 80,000 To record current and deferred income taxes Income Tax Expense 100,000 Deferred Tax Asset 80,000 Income Taxes Payable 20,000 Groh reports the $80,000 Benefit Due to the Loss Carryforward on the 2015 income statement. The company did not recognize it in 2014 because it was probable that it would not be realized. Assuming that Groh derives the income for 2015 from continuing operations, it prepares the income statement as shown in Illustration IFRS19-3. ILLUSTRATION GROH INC. IFRS19-3 INCOME STATEMENT (PARTIAL) FOR 2015 Recognition of Benefi t Income before income taxes $250,000 of Loss Carryforward Income tax expense When Realized Current $ 20,000 Deferred 80,000 Benefit due to loss carryforward (80,000) 20,000 Net income $230,000 Another method is to report only one line for total income tax expense of $20,000 on the face of the income statement and disclose the components of income tax expense in the notes to the financial statements. Statement of Financial Position Classifi cation Companies classify taxes receivable or payable as current assets or current liabilities. Although current tax assets and liabilities are separately recognized and measured, they are often offset in the statement of financial position. The offset occurs because companies normally have a legally enforceable right to offset a current tax asset (Taxes Receivable) against a current tax liability (Taxes Payable) when they relate to income taxes levied by the same taxation authority. Deferred tax assets and deferred tax liabilities are also sepa- rately recognized and measured but may be offset in the statement of financial position. Companies are permitted to offset deferred tax assets and deferred tax liabilities if, and

only if (1) the company has a legally enforceable right to offset current tax assets against current tax liabilities, and (2) the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same tax authority and for the same company. 1178 Chapter 19 Accounting for Income Taxes The net deferred tax asset or net deferred tax liability is reported in the non-current section of the statement of financial position. Deferred tax amounts should not be dis- counted. The IASB apparently considers discounting to be an unnecessary complication even if the effects are material. To illustrate, assume that K. Scott Company has four deferred tax items at December 31, 2014, as shown in Illustration IFRS19-4. ILLUSTRATION Resulting IFRS19-4 Deferred Tax Classifi cation of Temporary Difference (Asset) Liability Temporary Differences 1. Rent collected in advance: recognized when earned for accounting purposes and when received for tax purposes. $(42,000) 2. Use of straight-line depreciation for accounting purposes and accelerated depreciation for tax purposes. $214,000 3. Recognition of profits on installment sales during period of sale for accounting purposes and during period of collection for tax purposes. 45,000 4. Warranty liabilities: recognized for accounting purposes at time of sale; for tax purposes at time paid. (12,000) Totals $(54,000) $259,000 As indicated, K. Scott has a total deferred tax asset of $54,000 and a total deferred tax liability of $259,000. Assuming these two items can be offset, K. Scott reports a deferred tax liability of $205,000 ($259,000 2 $54,000) in the non-current liability section of its statement of financial position. ON THE HORIZON The IASB and the FASB have been working to address some of the differences in the ac- counting for income taxes. Some of the issues under discussion are the term “probable” under IFRS for recognition of a deferred tax asset, which might be interpreted to mean “more likely than not.” If the term is changed, the reporting for impairments of deferred tax assets will be essentially the same between GAAP and IFRS. In addition, the IASB is considering adoption of the classification approach used in GAAP for deferred assets and liabilities. Also, GAAP will likely continue to use the enacted tax rate in computing deferred taxes, except in situations where the taxing jurisdiction is not involved. In that case, companies should use IFRS, which is based on enacted rates or substantially en- acted tax rates. Finally, the issue of allocation of deferred income taxes to equity for certain transactions under IFRS must be addressed in order to converge with GAAP, which allocates the effects to income. At the time of this printing, deliberations on the income tax project have been suspended indefinitely. IFRS SELF-TEST QUESTIONS 1. Which of the following is false? (a) Under GAAP, deferred taxes are reported based on the classification of the asset or liability to which it relates. (b) Under IFRS, some potential liabilities are not recognized. (c) Under GAAP, the enacted tax rate is used to measure deferred tax assets and liabilities. (d) Under IFRS, all deferred tax assets and liabilities are classified as non-current. 2. Which of the following statements is correct with regard to IFRS and GAAP? (a) Under GAAP, all potential liabilities related to uncertain tax positions must be recognized. (b) The tax effects related to certain items are reported in equity under GAAP; under IFRS, the tax effects are charged or credited to income. IFRS Insights 1179 (c) IFRS uses an affirmative judgment approach for deferred tax assets, whereas GAAP uses an impairment approach for deferred tax assets. (d) IFRS classifies deferred taxes based on the classification of the asset or liability to which it relates. 3. Under IFRS: (a) “probable” is defined as a level of likelihood of at least slightly more than 60%. (b) a company should reduce a deferred tax asset when it is likely that some or all of it will not be realized by using a valuation allowance.

(c) a company considers only positive evidence when determining whether to recognize a deferred tax asset. (d) deferred tax assets must be evaluated at the end of each accounting period. 4. Stephens Company has a deductible temporary difference of $2,000,000 at the end of its first year of operations. Its tax rate is 40 percent. Stephens has $1,800,000 of income taxes payable. After a careful review of all available evidence, Stephens determines that it is probable that it will not realize $200,000 of this deferred tax asset. On Stephens Company’s statement of financial position at the end of its first year of operations, what is the amount of deferred tax asset? (a) $2,000,000. (c) $800,000. (b) $1,800,000. (d) $600,000. 5. Lincoln Company has the following four deferred tax items at December 31, 2014. The deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same tax authority. Deferred Deferred Temporary Difference Tax Asset Tax Liability Rent collected in advance: recognized when earned for accounting purposes and when received for tax purposes. $652,000 Use of straight-line depreciation for accounting purposes and accelerated depreciation for tax purposes. $330,000 Recognition of profi ts on installment sales during period of sale for accounting purposes and during period of collection for tax purposes. 64,000 Warranty liabilities: recognized for accounting purposes at time of sale; for tax purposes at time paid. 37,000 On Lincoln’s December 31, 2014, statement of financial position, it will report: (a) $394,000 non-current deferred tax liability and $689,000 non-current deferred tax asset. (b) $330,000 non-current liability and $625,000 current deferred tax asset. (c) $295,000 non-current deferred tax asset. (d) $295,000 current tax receivable. IFRS CONCEPTS AND APPLICATION IFRS19-1 Where can authoritative IFRS related to the accounting for taxes be found? IFRS19-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to income tax accounting. IFRS19-3 Describe the current convergence efforts of the FASB and IASB in the area of accounting for taxes. IFRS19-4 How are deferred tax assets and deferred tax liabilities reported on the statement of financial position under IFRS? IFRS19-5 Describe the procedure(s) involved in classifying deferred tax amounts on the statement of financial position under IFRS. IFRS19-6 At December 31, 2014, Hillyard Corporation has a deferred tax asset of $200,000. After a careful review of all available evidence, it is determined that it is probable that $60,000 of this deferred tax asset will not be realized. Prepare the necessary journal entry. 1180 Chapter 19 Accounting for Income Taxes IFRS19-7 Rode Inc. incurred a net operating loss of $500,000 in 2014. Combined income for 2012 and 2013 was $350,000. The tax rate for all years is 40%. Rode elects the carryback option. Prepare the journal entries to record the benefits of the loss carryback and the loss carryforward. IFRS19-8 Use the information for Rode Inc. given in IFRS19-7. Assume that it is probable that the entire net operating loss carryforward will not be realized in future years. Prepare the journal entry(ies) necessary at the end of 2014. IFRS19-9 Youngman Corporation has temporary differences at December 31, 2014, that result in the following deferred taxes. Deferred tax asset $24,000 Deferred tax liability $69,000 Indicate how these balances would be presented in Youngman’s December 31, 2014, statement of financial position. IFRS19-10 At December 31, 2014, Cascade Company had a net deferred tax liability of $450,000. An expla- nation of the items that compose this balance is as follows. Temporary Differences in Deferred Taxes Resulting Balances 1. Excess of tax depreciation over book depreciation. $200,000 2. Accrual, for book purposes, of estimated loss contingency from pending lawsuit that is expected to be settled in 2015. The loss will be deducted on the tax return when paid. $ (50,000) 3. Accrual method used for book purposes and installment

method used for tax purposes for an isolated installment sale of an investment. $300,000 In analyzing the temporary differences, you find that $30,000 of the depreciation temporary difference will reverse in 2015, and $120,000 of the temporary difference due to the installment sale will reverse in 2015. The tax rate for all years is 40%. Instructions Indicate the manner in which deferred taxes should be presented on Cascade Company’s December 31, 2014, statement of financial position. IFRS19-11 Callaway Corp. has a deferred tax asset account with a balance of $150,000 at the end of 2014 due to a single cumulative temporary difference of $375,000. At the end of 2015, this same temporary dif- ference has increased to a cumulative amount of $500,000. Taxable income for 2015 is $850,000. The tax rate is 40% for all years. Instructions (a) Record income tax expense, deferred income taxes, and income taxes payable for 2015, assuming that it is probable that the deferred tax asset will be realized. (b) Assuming that it is probable that $30,000 of the deferred tax asset will not be realized, prepare the journal entry at the end of 2015 to recognize this probability. Professional Research IFRS19-12 Kleckner Company started operations in 2010. Although it has grown steadily, the company reported accumulated operating losses of $450,000 in its first four years in business. In the most recent year (2014), Kleckner appears to have turned the corner and reported modest taxable income of $30,000. In ad- dition to a deferred tax asset related to its net operating loss, Kleckner has recorded a deferred tax asset related to product warranties and a deferred tax liability related to accelerated depreciation. Given its past operating results, Kleckner has determined that it is not probable that it will realize any of the deferred tax assets. However, given its improved performance, Kleckner management wonders whether there are any accounting consequences for its deferred tax assets. They would like you to conduct some research on the accounting for recognition of its deferred tax asset. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can IFRS Insights 1181 use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) Briefly explain to Kleckner management the importance of future taxable income as it relates to the recognition of deferred tax assets. (b) What are the sources of income that may be relied upon in assessing realization of a deferred tax asset? (c) What are tax-planning strategies? From the information provided, does it appear that Kleckner could employ a tax-planning strategy in evaluating its deferred tax asset? International Financial Reporting Problem Marks and Spencer plc IFRS19-13 The financial statements of Marks and Spencer plc (M&S) are available at the book’s com- panion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks- and-Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What amounts relative to income taxes does M&S report in its: (1) 2012 income statement? (2) 31 March 2012 statement of financial position? (3) 2012 statement of cash flows? (b) M&S’s provision for income taxes in 2011 and 2012 was computed at what effective tax rates? (See the notes to the financial statements.) (c) How much of M&S’s 2012 total provision for income taxes was current tax expense, and how much was deferred tax expense? (d) What did M&S report as the significant components (the details) of its 31 March 2012 deferred tax assets and liabilities? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. b 2. c 3. d 4. d 5. c Remember to check the book’s companion website to fi nd additional resources for this chapter. Accounting for Pensions

and Postretirement Benefits 1 Distinguish between accounting for the employer’s 6 Describe the amortization of prior service costs. pension plan and accounting for the pension fund. 7 Explain the accounting for unexpected gains and 2 Identify types of pension plans and their characteristics. losses. 3 Explain alternative measures for valuing the pension 8 Explain the corridor approach to amortizing gains obligation. and losses. 4 List the components of pension expense. 9 Describe the requirements for reporting pension plans in financial statements. 5 Use a worksheet for employer’s pension plan entries. Where Have All the Pensions Gone? Many companies have benefit plans that promise income and other benefits to retired employees in exchange for services during their working years. However, a shift is on from traditional defined benefit plans, in which employers bear the risk of meeting the benefit promises, to plans in which employees bear more of the risk. In some cases, employers are dropping retirement plans altogether. Here are some of the reasons for the shift. • Competition. Newer and foreign competitors do not have the same retiree costs that older U.S. companies do. Southwest Airlines does not offer a traditional pension plan, but United has a pension deficit exceeding $100,000 per employee. • Cost. Retirees are living longer, and the costs of retirement are higher. Combined with annual retiree healthcare costs, retirement benefits are costing the S&P 500 companies over $25 billion a year and are rising at double-digit rates. • Insurance. Pensions are backed by premiums paid to the Pension Benefit Guarantee Corporation (PBGC). When a company fails, the PBGC takes over the plan. But due to a number of significant company failures, the PBGC is running a deficit, and healthy companies are subsidizing the weak. • Accounting. To bring U.S. standards in line with international rules, accounting rule-makers are considering rules that will require companies to “mark their pensions to market” (value them at market rates). Such a move would increase the reported volatility of the retirement plan and of company financial statements. When Great Britain made this shift, 25 percent of British companies closed their plans to new entrants. As a result of such factors, it is understandable that experts can think of no major company that has instituted a traditional pension plan in the past decade. What does this mean for you as you evaluate job offers and ben- efit packages? To start, you should begin building your own retirement nest egg, rather than relying on your employer to provide postretirement income and healthcare benefits. Recently, a sample of Americans was asked the following question: When you retire, do you think you will have enough money to live comfortably, or not? RETPAHC 20 LEARNING OBJECTIVES After studying this chapter, you should be able to: 60% 40% 20% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 % Yes % No CONCEPTUAL FOCUS > See the Underlying Concepts on pages 1189, The graph on the previous page shows a substantial change in 1208, 1209, and 1213. responses from nonretired adults from 2002 to 2011. > Read the Evolving Issue on page 1202 for a In 2002, adults were nearly twice as likely to say they would discussion of the corridor approach. have enough money to live comfortably (59%) as to say they would not (32%). Those views changed as time passed. By INTERNATIONAL FOCUS 2011, a majority said they would not have enough money to live comfortably in retirement. > See the International Perspectives on pages General economic conditions affect how Americans look 1186 and 1207. at retirement. Americans were more positive about the overall > Read the IFRS Insights on pages 1250–1266 economy—and retirement—prior to the recent recession than for a discussion of: they are now. The continuing political discussion about the fragility —Accounting for pensions of the country’s Social Security and Medicare programs may —Using a pension worksheet also reduce nonretired Americans’ comfort with projections of

their monetary resources in their retirement. In addition, many are beginning to realize that retirement at the age of 65 may no longer be possible given the possible extension of social benefits to later ages. This means that retirement accounts, including individual retirement accounts and defined contribution pensions such as 401(k) plans, will need to become a bigger piece of the pie to fill the gap left by smaller government and employer-sponsored benefits. So get started now with a personal savings strategy to ensure an adequate nest egg at your retirement. Sources: Story adapted from Nanette Byrnes with David Welch, “The Benefits Trap,” BusinessWeek (July 19, 2004), pp. 54–72; and F. Newport, “In U.S., 53% Worry About Having Enough Money in Retirement,” http://www.gallup.com/poll/147254/%20-americans-biggest- financial-worry.aspx (April 25, 2011). As our opening story indicates, the cost of retirement benefits is PREVIEW OF CHAPTER 20 steep. For example, British Airways’ pension and healthcare costs for retirees in a recent year totaled $195 million, or approximately $6 per passenger carried. Many other companies are also facing substantial pension and other postretirement expenses and obligations. In this chapter, we discuss the accounting issues related to these benefit plans. The content and organization of the chapter are as follows. Accounting for Pensions and Postretirement Benefits Nature of Accounting for Using a Pension Reporting Pension Plans Pension Plans Pensions Worksheet in Financial Statements • Defined contribution plan • Alternative measures of • 2014 entries and worksheet • Within the financial • Defined benefit plan liability • Amortization of prior service statements • Role of actuaries • Recognition of net funded cost • Within the notes to the status • 2015 entries and worksheet financial statements • Components of pension • Gain or loss • Pension note disclosure expense • Corridor amortization • 2017 entries and worksheet— • 2016 entries and worksheet a comprehensive example • Special issues 1183 1184 Chapter 20 Accounting for Pensions and Postretirement Benefi ts NATURE OF PENSION PLANS A pension plan is an arrangement whereby an employer provides benefits LEARNING OBJECTIVE 1 (payments) to retired employees for services they provided in their working years. Distinguish between accounting for Pension accounting may be divided and separately treated as accounting for the the employer’s pension plan and employer and accounting for the pension fund. The company or employer is the accounting for the pension fund. organization sponsoring the pension plan. It incurs the cost and makes contribu- tions to the pension fund. The fund or plan is the entity that receives the contributions from the employer, administers the pension assets, and makes the benefit payments to the retired employees (pension recipients). Illustration 20-1 shows the three entities involved in a pension plan and indicates the flow of cash among them. ILLUSTRATION 20-1 Flow of Cash among Pension Plan Participants Pension Fund Contributions Benefits Pension Employer Investments Earnings $ $ Recipients (company) $ $ (employees) Fund Assets A pension plan is funded when the employer makes payments to a funding agency.1 That agency accumulates the assets of the pension fund and makes payments to the recipients as the benefits come due. Some pension plans are contributory. In these, the employees bear part of the cost of the stated benefits or voluntarily make payments to increase their benefits. Other plans are noncontributory. In these plans, the employer bears the entire cost. Compa- nies generally design their pension plans so as to take advantage of federal income tax benefits. Plans that offer tax benefits are called qualified pension plans. They permit deductibility of the employer’s contributions to the pension fund and tax-free status of earnings from pension fund assets. The pension fund should be a separate legal and accounting entity. The pension fund, as a separate entity, maintains a set of books and prepares financial statements. Maintaining

records and preparing financial statements for the fund, an activity known as “accounting for employee benefit plans,” is not the subject of this chapter.2 Instead, this chapter explains the pension accounting and reporting problems of the employer as the sponsor of a pension plan. The need to properly administer and account for pension funds becomes apparent when you understand the size of these funds. Listed in Illustration 20-2 are the pension fund assets and pension expenses of six major companies. ILLUSTRATION 20-2 Size of 2011 Pension Pension Expense Pension Funds and Company Pension Expense as % of Pretax Pension Expense ($ in millions) Fund (Income) Income General Motors $108,980 $(490) 28.19% Hewlett-Packard 10,662 280 3.12% Deere & Company 9,552 91 2.15% Merck 12,481 543 7.40% The Coca-Cola Company 6,171 249 2.18% Molson Coors Brewing 3,139 19 2.45% 1When used as a verb, fund means to pay to a funding agency (as to fund future pension See the FASB benefits or to fund pension cost). Used as a noun, it refers to assets accumulated in the hands of Codification section a funding agency (trustee) for the purpose of meeting pension benefits when they become due. (page 1229). 2The FASB issued a separate standard covering the accounting and reporting for employee benefit plans. [1] Nature of Pension Plans 1185 As Illustration 20-2 indicates, pension expense is a substantial percentage of total pretax income for many companies.3 The two most common types of pension plans are defined contribution plans and defined benefit plans, and we look at each of them in the following sections. Defi ned Contribution Plan In a defined contribution plan, the employer agrees to contribute to a pension 2 LEARNING OBJECTIVE trust a certain sum each period, based on a formula. This formula may consider Identify types of pension plans and such factors as age, length of employee service, employer’s profits, and compensa- their characteristics. tion level. The plan defines only the employer’s contribution. It makes no promise regarding the ultimate benefits paid out to the employees. A common form of this plan is a 401(k) plan. The size of the pension benefits that the employee finally collects under the plan depends on several factors: the amounts originally contributed to the pension trust, the income accumulated in the trust, and the treatment of forfeitures of funds caused by early terminations of other employees. A company usually turns over to an independent third-party trustee the amounts originally contributed. The trustee, acting on behalf of the beneficiaries (the participating employees), assumes ownership of the pension assets and is accountable for their investment and distribution. The trust is separate and distinct from the employer. The accounting for a defined contribution plan is straightforward. The employee gets the benefit of gain (or the risk of loss) from the assets contributed to the pension plan. The employer simply contributes each year based on the formula established in the plan. As a result, the employer’s annual cost (pension expense) is simply the amount that it is obligated to contribute to the pension trust. The employer reports a liability on its balance sheet only if it does not make the contribution in full. The employer reports an asset only if it contributes more than the required amount. In addition to pension expense, the employer must disclose the following for a defined contribution plan: a plan description, including employee groups covered; the basis for determining contributions; and the nature and effect of significant matters affecting comparability from period to period. [2] Defi ned Benefi t Plan A defined benefit plan outlines the benefits that employees will receive when they retire. These benefits typically are a function of an employee’s years of service and of the compensation level in the years approaching retirement. To meet the defined benefit commitments that will arise at retirement, a company must determine what the contribution should be today (a time value of money computation).

Companies may use many different contribution approaches. However, the funding method should provide enough money at retirement to meet the benefits defined by the plan. The employees are the beneficiaries of a defined contribution trust, but the employer is the beneficiary of a defined benefit trust. Under a defined benefit plan, the trust’s primary purpose is to safeguard and invest assets so that there will be enough to pay the employer’s obligation to the employees. In form, the trust is a separate entity. In substance, the trust assets and liabilities belong to the employer. That is, as long as 3Retirement assets in the 13 major global markets increased 4 percent to a record $27.5 trillion in 2011. The United States accounts for 59 percent of total pension assets, followed by Japan at 12 percent and the United Kingdom at 9 percent. Defined contribution assets for the seven largest markets—United States, United Kingdom, Japan, Netherlands, Canada, Australia, and Switzerland—now make up 43 percent of global retirement assets, up from 41 percent in 2005 and 38 percent in 2001. The United States, Australia, and Switzerland are the only countries with more defined contribution assets than defined benefit ones. See K. Olsen, “Global Pension Market Hits $27.5T,” http://www.pionline.com/article/20120206/PRINTSUB/302069986# (February 6, 2012). 1186 Chapter 20 Accounting for Pensions and Postretirement Benefi ts International the plan continues, the employer is responsible for the payment of the Perspective defined benefits (without regard to what happens in the trust). The employer must make up any shortfall in the accumulated assets held by the trust. On the Outside the United States, private pension plans are less other hand, the employer can recapture any excess accumulated in the trust, common because many other either through reduced future funding or through a reversion of funds. nations rely on government- Because a defined benefit plan specifies benefits in terms of uncertain future sponsored pension plans. variables, a company must establish an appropriate funding pattern to ensure Consequently, accounting for the availability of funds at retirement in order to provide the benefits promised. defi ned benefi t pension plans is This funding level depends on a number of factors such as turnover, mortality, typically a less important issue length of employee service, compensation levels, and interest earnings. elsewhere in the world. Employers are at risk with defined benefit plans because they must con- tribute enough to meet the cost of benefits that the plan defines. The expense recognized each period is not necessarily equal to the cash contribution. Similarly, the liability is controversial because its measurement and recognition relate to unknown future variables. Thus, the accounting issues related to this type of plan are complex. Our discussion in the following sections deals primarily with defined benefit plans.4 What do the numbers mean? WHICH PLAN IS RIGHT FOR YOU? Defi ned contribution plans have become much more popular contribution plans often cost no more than 3 percent of with employers than defi ned benefi t plans, as indicated in payroll, whereas defi ned benefi t plans can cost 5 to 6 percent the chart below. One reason is that they are cheaper. Defi ned of payroll. 4A recent federal law requires employees to explicitly opt out of an employer-sponsored defined contribution plan. This should help employees build their own nest eggs (as suggested in the opening story) and will contribute to further growth in defined contribution plans. However, note the following three warnings: (1) low-income workers will still not be able to stash enough away, (2) it leaves each participant alone to manage risk, and (3) companies establish a minimum contribution, which too many participants choose to use, instead of a larger contribution. )snoillim ni( stnapicitraP evitcA Number of Active Participants in Employer-Sponsored Retirement Plans (in thousands) by Type of Plan 140 120 100 80 60 40 20 0

1975 1980 1985 1990 1995 2000 2005 2010 Calendar Year Defined Benefit Plan Defined Contribution Plan Total Source: Form 5500 fi lings with U.S. Department of Labor, November 2012, “Private Pension Plan Bulletin.” The total amount of assets held by pension plans plan assets increased 12 percent to $2.4 trillion, while defi ned increased 14 percent to $6.3 trillion in 2010. Defi ned benefi t contribution plans increased 16 percent to $3.8 trillion. Accounting for Pensions 1187 The Role of Actuaries in Pension Accounting The problems associated with pension plans involve complicated mathematical consid- erations. Therefore, companies engage actuaries to ensure that a pension plan is appro- priate for the employee group covered.5 Actuaries are individuals trained through a long and rigorous certification program to assign probabilities to future events and their financial effects. The insurance industry employs actuaries to assess risks and to advise on the setting of premiums and other aspects of insurance policies. Employers rely heav- ily on actuaries for assistance in developing, implementing, and funding pension funds. Actuaries make predictions (called actuarial assumptions) of mortality rates, employee turnover, interest and earnings rates, early retirement frequency, future salaries, and any other factors necessary to operate a pension plan. They also compute the various pension measures that affect the financial statements, such as the pension obligation, the annual cost of servicing the plan, and the cost of amendments to the plan. In summary, accounting for defined benefit pension plans relies heavily upon information and measurements provided by actuaries. ACCOUNTING FOR PENSIONS In accounting for a company’s pension plan, two questions arise. (1) What is the 3 LEARNING OBJECTIVE pension obligation that a company should report in the financial statements? Explain alternative measures for (2) What is the pension expense for the period? Attempting to answer the first valuing the pension obligation. question has produced much controversy. Alternative Measures of the Liability Most agree that an employer’s pension obligation is the deferred compensation obli- gation it has to its employees for their service under the terms of the pension plan. Measuring that obligation is not so simple, though, because there are alternative ways of measuring it.6 One measure of the pension obligation is to base it only on the benefits vested to the employees. Vested benefits are those that the employee is entitled to receive even if he or she renders no additional services to the company. Most pension plans require a certain minimum number of years of service to the employer before an employee achieves vested benefits status. Companies compute the vested benefit obligation using only vested benefits, at current salary levels. Another way to measure the obligation uses both vested and nonvested years of service. On this basis, the company computes the deferred compensation amount on all years of employees’ service—both vested and nonvested—using current salary levels. This measurement of the pension obligation is called the accumulated benefit obligation. 5An actuary’s primary purpose is to ensure that the company has established an appropriate funding pattern to meet its pension obligations. This computation involves developing a set of assumptions and continued monitoring of these assumptions to ensure their realism. That the general public has little understanding of what an actuary does is illustrated by the following excerpt from the Wall Street Journal: “A polling organization once asked the general public what an actuary was, and received among its more coherent responses the opinion that it was a place where you put dead actors.” 6One measure of the pension obligation is to determine the amount that the Pension Benefit Guaranty Corporation would require the employer to pay if it defaulted. (This amount is limited to 30 percent of the employer’s net worth.) The accounting profession rejected this approach for

financial reporting because it is too hypothetical and ignores the going concern concept. 1188 Chapter 20 Accounting for Pensions and Postretirement Benefi ts A third measure bases the deferred compensation amount on both vested and nonvested service using future salaries. This measurement of the pension obligation is called the projected benefit obligation. Because future salaries are expected to be higher than current salaries, this approach results in the largest measurement of the pension obligation. The choice between these measures is critical. The choice affects the amount of a company’s pension liability and the annual pension expense reported. The diagram in Illustration 20-3 presents the differences in these three measurements. ILLUSTRATION 20-3 Different Measures of the Benefits for vested Pension Obligation and nonvested employees at future salaries. Benefits for nonvested Projected employees at benefit current salaries. Accumulated obligation benefit Benefits for obligation Vested vested employees benefit only at obligation current salaries. (FASB's choice) Present value of expected cash flows computed by actuaries Which of these alternative measures of the pension liability does the profession favor? The profession adopted the projected benefit obligation—the present value of vested and nonvested benefits accrued to date, based on employees’ future salary levels.7 Those in favor of the projected benefit obligation contend that a promise by an employer to pay benefits based on a percentage of the employees’ future salaries is far greater than a promise to pay a percentage of their current salary, and such a difference should be reflected in the pension liability and pension expense. Moreover, companies discount to present value the estimated future benefits to be paid. Minor changes in the interest rate used to discount pension benefits can dramati- cally affect the measurement of the employer’s obligation. For example, a 1 percent decrease in the discount rate can increase pension liabilities 15 percent. Accounting rules require that at each measurement date, a company must determine the appropri- ate discount rate used to measure the pension liability, based on current interest rates. 7When we use the term “present value of benefits” throughout this chapter, we really mean the actuarial present value of benefits. Actuarial present value is the amount payable adjusted to reflect the time value of money and the probability of payment (by means of decrements for events such as death, disability, withdrawals, or retirement) between the present date and the expected date of payment. For simplicity, though, we use the term “present value” instead of “actuarial present value” in our discussion. Accounting for Pensions 1189 Recognition of the Net Funded Status of the Pension Plan Companies must recognize on their balance sheet the full overfunded or underfunded status of their defined benefit pension plan.8 [3] The overfunded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation. To illustrate, assume that Coker Company has a projected benefit obligation of $300,000, and the fair value of its plan assets is $210,000. In this case, Coker Company’s pension plan is underfunded, and therefore it reports a pension liability of $90,000 ($300,000 2 $210,000) on its balance sheet. If instead the fair value of Coker’s plan assets were $430,000, it would report a pension asset of $130,000 ($430,000 2 $300,000). In 2007, by slowing the growth of pension liabilities and increasing contributions to pension funds, the S&P 500 companies reported aggregate overfunding (assets exceeded liabilities) of $47.2 billion. However, by 2011, these same pension plans were under- funded by $358.4 billion.9 Components of Pension Expense There is broad agreement that companies should account for pension cost on the 4 LEARNING OBJECTIVE accrual basis.10 The profession recognizes that accounting for pension plans re- List the components of pension

quires measurement of the cost and its identification with the appropriate time expense. periods. The determination of pension cost, however, is extremely complicated because it is a function of the following components. 1. Service cost. Service cost is the expense caused by the increase in pension ben- Underlying Concepts efi ts payable (the projected benefi t obligation) to employees because of their The expense recognition princi- services rendered during the current year. Actuaries compute service cost as ple and the defi nition of a liabil- the present value of the new benefi ts earned by employees during the year. ity justify accounting for pension 2. Interest on the liability. Because a pension is a deferred compensation cost on the accrual basis. This arrangement, there is a time value of money factor. As a result, companies re- requires recording an expense cord the pension liability on a discounted basis. Interest expense accrues each when employees earn the future year on the projected benefi t obligation just as it does on any discounted debt. benefi ts, and recognizing an existing obligation to pay The actuary helps to select the interest rate, referred to as the settlement rate. pensions later based on current 3. Actual return on plan assets. The return earned by the accumulated pension services received. fund assets in a particular year is relevant in measuring the net cost to the employer of sponsoring an employee pension plan. Therefore, a company should adjust annual pension expense for interest and dividends that accumulate within the fund, as well as increases and decreases in the fair value of the fund assets. 4. Amortization of prior service cost. Pension plan amendments (including initiation of a pension plan) often include provisions to increase benefi ts (or in rare situations, to decrease benefi ts) for employee service provided in prior years. A company grants plan amendments with the expectation that it will realize economic benefi ts in future periods. Thus, it allocates the cost (prior service cost) of providing these 8Recognize that GAAP applies to pensions as well as other postretirement benefit plans (OPEBs). Appendix 20A addresses the accounting for OPEBs. 9J. Ciesielski, “State of the Pension Promise: The S&P 500 in 2011,” The Analyst’s Accounting Observer (May 29, 2012). 10At one time, companies applied the cash basis of accounting to pension plans by recognizing the amount paid in a particular accounting period as the pension expense for the period. The problem was that the amount paid or funded in a fiscal period depended on financial manage- ment and was too often discretionary. For example, funding could depend on the availability of cash, the level of earnings, or other factors unrelated to the requirements of the plan. Applica- tion of the cash basis made it possible to manipulate the amount of pension expense appearing in the income statement simply by varying the cash paid to the pension fund. 1190 Chapter 20 Accounting for Pensions and Postretirement Benefi ts retroactive benefi ts to pension expense in the future, specifi cally to the remaining service-years of the affected employees. 5. Gain or loss. Volatility in pension expense can result from sudden and large changes in the fair value of plan assets and by changes in the projected benefi t obligation (which changes when actuaries modify assumptions or when actual experience differs from expected experience). Two items comprise this gain or loss: (1) the difference between the actual return and the expected return on plan assets, and (2) amortization of the net gain or loss from previous periods. We will discuss this complex computation later in the chapter. Illustration 20-4 shows the components of pension expense and their effect on total pension expense (increase or decrease). ILLUSTRATION 20-4 Components of Annual Pension Expense Interest on liability (increases pension expense) Service cost Actual return on for the year plan assets (increases pension (generally decreases expense) pension expense) Pension Expense

Amortization of Gain or loss prior service cost (decreases or (generally increases increases pension expense) pension expense) Service Cost The service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. That is, the actuary predicts the additional benefits that an employer must pay under the plan’s benefit formula as a result of the employees’ current year’s service, and then discounts the cost of those future benefits back to their present value. The Board concluded that companies must consider future compensation levels in measuring the present obligation and periodic pension expense if the plan benefit formula incorporates them. In other words, the present obligation resulting from a promise to pay a benefit of 1 percent of an employee’s final pay differs from the promise to pay 1 percent of current pay. To overlook this fact is to ignore an important aspect of pension expense. Thus, the FASB adopts the benefits/years-of-service actuarial method, which determines pension expense based on future salary levels. Some object to this determination, arguing that a company should have more free- dom to select an expense recognition pattern. Others believe that incorporating future salary increases into current pension expense is accounting for events that have not yet happened. They argue that if a company terminates the plan today, it pays only liabilities for accumulated benefits. Nevertheless, the FASB indicates that the projected benefit obligation provides a more realistic measure of the employer’s obligation under the Accounting for Pensions 1191 plan on a going concern basis and, therefore, companies should use it as the basis for determining service cost. Interest on the Liability The second component of pension expense is interest on the liability, or interest expense. Because a company defers paying the liability until maturity, the company records it on a discounted basis. The liability then accrues interest over the life of the employee. The interest component is the interest for the period on the projected ben- efit obligation outstanding during the period. The FASB did not address the question of how often to compound the interest cost. To simplify our illustrations and problem materials, we use a simple interest computation, applying it to the beginning-of- the-year balance of the projected benefit liability. How do companies determine the interest rate to apply to the pension liability? The Board states that the assumed discount rate should reflect the rates at which compa- nies can effectively settle pension benefits. In determining these settlement rates, companies should look to rates of return on high-quality fixed-income investments cur- rently available, whose cash flows match the timing and amount of the expected benefit payments. The objective of selecting the assumed discount rates is to measure a single amount that, if invested in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the pension benefits when due. Actual Return on Plan Assets Pension plan assets are usually investments in stocks, bonds, other securities, and real estate that a company holds to earn a reasonable return, generally at minimum risk. Employer contributions and actual returns on pension plan assets increase pension plan assets. Benefits paid to retired employees decrease them. As we indicated, the actual return earned on these assets increases the fund balance and correspondingly reduces the employer’s net cost of providing employees’ pension benefits. That is, the higher the actual return on the pension plan assets, the less the employer has to contribute eventu- ally and, therefore, the less pension expense that it needs to report. The actual return on the plan assets is the increase in pension funds from interest, dividends, and realized and unrealized changes in the fair value of the plan assets. Companies compute the actual return by adjusting the change in the plan assets for the

effects of contributions during the year and benefits paid out during the year. The equa- tion in Illustration 20-5, or a variation thereof, can be used to compute the actual return. ILLUSTRATION 20-5 Plan Plan Equation for Computing Actual Assets Assets 5 2 2 (Contributions 2 Benefits Paid) Actual Return Return Ending Beginning gBalance Balance h Stated another way, the actual return on plan assets is the difference between the fair value of the plan assets at the beginning of the period and at the end of the period, adjusted for contributions and benefit payments. Illustration 20-6 uses the equation above to compute the actual return, using some assumed amounts. ILLUSTRATION 20-6 Fair value of plan assets at end of period $5,000,000 Computation of Actual Deduct: Fair value of plan assets at beginning of period 4,200,000 Return on Plan Assets Increase in fair value of plan assets 800,000 Deduct: Contributions to plan during period $500,000 Less benefits paid during period 300,000 200,000 Actual return on plan assets $ 600,000 1192 Chapter 20 Accounting for Pensions and Postretirement Benefi ts If the actual return on the plan assets is positive (a gain) during the period, a com- pany subtracts it when computing pension expense. If the actual return is negative (a loss) during the period, the company adds it when computing pension expense.11 USING A PENSION WORKSHEET We will now illustrate the basic computation of pension expense using the first LEARNING OBJECTIVE 5 three components: (1) service cost, (2) interest on the liability, and (3) actual return Use a worksheet for employer’s on plan assets. We discuss the other pension expense components (amortization of pension plan entries. prior service cost, and gains and losses) in later sections. Companies often use a worksheet to record pension-related information. As its name suggests, the worksheet is a working tool. A worksheet is not a permanent accounting record. It is neither a journal nor part of the general ledger. The worksheet is merely a device to make it easier to prepare entries and the financial statements.12 Illustration 20-7 shows the format of the pension worksheet. ILLUSTRATION 20-7 PPeennssiioonn WWoorrkksshheeeett..xxllss Basic Format of Pension Home Insert Page Layout Formulas Data Review View Worksheet P18 fx A B C D E F 1 2 General Journal Entries Memo Record 3 Annual Pension Projected 4 Pension Asset/ Benefit Plan 5 Items Expense Cash Liability Obliga!on Assets 6 7 8 9 The “General Journal Entries” columns of the worksheet (near the left side) deter- mine the entries to record in the formal general ledger accounts. The “Memo Record” columns (on the right side) maintain balances in the projected benefit obligation and the plan assets. The difference between the projected benefit obligation and the fair value of the plan assets is the pension asset/liability, which is shown in the balance sheet. If the projected benefit obligation is greater than the plan assets, a pension liability occurs. If the projected benefit obligation is less than the plan assets, a pension asset occurs. On the first line of the worksheet, a company records the beginning balances (if any). It then records subsequent transactions and events related to the pension plan using debits and credits, using both sets of columns as if they were one. For each trans- action or event, the debits must equal the credits. The ending balance in the Pension Asset/Liability column should equal the net balance in the memo record. 2014 Entries and Worksheet To illustrate the use of a worksheet and how it helps in accounting for a pension plan, assume that on January 1, 2014, Zarle Company provides the following information related to its pension plan for the year 2014. 11At this point, we use the actual rate of return. Later, for purposes of computing pension expense, we use the expected rate of return. 12The use of a pension entry worksheet is recommended and illustrated by Paul B. W. Miller, “The New Pension Accounting (Part 2),” Journal of Accountancy (February 1987), pp. 86–94.

Using a Pension Worksheet 1193 Plan assets, January 1, 2014, are $100,000. Projected benefi t obligation, January 1, 2014, is $100,000. Annual service cost is $9,000. Settlement rate is 10 percent. Actual return on plan assets is $10,000. Funding contributions are $8,000. Benefi ts paid to retirees during the year are $7,000. Using this data, the worksheet in Illustration 20-8 presents the beginning balances and all of the pension entries recorded by Zarle in 2014. Zarle records the beginning bal- ances for the projected benefit obligation and the pension plan assets on the first line of the worksheet in the memo record. Because the projected benefit obligation and the plan assets are the same at January 1, 2014, the Pension Asset/Liability account has a zero balance at January 1, 2014. PPeennssiioonn WWoorrkksshheeeett——22001144..xxllss ILLUSTRATION 20-8 Home Insert Page Layout Formulas Data Review View Pension Worksheet—2014 P18 fx A B C D E F 1 2 General Journal Entries Memo Record 3 Annual Pension Projected 4 Pension Asset/ Benefit Plan 5 Items Expense Cash Liability Obliga!on Assets 6 Balance, Jan. 1, 2014 — 100,000 Cr. 100,000 Dr. 7 (a) Service cost 9,000 Dr. 9,000 Cr. 8 (b) Interest cost 10,000 Dr. 10,000 Cr. 9 (c) Actual return 10,000 Cr. 10,000 Dr. 10 (d) Contribu!ons 8,000 Cr. 8,000 Dr. 11 (e) Benefits 7,000 Dr. 7,000 Cr. 12 13 14 Journal entry for 2014 9,000 Dr. 8,000 Cr. 1,000 Cr.* 15 Balance, Dec. 31, 2014 1,000 Cr.** 112,000 Cr. 111,000 Dr. 16 17 *$9,000 – $8,000 = $1,000 18 **$112,000 – $111,000 = $1,000 Entry (a) in Illustration 20-8 records the service cost component, which increases pension expense by $9,000 and increases the liability (projected benefit obligation) by $9,000. Entry (b) accrues the interest expense component, which increases both the liability and the pension expense by $10,000 (the beginning projected benefit obligation multiplied by the settlement rate of 10 percent). Entry (c) records the actual return on the plan assets, which increases the plan assets and decreases the pension expense. Entry (d) records Zarle’s con- tribution (funding) of assets to the pension fund, thereby decreasing cash by $8,000 and in- creasing plan assets by $8,000. Entry (e) records the benefit payments made to retirees, which results in equal $7,000 decreases to the plan assets and the projected benefit obligation. Zarle makes the “formal journal entry” on December 31, which records the pension expense in 2014, as follows. 2014 Pension Expense 9,000 Cash 8,000 Pension Asset/Liability 1,000 1194 Chapter 20 Accounting for Pensions and Postretirement Benefi ts The credit to Pension Asset/Liability for $1,000 represents the difference between the 2014 pension expense of $9,000 and the amount funded of $8,000. Pension Asset/ Liability (credit) is a liability because Zarle underfunds the plan by $1,000. The Pension Asset/Liability account balance of $1,000 also equals the net of the balances in the memo accounts. Illustration 20-9 shows that the projected benefit obligation exceeds the plan assets by $1,000, which reconciles to the pension liability reported in the balance sheet. ILLUSTRATION 20-9 Projected benefit obligation (Credit) $(112,000) Pension Reconciliation Plan assets at fair value (Debit) 111,000 Schedule—December 31, Pension asset/liability (Credit) $ (1,000) 2014 If the net of the memo record balances is a credit, the reconciling amount in the pen- sion asset/liability column will be a credit equal in amount. If the net of the memo record balances is a debit, the pension asset/liability amount will be a debit equal in amount. The worksheet is designed to produce this reconciling feature, which is useful later in the preparation of the financial statements and required note disclosure related to pensions. In this illustration (for 2014), the debit to Pension Expense exceeds the credit to Cash, resulting in a credit to Pension Asset/Liability—the recognition of a liability. If the credit to Cash exceeded the debit to Pension Expense, Zarle would debit Pension Asset/ Liability—the recognition of an asset.

Amortization of Prior Service Cost (PSC) When either initiating (adopting) or amending a defined benefit plan, a company LEARNING OBJECTIVE 6 often provides benefits to employees for years of service before the date of initia- Describe the amortization of prior tion or amendment. As a result of this prior service cost, the projected benefit obli- service costs. gation is increased to recognize this additional liability. In many cases, the increase in the projected benefit obligation is substantial. Should a company report an expense for these prior service costs (PSC) at the time it initiates or amends a plan? The FASB says no. The Board’s rationale is that the employer would not provide credit for past years of service unless it expects to receive benefits in the future. As a result, a company should not recognize the retroactive benefits as pen- sion expense in the year of amendment. Instead, the employer initially records the prior service cost as an adjustment to other comprehensive income. The employer then rec- ognizes the prior service cost as a component of pension expense over the remaining service lives of the employees who are expected to benefit from the change in the plan. The cost of the retroactive benefits (including any benefits provided to existing retirees) is the increase in the projected benefit obligation at the date of the amend- ment. An actuary computes the amount of the prior service cost. Amortization of the prior service cost is also an accounting function performed with the assistance of an actuary. The Board prefers a years-of-service method that is similar to a units-of-production computation. First, the company computes the total number of service-years to be worked by all of the participating employees. Second, it divides the prior service cost by the total number of service-years, to obtain a cost per service-year (the unit cost). Third, the company multiplies the number of service-years consumed each year by the cost per service-year, to obtain the annual amortization charge. To illustrate the amortization of the prior service cost under the years-of-service method, assume that Zarle Company’s defined benefit pension plan covers 170 employees. In its negotiations with the employees, Zarle Company amends its pension plan on January 1, 2015, and grants $80,000 of prior service costs to its employees. The employees are grouped according to expected years of retirement, as shown on the next page. Using a Pension Worksheet 1195 Expected Group Number of Employees Retirement on Dec. 31 A 40 2015 B 20 2016 C 40 2017 D 50 2018 E 20 2019 170 Illustration 20-10 shows computation of the service-years per year and the total service-years. Service-Years ILLUSTRATION 20-10 Computation of Service- Year A B C D E Total Years 2015 40 20 40 50 20 170 2016 20 40 50 20 130 2017 40 50 20 110 2018 50 20 70 2019 20 20 40 40 120 200 100 500 Computed on the basis of a prior service cost of $80,000 and a total of 500 service- years for all years, the cost per service-year is $160 ($80,000 4 500). The annual amount of amortization based on a $160 cost per service-year is computed as follows. ILLUSTRATION 20-11 Total Cost per Annual 3 5 Computation of Annual Year Service-Years Service-Year Amortization Prior Service Cost 2015 170 $160 $27,200 Amortization 2016 130 160 20,800 2017 110 160 17,600 2018 70 160 11,200 2019 20 160 3,200 500 $80,000 An alternative method of computing amortization of prior service cost is permitted. Employers may use straight-line amortization over the average remaining service life of the employees. In this case, with 500 service-years and 170 employees, the average would be 2.94 years (500 4 170). The annual expense would be $27,211 ($80,000 4 2.94). Using this method, Zarle Company would charge cost to expense in 2015, 2016, and 2017 as follows. Year Expense 2015 $27,211 2016 27,211 2017 25,578* $80,000 *.94 3 $27,211 2015 Entries and Worksheet Continuing the Zarle Company illustration into 2015, we note that the company amends the pension plan on January 1, 2015, to grant employees prior service benefits with a

present value of $80,000. Zarle uses the annual amortization amounts, as computed in 1196 Chapter 20 Accounting for Pensions and Postretirement Benefi ts the previous section using the years-of-service approach ($27,200 for 2015). The follow- ing additional facts apply to the pension plan for the year 2015. Annual service cost is $9,500. Settlement rate is 10 percent. Actual return on plan assets is $11,100. Annual funding contributions are $20,000. Benefi ts paid to retirees during the year are $8,000. Amortization of prior service cost (PSC) using the years-of-service method is $27,200. Accumulated other comprehensive income (hereafter referred to as accumulated OCI) on December 31, 2014, is zero. Illustration 20-12 presents a worksheet of all the pension entries and information recorded by Zarle in 2015. We now add an additional column to the worksheet to record the prior service cost adjustment to other comprehensive income. In addition, as shown in rows 19, 21, and 22, the other comprehensive income amount related to prior service cost is added to accumulated other comprehensive income (“Accumulated OCI”) to arrive at a debit balance of $52,800 at December 31, 2015. PPeennssiioonn WWoorrkksshheeeett——22001155..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G 1 2 General Journal Entries Memo Record 3 Other 4 Comprehensive 5 Annual Income Pension Projected 6 Pension Prior Service Asset/ Benefit 7 Items Expense Cash Cost Liability Obliga!on Plan Assets 8 Balance, Dec. 31, 2014 1,000 Cr. 112,000 Cr. 111,000 Dr. 9 (f) Prior service cost 80,000 Dr. 80,000 Cr. 0 10 11 Balance, Jan. 1, 2015 192,000 Cr. 111,000 Dr. 12 (g) Service cost 9,500 Dr. 9,500 Cr. 13 (h) Interest cost 19,200 Dr. 19,200 Cr. 14 (i) Actual return 11,100 Cr. 11,100 Dr. 15 (j) Amor!za!on of PSC 27,200 Dr. 27,200 Cr. 16 (k) Contribu!ons 20,000 Cr. 20,000 Dr. 17 (l) Benefits 8,000 Dr. 8,000 Cr. 18 19 Journal entry for 2015 44,800 Dr. 20,000 Cr. 52,800 Dr. 77,600 Cr. 20 21 Accumulated OCI, Dec. 31, 2014 0 22 Balance, Dec. 31, 2015 52,800 Dr. 78,600 Cr. 212,700 Cr. 134,100 Dr. 23 ILLUSTRATION 20-12 Pension The first line of the worksheet shows the beginning balances of the Pension Asset/ Worksheet—2015 Liability account and the memo accounts. Entry (f) records Zarle’s granting of prior service cost, by adding $80,000 to the projected benefit obligation and decreasing other comprehensive income—prior service cost by the same amount. Entries (g), (h), (i), (k), and (l) are similar to the corresponding entries in 2014. To compute the interest cost on the projected benefit obligation for entry (h), we use the beginning projected benefit Using a Pension Worksheet 1197 balance of $192,000, which has been adjusted for the prior service cost amendment on January 1, 2015. Entry (j) records the 2015 amortization of prior service cost by debiting Pension Expense for $27,200 and crediting Other Comprehensive Income (PSC) for the same amount. Zarle makes the following journal entry on December 31 to formally record the 2015 pension expense (the sum of the annual pension expense column), and related pension information. 2015 Pension Expense 44,800 Other Comprehensive Income (PSC) 52,800 Cash 20,000 Pension Asset/Liability 77,600 Because the debits to Pension Expense and to Other Comprehensive Income (PSC) exceed the funding, Zarle credits the Pension Asset/Liability account for the $77,600 difference. That account is a liability. In 2015, as in 2014, the balance of the Pension Asset/Liability account ($78,600) is equal to the net of the balances in the memo accounts, as shown in Illustration 20-13. ILLUSTRATION 20-13 Projected benefit obligation (Credit) $(212,700) Pension Reconciliation Plan assets at fair value (Debit) 134,100 Schedule—December 31, Pension asset/liability (Credit) $ (78,600) 2015 The reconciliation is the formula that makes the worksheet work. It relates the components of pension accounting, recorded and unrecorded, to one another. Gain or Loss Of great concern to companies that have pension plans are the uncontrollable and

7 LEARNING OBJECTIVE unexpected swings in pension expense that can result from (1) sudden and large Explain the accounting for unexpected changes in the fair value of plan assets, and (2) changes in actuarial assumptions gains and losses. that affect the amount of the projected benefit obligation. If these gains or losses impact fully the financial statements in the period of realization or incurrence, substan- tial fluctuations in pension expense result. Therefore, the FASB decided to reduce the volatility associated with pension ex- pense by using smoothing techniques that dampen and in some cases fully eliminate the fluctuations. Smoothing Unexpected Gains and Losses on Plan Assets One component of pension expense, actual return on plan assets, reduces pension ex- pense (assuming the actual return is positive). A large change in the actual return can substantially affect pension expense for a year. Assume a company has a 40 percent return in the stock market for the year. Should this substantial, and perhaps one-time, event affect current pension expense? Actuaries ignore current fluctuations when they develop a funding pattern to pay expected benefits in the future. They develop an expected rate of return and multiply it by an asset value weighted over a reasonable period of time to arrive at an expected return on plan assets. They then use this return to determine a company’s funding pattern. The FASB adopted the actuary’s approach to dampen wide swings that might occur in the actual return. That is, a company includes the expected return on the plan assets as a component of pension expense, not the actual return in a given year. To achieve this 1198 Chapter 20 Accounting for Pensions and Postretirement Benefi ts goal, the company multiplies the expected rate of return by the market-related value of the plan assets. The market-related asset value of the plan assets is either the fair value of plan assets or a calculated value that recognizes changes in fair value in a systematic and rational manner. [4]13 The difference between the expected return and the actual return is referred to as the unexpected gain or loss; the FASB uses the term asset gains and losses. Asset gains occur when actual return exceeds expected return; asset losses occur when actual return is less than expected return. What happens to unexpected gains or losses in the accounting for pensions? Com- panies record asset gains and asset losses in an account, Other Comprehensive Income (G/L), combining them with gains and losses accumulated in prior years. This treatment is similar to prior service cost. The Board believes this treatment is consistent with the practice of including in other comprehensive income certain changes in value that have not been recognized in net income (for example, unrealized gains and losses on available-for-sale securities). [5] In addition, the accounting is simple, transparent, and symmetrical. To illustrate the computation of an unexpected gain or loss and its related ac- counting, assume that in 2016, Zarle Company has an actual return on plan assets of $12,000 when the expected return is $13,410 (the expected rate of return of 10% on plan assets times the beginning-of-the-year plan assets). The unexpected asset loss of $1,410 ($12,000 2 $13,410) is debited to Other Comprehensive Income (G/L) and credited to Pension Expense. What do the numbers mean? PENSION COSTS UPS AND DOWNS For some companies, pension plans generated real profi ts in Unfortunately, when the stock market stops booming, 2011. The plans not only paid for themselves but also in- pension expense substantially increases for many compa- creased earnings. This happens when the expected return on nies. The reason: Expected return on a smaller asset base no pension assets exceed the company’s annual costs. At Mead- longer offsets pension service costs and interest on the pro- Westvaco, pension income amounted to approximately jected benefi t obligation. As a result, many companies fi nd it 27 percent of operating profi t. It tallied 11 percent of operating diffi cult to meet their earnings targets, and at a time when

profi t at CenturyTel and 9.5 percent at Sun Trust Banks. The meeting such targets is crucial to maintaining the stock issue is important because in these cases management is not price. driving the operating income—pension income is. And as a result, income can change quickly. Smoothing Unexpected Gains and Losses on the Pension Liability In estimating the projected benefit obligation (the liability), actuaries make assumptions about such items as mortality rate, retirement rate, turnover rate, disability rate, and salary amounts. Any change in these actuarial assumptions affects the amount of the projected benefit obligation. Seldom does actual experience coincide exactly with actu- arial predictions. These unexpected gains or losses from changes in the projected benefit obligation are called liability gains and losses. 13Companies may use different ways of determining the calculated market-related value for different classes of assets. For example, an employer might use fair value for bonds and a five-year moving-average for equities. But companies should consistently apply the manner of determining market-related value from year to year for each asset class. Throughout our Zarle illustrations, we assume that market-related values based on a calculated value and the fair value of plan assets are equal. For homework purposes, use the fair value of plan assets as the measure for the market-related value. Using a Pension Worksheet 1199 Companies report liability gains (resulting from unexpected decreases in the liabil- ity balance) and liability losses (resulting from unexpected increases) in Other Compre- hensive Income (G/L). Companies combine the liability gains and losses in the same Other Comprehensive Income (G/L) account used for asset gains and losses. They ac- cumulate the asset and liability gains and losses from year to year that are not amortized in Accumulated Other Comprehensive Income. This amount is reported on the balance sheet in the stockholders’ equity section. Corridor Amortization The asset gains and losses and the liability gains and losses can offset each other. 8 LEARNING OBJECTIVE As a result, the Accumulated OCI account related to gains and losses may not Explain the corridor approach to grow very large. But, it is possible that no offsetting will occur and that the balance amortizing gains and losses. in the Accumulated OCI account related to gains and losses will continue to grow. To limit the growth of the Accumulated OCI account, the FASB invented the corridor approach for amortizing the account’s accumulated balance when it gets too large. How large is too large? The FASB set a limit of 10 percent of the larger of the beginning balances of the projected benefit obligation or the market-related value of the plan assets. Above that size, the Accumulated OCI account related to gains and losses is considered too large and must be amortized. To illustrate the corridor approach, data for Callaway Co.’s projected benefit obliga- tion and plan assets over a period of six years are shown in Illustration 20-14. ILLUSTRATION 20-14 Projected Market-Related Computation of the Beginning-of-the- Benefit Asset Corridor* Corridor Year Balances Obligation Value 1/2 10% 2013 $1,000,000 $ 900,000 $100,000 2014 1,200,000 1,100,000 120,000 2015 1,300,000 1,700,000 170,000 2016 1,500,000 2,250,000 225,000 2017 1,700,000 1,750,000 175,000 2018 1,800,000 1,700,000 180,000 *The corridor becomes 10% of the larger (in red type) of the projected benefit obligation or the market-related plan asset value. How the corridor works becomes apparent when we portray the data graphically, as in Illustration 20-15. 250 200 150 100 50 0 )sdnasuoht ni( ILLUSTRATION 20-15 Graphic Illustration of 225 the Corridor 170 175 180 120 100 The Corridor 50 100 120 100 150 170 175 180 200 225 250 2013 2014 2015 2016 2017 2018 1200 Chapter 20 Accounting for Pensions and Postretirement Benefi ts If the balance in the Accumulated OCI account related to gains and losses stays within the upper and lower limits of the corridor, no amortization is required. In that

case, Callaway carries forward unchanged the accumulated OCI related to gains and losses. If amortization is required, the minimum amortization is the excess divided by the average remaining service period of active employees who are expected to receive ben- efits under the plan. Callaway may use any systematic method of amortization of gains and losses in lieu of the minimum, provided it is greater than the minimum. It must use the method consistently for both gains and losses, and must disclose the amortization method used. Example of Gains/Losses In applying the corridor, companies should include amortization of the net gain or loss as a component of pension expense only if, at the beginning of the year, the net gain or loss in Accumulated OCI exceeded the corridor. That is, if no net gain or loss exists in Accumulated OCI at the beginning of the period, the company cannot recognize pension expense gains or losses in that period. To illustrate the amortization of net gains and losses, assume the following informa- tion for Soft-White, Inc. 2014 2015 2016 (beginning of the year) Projected benefit obligation $2,100,000 $2,600,000 $2,900,000 Market-related asset value 2,600,000 2,800,000 2,700,000 Soft-White recorded in Other Comprehensive Income actuarial losses of $400,000 in 2014 and $300,000 in 2015. If the average remaining service life of all active employees is 5.5 years, the schedule to amortize the net gain or loss is as shown in Illustration 20-16. ILLUSTRATION 20-16 Minimum Corridor Test and Projected Amortization Gain/Loss Amortization Benefit Plan Accumulated of Loss Schedule Year Obligationa Assetsa Corridorb OCI (G/L)a (For Current Year) 2014 $2,100,000 $2,600,000 $260,000 $ –0– $ –0– 2015 2,600,000 2,800,000 280,000 400,000 21,818c 2016 2,900,000 2,700,000 290,000 678,182d 70,579d aAll as of the beginning of the period. b10% of the greater of projected benefit obligation or plan assets’ market-related value. c$400,000 2 $280,000 5 $120,000; $120,000 4 5.5 5 $21,818. d$400,000 2 $21,818 1 $300,000 5 $678,182; $678,182 2 $290,000 5 $388,182; $388,182 4 5.5 5 $70,579. As Illustration 20-16 indicates, the loss recognized in 2015 increased pension expense by $21,818. This amount is small in comparison with the total loss of $400,000. It indicates that the corridor approach dampens the effects (reduces volatility) of these gains and losses on pension expense. The rationale for the corridor is that gains and losses result from refinements in estimates as well as real changes in economic value. Over time, some of these gains and losses will offset one another. It therefore seems reasonable that Soft-White should not fully recognize gains and losses as a component of pension expense in the period in which they arise. Using a Pension Worksheet 1201 However, Soft-White should immediately recognize in net income certain gains and losses—if they arise from a single occurrence not directly related to the operation of the pension plan and not in the ordinary course of the employer’s business. For example, a gain or loss that is directly related to a plant closing, a disposal of a business component, or a similar event that greatly affects the size of the employee work force should be recognized as a part of the gain or loss associated with that event. For example, at one time, Bethlehem Steel reported a quarterly loss of $477 million. A great deal of this loss was attributable to future estimated benefits payable to workers who were permanently laid off. In this situation, the loss should be treated as an adjust- ment to the gain or loss on the plant closing and should not affect pension cost for the current or future periods. Summary of Calculations for Asset Gain or Loss The difference between the actual return on plan assets and the expected return on plan assets is the unexpected asset gain or loss component. This component defers the dif- ference between the actual return and expected return on plan assets in computing current-year pension expense. Thus, after considering this component, it is really the

expected return on plan assets (not the actual return) that determines current pension expense. Companies determine the amortized net gain or loss by amortizing the Accumu- lated OCI amount related to net gain or loss at the beginning of the year subject to the corridor limitation. In other words, if the accumulated gain or loss is greater than the corridor, these net gains and losses are subject to amortization. Soft-White computed this minimum amortization by dividing the net gains or losses subject to amortization by the average remaining service period. When the current-year unexpected gain or loss is combined with the amortized net gain or loss, we determine the current-year gain or loss. Illustration 20-17 summarizes these gain and loss computations. ILLUSTRATION 20-17 Graphic Summary of Gain or Loss Current Year Current Year Current Year Computation = Unexpected Gain Actual Return Expected Return or Loss + Beginning-of- Current Year Average Year Corridor Remaining = Amortized Accumulated Service Life Net Gain OCI (G/L) or Loss = Current-Year Gain or Loss In essence, these gains and losses are subject to triple smoothing. That is, companies first smooth the asset gain or loss by using the expected return. Second, they do not amortize the accumulated gain or loss at the beginning of the year unless it is greater than the corridor. Finally, they spread the excess over the remaining service life of existing employees. 1202 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Evolving Issue BYE BYE CORRIDOR Many companies have significant actuarial losses in their Deferred Losses as Losses as % of pension plans, which are presently deferred through use of 2009 (in billions) Pension Assets of the corridor approach. However, companies do have a AT&T $23.04 49% choice—they may select any method of accounting for these Verizon $12.20 43 deferred losses as long as it is systematic, rational, and con- Honeywell $7.57 55 sistently applied, and meets a minimum for recognition in the income statement. When AT&T changed to immediate recognition in 2010, it Some companies are now shifting away from the corridor restated its previous years. In 2008, for example, AT&T approach and recognizing actuarial losses immediately. For increased its pension cost by $24.9 billion, which led to a net example, AT&T, Verizon Communications, and Honeywell loss in 2008 of $2.6 billion instead of a profit of $12.9 billion. International have recently changed accounting principles As a result, in 2010 it recognized a much smaller pension cost from smoothing these losses to recognizing them in the year of $3 billion. Skeptics suggest that AT&T made this change to incurred. charge these losses to prior periods. In other words, does Companies argue this approach provides more trans- anyone in 2011 care that the profit in 2008 was changed to a parency for these losses that will directly affect pension ex- loss? In addition, once these losses are charged to prior peri- pense in the current period (and this accounting is also more ods, they no longer affect current and future earnings. similar to IFRS). However, there is a silver lining for these Although earnings in the future will probably be more volatile companies—they can charge many of these deferred losses due to fluctuations in pension expense, more companies are will- to past years. For example, the table at the top of the right- ing to move in the direction of immediate expensing to eliminate hand column indicates deferred losses as of 2009 for three large deferred losses which would be a drag on future income. major companies. Source: Michael Rapoport, “Rewriting Pension History,” Wall Street Journal (March 9, 2011). 2016 Entries and Worksheet Continuing the Zarle Company illustration, the following facts apply to the pension plan for 2016. Annual service cost is $13,000. Settlement rate is 10 percent; expected earnings rate is 10 percent. Actual return on plan assets is $12,000. Amortization of prior service cost (PSC) is $20,800. Annual funding contributions are $24,000.

Benefi ts paid to retirees during the year are $10,500. Changes in actuarial assumptions resulted in an end-of-year projected benefi t obligation of $265,000. The worksheet in Illustration 20-18 presents all of Zarle’s 2016 pension entries and related information. The first line of the worksheet records the beginning balances that relate to the pension plan. In this case, Zarle’s beginning balances are the ending bal- ances from its 2015 pension worksheet in Illustration 20-12 (page 1196). Entries (m), (n), (o), (q), (r), and (s) are similar to the corresponding entries in 2014 or 2015. Entries (o) and (p) are related. We explained the recording of the actual return in entry (o) in both 2014 and 2015; it is recorded similarly in 2016. In both 2014 and 2015, Zarle assumed that the actual return on plan assets was equal to the expected return on plan assets. In 2016, the expected return of $13,410 (the expected rate of return of Using a Pension Worksheet 1203 PPeennssiioonn WWoorrkksshheeeett——22001166..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G H 1 2 General Journal Entries Memo Record 3 4 Other 5 Annual Comprehensive Income Pension Projected 6 Pension Prior Service Asset/ Benefit 7 Items Expense Cash Cost Gains/Losses Liability Obliga!on Plan Assets 8 Balance, Jan. 1, 2016 78,600 Cr. 212,700 Cr. 134,100 Dr. 9 (m) Service cost 13,000 Dr. 13,000 Cr. 10 (n) Interest cost 21,270 Dr. 21,270 Cr. 11 (o) Actual return 12,000 Cr. 12,000 Dr. 12 (p) Unexpected loss 1,410 Cr. 1,410 Dr. 13 (q) Amor!za!on of PSC 20,800 Dr. 20,800 Cr. 14 (r) Contribu!ons 24,000 Cr. 24,000 Dr. 15 (s) Benefits 10,500 Dr. 10,500 Cr. 16 (t) Liability increase 28,530 Dr. 28,530 Cr. 17 18 Journal entry for 2016 41,660 Dr. 24,000 Cr. 20,800 Cr. 29,940 Dr. 26,800 Cr. 19 20 Accumulated OCI, Dec. 31, 2015 52,800 Dr. 0 21 Balance, Dec. 31, 2016* 32,000 Dr. 29,940 Dr. 105,400 Cr. 265,000 Cr. 159,600 Dr. 22 23 *Accumulated OCI (PSC) $32,000 Dr. 24 Accumulated OCI (G/L) 29,940 Dr. 25 Accumulated OCI, Dec. 31, 2016 $61,940 Dr. 26 ILLUSTRATION 20-18 10 percent times the beginning-of-the-year plan assets’ balance of $134,100) is higher than Pension Worksheet—2016 the actual return of $12,000. To smooth pension expense, Zarle defers the unexpected loss of $1,410 ($13,410 2 $12,000) by debiting the Other Comprehensive Income (G/L) account and crediting Pension Expense. As a result of this adjustment, the expected return on the plan assets is the amount actually used to compute pension expense. Entry (t) records the change in the projected benefit obligation resulting from the change in the actuarial assumptions. As indicated, the actuary has now computed the ending balance to be $265,000. Given the PBO balance at December 31, 2015, and the related transactions during 2016, the PBO balance to date is computed as shown in Illustration 20-19. ILLUSTRATION 20-19 December 31, 2015, PBO balance $212,700 Projected Benefi t Service cost [entry (m)] 13,000 Obligation Balance Interest cost [entry (n)] 21,270 Benefits paid [entry (s)] (10,500) (Unadjusted) December 31, 2016, PBO balance (before liability increases) $236,470 The difference between the ending balance of $265,000 and the balance of $236,470 before the liability increase is $28,530 ($265,000 2 $236,470). This $28,530 increase in the employer’s liability is an unexpected loss. The journal entry on December 31, 2016, to record the pension information is as follows. 1204 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Pension Expense 41,660 Other Comprehensive Income (G/L) 29,940 Cash 24,000 Other Comprehensive Income (PSC) 20,800 Pension Asset/Liability 26,800 As the 2016 worksheet indicates, the $105,400 balance in the Pension Asset/Liability account at December 31, 2016, is equal to the net of the balances in the memo accounts. Illustration 20-20 shows this computation. ILLUSTRATION 20-20 Projected benefit obligation (Credit) $(265,000) Pension Reconciliation Plan assets at fair value (Debit) 159,600 Schedule—December 31, Pension asset/liability $(105,400) 2016

What do the numbers mean? ROLLER COASTER The chart below shows what has happened to the fi nancial plans are now underfunded again and the future is highly health of pension plans over the last few years. It is a real uncertain. roller coaster. A number of factors cause a fund to change from being At the turn of the century, when the stock market was overfunded to underfunded. First, low interest rates deci- strong, pension plans were overfunded. However, the bub- mate returns on pension plan assets. Second, using low in- ble burst, and by 2002 companies in the S&P 500 saw their terest rates to discount the projected benefi t payments pension plans funded at just 85 percent of reported liabili- leads to a higher pension liability. Finally, more individuals ties. Then, plans bounced back, and by 2007 pension plans are retiring, which leads to a depletion of the pension plan were overfunded again. However, due to recent downturns, assets. 130 120 110 100 90 80 70 dednuF tnecreP Funded Status of Defined Benefit Pension Plans for the S&P 500 Historical Evenly Funded ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 Source: D. Zion, A. Varshay, and N. Burnap, “From Bad to Worse,” Credit Suisse Equity Research (October 10, 2011). REPORTING PENSION PLANS IN FINANCIAL STATEMENTS As you might suspect, a phenomenon as significant and complex as pensions LEARNING OBJECTIVE 9 involves extensive reporting and disclosure requirements. We will cover these Describe the requirements for reporting requirements in two categories: (1) those within the financial statements, and pension plans in financial statements. (2) those within the notes to the financial statements. Reporting Pension Plans in Financial Statements 1205 Within the Financial Statements Recognition of the Net Funded Status of the Pension Plan Companies must recognize on their balance sheet the overfunded (pension asset) or underfunded (pension liability) status of their defined benefit pension plan. The over- funded or underfunded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation. Classifi cation of Pension Asset or Pension Liability No portion of a pension asset is reported as a current asset. The excess of the fair value of the plan assets over the benefit obligation is classified as a noncurrent asset. The rationale for noncurrent classification is that the pension plan assets are restricted. That is, these assets are used to fund the projected benefit obligation, and therefore noncur- rent classification is appropriate. The current portion of a net pension liability represents the amount of benefit pay- ments to be paid in the next 12 months (or operating cycle, if longer), if that amount cannot be funded from existing plan assets. Otherwise, the pension liability is classified as a noncurrent liability.14 Aggregation of Pension Plans Some companies have two or more pension plans. In such instances, a question arises as to whether these multiple plans should be combined and shown as one amount on the balance sheet. The Board takes the position that all overfunded plans should be combined and shown as a pension asset on the balance sheet. Similarly, if the company has two or more underfunded plans, the underfunded plans are combined and shown as one amount on the balance sheet. The FASB rejected the alternative of combining all plans and representing the net amount as a single net asset or net liability. The rationale: A company does not have the ability to offset excess assets of one plan against underfunded obligations of another plan. Furthermore, netting all plans is inappropriate because offsetting assets and liabil- ities is not permitted under GAAP unless a right of offset exists. To illustrate, assume that Cresci Company has three pension plans as shown in Illustration 20-21. ILLUSTRATION 20-21 Pension Assets Projected Benefit Pension Multiple Pension Plans’ (at Fair Value) Obligation Asset/Liability Funded Status Plan A $400,000 $300,000 $100,000 Asset Plan B 600,000 720,000 120,000 Liability

Plan C 550,000 700,000 150,000 Liability In this case, Cresci reports a pension plan asset of $100,000 and a pension plan liability of $270,000 ($120,000 1 $150,000). Actuarial Gains and Losses/Prior Service Cost Actuarial gains and losses not recognized as part of pension expense are recognized as increases and decreases in other comprehensive income. The same type of accounting is also used for prior service cost. The Board requires that the prior service cost arising in the year of the amendment (which increases the projected benefit obligation) be recognized 14Recently, the FASB required more extensive disclosures related to pension plan assets. At a minimum, companies must disclose the amount of assets allocated to equities, government and corporate bonds, mortgage-backed securities, derivatives, and real estate. Also, information on concentrations of risk must be explained. Finally, fair value disclosures would be required, including classification of amounts into levels of the fair value hierarchy. [6] 1206 Chapter 20 Accounting for Pensions and Postretirement Benefi ts by an offsetting debit to other comprehensive income. By recognizing both actuarial gains and losses and prior service cost as part of other comprehensive income, the Board believes that the usefulness of financial statements is enhanced. To illustrate the presentation of other comprehensive income and related accumu- lated OCI, assume that Obey Company provides the following information for the year 2014. None of the Accumulated OCI on January 1, 2014, should be amortized in 2014. Net income for 2014 $100,000 Actuarial liability loss for 2014 60,000 Prior service cost adjustment to provide additional benefits in December 2014 15,000 Accumulated OCI, January 1, 2014 40,000 Both the actuarial liability loss and the prior service adjustment decrease the funded status of the plan on the balance sheet. This results because the projected benefit obliga- tion increases. However, neither the actuarial liability loss nor the prior service cost ad- justment affects pension expense in 2014. In subsequent periods, these items will impact pension expense through amortization. For Obey Company, the computation of “Other comprehensive loss” for 2014 is as follows. ILLUSTRATION 20-22 Actuarial liability loss $60,000 Computation of Other Prior service cost benefit adjustment 15,000 Comprehensive Income Other comprehensive loss $75,000 The computation of “Comprehensive income” for 2014 is as follows. ILLUSTRATION 20-23 Net income $100,000 Computation of Other comprehensive loss 75,000 Comprehensive Income Comprehensive income $ 25,000 The components of other comprehensive income must be reported in one of two ways: (1) in a second income statement, or (2) in a combined statement of comprehen- sive income. Regardless of the format used, net income must be added to other compre- hensive income to arrive at comprehensive income. For homework purposes, use the second income statement approach unless stated otherwise. Earnings per share information related to comprehensive income is not required. To illustrate the second income statement approach, assume that Obey Company has reported a traditional income statement. The comprehensive income statement is shown in Illustration 20-24. ILLUSTRATION 20-24 OBEY COMPANY Comprehensive Income COMPREHENSIVE INCOME STATEMENT Reporting FOR THE YEAR ENDED DECEMBER 31, 2014 Net income $100,000 Other comprehensive loss Actuarial liability loss $60,000 Prior service cost 15,000 75,000 Comprehensive income $ 25,000 Reporting Pension Plans in Financial Statements 1207 The computation of “Accumulated other comprehensive income” as reported in stock- holders’ equity at December 31, 2014, is as follows. ILLUSTRATION 20-25 Accumulated other comprehensive income, January 1, 2014 $40,000 Computation of Other comprehensive loss 75,000 Accumulated Other Accumulated other comprehensive loss, December 31, 2014 $35,000 Comprehensive Income Regardless of the display format for the income statement, the accumulated other comprehensive loss is reported in the stockholders’ equity section of the balance sheet

of Obey Company as shown in Illustration 20-26. (Illustration 20-26 uses assumed data for the common stock and retained earnings information.) ILLUSTRATION 20-26 OBEY COMPANY Reporting of BALANCE SHEET Accumulated OCI AS OF DECEMBER 31, 2014 (STOCKHOLDERS’ EQUITY SECTION) Stockholders’ equity Common stock $100,000 Retained earnings 60,000 Accumulated other comprehensive loss 35,000 Total stockholders’ equity $125,000 By providing information on the components of comprehensive income as well as total accumulated other comprehensive income, the company communicates all changes in net assets. In this illustration, it is assumed that the accumulated other comprehensive income at January 1, 2014, is not adjusted for the amortization of any prior service cost or actu- arial gains and losses that would change pension expense. As discussed in the earlier examples, these items will be amortized into pension expense in future periods. Within the Notes to the Financial Statements Pension plans are frequently important to understanding a company’s financial posi- tion, results of operations, and cash flows. Therefore, a company discloses the following information, either in the body of the financial statements or in the notes. [7] 1. A schedule showing all the major components of pension expense. Rationale: Information provided about the components of pension expense International helps users better understand how a company determines pension expense. Perspective It also is useful in forecasting a company’s net income. The IASB and FASB are studying 2. A reconciliation showing how the projected benefi t obligation and the fair whether the various components value of the plan assets changed from the beginning to the end of the period. of pension expense, such as Rationale: Disclosing the projected benefi t obligation, the fair value of the interest cost and investment earnings on plan assets, should plan assets, and changes in them should help users understand the eco- be presented separately in the nomics underlying the obligations and resources of these plans. Explaining income statement along with the changes in the projected benefi t obligation and fair value of plan assets other interest expense and in the form of a reconciliation provides a more complete disclosure and investment earnings. makes the fi nancial statements more understandable. 1208 Chapter 20 Accounting for Pensions and Postretirement Benefi ts 3. A disclosure of the rates used in measuring the benefi t amounts (discount rate, expected return on plan assets, rate of compensation). Rationale: Disclosure of these rates permits users to determine the reasonableness of the assumptions applied in measuring the pension liability and pension expense. 4. A table indicating the allocation of pension plan assets by category (equity securi- ties, debt securities, real estate, and other assets), and showing the percentage of the fair value to total plan assets. In addition, a company must include a narrative description of investment policies and strategies, including the target allocation percentages (if used by the company). Rationale: Such information helps fi nancial statement users evaluate the pension plan’s exposure to market risk and possible cash fl ow demands on the company. It also will help users better assess the reasonableness of the company’s expected rate of return assumption. 5. The expected benefi t payments to be paid to current plan participants for each of the next fi ve fi scal years and in the aggregate for the fi ve fi scal years thereafter. Also required is disclosure of a company’s best estimate of expected contributions to be paid to the plan during the next year. Rationale: These disclosures provide information related to the cash outfl ows of the company. With this information, fi nancial statement users can better understand the potential cash outfl ows related to the pension plan. They can better assess the liquidity and solvency of the company, which helps in assessing the company’s overall fi nancial fl exibility.

6. The nature and amount of changes in plan assets and benefi t obligations recognized in net income and in other comprehensive income of each period. Rationale: This disclosure provides information on pension elements affecting the projected benefi t obligation and plan assets and on whether those amounts have been recognized in income or deferred to future periods. 7. The accumulated amount of changes in plan assets and benefi t obligations that have been recognized in other comprehensive income and that will be recycled into net income in future periods. Rationale: This information indicates the pension-related balances recognized in stockholders’ equity, which will affect future income. 8. T he amount of estimated net actuarial gains and losses and prior service Underlying Concepts costs and credits that will be amortized from accumulated other comprehen- Does it make a difference to sive income into net income over the next fi scal year. users of fi nancial statements Rationale: This information helps users predict the impact of deferred pen- whether companies recognize sion expense items on next year’s income. pension information in the fi nancial statements or disclose In summary, the disclosure requirements are extensive, and purposely so. it only in the notes? The FASB One factor that has been a challenge for useful pension reporting has been the was unsure, so in accord with lack of consistent terminology. Furthermore, a substantial amount of offsetting the full disclosure principle, it is inherent in the measurement of pension expense and the pension liability. decided to provide extensive These disclosure requirements are designed to address these concerns and take pension plan disclosures. some of the mystery out of pension reporting. Example of Pension Note Disclosure In the following sections, we provide examples and explain the key pension disclosure elements. Components of Pension Expense The FASB requires disclosure of the individual pension expense components (derived from the information in the pension expense worksheet column): (1) service cost, Reporting Pension Plans in Financial Statements 1209 (2) interest cost, (3) expected return on assets, (4) other gains or losses component, and (5) prior service cost component. The purpose of such disclosure is to clarify to more sophisticated readers how companies determine pension expense. Providing informa- tion on the components should also be useful in predicting future pension expense. Illustration 20-27 presents an example of this part of the disclosure. It uses the infor- mation from the Zarle illustration, specifically the expense component information from the worksheets in Illustrations 20-8 (page 1193), 20-12 (page 1196), and 20-18 (page 1203). ILLUSTRATION 20-27 ZARLE COMPANY Summary of Expense 2014 2015 2016 Components—2014, Components of Pension Expense 2015, 2016 Service cost $ 9,000 $ 9,500 $13,000 Interest cost 10,000 19,200 21,270 Expected return on plan assets (10,000) (11,100) (13,410)* Amortization of prior service cost –0– 27,200 20,800 Pension expense $ 9,000 $44,800 $41,660 *Note that the expected return must be disclosed, not the actual return. In 2016, the expected return is $13,410, which is the actual gain ($12,000) adjusted by the unrecognized loss ($1,410). Funded Status of Plan Underlying Concepts Having a reconciliation of the changes in the assets and liabilities from the beginning of the year to the end of the year, statement readers can better under- This represents another compromise between relevance stand the underlying economics of the plan. In essence, this disclosure contains and faithful representation. the information in the pension worksheet for the projected benefit obligation Disclosure attempts to balance and plan asset columns. Using the information for Zarle, the schedule in Illus- these objectives. tration 20-28 provides an example of the reconciliation. ILLUSTRATION 20-28 ZARLE COMPANY Pension Disclosure for PENSION DISCLOSURE Zarle Company—2014, 2014 2015 2016 2015, 2016 Change in benefit obligation

Benefit obligation at beginning of year $100,000 $112,000 $ 212,700 Service cost 9,000 9,500 13,000 Interest cost 10,000 19,200 21,270 Amendments (Prior service cost) –0– 80,000 –0– Actuarial loss –0– –0– 28,530 Benefits paid (7,000) (8,000) (10,500) Benefit obligation at end of year 112,000 212,700 265,000 Change in plan assets Fair value of plan assets at beginning of year 100,000 111,000 134,100 Actual return on plan assets 10,000 11,100 12,000 Contributions 8,000 20,000 24,000 Benefits paid (7,000) (8,000) (10,500) Fair value of plan assets at end of year 111,000 134,100 159,600 Funded status (Pension asset/liability) $ (1,000) $ (78,600) $(105,400) The 2014 column reveals that Zarle underfunds the projected benefit obligation by $1,000. The 2015 column reveals that Zarle reports the underfunded liability of $78,600 in the balance sheet. Finally, the 2016 column indicates that Zarle recognizes the under- funded liability of $105,400 in the balance sheet. 1210 Chapter 20 Accounting for Pensions and Postretirement Benefi ts 2017 Entries and Worksheet—A Comprehensive Example Incorporating the corridor computation and the required disclosures, we continue the Zarle Company pension plan accounting based on the following facts for 2017. Service cost is $16,000. Settlement rate is 10 percent; expected rate of return is 10 percent. Actual return on plan assets is $22,000. Amortization of prior service cost is $17,600. Annual funding contributions are $27,000. Benefi ts paid to retirees during the year are $18,000. Average service life of all covered employees is 20 years. Zarle prepares a worksheet to facilitate accumulation and recording of the compo- nents of pension expense and maintenance of amounts related to the pension plan. Illustration 20-29 shows that worksheet, which uses the basic data presented above. Beginning-of-the-year 2017 account balances are the December 31, 2016, balances from Zarle’s revised 2016 pension worksheet in Illustration 20-18 (on page 1203). CCoommpprreehheennssiivvee PPeennssiioonn WWoorrkksshheeeett——22001177..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G H 1 2 General Journal Entries Memo Record 3 4 Other 5 Annual Comprehensive Income Pension Projected 6 Pension Prior Service Asset/ Benefit 7 Items Expense Cash Cost Gains/Losses Liability Obliga!on Plan Assets 8 Balance, Dec. 31, 2016 105,400 Cr. 265,000 Cr. 159,600 Dr. 9 (aa) Service cost 16,000 Dr. 16,000 Cr. 10 (bb) Interest cost 26,500 Dr. 26,500 Cr. 11 (cc) Actual return 22,000 Cr. 22,000 Dr. 12 (dd) Unexpected gain 6,040 Dr. 6,040 Cr. 13 (ee) Amor!za!on of PSC 17,600 Dr. 17,600 Cr. 14 (ff) Contribu!ons 27,000 Cr. 27,000 Dr. 15 (gg) Benefits 18,000 Dr. 18,000 Cr. 16 (hh) Amor!za!on of loss 172 Dr. 172 Cr. 17 18 Journal entry for 2017 44,312 Dr. 27,000 Cr. 17,600 Cr. 6,212 Cr. 6,500 Dr. 19 20 Accumulated OCI, Dec. 31, 2016 32,000 Dr. 29,940 Dr. 21 Balance, Dec. 31, 2017* 14,400 Dr. 23,728 Dr. 98,900 Cr. 289,500 Cr. 190,600 Dr. 22 23 *Accumulated OCI (PSC) $14,400 Dr. 24 Accumulated OCI (G/L) 23,728 Dr. 25 Accumulated OCI, Dec. 31, 2017 $38,128 Dr. 26 ILLUSTRATION 20-29 Comprehensive Pension Worksheet Explanations and Entries Worksheet—2017 Entries (aa) through (gg) are similar to the corresponding entries previously explained in the prior years’ worksheets, with the exception of entry (dd). In 2016, the expected Reporting Pension Plans in Financial Statements 1211 return on plan assets exceeded the actual return, producing an unexpected loss. In 2017, the actual return of $22,000 exceeds the expected return of $15,960 ($159,600 3 10%), resulting in an unexpected gain of $6,040, entry (dd). By netting the gain of $6,040 against the actual return of $22,000, pension expense is affected only by the expected return of $15,960. A new entry (hh) in Zarle’s worksheet results from application of the corridor test on the accumulated balance of net gain or loss in accumulated other comprehensive income. Zarle Company begins 2017 with a balance in the net loss account of $29,940. The company applies the corridor criterion in 2017 to determine whether the balance is

excessive and should be amortized. In 2017, the corridor is 10 percent of the larger of the beginning-of-the-year projected benefit obligation of $265,000 or the plan asset’s $159,600 market-related asset value (assumed to be fair value). The corridor for 2017 is $26,500 ($265,000 3 10%). Because the balance in Accumulated OCI is a net loss of $29,940, the excess (outside the corridor) is $3,440 ($29,940 2 $26,500). Zarle amortizes the $3,440 excess over the average remaining service life of all employees. Given an average remaining service life of 20 years, the amortization in 2017 is $172 ($3,440 4 20). In the 2017 pension worksheet, Zarle debits Pension Expense for $172 and credits that amount to Other Comprehensive Income (G/L). Illustration 20-30 shows the computation of the $172 amortization charge. ILLUSTRATION 20-30 2017 Corridor Test Computation of 2017 Net (gain) or loss at beginning of year in accumulated OCI $29,940 Amortization Charge 10% of larger of PBO or market-related asset value of plan assets (26,500) (Corridor Test) Amortizable amount $ 3,440 Average service life of all employees 20 years 2017 amortization ($3,440 4 20 years) $172 Zarle formally records pension expense for 2017 as follows. 2017 Pension Expense 44,312 Pension Asset/Liability 6,500 Cash 27,000 Other Comprehensive Income (G/L) 6,212 Other Comprehensive Income (PSC) 17,600 Note Disclosure Illustration 20-31 (page 1212) shows the note disclosure of Zarle’s pension plan for 2017. Note that this example assumes that the pension liability is noncurrent and that the 2018 adjustment for amortization of the net gain or loss and amortization of prior service cost are the same as 2017. Special Issues The Pension Reform Act of 1974 A classic example of the unfortunate consequences of an underfunded pension plan is the 1963 shutdown of the Studebaker Automobile operations in South Bend, Indiana, in which 4,500 workers lost 85 percent of their vested benefits. As a result of such situa- tions, the Employee Retirement Income Security Act of 1974—ERISA—was passed. The legislation affects virtually every private retirement plan in the United States. It attempts 1212 Chapter 20 Accounting for Pensions and Postretirement Benefi ts ILLUSTRATION 20-31 ZARLE COMPANY Minimum Note NOTES TO THE FINANCIAL STATEMENTS Disclosure of Pension Plan, Zarle Company, Note D. The company has a pension plan covering substantially all of its employees. The plan is noncon- 2017 tributory and provides pension benefits that are based on the employee’s compensation during the three years immediately preceding retirement. The pension plan’s assets consist of cash, stocks, and bonds. The company’s funding policy is consistent with the relevant government (ERISA) and tax regulations. Pension expense for 2017 is comprised of the following components of pension cost. Service cost $16,000 Interest on projected benefit obligation 26,500 Components of pension Expected return on plan assets (15,960) expense Amortization of prior service cost 17,600 Amortization of net loss 172 Pension expense $44,312 Other changes in plan assets and benefit obligations recognized in other comprehensive income Net actuarial gain $ 6,212 Amounts recognized in other Amortization of prior service cost 17,600 comprehensive income Total recognized in other comprehensive income (23,812) Total recognized in pension expense and other comprehensive income $20,500 The estimated net actuarial loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive into pension expense over the next year are estimated to be the same as this year. The amount recognized as a long-term liability in the balance sheet is as follows: Noncurrent liability Pension liability $98,900 Amounts recognized in the The amounts recognized in accumulated other comprehensive income related to pensions consist of: balance sheet Net actuarial loss $23,728 Prior service cost 14,400 Total $38,128 Change in benefit obligation Benefit obligation at beginning of year $265,000

Service cost 16,000 Interest cost 26,500 Amendments (Prior service cost) –0– Actuarial gain –0– Benefits paid (18,000) Reconciliations of pension Benefit obligation at end of year 289,500 liability and plan assets Change in plan assets Fair value of plan assets at beginning of year 159,600 Actual return on plan assets 22,000 Contributions 27,000 Benefits paid (18,000) Fair value of plan assets at end of year 190,600 Funded status of plan Funded status (liability) $ 98,900 The weighted-average discount rate used in determining the 2017 projected benefit obligation Rates used to estimate was 10 percent. The rate of increase in future compensation levels used in computing the 2017 p rojected plan elements benefit obligation was 4.5 percent. The weighted-average expected long-term rate of return on the plan’s assets was 10 percent. to safeguard employees’ pension rights by mandating many pension plan requirements, including minimum funding, participation, and vesting. These requirements can influence the employers’ cash flows significantly. Under this legislation, annual funding is no longer discretionary. An employer now must fund the plan in accordance with an actuarial funding method that over time will be sufficient to Reporting Pension Plans in Financial Statements 1213 pay for all pension obligations. If companies do not fund their plans in a reason- Underlying Concepts able manner, they may be subject to fines and/or loss of tax deductions.15 The law requires plan administrators to publish a comprehensive descrip- Many plans are underfunded but tion and summary of their plans, along with detailed annual reports that in- still quite viable. For example, clude many supplementary schedules and statements. at one time Loews Corp. had a Another important provision of the act is the creation of the Pension $159 million shortfall, but also Benefit Guaranty Corporation (PBGC). The PBGC’s purpose is to administer had earnings of $594 million and terminated plans and to impose liens on an employer’s assets for certain a good net worth. Thus, the going concern assumption unfunded pension liabilities. If a company terminates its pension plan, the permits us to ignore pension PBGC can effectively impose a lien against the employer’s assets for the excess underfundings in some cases of the present value of guaranteed vested benefits over the pension fund assets. because in the long run they are This lien generally has had the status of a tax lien; it takes priority over most not signifi cant. other creditorship claims. This section of the act gives the PBGC the power to force an involuntary termination of a pension plan whenever the risks related to nonpayment of the pension obligation seem too great. Because ERISA restricts to 30 percent of net worth the lien that the PBGC can impose, the PBGC must monitor all plans to ensure that net worth is sufficient to meet the pension benefit obligations. A large number of terminated plans have caused the PBGC to pay out substantial benefits. Currently the PBGC receives its funding from employers, who contribute a certain dollar amount for each employee covered under the plan.16 What do the numbers mean? WHO GUARANTEES THE GUARANTOR? The Pension Benefi t Guaranty Corporation (PBGC) in its • Left on their own, many people save less, as well as in- 2012 annual report indicates that its primary mission is to vest and plan less well. They also pay higher fees and encourage the continuation and maintenance of voluntary they get lower returns. private pension plans. It‘s an obligation which the PBGC • Many people defer retirement but still don‘t have takes seriously. However, the trends are ominous: enough money for retirement—and they’re worried. One poll cited by the Senate Health, Education, Labor, • Americans today are spending more years in retirement. and Pensions Committee says that 92 percent of people They’re healthier and more active, which is great news. think there’s a retirement crisis. They’re right to be Unfortunately, pensions haven’t kept up. concerned.

• Many businesses, for competitive and other reasons, con- tinue to reduce their support for retirement plans. Some Add to these concerns that obligations in pension plans have switched from a defi ned benefi t plan to a defi ned t oday greatly exceed pension assets. Finally, the PBGC has a contribution plan which costs less and comes with fewer problem as well—a large defi cit in its accounts. The chart on obligations. Others offer lump-sum cash payments to page 1214 indicates that downward spiral in the net worth employees or retirees to settle the employer‘s obligations. of the PBGC over the last 10 years. 15In 2006, Congress passed the Pension Protection Act. This law has many provisions. One important aspect of the act is that it forced many companies to expedite their contributions to their pension plans. One group estimates that companies in the S&P 500 would have had to contribute $47 billion to their pension plans if the new rules were fully phased in for 2006. That amount is about 57 percent more than the $30 billion that companies were expecting to contrib- ute to their plans that year. Subsequently, Congress continues to provide pension funding relief. For example, in the “Moving Ahead for Progress in the 21st Century” Act (enacted July 6, 2012), companies can use a higher discount rate based on high-grade bond yields averaged over 25 years, which helps reduce the pension liability and required contributions. 16Pan American Airlines is a good illustration of how difficult it is to assess when to terminate. When Pan Am filed for bankruptcy in 1991, it had a pension liability of $900 million. From 1983 to 1991, the IRS gave it six waivers so it did not have to make contributions. When Pan Am terminated the plan, there was little net worth left upon which to impose a lien. An additional accounting problem relates to the manner of disclosing the possible termination of a plan. For example, should Pan Am have disclosed a contingent liability for its struggling plan? At present this issue is unresolved, and considerable judgment is needed to analyze a company with these contingent liabilities. 1214 Chapter 20 Accounting for Pensions and Postretirement Benefi ts PBGC Deficit Net Worth Trend, 2002–2011 Single-Employer Program $5 $0 ($5) ($10) ($15) ($20) ($25) In February 2012, American Airlines announced that it is $35 billion. The result is a growing defi cit problem which is ending its defi ned benefi t plans, which would result in the likely to continue. Who has the risk? You guessed it, the PBGC having to increase its defi cit even more to an estimated American taxpayer. Pension Terminations A congressman at one time noted, “Employers are simply treating their employee pen- sion plans like company piggy banks, to be raided at will.” What this congressman was referring to is the practice of paying off the projected benefit obligation and pocketing any excess. ERISA prevents companies from recapturing excess assets unless they pay participants what is owed to them and then terminate the plan. As a result, companies were buying annuities to pay off the pension claimants and then used the excess funds for other corporate purposes.17 For example, at one time, pension plan terminations netted $363 million for Occidental Petroleum Corp., $95 million for Stroh’s Brewery Co., $58 million for Kellogg Co., and $29 million for Western Airlines. Recently, many large companies have terminated their pension plans and captured billions in surplus assets. The U.S. Treasury also benefits: Federal legislation requires companies to pay an excise tax of anywhere from 20 percent to 50 percent on the gains. All of this is quite legal.18 17A question exists as to whose money it is. Some argue that the excess funds belong to the employees, not the employer. In addition, given that the funds have been reverting to the employer, critics charge that cost-of-living increases and the possibility of other increased benefits are reduced because companies will be reluctant to use those remaining funds to pay

for such increases. 18Another way that companies have reduced their pension obligations is through adoption of cash-balance plans. These are hybrid plans combining features of defined benefit and defined contribution plans. Although these plans permit employees to transfer their pension benefits when they change employers (like a defined contribution plan), they are controversial because the change to a cash-balance plan often reduces benefits to older workers. The accounting for cash-balance plans is similar to that for defined benefit plans, because employers bear the investment risk in cash-balance plans. When an employer adopts a cash- balance plan, the measurement of the future benefit obligation to employees generally is lower, compared to a traditional defined benefit plan. See A. T. Arcady and F. Mellors, “Cash-Balance Conversions,” Journal of Accountancy (February 2000), pp. 22–28. )snoillib ni( 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Alex Pollock, “The Pension Benefi t Guaranty Corporation: Who Will Guarantee This Guarantor?” 2012 Annual Report of the Pension Benefi t Guarantee Corporation (June 26, 2012). Summary of Learning Objectives 1215 The accounting issue that arises from these terminations is whether a company should recognize a gain when pension plan assets revert back to the company (often called asset reversion transactions). The issue is complex. In some cases, a company starts a new defined benefit plan after it eliminates the old one. Thus, some contend that there has been no change in substance but merely a change in form. However, the FASB disagrees. It requires recognition in earnings of a gain or loss when the employer settles a pension obligation either by lump-sum cash payments to participants or by purchasing nonparticipating annuity contracts. [8]19 You will Concluding Observations want to read the Hardly a day goes by without the financial press analyzing in depth some issue related IFRS INSIGHTS to pension plans in the United States. This is not surprising, since pension funds exceed on pages 1250–1266 over $22 trillion in assets globally. As you have seen, the accounting issues related to for discussion of pension plans are complex. Recent changes to GAAP have clarified many of these issues IFRS related to and should help users understand the financial implications of a company’s pension pension accounting. plans on its financial position, results of operations, and cash flows. KEY TERMS SUMMARY OF LEARNING OBJECTIVES accumulated benefit obligation, 1187 actual return on plan 1 Distinguish between accounting for the employer’s pension plan and assets, 1191 accounting for the pension fund. The company or employer is the organization actuarial present sponsoring the pension plan. It incurs the cost and makes contributions to the pension value, 1188(n) fund. The fund or plan is the entity that receives the contributions from the employer, actuaries, 1187 administers the pension assets, and makes the benefit payments to the pension recipi- asset gains and ents (retired employees). The fund should be a separate legal and accounting entity; it losses, 1198 maintains a set of books and prepares financial statements. cash-balance 2 Identify types of pension plans and their characteristics. The two most plans, 1214(n) common types of pension arrangements are as follows. (1) Defined contribution plans: components of pension expense, 1190 The employer agrees to contribute to a pension trust a certain sum each period based on a formula. This formula may consider such factors as age, length of employee contributory pension plan, 1184 service, employer’s profits, and compensation level. Only the employer’s contribution is defined; no promise is made regarding the ultimate benefits paid out to the employ- corridor approach, 1199 ees. (2) Defined benefit plans: These plans define the benefits that the employee will defined benefit receive at the time of retirement. The formula typically provides for the benefits to be a plan, 1185 function of the employee’s years of service and the compensation level when he or she defined contribution

nears retirement. plan, 1185 ERISA, 1211 3 Explain alternative measures for valuing the pension obligation. One expected rate of measure bases the pension obligation only on the benefits vested to the employees. return, 1197 Vested benefits are those that the employee is entitled to receive even if he or she renders expected return on plan no additional services under the plan. Companies compute the vested benefit pension assets, 1197 obligation using current salary levels; this obligation includes only vested benefits. fair value of plan Another measure of the obligation, called the accumulated benefit obligation, computes the assets, 1191 deferred compensation amount based on all years of service performed by employees funded pension plan, 1184 funded status (overfunded or 19Some companies have established pension poison pills as an anti-takeover measure. These plans underfunded), 1189 require asset reversions from termination of a plan to benefit employees and retirees rather than the acquiring company. For a discussion of pension poison pills, see Eugene E. Comiskey and interest on the liability Charles W. Mulford, “Interpreting Pension Disclosures: A Guide for Lending Officers,” Commercial (interest expense), 1191 Lending Review (Winter 1993–94), Vol. 9, No. 1. 1216 Chapter 20 Accounting for Pensions and Postretirement Benefi ts liability gains and under the plan—both vested and nonvested—using current salary levels. A third measure, losses, 1198 called the projected benefit obligation, bases the computation of the deferred compensa- market-related asset tion amount on both vested and nonvested service using future salaries. value, 1198 4 List the components of pension expense. Pension expense is a function of noncontributory pension the following components: (1) service cost, (2) interest on the liability, (3) return on plan plan, 1184 assets, (4) amortization of prior service cost, and (5) gain or loss. Other Comprehensive Income (G/L), 1198 5 Use a worksheet for employer’s pension plan entries. Companies may Other Comprehensive use a worksheet unique to pension accounting. This worksheet records both the formal Income (PSC), 1197 entries and the memo entries to keep track of all the employer’s relevant pension plan pension asset/ items and components. liability, 1192 pension plan, 1184 6 Describe the amortization of prior service costs. An actuary computes the amount of the prior service cost, and the company then records it as an adjustment pension worksheet, 1192 to the projected benefit obligation and other comprehensive income. It then amortizes prior service cost it, generally using a “years-of-service” amortization method, similar to a units-of- (PSC), 1194 production computation. First, the company computes total estimated number of projected benefit service-years to be worked by all of the participating employees. Second, it divides the obligation, 1188 accumulated prior service cost by the total number of service-years, to obtain a cost per qualified pension service-year (the unit cost). Third, the company multiplies the number of service-years plan, 1184 consumed each year times the cost per service-year, to obtain the annual amortization reconciliation, 1207 charge. retroactive benefits, 1194 service cost, 1190 7 Explain the accounting for unexpected gains and losses. In estimating settlement rate, 1191 the projected benefit obligation (the liability), actuaries make assumptions about such unexpected gain or items as mortality rate, retirement rate, turnover rate, disability rate, and salary amounts. loss, 1198 Any change in these actuarial assumptions affects the amount of the projected benefit vested benefit obligation. These unexpected gains or losses from changes in the projected benefit obligation, 1187 obligation are liability gains and losses. Liability gains result from unexpected vested benefits, 1187 decreases in the liability balance; liability losses result from unexpected increases. years-of-service Companies also incur asset gains or losses. Both types of actuarial gains and losses are

method, 1194 recorded in other comprehensive income and adjust either the projected benefit obliga- tion or the plan assets. 8 Explain the corridor approach to amortizing gains and losses. The FASB set a limit for the size of an accumulated net gain or loss balance. That arbitrarily selected limit (called a corridor) is 10 percent of the larger of the beginning balances of the projected benefit obligation or the market-related value of the plan assets. Beyond that limit, an accumulated net gain or loss balance is considered too large and must be amortized. If the balance of the accumulated net gain or loss account stays within the upper and lower limits of the corridor, no amortization is required. 9 Describe the requirements for reporting pension plans in financial statements. Currently, companies must disclose the following pension plan infor- mation in their financial statements. (1) The components of pension expense for the period. (2) A schedule showing changes in the benefit obligation and plan assets during the year. (3) The amount of prior service cost and net gains and losses in accumulated OCI, including the estimated prior service cost and gains and losses that will affect net income in the next year. (4) The weighted-average assumed discount rate, the rate of compensation increase used to measure the projected benefit obliga- tion, and the weighted-average expected long-term rate of return on plan assets. (5) A table showing the allocation of pension plan assets by category and the percentage of the fair value to total plan assets. (6) The expected benefit payments for current plan participants for each of the next five fiscal years and for the following five years in aggregate, along with an estimate of expected contributions to the plan during the next year. Appendix 20A: Accounting for Postretirement Benefi ts 1217 APPENDIX 20A ACCOUNTING FOR POSTRETIREMENT BENEFITS IBM’s adoption of the GAAP requirements on postretirement benefits resulted in 10 LEARNING OBJECTIVE a $2.3 billion charge and a historical curiosity—IBM’s first-ever quarterly loss. Identify the differences between General Electric disclosed that its charge for adoption of the same GAAP rules pensions and postretirement healthcare would be $2.7 billion. AT&T absorbed a $2.1 billion pretax hit for postretirement benefits. benefits upon adoption. What is GAAP in this area, and how could its adoption have so grave an impact on companies’ earnings? ACCOUNTING GUIDANCE After a decade of study, the FASB in December 1990 issued GAAP for “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” [9] It alone was the cause for the large charges to income cited above. These rules cover for healthcare and other “welfare benefits” provided to retirees, their spouses, dependents, and beneficiaries.20 These other welfare benefits include life insurance offered outside a pension plan; medical, dental, and eye care; legal and tax services; tuition assistance; day care; and housing assistance.21 Because healthcare benefits are the largest of the other postretirement benefits, we use this item to illustrate accounting for postretire- ment benefits. For many employers (about 95 percent), these GAAP rules required a change from the predominant practice of accounting for postretirement benefits on a pay-as-you-go (cash) basis to an accrual basis. Similar to pension accounting, the accrual basis neces- sitates measuring the employer’s obligation to provide future benefits and accrual of the cost during the years that the employee provides service. One of the reasons companies had not prefunded these benefit plans was that payments to prefund healthcare costs, unlike excess contributions to a pension trust, are not tax-deductible. Another reason was that postretirement healthcare benefits were once perceived to be a low-cost employee benefit that could be changed or eliminated at will and therefore were not a legal liability. Now, the accounting definition of a liability goes beyond the notion of a legally enforceable claim; the definition now encompasses

equitable or constructive obligations as well, making it clear that the postretirement benefit promise is a liability.22 20Accounting Trends and Techniques recently reported that of its 500 surveyed companies, 317 reported benefit plans that provide postretirement healthcare benefits. In response to rising healthcare costs and higher premiums on healthcare insurance, companies are working to get their postretirement benefit costs under control. 21“OPEB” is the acronym frequently used to describe postretirement benefits other than pensions. This term came into being before the scope of guidance was narrowed from “other postemployment benefits” to “other postretirement benefits,” thereby excluding postemploy- ment benefits related to severance pay or wage continuation to disabled, terminated, or laid-off employees. 22“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: 1985), p. 13, footnote 21. 1218 Chapter 20 Accounting for Pensions and Postretirement Benefi ts DIFFERENCES BETWEEN PENSION BENEFITS AND HEALTHCARE BENEFITS The FASB used the GAAP rules on pensions as a reference for the accounting prescribed for healthcare and other nonpension postretirement benefits.23 Why didn’t the FASB cover these other types of postretirement benefits in the earlier pension accounting statement? Because the apparent similarities between the two benefits mask some significant differences. Illustration 20A-1 shows these differences.24 ILLUSTRATION 20A-1 Item Pensions Healthcare Benefits Differences between Funding Generally funded. Generally not funded. Pensions and Benefit Well-defined and level dollar Generally uncapped and great Postretirement amount. variability. Healthcare Benefi ts Beneficiary Retiree (maybe some benefit Retiree, spouse, and other to surviving spouse). dependents. Benefit payable Monthly. As needed and used. Predictability Variables are reasonably Utilization difficult to predict. predictable. Level of cost varies geographically and fluctuates over time. Two of the differences in Illustration 20A-1 highlight why measuring the future payments for healthcare benefit plans is so much more difficult than for pension plans. 1. Many postretirement plans do not set a limit on healthcare benefi ts. No matter how serious the illness or how long it lasts, the benefi ts continue to fl ow. (Even if the employer uses an insurance company plan, the premiums will escalate according to the increased benefi ts provided.) 2. The levels of healthcare benefit use and healthcare costs are difficult to predict. Increased longevity, unexpected illnesses (e.g., AIDS, SARS, and avian fl u), along with new medical technologies and cures, cause changes in healthcare utilization. Additionally, although the fiduciary and reporting standards for employee benefit funds under government regulations generally cover healthcare benefits, the stringent minimum vesting, participation, and funding standards that apply to pensions do not ap- ply to healthcare benefits. Nevertheless, as you will learn, many of the basic concepts of pensions, and much of the related accounting terminology and measurement methodol- ogy, do apply to other postretirement benefits. Therefore, in the following discussion and illustrations, we point out the similarities and differences in the accounting and reporting for these two types of postretirement benefits. 23Other postemployment (but before retirement) benefits include, but are not limited to, salary continuation, disability-related benefits, severance benefits, and continuance of healthcare benefits and life insurance for inactive or former (e.g., terminated, disabled, or deceased) employees or their beneficiaries. These benefits are accounted for similar to accounting for compensated absences (see Chapter 13). [10] 24D. Gerald Searfoss and Naomi Erickson, “The Big Unfunded Liability: Postretirement Health- Care Benefits,” Journal of Accountancy (November 1988), pp. 28–39. Appendix 20A: Accounting for Postretirement Benefi ts 1219 What do the numbers mean? OPEBs—HOW BIG ARE THEY?

For many companies, other postretirement benefi t obligations That is, the company may not claim a tax deduction until it (OPEBs) are substantial. Generally, OPEBs are not well makes a payment to the participant (pay-as-you-go). funded because companies are not permitted a tax deduction Presented below are companies with the largest OPEB obli- for contributions to the plan assets, as is the case with pensions. gations, indicating their relationship with other fi nancial items. For year ended % Obligation as a % of 12/31/2011 ($ in millions) Obligation Underfunded Stockholders’ Equity General Motors $ 7,312 100.00% 18.75% AT&T Inc. 34,963 71.70% 33.04% Verizon Communications 27,369 90.40% 81.86% General Electric 11,637 27.98% 9.85% Boeing Company 7,997 98.72% 221.65% Alcatel-Lucent 4,541 85.22% 76.08% So, how big are OPEB obligations? REALLY big. Source: Company reports. POSTRETIREMENT BENEFITS ACCOUNTING PROVISIONS Healthcare and other postretirement benefits for current and future retirees and their dependents are forms of deferred compensation. They are earned through employee service and are subject to accrual during the years an employee is working. The period of time over which the postretirement benefit cost accrues is called the attribution period. It is the period of service during which the employee earns the ben- efits under the terms of the plan. The attribution period, shown in Illustration 20A-2 for a hypothetical employee, generally begins when an employee is hired and ends on the date the employee is eligible to receive the benefits and ceases to earn additional bene- fits by performing service, the vesting date.25 ILLUSTRATION 20A-2 Range of Possible Date Plan Beginning of Eligibility Estimated Attribution Periods of Amendment Eligibility (Vesting) Retirement Hire Date Period Date Date (age 29) (age 34) (age 45) (age 55) (age 61) FASB Attribution Period Prior Service Cost 25This is a benefit-years-of-service approach (the projected unit credit actuarial cost method). The FASB found no compelling reason to switch from the traditional pension accounting approach. It rejected the employee’s full service period (i.e., to the estimated retirement date) because it was unable to identify any approach that would appropriately attribute benefits beyond the date when an employee attains full eligibility for those benefits. Employees attain full eligibility by meeting specified age, service, or age and service requirements of the plan. 1220 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Obligations Under Postretirement Benefi ts In defining the obligation for postretirement benefits, the FASB maintained many concepts similar to pension accounting. It also designed some new and modified terms specifically for postretirement benefits. Two of the most important of these specialized terms are (a) expected postretirement benefit obligation and (b) accumulated postretire- ment benefit obligation. The expected postretirement benefit obligation (EPBO) is the actuarial present value as of a particular date of all benefits a company expects to pay after retirement to employees and their dependents. Companies do not record the EPBO in the financial statements, but they do use it in measuring periodic expense. The accumulated postretirement benefit obligation (APBO) is the actuarial present value of future benefits attributed to employees’ services rendered to a particular date. The APBO is equal to the EPBO for retirees and active employees fully eligible for benefits. Before the date an employee achieves full eligibility, the APBO is only a portion of the EPBO. Or stated another way, the difference between the APBO and the EPBO is the future service costs of active employees who are not yet fully eligible. Illustration 20A-3 contrasts the EPBO and the APBO. At the date an employee is fully eligible (the end of the attribution period), the APBO and the EPBO for that em- ployee are equal. ILLUSTRATION 20A-3 APBO and EPBO Contrasted Active employees not yet eligible for benefits Active employees fully EPBO

eligible for benefits APBO Retirees and dependents receiving benefits Present value of future benefits at a particular date Postretirement Expense Postretirement expense is the employer’s annual expense for postretirement benefits. Also called net periodic postretirement benefit cost, this expense consists of many of the familiar components used to compute annual pension expense. The components of net periodic postretirement benefit cost are as follows. [11] 26 1. Service cost. The portion of the EPBO attributed to employee service during the period. 2. Interest cost. The increase in the APBO attributable to the passage of time. Compa- nies compute interest cost by applying the beginning-of-the-year discount rate to 26See James R. Wilbert and Kenneth E. Dakdduk, “The New FASB 106: How to Account for Postretirement Benefits,” Journal of Accountancy (August 1991), pp. 36–41. Appendix 20A: Accounting for Postretirement Benefi ts 1221 the beginning-of-the-year APBO, adjusted for benefi t payments to be made during the period. The discount rate is based on the rates of return on high-quality, fi xed- income investments that are currently available.27 3. Actual return on plan assets. The change in the fair value of the plan’s assets ad- justed for contributions and benefi t payments made during the period. Because companies charge or credit the postretirement expense for the gain or loss on plan assets (the difference between the actual and the expected return), this component is actually the expected return. 4. Amortization of prior service cost. The amortization of the cost of retroactive benefi ts resulting from plan amendments. The typical amortization period, beginning at the date of the plan amendment, is the remaining service periods through the full eligibility date. 5. Gains and losses. In general, changes in the APBO resulting from changes in as- sumptions or from experience different from that assumed. For funded plans, this component also includes the difference between actual return and expected return on plan assets. ILLUSTRATIVE ACCOUNTING ENTRIES Like pension accounting, the accounting for postretirement plans must recognize in 11 LEARNING OBJECTIVE the accounts and in the financial statements effects of several significant items. These Contrast accounting for pensions to items are: accounting for other postretirement benefits. 1. Expected postretirement benefi t obligation (EPBO). 2. Accumulated postretirement benefi t obligation (APBO). 3. Postretirement benefi t plan assets. 4. Prior service cost. 5. Net gain or loss. The EPBO is not recognized in the financial statements or disclosed in the notes. Companies recompute it each year, and the actuary uses it in measuring the annual service cost. Because of the numerous assumptions and actuarial complexity involved in measuring annual service cost, we have omitted these computations of the EPBO. Similar to pensions, companies must recognize in the financial statements items 2 through 5 listed above. In addition, as in pension accounting, companies must know the exact amount of these items in order to compute postretirement expense. Therefore, companies use the worksheet like that for pension accounting to record both the formal general journal entries and the memo entries. 2014 Entries and Worksheet To illustrate the use of a worksheet in accounting for a postretirement benefits plan, assume that on January 1, 2014, Quest Company adopts a healthcare benefit plan. The following facts apply to the postretirement benefits plan for the year 2014. Plan assets at fair value on January 1, 2014, are zero. Actual and expected returns on plan assets are zero. Accumulated postretirement benefi t obligation (APBO), January 1, 2014, is zero. 27The FASB concluded that the discount rate for measuring the present value of the postretire- ment benefit obligation and the service cost component should be the same as that applied to pension measurements. It chose not to label it the settlement rate, in order to clarify that the objective of the discount rate is to measure the time value of money.

1222 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Service cost is $54,000. No prior service cost exists. Interest cost on the APBO is zero. Funding contributions during the year are $38,000. Benefi t payments to employees from plan are $28,000. ILLUSTRATION 20A-4 Using that data, the worksheet in Illustration 20A-4 presents the postretirement Postretirement entries for 2014. Worksheet—2014 PPoossttrreettiirreemmeenntt WWoorrkksshheeeett——22001144..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F 1 2 General Journal Entries Memo Record 3 Annual 4 Postre!rement Postre!rement 5 Items Expense Cash Asset/Liability APBO Plan Assets 6 Balance, Jan. 1, 2014 7 (a) Service cost 54,000 Dr. 54,000 Cr. 8 (b) Contribu!ons 38,000 Cr. 38,000 Dr. 9 (c) Benefits 28,000 Dr. 28,000 Cr. 10 11 Journal entry for 2014 54,000 Dr. 38,000 Cr. 16,000 Cr.* 12 Balance, Dec. 31, 2014 16,000 Cr.** 26,000 Cr. 10,000 Dr. 13 14 *$54,000 – $38,000 = $16,000 15 **$26,000 – $10,000 = $16,000 16 Entry (a) records the service cost component, which increases postretirement expense $54,000 and increases the liability (APBO) $54,000. Entry (b) records Quest’s funding of assets to the postretirement fund. The funding decreases cash $38,000 and increases plan assets $38,000. Entry (c) records the benefit payments made to retirees, which results in equal $28,000 decreases to the plan assets and the liability (APBO). Quest’s December 31 adjusting entry formally records the postretirement expense in 2014, as follows. December 31, 2014 Postretirement Expense 54,000 Cash 38,000 Postretirement Asset/Liability 16,000 The credit to Postretirement Asset/Liability for $16,000 represents the difference between the APBO and the plan assets. The $16,000 credit balance is a liability because the plan is underfunded. The Postretirement Asset/Liability account balance of $16,000 also equals the net of the balances in the memo accounts. Illustration 20A-5 shows the funded status reported in the balance sheet. (Notice its similarity to the pension schedule.) ILLUSTRATION 20A-5 Accumulated postretirement benefit obligation (Credit) $(26,000) Postretirement Plan assets at fair value (Debit) 10,000 Reconciliation Schedule— Postretirement asset/liability (Credit) $(16,000) December 31, 2014 Appendix 20A: Accounting for Postretirement Benefi ts 1223 Recognition of Gains and Losses Gains and losses represent changes in the APBO or the value of plan assets. These changes result either from actual experience different from that expected or from changes in actuarial assumptions. The amortization of these gains and losses follows the approach used for pensions. That is, the gains and losses are recorded in other compre- hensive income. The Corridor Approach Consistent with pension accounting, companies amortize the gains and losses in accu- mulated other comprehensive income as a component of postretirement expense if, at the beginning of the period, they exceed a “corridor” limit. The corridor is measured as the greater of 10 percent of the APBO or 10 percent of the market-related value of plan assets. The intent of the corridor approach is to reduce volatility of postretirement expense by providing a reasonable opportunity for gains and losses to offset over time without affecting net periodic expense. Amortization Methods If the company must amortize gains and losses (beyond the corridor) on postretirement benefit plans, the minimum amortization amount is the excess gain or loss divided by the average remaining service life to expected retirement of all active employees. Com- panies may use any systematic method of amortization provided that: (1) the amount amortized in any period is equal to or greater than the minimum amount, (2) the com- pany applies the method consistently, and (3) the company applies the method similarly for gains and losses. The company must recompute the amount of gain or loss in accumulated other comprehensive income each year and amortize the gain or loss over the average remain- ing service life if the net amount exceeds the “corridor.”

2015 Entries and Worksheet Continuing the Quest Company illustration into 2015, the following facts apply to the postretirement benefits plan for the year 2015. Actual return on plan assets is $600. Expected return on plan assets is $800. Discount rate is 8 percent. Increase in APBO due to change in actuarial assumptions is $60,000. Service cost is $26,000. Funding contributions during the year are $18,000. Benefi t payments to employees during the year are $5,000. Average remaining service to expected retirement: 25 years. The worksheet in Illustration 20A-6 (on page 1224) presents all of Quest’s postretire- ment benefit entries and information for 2015. The beginning balances on the first line of the worksheet are the ending balances from Quest’s 2014 postretirement benefits worksheet in Illustration 20A-4 (on page 1222). Entries (d), (h), and (i) are similar to the corresponding entries previously ex- plained for 2014. Entry (e) accrues the interest expense component, which increases both the liability and the postretirement expense by $2,080 (the beginning APBO mul- tiplied by the discount rate of 8%). Entries (f) and (g) are related. The expected return of $800 is higher than the actual return of $600. To smooth postretirement expense, 1224 Chapter 20 Accounting for Pensions and Postretirement Benefi ts PPoossttrreettiirreemmeenntt BBeenneeffiittss WWoorrkksshheeeett——22001155..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G 1 2 General Journal Entries Memo Record 3 Annual Other 4 Postre!rement Comprehensive Postre!rement 5 Items Expense Cash Income (G/L) Asset/Liability APBO Plan Assets 6 Balance, Jan. 1, 2015 16,000 Cr. 26,000 Cr. 10,000 Dr. 7 (d) Service cost 26,000 Dr. 26,000 Cr. 8 (e) Interest cost 2,080 Dr. 2,080 Cr. 9 (f) Actual return 600 Cr. 600 Dr. 10 (g) Unexpected loss 200 Cr. 200 Dr. 11 (h) Contribu!ons 18,000 Cr. 18,000 Dr. 12 (i) Benefits 5,000 Dr. 5,000 Cr. 13 (j) Increase in APBO (Loss) 60,000 Dr. 60,000 Cr. 14 Journal entry for 2015 27,280 Dr. 18,000 Cr. 60,200 Dr. 69,480 Cr. 15 16 Accumulated OCI, Dec. 31, 2014 0 17 Balance, Dec. 31, 2015 60,200 Dr. 85,480 Cr. 109,080 Cr. 23,600 Dr. 18 ILLUSTRATION 20A-6 Postretirement Benefi ts Quest defers the unexpected loss of $200 ($800 2 $600) by debiting Other Compre- Worksheet—2015 hensive Income (G/L) and crediting Postretirement Expense. As a result of this adjust- ment, the expected return on the plan assets is the amount actually used to compute postretirement expense. Entry (j) records the change in the APBO resulting from a change in actuarial assumptions. This $60,000 increase in the employer’s accumulated liability is an unex- pected loss. Quest debits this loss to Other Comprehensive Income (G/L). On December 31 Quest formally records net periodic expense for 2015 as follows. December 31, 2015 Postretirement Expense 27,280 Other Comprehensive Income (G/L) 60,200 Cash 18,000 Postretirement Asset/Liability 69,480 The balance of the Postretirement Asset/Liability account at December 31, 2015, is $85,480. This balance is equal to the net of the balances in the memo accounts as shown in the reconciliation schedule in Illustration 20A-7. ILLUSTRATION 20A-7 Accumulated postretirement benefit obligation (Credit) $(109,080) Postretirement Benefi ts Plan assets at fair value (Debit) 23,600 Reconciliation Schedule— Postretirement asset/liability (Credit) $ (85,480) December 31, 2015 Amortization of Net Gain or Loss in 2016 Quest has a beginning balance in Accumulated OCI related to losses of $60,200. Therefore, Quest must apply the corridor test for amortization of the balance for 2016. Illustration 20A-8 shows the computation of the amortization charge for the loss. Appendix 20A: Accounting for Postretirement Benefi ts 1225 ILLUSTRATION 20A-8 2016 Corridor Test Computation of Accumulated OCI at beginning of year $60,200 Amortization Charge 10% of greater of APBO or market-related value (Corridor Test)—2016 of plan assets ($109,080 3 .10) (10,908) Amortizable amount $49,292 Average remaining service to expected retirement 25 years

2016 amortization of loss ($49,292 4 25) $1,972 DISCLOSURES IN NOTES TO THE FINANCIAL STATEMENTS The disclosures required for other postretirement benefit plans are similar to and just as detailed and extensive as those required for pensions. The note disclosure for Tootsie Roll, Inc. in Illustration 20A-9 (page 1226) provides a good example of the extensive disclosure required for other postretirement benefit plans. As indicated in Illustration 20A-9, Tootsie Roll shows the impact of the postretire- ment benefit plan on income, the balance sheet, and the cash flow statement, and it provides information on important assumptions used in the measurement of the post- retirement benefit obligation. Also note that given no tax incentives for funding, Tootsie Roll (like many companies) does not have any assets set aside for its other postretire- ment benefit obligations. While Tootsie Roll has only an other postretirement benefit plan, many companies sponsor both defined benefit pension and other postretirement plans. Given the simi- larities in accounting for these plans, companies can combine pension and other postre- tirement benefit disclosures. ACTUARIAL ASSUMPTIONS AND CONCEPTUAL ISSUES Measurement of the EPBO, the APBO, and the net periodic postretirement benefit cost is involved and complex. Due to the uncertainties in forecasting healthcare costs, rates of use, changes in government health programs, and the differences employed in non- medical assumptions (e.g., discount rate, employee turnover, rate of pre-65 retirement, spouse-age difference), estimates of postretirement benefit costs may have a large margin of error. Is the information relevant, reliable, or verifiable? The FASB concluded that “the obligation to provide postretirement benefits meets the definition of a liability, is representationally faithful, is relevant to financial statement users, and can be measured with sufficient reliability at a justifiable cost.” [12] Failure to accrue an obligation and an expense prior to payment of benefits would result in an unfaithful representation of what financial statements should represent. The FASB took a momentous step by requiring recognition of a postretirement lia- bility. Many opposed the requirement, warning that the GAAP rules would devastate earnings. Others argued that putting these numbers on the balance sheet was inappro- priate. Others noted that the requirement would force companies to curtail postretirement benefits to employees. The authors believe that the FASB deserves special praise. Because the Board addressed this issue, companies now recognize the magnitude of these costs. This recognition has 1226 Chapter 20 Accounting for Pensions and Postretirement Benefi ts ILLUSTRATION 20A-9 Tootsie Roll Industries, Inc. Postretirement Benefi t Disclosure Notes to Financial Statements Note 7 Employee Benefit Plans (partial) Postretirement health care and life insurance benefit plans: The Company provides certain postretirement health care and life insurance benefits for corporate office and management employees based upon their age, years of service, date of hire and if they agree to contribute a portion of the cost as determined by the Company. The Company has the right to modify or terminate these benefits and does not fund postretirement health care and life insurance benefits in advance of payments for benefit claims. The Company is currently contemplating changes to its postretirement health care and life insurance benefits with the intention of reducing the Company’s cost of providing such benefits. These changes are likely to include increasing retiree premium contributions, reducing and eliminating certain benefits, and taking steps to ensure that the Company does not become subject to the excise tax on high value coverage instituted by the Patient Protection and Affordability Act. The Company is not presently able to determine the effects of such changes on its financial statements. Amounts recognized in accumulated other comprehensive loss (pre-tax) at December 31, 2011 are as follows:

Prior service credit $ (626) Net actuarial loss 8,255 Amounts recognized in other Net amount recognized in accumulated other comprehensive loss $7,629 comprehensive income The estimated actuarial loss and prior service credit to be amortized from accumulated other comprehensive income into net periodic benefit cost during 2012 are $1,146 and $(125), respectively. The changes in the accumulated postretirement benefit obligation at December 31, 2011 and 2010 consist of the following: December 31, 2011 2010 Benefit obligation, beginning of year $20,689 $16,674 Reconciliation of OPEB Service cost 831 696 liability Interest cost 1,117 958 Actuarial loss 3,898 2,714 Benefits paid (427) (353) Benefit obligation, end of year $26,108 $20,689 Net periodic postretirement benefit cost included the following components: 2011 2010 2009 Components of OPEB Service cost—benefits attributed to service during the period $ 831 $ 696 $ 704 expense Interest cost on the accumulated postretirement benefit obligation 1,117 958 853 Net amortization 501 128 140 Net periodic postretirement benefit cost $2,449 $1,782 $1,697 For measurement purposes, the 2012 annual rate of increase in the per capita cost of covered health care benefits was assumed to be 8.2% for pre-age 65 retirees, post 65 retirees and for prescription drugs; these rates were assumed to decrease gradually to 5.0% for 2019 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 4.31% and 5.47% Rates used to estimate at December 31, 2011 and 2010, respectively. plan elements Increasing or decreasing the health care trend rates by one percentage point in each year would have the following effect: 1% Increase 1% Decrease Postretirement benefit obligation $6,247 $(4,277) Total of service and interest cost components $ 484 $ (320) The Company estimates future benefit payments will be $574, $710, $882, $993 and $1,095 in 2012 through 2016, respectively, and a total of $7,002 in 2017 through 2020. The future benefit payments are net of the annual Medicare Part D subsidy of approximately $1,094 beginning in 2012. Summary of Learning Objectives for Appendix 20A 1227 led to efforts to control escalating healthcare costs. As John Ruffle, a former president of the Financial Accounting Foundation noted, “The Board has done American industry a gigantic favor. Over the long term, industry will look back and say thanks.” What do the numbers mean? WANT SOME BAD NEWS? Many companies have underfunded pension and other post- 45 percent of the state’s pension liabilities were funded. retirement plans. Unfortunately, many governmental entities California alone had $113 billion in unfunded liability. also have the same problem but on a much larger scale. Here So what does all this have to do with accounting? Similar are some examples. to the FASB, there is an organization called the Governmen- • The actual liabilities of the federal government—including tal Accounting Standards Board (GASB), which establishes Social Security, Medicare, and federal employees’ future standards of fi nancial accounting and reporting for state and retirement benefits—is estimated to be $86.8 trillion or local governmental agencies. 550 percent of GDP at the end of 2011. When the accrued Until recently, the GASB went about its work in relative expenses of the government’s entitled programs are obscurity. How did the GASB get everyone’s attention? It re- counted, we need to collect over $8 trillion in tax cently required that governmental units recognize postretire- revenues annually. Even if you take all the taxable in- ment benefi ts on their balance sheets on an accrual basis. come of corporations and of individuals earning over ap- Some states do not like this requirement and have proposed proximately $66,000, that still falls short of the $8 trillion. legislation that will allow them to ignore GASB standards.

However, the GASB, with the support of users of government • A State Budget Crisis Task Force recently declared un- reports, has pushed for the change. They are concerned that derfunded retirement promises as one of the six major without the new requirements, governments will continue to threats to states’ “fiscal sustainability.” misrepresent the true cost of their retirement-related prom- • According to the Milliman’s Public Pension Fund Study ises to public employees. In their view, the new accounting and the Pew Center for the States Report, an $859 billion rules are in the best interests of municipal bondholders and gap exists between obligations for the country’s 100 largest the public in general. Thus, it appears that the FASB is not the public pension plans and the funding of these plans. only standard-setter subject to political pressure. Nine states were 60 percent funded or less. In Illinois, just Sources: R. H. Attmore, “Who Do Texas Elected Offi cials Think They Are Fooling?” The Bond Buyer (June 18, 2007); Chris Cox and Bill Archer, “Why $16 Trillion Only Hints at the True U.S. Debt,” Wall Street Journal (November 27, 2012); and “More Bad News for Public Pensions,” Wall Street Journal (July 12, 2012). For more information on the GASB, go to www.gasb.org/. KEY TERMS SUMMARY OF LEARNING OBJECTIVES accumulated FOR APPENDIX 20A postretirement benefit obligation (APBO), 1220 attribution period, 1219 10 Identify the differences between pensions and postretirement health- care benefits. Pension plans are generally funded, but healthcare benefit plans are corridor approach, 1223 expected postretirement not. Pension benefits are generally well-defined and level in amount; healthcare benefits benefit obligation are generally uncapped and variable. Pension benefits are payable monthly; healthcare (EPBO), 1220 benefits are paid as needed and used. Pension plan variables are reasonably predictable, whereas healthcare plan variables are difficult to predict. 11 Contrast accounting for pensions to accounting for other postretire- ment benefits. Many of the basic concepts, accounting terminology, and measure- ment methodology that apply to pensions also apply to other postretirement benefit accounting. Because other postretirement benefit plans are unfunded, large obligations can occur. Two significant concepts peculiar to accounting for other postretirement ben- efits are (1) expected postretirement benefit obligation (EPBO), and (2) accumulated postretirement benefit obligation (APBO). DEMONSTRATION PROBLEM Jablonski Corp. sponsors a defined benefit pension plan for its employees. On January 1, 2014, the follow- ing balances related to this plan. Plan assets (market-related value) $170,000 Projected benefi t obligation 340,000 Pension asset/liability 170,000 Cr. Prior service cost 100,000 OCI—Loss 39,000 As a result of the operation of the plan during 2014, the actuary provided the following additional data at December 31, 2014. Service cost for 2014 $45,000 Actual return on plan assets in 2014 27,000 Amortization of prior service cost 20,000 Contributions in 2014 85,000 Benefi ts paid retirees in 2014 51,000 Settlement rate 7% Expected return on plan assets 8% Average remaining service life of active employees 10 years Instructions (a) Compute pension expense for Jablonski Corp. for the year 2014 by preparing a pension worksheet that shows the journal entry for pension expense. (b) Indicate the pension amounts reported in the financial statements. Solution (a) JJaabblloonnsskkii CCoorrpp..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G H 1 2 JABLONSKI CORP. 3 Pension Worksheet—2014 4 General Journal Entries Memo Record 5 Annual Other Pension Projected Comprehensive Income 6 Pension Asset/ Benefit 7 Items Expense Cash Prior Service Cost Gain/Loss Liability Obliga!on Plan Assets 8 Balance, Jan. 1, 2014 170,000 Cr. 340,000 Cr. 170,000 Dr. 9 Service cost 45,000 Dr. 45,000 Cr. 10 Interest cost* 23,800 Dr. 23,800 Cr. 11 Actual return 27,000 Cr. 27,000 Dr. 12 Unexpected gain** 13,400 Dr. 13,400 Cr.

13 Amor!za!on of PSC 20,000 Dr. 20,000 Cr. 14 Amor!za!on of loss*** 500 Dr. 500 Cr. 15 Contribu!ons 85,000 Cr. 85,000 Dr. 16 Benefits 51,000 Dr. 51,000 Cr. 17 Journal entry for 2014 75,700 Dr. 85,000 Cr. 20,000 Cr. 13,900 Cr. 43,200 Dr. 18 Accumulated OCI, Dec. 31, 2014 100,000 Dr. 39,000 Dr. 19 Balance, Dec. 31, 2014 80,000 Dr. 25,100 Dr. 126,800 Cr. 357,800 Cr. 231,000 Dr. 20 21 *$23,800 = $340,000 × .07 22 **$13,400 = ($170,000 × .08) − $27,000 23 *** 1/1 Projected Minimum 24 Benefit Value of 1/1 10% Accumulated Amor!za!on of Loss for 25 Year Obliga!on Plan Assets Corridor OCI (G/L), 1/1 2013 26 2014 $340,000 $170,000 $34,000 $39,000 $500**** 27 **** ($39,000 − $34,000) = $5,000 ÷ 10 = $500 FASB Codifi cation 1229 2014 Pension Expense 75,700 Pension Asset/Liability 43,200 Other Comprehensive Income (PSC) 20,000 Other Comprehensive Income (G/L) 13,400 Cash 85,000 (b) The pension amounts reported in the 2014 fi nancial statements are as follows. Income Statement Pension expense $ 75,700 Comprehensive Income Statement Net Income $ XXXX Other comprehensive income Asset gain $13,900 Amortization of loss 500 Prior service cost amortization 20,000 34,400 Comprehensive income $ XXXX Balance Sheet Liabilities Pension liability $126,800 Stockholders’ equity Accumulated other comprehensive loss (PSC) $ 80,000 Accumulated other comprehensive loss (G/L) 25,100 FASB CODIFICATION FASB Codification References [1] FASB ASC 960. [Predecessor literature: “Accounting and Reporting by Defined Benefit Pension Plans,” Statement of Finan- cial Accounting Standards No. 35 (Stamford, Conn.: FASB, 1979).] [2] FASB ASC 715-70-50-1. [Predecessor literature: “Employers’ Accounting for Pension Plans,” Statement of Financial Account- ing Standards No. 87 (Stamford, Conn.: FASB, 1985), paras. 63–66.] [3] FASB ASC 715-30-25-1. [Predecessor literature: “Employers’ Accounting for Defined Benefit Pension and Other Postretire- ment Plans: An Amendment to SFAS Nos. 87, 88, 106, and 132(R),” Statement of Financial Accounting Standards No. 158 (Norwalk, Conn.: FASB, 2006).] [4] FASB ASC 715-30-35-22. [Predecessor literature: “Employers’ Accounting for Pension Plans,” Statement of Financial Account- ing Standards No. 87 (Stamford, Conn.: FASB, 1985), par. 30.] [5] FASB ASC 220-10-45-13. [Predecessor literature: “Employers’ Accounting for Defined Benefit Pension and Other Postretire- ment Plans: An Amendment of SFAS Nos. 87, 88, 106, and 132(R),” Statement of Financial Accounting Standards No. 158 (Norwalk, Conn.: FASB, 2006), par. B41.] [6] FASB ASC 715-20-50-1. [Predecessor literature: None.] [7] FASB ASC 715-20-50-1. [Predecessor literature: “Employers’ Disclosure about Pensions and Other Postretirement Benefits,” Statement of Financial Accounting Standards No. 132 (Stamford, Conn.: FASB, 1998; revised 2003); and “Employers’ Account- ing for Defined Benefit Pension and Other Postretirement Plans: An Amendment of SFAS Nos. 87, 88, 106, and 132(R),” Statement of Financial Accounting Standards No. 158 (Norwalk, Conn.: FASB, 2006).] [8] FASB ASC 715-30-05-9. [Predecessor literature: “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).] [9] FASB ASC 715-60. [Predecessor literature: “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” Statement of Financial Accounting Standards No. 106 (Norwalk, Conn.: FASB, 1990).] [10] FASB ASC 712-10-05. [Predecessor literature: “Employers’ Accounting for Postemployment Benefits,” Statement of Financial Accounting Standards No. 112 (Norwalk, Conn.: FASB, 1992).] 1230 Chapter 20 Accounting for Pensions and Postretirement Benefi ts [11] FASB ASC 715-60-35-9. [Predecessor literature: “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” Statement of Financial Accounting Standards No. 106 (Norwalk, Conn.: FASB, 1990), paras. 46–66.] [12] F ASB ASC 715-60-25. [Predecessor literature: “Employers’ Accounting for Postretirement Benefits Other Than Pensions,”

Statement of Financial Accounting Standards No. 106 (Norwalk, Conn.: FASB, 1990), par. 163.] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE20-1 Access the glossary (“Master Glossary”) to answer the following. (a) What is an accumulated benefit obligation? (b) What is a defined benefit postretirement plan? (c) What is the definition of “actuarial present value”? (d) What is a prior service cost? CE20-2 In general, how can an employer choose an appropriate discount rate for its pension plan? What information could an employer use in choosing a discount rate? CE20-3 If an employer has a defined benefit pension plan, what components would make up its net periodic pension cost? CE20-4 What information about its pension plan must a publicly traded company disclose in its interim financial statements? An additional Codification case can be found in the Using Your Judgment section, on page 1250. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter. QUESTIONS 1. What is a private pension plan? How does a contributory 7. Name three approaches to measuring benefit obligations pension plan differ from a noncontributory plan? from a pension plan and explain how they differ. 2. Differentiate between a defined contribution pension plan 8. Explain how cash-basis accounting for pension plans dif- and a defined benefit pension plan. Explain how the em- fers from accrual-basis accounting for pension plans. Why ployer’s obligation differs between the two types of plans. is cash-basis accounting generally considered unaccept- 3. Differentiate between “accounting for the employer” and able for pension plan accounting? “accounting for the pension fund.” 9. Identify the five components that comprise pension 4. The meaning of the term “fund” depends on the context expense. Briefly explain the nature of each component. in which it is used. Explain its meaning when used as a 10. What is service cost, and what is the basis of its mea- noun. Explain its meaning when it is used as a verb. surement? 5. What is the role of an actuary relative to pension plans? 11. In computing the interest component of pension expense, What are actuarial assumptions? what interest rates may be used? 6. What factors must be considered by the actuary in mea- 12. Explain the difference between service cost and prior suring the amount of pension benefits under a defined service cost. benefit plan? Brief Exercises 1231 13. What is meant by “prior service cost”? When is prior 22. Boey Company reported net income of $25,000 in 2015. It service cost recognized as pension expense? had the following amounts related to its pension plan in 14. What are “liability gains and losses,” and how are they 2015: Actuarial liability gain $10,000; Unexpected asset loss $14,000; Accumulated other comprehensive income accounted for? (G/L) (beginning balance), zero. Determine for 2015 (a) 15. If pension expense recognized in a period exceeds the Boey’s other comprehensive income, and (b) comprehen- c urrent amount funded by the employer, what kind of sive income. account arises, and how should it be reported in the finan- 23. Describe the reporting of pension plans for a company cial statements? If the reverse occurs—that is, current with multiple plans, some of which are underfunded and funding by the employer exceeds the amount recognized some of which are overfunded. as pension expense—what kind of account arises, and how should it be reported? 24. Determine the meaning of the following terms. 16. Given the following items and amounts, compute the ac- (a) Contributory plan. tual return on plan assets: fair value of plan assets at the (b) Vested benefits.

beginning of the period $9,500,000; benefits paid during (c) Retroactive benefits. the period $1,400,000; contributions made during the (d) Years-of-service method. period $1,000,000; and fair value of the plan assets at the end of the period $10,150,000. 25. A headline in the Wall Street Journal stated, “Firms Increas- 17. How does an “asset gain or loss” develop in pension ac- ingly Tap Their Pension Funds to Use Excess Assets.” What is the accounting issue related to the use of these counting? How does a “liability gain or loss” develop in “excess assets” by companies? pension accounting? 18. What is the meaning of “corridor amortization”? * 26. What are postretirement benefits other than pensions? 19. At the end of the current period, Agler Inc. had a pro- * 27. Why didn’t the FASB cover both types of postretirement benefits—pensions and healthcare—in the earlier pension jected benefit obligation of $400,000 and pension plan as- accounting rules? sets (at fair value) of $350,000. What are the accounts and amounts that will be reported on the company’s balance * 28. What are the major differences between postretirement sheet as pension assets or pension liabilities? healthcare benefits and pension benefits? 20. At the end of the current year, Pociek Co. has prior ser- * 29. What is the difference between the APBO and the EPBO? vice cost of $9,150,000. Where should the prior service What are the components of postretirement expense? cost be reported on the balance sheet? 21. Describe the accounting for actuarial gains and losses. BRIEF EXERCISES 4 BE20-1 AMR Corporation (parent company of American Airlines) reported the following for 2011 (in millions). Service cost $366 Interest on P.B.O. 737 Return on plan assets 593 Amortization of prior service cost 13 Amortization of net loss 154 Compute AMR Corporation’s 2011 pension expense. 4 BE20-2 For Warren Corporation, year-end plan assets were $2,000,000. At the beginning of the year, plan assets were $1,780,000. During the year, contributions to the pension fund were $120,000, and benefits paid were $200,000. Compute Warren’s actual return on plan assets. 5 BE20-3 At January 1, 2014, Hennein Company had plan assets of $280,000 and a projected benefit obliga- tion of the same amount. During 2014, service cost was $27,500, the settlement rate was 10%, actual and expected return on plan assets were $25,000, contributions were $20,000, and benefits paid were $17,500. Prepare a pension worksheet for Hennein Company for 2014. 4 BE20-4 For 2012, Campbell Soup Company had pension expense of $73 million and contributed $71 million to the pension fund. Prepare Campbell Soup Company’s journal entry to record pension expense and funding. 1232 Chapter 20 Accounting for Pensions and Postretirement Benefi ts 6 BE20-5 Mancuso Corporation amended its pension plan on January 1, 2014, and granted $160,000 of prior service costs to its employees. The employees are expected to provide 2,000 service years in the future, with 350 service years in 2014. Compute prior service cost amortization for 2014. 9 BE20-6 At December 31, 2014, Besler Corporation had a projected benefit obligation of $560,000, plan as- sets of $322,000, and prior service cost of $127,000 in accumulated other comprehensive income. Determine the pension asset/liability at December 31, 2014. 8 BE20-7 Shin Corporation had a projected benefit obligation of $3,100,000 and plan assets of $3,300,000 at January 1, 2014. Shin also had a net actuarial loss of $465,000 in accumulated OCI at January 1, 2014. The average remaining service period of Shin’s employees is 7.5 years. Compute Shin’s minimum amortization of the actuarial loss. 9 BE20-8 Hawkins Corporation has the following balances at December 31, 2014. Projected benefi t obligation $2,600,000 Plan assets at fair value 2,000,000 Accumulated OCI (PSC) 1,100,000 How should these balances be reported on Hawkins’s balance sheet at December 31, 2014? 9 BE20-9 Norton Co. had the following amounts related to its pension plan in 2014. Actuarial liability loss for 2014 $28,000

Unexpected asset gain for 2014 18,000 Accumulated other comprehensive income (G/L) (beginning balance) 7,000 Cr. Determine for 2014: (a) Norton’s other comprehensive income (loss), and (b) comprehensive income. Net income for 2014 is $26,000; no amortization of gain or loss is necessary in 2014. 9 BE20-10 Lahey Corp. has three defined benefit pension plans as follows. Pension Assets Projected Benefi t (at Fair Value) Obligation Plan X $600,000 $500,000 Plan Y 900,000 720,000 Plan Z 550,000 700,000 How will Lahey report these multiple plans in its financial statements? 10 11 *B E20-11 Manno Corporation has the following information available concerning its postretirement benefit plan for 2014. Service cost $40,000 Interest cost 47,400 Actual and expected return on plan assets 26,900 Compute Manno’s 2014 postretirement expense. 10 11 *B E20-12 For 2014, Sampsell Inc. computed its annual postretirement expense as $240,900. Sampsell’s con- tribution to the plan during 2014 was $180,000. Prepare Sampsell’s 2014 entry to record postretirement expense. EXERCISES 4 6 E20-1 (Pension Expense, Journal Entries) The following information is available for the pension plan of Radcliffe Company for the year 2014. Actual and expected return on plan assets $ 15,000 Benefi ts paid to retirees 40,000 Contributions (funding) 90,000 Interest/discount rate 10% Prior service cost amortization 8,000 Projected benefi t obligation, January 1, 2014 500,000 Service cost 60,000 Exercises 1233 Instructions (a) Compute pension expense for the year 2014. (b) Prepare the journal entry to record pension expense and the employer’s contribution to the pension plan in 2014. 4 6 E20-2 (Computation of Pension Expense) Veldre Company provides the following information about its defined benefit pension plan for the year 2014. Service cost $ 90,000 Contribution to the plan 105,000 Prior service cost amortization 10,000 Actual and expected return on plan assets 64,000 Benefi ts paid 40,000 Plan assets at January 1, 2014 640,000 Projected benefi t obligation at January 1, 2014 700,000 Accumulated OCI (PSC) at January 1, 2014 150,000 Interest/discount (settlement) rate 10% Instructions Compute the pension expense for the year 2014. 5 E20-3 (Preparation of Pension Worksheet) Using the information in E20-2, prepare a pension worksheet inserting January 1, 2014, balances, showing December 31, 2014, balances, and the journal entry recording pension expense. 5 E20-4 (Basic Pension Worksheet) The following facts apply to the pension plan of Boudreau Inc. for the year 2014. Plan assets, January 1, 2014 $490,000 Projected benefi t obligation, January 1, 2014 490,000 Settlement rate 8% Service cost 40,000 Contributions (funding) 25,000 Actual and expected return on plan assets 49,700 Benefi ts paid to retirees 33,400 Instructions Using the preceding data, compute pension expense for the year 2014. As part of your solution, prepare a pension worksheet that shows the journal entry for pension expense for 2014 and the year-end balances in the related pension accounts. 6 E20-5 (Application of Years-of-Service Method) Andrews Company has five employees participating in its defined benefit pension plan. Expected years of future service for these employees at the beginning of 2014 are as follows. Future Employee Years of Service Jim 3 Paul 4 Nancy 5 Dave 6 Kathy 6 On January 1, 2014, the company amended its pension plan, increasing its projected benefit obligation by $72,000. Instructions Compute the amount of prior service cost amortization for the years 2014 through 2019 using the years-of- service method, setting up appropriate schedules. 4 E20-6 (Computation of Actual Return) Gingrich Importers provides the following pension plan information. Fair value of pension plan assets, January 1, 2014 $2,400,000 Fair value of pension plan assets, December 31, 2014 2,725,000 Contributions to the plan in 2014 280,000 Benefi ts paid retirees in 2014 350,000 1234 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Instructions From the data above, compute the actual return on the plan assets for 2014.

5 6 E20-7 (Basic Pension Worksheet) The following defined pension data of Rydell Corp. apply to the year 2014. Projected benefi t obligation, 1/1/14 (before amendment) $560,000 Plan assets, 1/1/14 546,200 Pension liability 13,800 On January 1, 2014, Rydell Corp., through plan amendment, grants prior service benefi ts having a present value of 120,000 Settlement rate 9% Service cost 58,000 Contributions (funding) 65,000 Actual (expected) return on plan assets 52,280 Benefi ts paid to retirees 40,000 Prior service cost amortization for 2014 17,000 Instructions For 2014, prepare a pension worksheet for Rydell Corp. that shows the journal entry for pension expense and the year-end balances in the related pension accounts. 8 E20-8 (Application of the Corridor Approach) Kenseth Corp. has the following beginning-of-the-year present values for its projected benefit obligation and market-related values for its pension plan assets. Projected Plan Benefi t Assets Obligation Value 2013 $2,000,000 $1,900,000 2014 2,400,000 2,500,000 2015 2,950,000 2,600,000 2016 3,600,000 3,000,000 The average remaining service life per employee in 2013 and 2014 is 10 years and in 2015 and 2016 is 12 years. The net gain or loss that occurred during each year is as follows: 2013, $280,000 loss; 2014, $90,000 loss; 2015, $11,000 loss; and 2016, $25,000 gain. (In working the solution, the gains and losses must be aggregated to arrive at year-end balances.) Instructions Using the corridor approach, compute the amount of net gain or loss amortized and charged to pension expense in each of the four years, setting up an appropriate schedule. 9 E20-9 (Disclosures: Pension Expense and Other Comprehensive Income) Taveras Enterprises provides the following information relative to its defined benefit pension plan. Balances or Values at December 31, 2014 Projected benefi t obligation $2,737,000 Accumulated benefi t obligation 1,980,000 Fair value of plan assets 2,278,329 Accumulated OCI (PSC) 210,000 Accumulated OCI—Net loss (1/1/14 balance, –0–) 45,680 Pension liability 458,671 Other pension plan data for 2014: Service cost 94,000 Prior service cost amortization 42,000 Actual return on plan assets 130,000 Expected return on plan assets 175,680 Interest on January 1, 2014, projected benefi t obligation 253,000 Contributions to plan 93,329 Benefi ts paid 140,000 Instructions (a) Prepare the note disclosing the components of pension expense for the year 2014. (b) Determine the amounts of other comprehensive income and comprehensive income for 2014. Net income for 2014 is $35,000. (c) Compute the amount of accumulated other comprehensive income reported at December 31, 2014. 5 E20-10 (Pension Worksheet) Webb Corp. sponsors a defined benefit pension plan for its employees. On January 1, 2014, the following balances relate to this plan. Exercises 1235 Plan assets $480,000 Projected benefi t obligation 600,000 Pension asset/liability 120,000 Accumulated OCI (PSC) 100,000 Dr. As a result of the operation of the plan during 2014, the following additional data are provided by the actuary. Service cost $90,000 Settlement rate, 9% Actual return on plan assets 55,000 Amortization of prior service cost 19,000 Expected return on plan assets 52,000 Unexpected loss from change in projected benefi t obligation, due to change in actuarial predictions 76,000 Contributions 99,000 Benefi ts paid retirees 85,000 Instructions (a) Using the data above, compute pension expense for Webb Corp. for the year 2014 by preparing a pension worksheet. (b) Prepare the journal entry for pension expense for 2014. 4 9 E20-11 (Pension Expense, Journal Entries, Statement Presentation) Henning Company sponsors a de- fined benefit pension plan for its employees. The following data relate to the operation of the plan for the year 2014 in which no benefits were paid. 1. The actuarial present value of future benefits earned by employees for services rendered in 2014 amounted to $56,000. 2. The company’s funding policy requires a contribution to the pension trustee amounting to $145,000 for 2014.

3. As of January 1, 2014, the company had a projected benefit obligation of $900,000, an accumulated benefit obligation of $800,000, and a debit balance of $400,000 in accumulated OCI (PSC). The fair value of pension plan assets amounted to $600,000 at the beginning of the year. The actual and ex- pected return on plan assets was $54,000. The settlement rate was 9%. No gains or losses occurred in 2014 and no benefits were paid. 4. Amortization of prior service cost was $50,000 in 2014. Amortization of net gain or loss was not required in 2014. Instructions (a) Determine the amounts of the components of pension expense that should be recognized by the company in 2014. (b) Prepare the journal entry or entries to record pension expense and the employer’s contribution to the pension trustee in 2014. (c) Indicate the amounts that would be reported on the income statement and the balance sheet for the year 2014. 4 6 E20-12 (Pension Expense, Journal Entries, Statement Presentation) Ferreri Company received the 7 8 following selected information from its pension plan trustee concerning the operation of the company’s defined benefit pension plan for the year ended December 31, 2014. 9 January 1, December 31, 2014 2014 Projected benefi t obligation $1,500,000 $1,527,000 Market-related and fair value of plan assets 800,000 1,130,000 Accumulated benefi t obligation 1,600,000 1,720,000 Accumulated OCI (G/L)—Net gain –0– (200,000) The service cost component of pension expense for employee services rendered in the current year amounted to $77,000 and the amortization of prior service cost was $120,000. The company’s actual fund- ing (contributions) of the plan in 2014 amounted to $250,000. The expected return on plan assets and the actual rate were both 10%; the interest/discount (settlement) rate was 10%. Accumulated other compre- hensive income (PSC) had a balance of $1,200,000 on January 1, 2014. Assume no benefits paid in 2014. Instructions (a) Determine the amounts of the components of pension expense that should be recognized by the company in 2014. (b) Prepare the journal entry to record pension expense and the employer’s contribution to the pension plan in 2014. 1236 Chapter 20 Accounting for Pensions and Postretirement Benefi ts (c) Indicate the pension-related amounts that would be reported on the income statement and the balance sheet for Ferreri Company for the year 2014. 4 6 E20-13 (Computation of Actual Return, Gains and Losses, Corridor Test, and Pension Expense) Erickson 7 8 Company sponsors a defined benefit pension plan. The corporation’s actuary provides the following infor- mation about the plan. 9 January 1, December 31, 2014 2014 Vested benefi t obligation $1,500 $1,900 Accumulated benefi t obligation 1,900 2,730 Projected benefi t obligation 2,500 3,300 Plan assets (fair value) 1,700 2,620 Settlement rate and expected rate of return 10% Pension asset/liability 800 ? Service cost for the year 2014 400 Contributions (funding in 2014) 700 Benefi ts paid in 2014 200 Instructions (a) Compute the actual return on the plan assets in 2014. (b) Compute the amount of the other comprehensive income (G/L) as of December 31, 2014. (Assume the January 1, 2014, balance was zero.) (c) Compute the amount of net gain or loss amortization for 2014 (corridor approach). (d) Compute pension expense for 2014. 5 E20-14 (Worksheet for E20-13) Using the information in E20-13 about Erickson Company’s defined ben- efit pension plan, prepare a 2014 pension worksheet with supplementary schedules of computations. Pre- pare the journal entries at December 31, 2014, to record pension expense and related pension transactions. Also, indicate the pension amounts reported in the balance sheet. 4 E20-15 (Pension Expense, Journal Entries) Latoya Company provides the following selected information related to its defined benefit pension plan for 2014. Pension asset/liability (January 1) $ 25,000 Cr. Accumulated benefi t obligation (December 31) 400,000 Actual and expected return on plan assets 10,000 Contributions (funding) in 2014 150,000

Fair value of plan assets (December 31) 800,000 Settlement rate 10% Projected benefi t obligation (January 1) 700,000 Service cost 80,000 Instructions (a) Compute pension expense and prepare the journal entry to record pension expense and the employer’s contribution to the pension plan in 2014. Preparation of a pension worksheet is not required. Benefits paid in 2014 were $35,000. (b) Indicate the pension-related amounts that would be reported in the company’s income statement and balance sheet for 2014. 8 E20-16 (Amortization of Accumulated OCI (G/L), Corridor Approach, Pension Expense Computation) The actuary for the pension plan of Gustafson Inc. calculated the following net gains and losses. Incurred during the Year (Gain) or Loss 2014 $300,000 2015 480,000 2016 (210,000) 2017 (290,000) Other information about the company’s pension obligation and plan assets is as follows. Projected Benefi t Plan Assets As of January 1, Obligation (market-related asset value) 2014 $4,000,000 $2,400,000 2015 4,520,000 2,200,000 2016 5,000,000 2,600,000 2017 4,240,000 3,040,000 Gustafson Inc. has a stable labor force of 400 employees who are expected to receive benefits under the plan. The total service-years for all participating employees is 5,600. The beginning balance of accumulated Exercises 1237 OCI (G/L) is zero on January 1, 2014. The market-related value and the fair value of plan assets are the same for the 4-year period. Use the average remaining service life per employee as the basis for amortization. Instructions (Round to the nearest dollar.) Prepare a schedule which reflects the minimum amount of accumulated OCI (G/L) amortized as a compo- nent of net periodic pension expense for each of the years 2014, 2015, 2016, and 2017. Apply the “corridor” approach in determining the amount to be amortized each year. 8 E20-17 (Amortization of Accumulated OCI Balances) Keeton Company sponsors a defined benefit pen- sion plan for its 600 employees. The company’s actuary provided the following information about the plan. January 1, December 31, 2014 2014 2015 Projected benefi t obligation $2,800,000 $3,650,000 $4,195,000 Accumulated benefi t obligation 1,900,000 2,430,000 2,900,000 Plan assets (fair value and market-related asset value) 1,700,000 2,900,000 3,790,000 Accumulated net (gain) or loss (for purposes of the corridor calculation) –0– 198,000 (24,000) Discount rate (current settlement rate) 9% 8% Actual and expected asset return rate 10% 10% Contributions 1,030,000 600,000 The average remaining service life per employee is 10.5 years. The service cost component of net periodic pension expense for employee services rendered amounted to $400,000 in 2014 and $475,000 in 2015. The accumulated OCI (PSC) on January 1, 2014, was $1,260,000. No benefits have been paid. Instructions (Round to the nearest dollar.) (a) Compute the amount of accumulated OCI (PSC) to be amortized as a component of net periodic pension expense for each of the years 2014 and 2015. (b) Prepare a schedule which reflects the amount of accumulated OCI (G/L) to be amortized as a com- ponent of pension expense for 2014 and 2015. (c) Determine the total amount of pension expense to be recognized by Keeton Company in 2014 and 2015. 5 8 E20-18 (Pension Worksheet—Missing Amounts) The accounting staff of Usher Inc. has prepared the fol- lowing pension worksheet. Unfortunately, several entries in the worksheet are not decipherable. The com- pany has asked your assistance in completing the worksheet and completing the accounting tasks related to the pension plan for 2014. PPeennssiioonn WWoorrkksshheeeett——UUsshheerr IInncc..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G H 1 2 General Journal Entries Memo Record 3 Annual Pension Projected 4 Pension OCI—Prior OCI— Asset/ Benefit 5 Items Expense Cash Service Cost Gain/Loss Liability Obliga!on Plan Assets 6 Balance, Jan. 1, 2014 1,100 Cr. 2,800 1,700 7 Service cost (1) 500 8 Interest cost (2) 280 9 Actual return (3) 220 10 Unexpected gain 150 (4) 11 Amor!za!on of PSC (5) 55 12 Contribu!ons 800 800

13 Benefits 200 200 14 Liability increase (6) 365 15 Journal entry (7) (8) (9) (10) (11) 16 17 Accumulated OCI, Dec. 31, 2013 1,100 0 18 Balance, Dec. 31, 2014 1,045 215 1,225 3,745 2,520 19 1238 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Instructions (a) Determine the missing amounts in the 2014 pension worksheet, indicating whether the amounts are debits or credits. (b) Prepare the journal entry to record 2014 pension expense for Usher Inc. (c) The accounting staff has heard of a pension accounting procedure called “corridor amortiza- tion.” Is Usher required to record any amounts for corridor amortization in (1) 2014? In (2) 2015? Explain. 10 11 *E 20-19 (Postretirement Benefit Expense Computation) Kreter Co. provides the following information about its postretirement benefit plan for the year 2014. Service cost $ 45,000 Contribution to the plan 10,000 Actual and expected return on plan assets 11,000 Benefi ts paid 20,000 Plan assets at January 1, 2014 110,000 Accumulated postretirement benefi t obligation at January 1, 2014 330,000 Discount rate 8% Instructions Compute the postretirement benefit expense for 2014. 10 11 *E 20-20 (Postretirement Benefit Worksheet) Using the information in E20-19, prepare a worksheet insert- ing January 1, 2014, balances, and showing December 31, 2014, balances. Prepare the journal entry record- ing postretirement benefit expense. 10 11 *E 20-21 (Postretirement Benefit Expense Computation) Garner Inc. provides the following information related to its postretirement benefits for the year 2014. Accumulated postretirement benefi t obligation at January 1, 2014 $710,000 Actual and expected return on plan assets 34,000 Prior service cost amortization 21,000 Discount rate 10% Service cost 83,000 Instructions Compute postretirement benefit expense for 2014. 10 11 * E20-22 (Postretirement Benefit Expense Computation) Englehart Co. provides the following informa- tion about its postretirement benefit plan for the year 2014. Service cost $ 90,000 Prior service cost amortization 3,000 Contribution to the plan 56,000 Actual and expected return on plan assets 62,000 Benefi ts paid 40,000 Plan assets at January 1, 2014 710,000 Accumulated postretirement benefi t obligation at January 1, 2014 760,000 Accumulated OCI (PSC) at January 1, 2014 100,000 Dr. Discount rate 9% Instructions Compute the postretirement benefit expense for 2014. 10 11 *E 20-23 (Postretirement Benefit Worksheet) Using the information in E20-22, prepare a worksheet insert- ing January 1, 2014, balances, showing December 31, 2014, balances, and the journal entry recording post- retirement benefit expense. 10 11 *E 20-24 (Postretirement Benefit Worksheet—Missing Amounts) The accounting staff of Holder Inc. has prepared the following postretirement benefit worksheet. Unfortunately, several entries in the worksheet are not decipherable. The company has asked your assistance in completing the worksheet and completing the accounting tasks related to the pension plan for 2014. Problems 1239 PPoossttrreettiirreemmeenntt BBeenneeffiitt WWoorrkksshheeeett——HHoollddeerr IInncc..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G 1 2 General Journal Entries Memo Record 3 Other 4 Annual Comprehensive Postre!rement 5 Items Expense Cash Income—PSC Asset/Liability APBO Plan Assets 6 Balance, Jan. 1, 2014 290,000 410,000 120,000 7 Service cost (1) 56,000 8 Interest cost (2) 36,900 9 Actual/Expected return (3) 2,000 10 Contribu!ons 66,000 (4) 11 Benefits 5,000 5,000 12 Amor!za!on of PSC 3,000 (5) 13 Journal entry for 2014 (6) (7) (8) (9) 14 15 Accumulated OCI, Dec. 31, 2013 30,000 Dr. 16 Balance, Dec. 31, 2014 27,000 Dr. 314,900 Cr. 497,900 Cr. 183,000 Dr. 17 Instructions (a) Determine the missing amounts in the 2014 postretirement worksheet, indicating whether the amounts are debits or credits. (b) Prepare the journal entry to record 2014 postretirement expense for Holder Inc. (c) What discount rate is Holder using in accounting for the interest on its other postretirement benefit plan? Explain.

EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 5 6 P20-1 (2-Year Worksheet) On January 1, 2014, Harrington Company has the following defined benefit pension plan balances. 7 9 Projected benefi t obligation $4,500,000 Fair value of plan assets 4,200,000 The interest (settlement) rate applicable to the plan is 10%. On January 1, 2015, the company amends its pension agreement so that prior service costs of $500,000 are created. Other data related to the pension plan are as follows. 2014 2015 Service cost $150,000 $180,000 Prior service cost amortization –0– 90,000 Contributions (funding) to the plan 240,000 285,000 Benefi ts paid 200,000 280,000 Actual return on plan assets 252,000 260,000 Expected rate of return on assets 6% 8% 1240 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Instructions (a) Prepare a pension worksheet for the pension plan for 2014 and 2015. (b) For 2015, prepare the journal entry to record pension-related amounts. 5 6 P20-2 (3-Year Worksheet, Journal Entries, and Reporting) Jackson Company adopts acceptable account- 7 9 ing for its defined benefit pension plan on January 1, 2013, with the following beginning balances: plan assets $200,000; projected benefit obligation $250,000. Other data relating to 3 years’ operation of the plan are as follows. 2013 2014 2015 Annual service cost $16,000 $ 19,000 $ 26,000 Settlement rate and expected rate of return 10% 10% 10% Actual return on plan assets 18,000 22,000 24,000 Annual funding (contributions) 16,000 40,000 48,000 Benefi ts paid 14,000 16,400 21,000 Prior service cost (plan amended, 1/1/14) 160,000 Amortization of prior service cost 54,400 41,600 Change in actuarial assumptions establishes a December 31, 2015, projected benefi t obligation of: 520,000 Instructions (a) Prepare a pension worksheet presenting all 3 years’ pension balances and activities. (b) Prepare the journal entries (from the worksheet) to reflect all pension plan transactions and events at December 31 of each year. (c) Indicate the pension-related amounts reported in the financial statements for 2015. 6 7 P20-3 (Pension Expense, Journal Entries, Amortization of Loss) Gottschalk Company sponsors a de- 8 9 fined benefit plan for its 100 employees. On January 1, 2014, the company’s actuary provided the following information. Accumulated other comprehensive loss (PSC) $150,000 Pension plan assets (fair value and market-related asset value) 200,000 Accumulated benefi t obligation 260,000 Projected benefi t obligation 380,000 The average remaining service period for the participating employees is 10 years. All employees are expected to receive benefits under the plan. On December 31, 2014, the actuary calculated that the pres- ent value of future benefits earned for employee services rendered in the current year amounted to $52,000; the projected benefit obligation was $490,000; fair value of pension assets was $276,000; the accumulated benefit obligation amounted to $365,000. The expected return on plan assets and the dis- count rate on the projected benefit obligation were both 10%. The actual return on plan assets is $11,000. The company’s current year’s contribution to the pension plan amounted to $65,000. No benefits were paid during the year. Instructions (a) Determine the components of pension expense that the company would recognize in 2014. (With only one year involved, you need not prepare a worksheet.) (b) Prepare the journal entry to record the pension expense and the company’s funding of the pension plan in 2014. (c) Compute the amount of the 2014 increase/decrease in gains or losses and the amount to be amor- tized in 2014 and 2015. (d) Indicate the pension amounts reported in the financial statement as of December 31, 2014. 5 6 P20-4 (Pension Expense, Journal Entries for 2 Years) Gordon Company sponsors a defined benefit pension 7 8 plan. The following information related to the pension plan is available for 2014 and 2015. 2014 2015 Plan assets (fair value), December 31 $699,000 $849,000

Projected benefi t obligation, January 1 700,000 800,000 Pension asset/liability, January 1 140,000 Cr. ? Prior service cost, January 1 250,000 240,000 Service cost 60,000 90,000 Actual and expected return on plan assets 24,000 30,000 Amortization of prior service cost 10,000 12,000 Contributions (funding) 115,000 120,000 Accumulated benefi t obligation, December 31 500,000 550,000 Interest/settlement rate 9% 9% Problems 1241 Instructions (a) Compute pension expense for 2014 and 2015. (b) Prepare the journal entries to record the pension expense and the company’s funding of the pension plan for both years. 7 8 P20-5 (Computation of Pension Expense, Amortization of Net Gain or Loss–Corridor Approach, Journal Entries for 3 Years) Hiatt Toothpaste Company initiates a defined benefit pension plan for its 50 employees on January 1, 2014. The insurance company which administers the pension plan provided the following selected information for the years 2014, 2015, and 2016. For Year Ended December 31, 2014 2015 2016 Plan assets (fair value) $50,000 $ 85,000 $180,000 Accumulated benefi t obligation 45,000 165,000 292,000 Projected benefi t obligation 60,000 200,000 324,000 Net (gain) loss (for purposes of corridor calculation) –0– 78,400 86,121 Employer’s funding contribution (made at end of year) 50,000 60,000 105,000 There were no balances as of January 1, 2014, when the plan was initiated. The actual and expected return on plan assets was 10% over the 3-year period, but the settlement rate used to discount the company’s pension obligation was 13% in 2014, 11% in 2015, and 8% in 2016. The service cost component of net peri- odic pension expense amounted to the following: 2014, $60,000; 2015, $85,000; and 2016, $119,000. The aver- age remaining service life per employee is 12 years. No benefits were paid in 2014, $30,000 of benefits were paid in 2015, and $18,500 of benefits were paid in 2016 (all benefits paid at end of year). Instructions (Round to the nearest dollar.) (a) Calculate the amount of net periodic pension expense that the company would recognize in 2014, 2015, and 2016. (b) Prepare the journal entries to record net periodic pension expense, employer’s funding contribu- tion, and related pension amounts for the years 2014, 2015, and 2016. 6 7 P20-6 (Computation of Prior Service Cost Amortization, Pension Expense, Journal Entries, and Net 8 Gain or Loss) Aykroyd Inc. has sponsored a noncontributory, defined benefit pension plan for its employ- ees since 1991. Prior to 2014, cumulative net pension expense recognized equaled cumulative contributions to the plan. Other relevant information about the pension plan on January 1, 2014, is as follows. 1. The company has 200 employees. All these employees are expected to receive benefits under the plan. The average remaining service life per employee is 12 years. 2. The projected benefit obligation amounted to $5,000,000 and the fair value of pension plan assets was $3,000,000. The market-related asset value was also $3,000,000. Unrecognized prior service cost was $2,000,000. On December 31, 2014, the projected benefit obligation and the accumulated benefit obligation were $4,850,000 and $4,025,000, respectively. The fair value of the pension plan assets amounted to $4,100,000 at the end of the year. A 10% settlement rate and a 10% expected asset return rate were used in the actuarial present value computations in the pension plan. The present value of benefits attributed by the pension benefit formula to employee service in 2014 amounted to $200,000. The employer’s contribution to the plan assets amounted to $775,000 in 2014. This problem assumes no payment of pension benefits. Instructions (Round all amounts to the nearest dollar.) (a) Prepare a schedule, based on the average remaining life per employee, showing the prior service cost that would be amortized as a component of pension expense for 2014, 2015, and 2016. (b) Compute pension expense for the year 2014. (c) Prepare the journal entries required to report the accounting for the company’s pension plan for 2014.

(d) Compute the amount of the 2014 increase/decrease in net gains or losses and the amount to be amortized in 2014 and 2015. 5 6 P20-7 (Pension Worksheet) Hanson Corp. sponsors a defined benefit pension plan for its employees. On 7 January 1, 2014, the following balances related to this plan. Plan assets (market-related value) $520,000 Projected benefi t obligation 700,000 Pension asset/liability 180,000 Cr. Prior service cost 81,000 Net gain or loss (debit) 91,000 1242 Chapter 20 Accounting for Pensions and Postretirement Benefi ts As a result of the operation of the plan during 2014, the actuary provided the following additional data for 2014. Service cost $108,000 Settlement rate, 9%; expected return rate, 10% Actual return on plan assets 48,000 Amortization of prior service cost 25,000 Contributions 133,000 Benefi ts paid retirees 85,000 Average remaining service life of active employees 10 years Instructions Using the preceding data, compute pension expense for Hanson Corp. for the year 2014 by preparing a pension worksheet that shows the journal entry for pension expense. Use the market-related asset value to compute the expected return and for corridor amortization. 5 6 P20-8 (Comprehensive 2-Year Worksheet) Lemke Company sponsors a defined benefit pension plan for 7 8 its employees. The following data relate to the operation of the plan for the years 2014 and 2015. 9 2014 2015 Projected benefi t obligation, January 1 $600,000 Plan assets (fair value and market-related value), January 1 410,000 Pension asset/liability, January 1 190,000 Cr. Prior service cost, January 1 160,000 Service cost 40,000 $ 59,000 Settlement rate 10% 10% Expected rate of return 10% 10% Actual return on plan assets 36,000 61,000 Amortization of prior service cost 70,000 50,000 Annual contributions 97,000 81,000 Benefi ts paid retirees 31,500 54,000 Increase in projected benefi t obligation due to changes in actuarial assumptions 87,000 –0– Accumulated benefi t obligation at December 31 721,800 789,000 Average service life of all employees 20 years Vested benefi t obligation at December 31 464,000 Instructions (a) Prepare a pension worksheet presenting both years 2014 and 2015 and accompanying computations and amortization of the loss (2015) using the corridor approach. (b) Prepare the journal entries (from the worksheet) to reflect all pension plan transactions and events at December 31 of each year. (c) For 2015, indicate the pension amounts reported in the financial statements. 5 6 P20-9 (Comprehensive 2-Year Worksheet) Hobbs Co. has the following defined benefit pension plan 7 balances on January 1, 2014. Projected benefi t obligation $4,600,000 Fair value of plan assets 4,600,000 The interest (settlement) rate applicable to the plan is 10%. On January 1, 2015, the company amends its pension agreement so that prior service costs of $600,000 are created. Other data related to the pension plan are: 2014 2015 Service cost $150,000 $170,000 Prior service cost amortization –0– 90,000 Contributions (funding) to the plan 200,000 184,658 Benefi ts paid 220,000 280,000 Actual return on plan assets 252,000 350,000 Expected rate of return on assets 6% 8% Instructions (a) Prepare a pension worksheet for the pension plan in 2014. (b) Prepare any journal entries related to the pension plan that would be needed at December 31, 2014. (c) Prepare a pension worksheet for 2015 and any journal entries related to the pension plan as of December 31, 2015. (d) Indicate the pension-related amounts reported in the 2015 financial statements. Problems 1243 5 6 P20-10 (Pension Worksheet—Missing Amounts) Kramer Co. has prepared the following pension work- sheet. Unfortunately, several entries in the worksheet are not decipherable. The company has asked your 7 assistance in completing the worksheet and completing the accounting tasks related to the pension plan for 2014. PPeennssiioonn WWoorrkksshheeeett——KKrraammeerr CCoo..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G H 1 2 General Journal Entries Memo Record 3 Annual Pension Projected

4 Pension OCI—Prior OCI— Asset/ Benefit 5 Items Expense Cash Service Cost Gain/Loss Liability Obliga!on Plan Assets 6 Balance, Jan. 1, 2014 120,000 325,000 205,000 Dr. 7 Service cost (1) 20,000 8 Interest cost (2) 26,000 9 Actual return (3) 18,000 Dr. 10 Unexpected loss 2,500 (4) 11 Amor!za!on of PSC (5) 35,000 12 Contribu!ons 41,000 41,000 Dr. 13 Benefits 15,000 15,000 Cr. 14 Increase in PBO (6) 43,500 15 Journal entry for 2014 (7) (8) (9) (10) (11) 16 Accumulated OCI, Dec. 31, 2013 80,000 0 17 Balance, Dec. 31, 2014 45,000 46,000 150,500 Cr. 399,500 Cr. 249,000 Dr. 18 Instructions (a) Determine the missing amounts in the 2014 pension worksheet, indicating whether the amounts are debits or credits. (b) Prepare the journal entry to record 2014 pension expense for Kramer Co. (c) Determine the following for Kramer for 2014: (1) settlement rate used to measure the interest on the liability and (2) expected return on plan assets. 5 6 P20-11 (Pension Worksheet) The following data relate to the operation of Kramer Co.’s pension plan in 7 8 2015. The pension worksheet for 2014 is provided in P20-10. 9 Service cost $59,000 Actual return on plan assets 32,000 Amortization of prior service cost 28,000 Annual contributions 51,000 Benefi ts paid retirees 27,000 Average service life of all employees 25 years For 2015, Kramer will use the same assumptions as 2014 for the expected rate of returns on plan assets. The settlement rate for 2015 is 10%. Instructions (a) Prepare a pension worksheet for 2015 and accompanying computations and amortization of the loss, if any, in 2015 using the corridor approach. (b) Prepare the journal entries (from the worksheet) to reflect all pension plan transactions and events at December 31. (c) Indicate the pension amounts reported in the financial statements. 5 6 P20-12 (Pension Worksheet) Larson Corp. sponsors a defined benefit pension plan for its employees. On 7 8 January 1, 2015, the following balances related to this plan. 9 Plan assets (market-related value) $270,000 Projected benefi t obligation 340,000 Pension asset/liability 70,000 Cr. Prior service cost 90,000 OCI—Loss 39,000 1244 Chapter 20 Accounting for Pensions and Postretirement Benefi ts As a result of the operation of the plan during 2015, the actuary provided the following additional data for 2015. Service cost $45,000 Actual return on plan assets 27,000 Amortization of prior service cost 12,000 Contributions 65,000 Benefi ts paid retirees 41,000 Settlement rate 7% Expected return on plan assets 8% Average remaining service life of active employees 10 years Instructions (a) Compute pension expense for Larson Corp. for the year 2015 by preparing a pension worksheet that shows the journal entry for pension expense. (b) Indicate the pension amounts reported in the financial statements. 10 11 * P20-13 (Postretirement Benefit Worksheet) Hollenbeck Foods Inc. sponsors a postretirement medical and dental benefit plan for its employees. The following balances relate to this plan on January 1, 2014. Plan assets $200,000 Expected postretirement benefi t obligation 820,000 Accumulated postretirement benefi t obligation 200,000 No prior service costs exist. As a result of the plan’s operation during 2014, the following additional data are provided by the actuary. Service cost is $70,000 Discount rate is 10% Contributions to plan are $65,000 Expected return on plan assets is $10,000 Actual return on plan assets is $15,000 Benefi ts paid to employees are $44,000 Average remaining service to full eligibility: 20 years Instructions (a) Using the preceding data, compute the net periodic postretirement benefit cost for 2014 by prepar- ing a worksheet that shows the journal entry for postretirement expense and the year-end balances in the related postretirement benefit memo accounts. (Assume that contributions and benefits are paid at the end of the year.) (b) Prepare any journal entries related to the postretirement plan for 2014 and indicate the postretire- ment amounts reported in the financial statements for 2014. 10 11 *P 20-14 (Postretirement Benefit Worksheet—2 Years) Elton Co. has the following postretirement benefit

plan balances on January 1, 2014. Accumulated postretirement benefi t obligation $2,250,000 Fair value of plan assets 2,250,000 The interest (settlement) rate applicable to the plan is 10%. On January 1, 2015, the company amends the plan so that prior service costs of $175,000 are created. Other data related to the plan are: 2014 2015 Service costs $ 75,000 $ 85,000 Prior service costs amortization –0– 12,000 Contributions (funding) to the plan 45,000 35,000 Benefi ts paid 40,000 45,000 Actual return on plan assets 140,000 120,000 Expected rate of return on assets 8% 6% Instructions (a) Prepare a worksheet for the postretirement plan in 2014. (b) Prepare any journal entries related to the postretirement plan that would be needed at December 31, 2014. (c) Prepare a worksheet for 2015 and any journal entries related to the postretirement plan as of December 31, 2015. (d) Indicate the postretirement-benefit–related amounts reported in the 2015 financial statements. Concepts for Analysis 1245 PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. CONCEPTS FOR ANALYSIS CA20-1 (Pension Terminology and Theory) Many business organizations have been concerned with providing for the retirement of employees since the late 1800s. During recent decades, a marked increase in this concern has resulted in the establishment of private pension plans in most large companies and in many medium- and small-sized ones. The substantial growth of these plans, both in numbers of employees covered and in amounts of retire- ment benefits, has increased the significance of pension costs in relation to the financial position, results of operations, and cash flows of many companies. In examining the costs of pension plans, a CPA encounters certain terms. The components of pension costs that the terms represent must be dealt with appropriately if generally accepted accounting principles are to be reflected in the financial statements of entities with pension plans. Instructions (a) Define a private pension plan. How does a contributory pension plan differ from a noncontributory plan? (b) Differentiate between “accounting for the employer” and “accounting for the pension fund.” (c) Explain the terms “funded” and “pension liability” as they relate to: (1) The pension fund. (2) The employer. (d) (1) Discuss the theoretical justification for accrual recognition of pension costs. (2) D iscuss the relative objectivity of the measurement process of accrual versus cash (pay-as-you-go) accounting for annual pension costs. (e) Distinguish among the following as they relate to pension plans. (1) Service cost. (2) Prior service costs. (3) Vested benefits. CA20-2 (Pension Terminology) The following items appear on Brueggen Company’s financial statements. 1. Under the caption Assets: Pension asset/liability. 2. Under the caption Liabilities: Pension asset/liability. 3. Under the caption Stockholders’ Equity: Prior service cost as a component of Accumulated Other Comprehensive Income. 4. On the income statement: Pension expense. Instructions Explain the significance of each of the items above on corporate financial statements. (Note: All items set forth above are not necessarily to be found on the statements of a single company.) CA20-3 (Basic Terminology) In examining the costs of pension plans, Helen Kaufman, CPA, encounters certain terms. The components of pension costs that the terms represent must be dealt with appropriately if generally accepted accounting principles are to be reflected in the financial statements of entities with pension plans. Instructions (a) (1) Discuss the theoretical justification for accrual recognition of pension costs. (2) D iscuss the relative objectivity of the measurement process of accrual versus cash (pay-as-you- go) accounting for annual pension costs. (b) Explain the following terms as they apply to accounting for pension plans. (1) Market-related asset value. (2) Projected benefit obligation. (3) Corridor approach. 1246 Chapter 20 Accounting for Pensions and Postretirement Benefi ts

(c) What information should be disclosed about a company’s pension plans in its financial statements and its notes? (AICPA adapted) CA20-4 (Major Pension Concepts) Davis Corporation is a medium-sized manufacturer of paperboard containers and boxes. The corporation sponsors a noncontributory, defined benefit pension plan that covers its 250 employees. Sid Cole has recently been hired as president of Davis Corporation. While reviewing last year’s financial statements with Carol Dilbeck, controller, Cole expressed confusion about several of the items in the footnote to the financial statements relating to the pension plan. In part, the footnote reads as follows. Note J. The company has a defined benefit pension plan covering substantially all of its employees. The benefits are based on years of service and the employee’s compensation during the last four years of employment. The company’s funding policy is to contribute annually the maximum amount al- lowed under the federal tax code. Contributions are intended to provide for benefits expected to be earned in the future as well as those earned to date. The net periodic pension expense on Davis Corporation’s comparative income statement was $72,000 in 2014 and $57,680 in 2013. The following are selected figures from the plan’s funded status and amounts recognized in the Davis Corporation’s Statement of Financial Position at December 31, 2014 ($000 omitted). Actuarial present value of benefi t obligations: Accumulated benefi t obligation (including vested benefi ts of $636) $ (870) Projected benefi t obligation $(1,200) Plan assets at fair value 1,050 Projected benefi t obligation in excess of plan assets $ (150) Given that Davis Corporation’s work force has been stable for the last 6 years, Cole could not under- stand the increase in the net periodic pension expense. Dilbeck explained that the net periodic pension expense consists of several elements, some of which may increase or decrease the net expense. Instructions (a) The determination of the net periodic pension expense is a function of five elements. List and briefly describe each of the elements. (b) Describe the major difference and the major similarity between the accumulated benefit obligation and the projected benefit obligation. (c) (1) E xplain why pension gains and losses are not recognized on the income statement in the period in which they arise. (2) Briefly describe how pension gains and losses are recognized. (CMA adapted) CA20-5 (Implications of GAAP Rules on Pensions) Jill Vogel and Pete Dell have to do a class presenta- tion on GAAP rules for reporting pension information. In developing the class presentation, they decided to provide the class with a series of questions related to pensions and then discuss the answers in class. Given that the class has all read the rules related to pension accounting and reporting, they felt this approach would provide a lively discussion. Here are the questions: 1. In an article in BusinessWeek prior to new rules related to pensions, it was reported that the discount rates used by the largest 200 companies for pension reporting ranged from 5% to 11%. How can such a situation exist, and does GAAP alleviate this problem? 2. An article indicated that when new GAAP rules were issued related to pensions, it caused an in- crease in the liability for pensions for approximately 20% of companies. Why might this situation occur? 3. A recent article noted that while “smoothing” is not necessarily an accounting virtue, pension ac- counting has long been recognized as an exception—an area of accounting in which at least some dampening of market swings is appropriate. This is because pension funds are managed so that their performance is insulated from the extremes of short-term market swings. A pension expense that reflects the volatility of market swings might, for that reason, convey information of little rele- vance. Are these statements true? Concepts for Analysis 1247 4. Understanding the impact of the changes required in pension reporting requires detailed informa-

tion about its pension plan(s) and an analysis of the relationship of many factors, particularly the: (a) Type of plan(s) and any significant amendments. (b) Plan participants. (c) Funding status. (d) Actuarial funding method and assumptions currently used. What impact does each of these items have on financial statement presentation? 5. An article noted “You also need to decide whether to amortize gains and losses using the corridor method, or to use some other systematic method. Under the corridor approach, only gains and losses in excess of 10% of the greater of the projected benefit obligation or the plan assets would have to be amortized.” What is the corridor method and what is its purpose? Instructions What answers do you believe Jill and Pete gave to each of these questions? CA20-6 (Gains and Losses, Corridor Amortization) Vickie Plato, accounting clerk in the personnel office of Streisand Corp., has begun to compute pension expense for 2016 but is not sure whether or not she should include the amortization of unrecognized gains/losses. She is currently working with the following beginning-of-the-year present values for the projected benefit obligation and market-related values for the pension plan: Projected Plan Benefit Assets Obligation Value 2013 $2,200,000 $1,900,000 2014 2,400,000 2,500,000 2015 2,900,000 2,600,000 2016 3,900,000 3,000,000 The average remaining service life per employee in 2013 and 2014 is 10 years and in 2015 and 2016 is 12 years. The net gain or loss that occurred during each year is as follows. 2013 $280,000 loss 2014 85,000 loss 2015 12,000 loss 2016 25,000 gain (In working the solution, you must aggregate the unrecognized gains and losses to arrive at year-end balances.) Instructions You are the manager in charge of accounting. Write a memo to Vickie Plato, explaining why in some years she must amortize some of the net gains and losses and in other years she does not need to. In order to explain this situation fully, you must compute the amount of net gain or loss that is amortized and charged to pension expense in each of the 4 years listed above. Include an appropriate amortization schedule, refer- ring to it whenever necessary. CA20-7 (Nonvested Employees—An Ethical Dilemma) Thinken Technology recently merged with College Electronix (CE), a computer graphics manufacturing firm. In performing a comprehensive audit of CE’s accounting system, Gerald Ott, internal audit manager for Thinken Technology, discovered that the new subsidiary did not record pension assets and liabilities, subject to GAAP. The net present value of CE’s pension assets was $15.5 million, the vested benefit obligation was $12.9 million, and the projected benefit obligation was $17.4 million. Ott reported this audit finding to Julie Habbe, the newly appointed controller of CE. A few days later, Habbe called Ott for his advice on what to do. Habbe started her conversation by asking, “Can’t we eliminate the negative income effect of our pension dilemma simply by terminating the employment of nonvested employees before the end of our fiscal year?” Instructions How should Ott respond to Habbe’s remark about firing nonvested employees? 1248 Chapter 20 Accounting for Pensions and Postretirement Benefi ts USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) What kind of pension plan does P&G provide its employees in the United States? (b) What was P&G’s pension expense for 2011, 2010, and 2009 for the United States? (c) What is the impact of P&G’s pension plans for 2011 on its financial statements? (d) What information does P&G provide on the target allocation of its pension assets? (Compare the asset allocation for “Pensions and Other Retiree Benefits.”) How do the allocations relate to the expected

returns on these assets? Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What kind of pension plans do Coca-Cola and PepsiCo provide their employees? (b) What net periodic pension expense (cost) did Coca-Cola and PepsiCo report in 2011? (c) What is the year-end 2011 funded status of Coca-Cola’s and PepsiCo’s U.S. plans? (d) What relevant rates were used by Coca-Cola and PepsiCo in computing their pension amounts? (e) Compare the expected benefit payments and contributions for Coca-Cola and PepsiCo. *Financial Statement Analysis Case General Electric A Wall Street Journal article discussed a $1.8 billion charge to income made by General Electric for post- retirement benefit costs. It was attributed to previously unrecognized healthcare and life insurance cost. As financial vice president and controller for Peake, Inc., you found this article interesting because the presi- dent recently expressed interest in adopting a postemployment benefit program for Peake’s employees, to complement the company’s existing defined benefit plan. The president, Martha Beyerlein, wants to know how the expense on the new plan will be determined and what impact the accounting for the plan will have on Peake’s financial statements. Instructions (a) As financial vice president and controller of Peake, Inc., explain the calculation of postemployment benefit expense under GAAP, and indicate how the accounting for the plan will affect Peake’s financial statements. (b) Discuss the similarities and differences in the accounting for the other postemployment benefit plan relative to the accounting for the defined benefit plan. Accounting, Analysis, and Principles PENCOMP’s balance sheet at December 31, 2014, is as follows. Using Your Judgment 1249 PENCOMP, INC. BALANCE SHEET AS OF DECEMBER 31, 2014 Assets Liabilities Cash $ 438 Notes payable $1,000 Inventory 1,800 Pension liability 344 Total current assets 2,238 Total liabilities 1,344 Plant and equipment 2,000 Stockholders’ equity Accumulated depreciation (240) Common stock 2,000 1,760 Retained earnings 896 Accumulated other comprehensive income (242) Total assets $3,998 Total stockholders’ equity 2,654 Total liabilities and stockholders’ equity $3,998 Additional information concerning PENCOMP’s defi ned benefi t pension plan is as follows. Projected benefi t obligation at 12/31/14 $ 820.5 Plan assets (fair value) at 12/31/14 476.5 Unamortized past service cost at 12/31/14 150.0 Amortization of past service cost during 2015 15.0 Service cost for 2015 42.0 Discount rate 10% Expected rate of return on plan assets in 2015 12% Actual return on plan assets in 2015 10.4 Contributions to pension fund in 2015 70.0 Benefi ts paid during 2015 40.0 Unamortized net loss due to changes in actuarial assumptions and deferred net losses on plan assets at 12/31/14 92.0 Expected remaining service life of employees 15.0 Average period to vesting of prior service costs 10.0 Other information about PENCOMP is as follows. Salary expense, all paid with cash during 2015 $ 700.0 Sales, all for cash 3,000.0 Purchases, all for cash 2,000.0 Inventory at 12/31/15 1,800.0 Property originally cost $2,000 and is depreciated on a straight-line basis over 25 years with no residual value. Interest on the note payable is 10% annually and is paid in cash on 12/31 of each year. Dividends declared and paid are $200 in 2015. Accounting Prepare an income statement for 2015 and a balance sheet as of December 31, 2015. Also, prepare the pension expense journal entry for the year ended December 31, 2015. Round to the nearest tenth (e.g., round 2.87 to 2.9). Analysis Compute return on equity for PENCOMP for 2015 (assume stockholders’ equity is equal to year-end aver- age stockholders’ equity). Do you think an argument can be made for including some or even all of the change in accumulated other comprehensive income (due to pensions) in the numerator of return on

equity? Illustrate that calculation. Principles Explain a rationale for why the FASB has (so far) decided to exclude from the current period income statement the effects of pension plan amendments and gains and losses due to changes in actuarial as- sumptions. 1250 Chapter 20 Accounting for Pensions and Postretirement Benefi ts BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation Monat Company has grown rapidly since its founding in 2004. To instill loyalty in its employees, Monat is contemplating establishment of a defined benefit plan. Monat knows that lenders and potential investors will pay close attention to the impact of the pension plan on the company’s financial statements, particu- larly any gains or losses that develop in the plan. Monat has asked you to conduct some research on the accounting for gains and losses in a defined benefit plan. Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) Briefly describe how pension gains and losses are accounted for. (b) Explain the rationale behind the accounting method described in part (a). (c) What is the related pension asset or liability that will show up on the balance sheet? When will each of these situations occur? Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS The accounting for various forms of compensation plans under IFRS is found LEARNING OBJECTIVE 12 in IAS 19 (“Employee Benefits”) and IFRS 2 (“Share-Based Payment”). IAS 19 Compare the accounting for pensions addresses the accounting for a wide range of compensation elements—wages, under GAAP and IFRS. bonuses, postretirement benefits, and compensated absences. The underlying concepts for the accounting for postretirement benefits are similar between GAAP and IFRS—both GAAP and IFRS view pensions and other postretirement benefits as forms of deferred compensation. At present, there are significant differences in the specific accounting provisions as applied to these plans. RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to pensions. Similarities • IFRS and GAAP separate pension plans into defi ned contribution plans and defi ned benefi t plans. The accounting for defi ned contribution plans is similar. • IFRS and GAAP recognize a pension asset or liability as the funded status of the plan (i.e., defi ned benefi t obligation minus the fair value of plan assets). (Note that defi ned benefi t obligation is referred to as the projected benefi t obligation in GAAP.) • IFRS and GAAP compute unrecognized past service cost (PSC) (referred to as prior service cost in GAAP) in the same manner. However, IFRS recognizes past service cost as a component of pension expense in income immediately. GAAP amortizes PSC over the remaining service lives of employees. IFRS Insights 1251 Differences • IFRS and GAAP include interest expense on the liability in pension expense. Regard- ing asset returns, IFRS reduces pension expense by the amount of interest revenue (based on the discount rate times the beginning value of pension assets). GAAP in- cludes an asset return component based on the expected return on plan assets. • Under IFRS, companies recognize both liability and asset gains and losses (referred to as remeasurements) in other comprehensive income. These gains and losses are not “recycled” into income in subsequent periods. GAAP recognizes liability and asset gains and losses in “Accumulated other comprehensive income” and amortizes these amounts to income over remaining service lives, using the “corridor approach.” • The accounting for pensions and other postretirement benefi t plans is the same under IFRS. GAAP has separate standards for these types of benefi ts, and signifi cant differ- ences exist in the accounting. ABOUT THE NUMBERS Accounting for Pensions

Net Defi ned Benefi t Obligation (Asset) As in GAAP, under IFRS the net defined benefit liability (asset) is the deficit or surplus related to a defined benefit pension plan. The deficit or surplus is measured as follows. Defined Benefit Obligation 2 Fair Value of Plan Assets (if any) The deficit or surplus is often referred to as the funded status of the plan. If the defined benefit obligation is greater than the plan assets, the pension plan has a deficit. Conversely, if the defined pension obligation is less than the plan assets, the pension plan has a surplus. Illustration IFRS20-1 shows these relationships. ILLUSTRATION Deficit Surplus IFRS20-1 Defined benefit obligation $1,000,000 Defined benefit obligation $150,000 Presentation of Funded Plan assets 900,000 Plan assets 200,000 Status Net defined benefit obligation $ 100,000 Net defined benefit asset $ 50,000 The net defined benefit obligation (asset) is often referred to simply as the pension liability or the pension asset on the statement of financial position. As indicated, companies should report either a pension asset or pension liability related to a pension plan on the statement of financial position (often referred to as the net approach). To illustrate, assume that at year-end Acer Company has a defined pension obligation of $4,000,000 and plan assets of $3,700,000. In this case, Acer reports $300,000 ($4,000,000 2 $3,700,000) as a pension liability on its statement of financial position. Some believe that companies should report separately both the defined benefit obligation and the plan assets on the statement of financial position. This approach (of- ten referred to as the gross approach) would report Acer’s defined benefit obligation of $4,000,000 and its plan assets of $3,700,000 on the statement of financial position. The IASB disagrees, indicating that offsetting these amounts is consistent with its standard on when assets and liabilities should be netted.28 28IAS 32 states that a financial asset and a financial liability should be offset and the net amount reported in the statement of financial position when a company (a) has a legally enforceable right to set off the recognized amounts and (b) intends either to settle on a net basis, or to realize the asset and settle it simultaneously. 1252 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Reporting Changes in the Defi ned Benefi t Obligation (Asset) The IASB requires that all changes in the defined benefit obligation and plan assets in the current period be recognized in comprehensive income. The Board believes that im- mediate recognition of the effects of these changes in the statement of comprehensive income provides the most understandable and useful information to financial statement users. The IASB requires that companies report changes arising from different elements of pension liabilities and assets in different sections of the statement of comprehensive income, depending on their nature. In the past, companies often reported only a single pension expense number in the comprehensive income statement. Providing additional segmentation of the compo- nents of pension cost provides additional transparency about the nature of these costs. The three components are as follows. • Service cost. Service cost is either current service cost or past service cost. Current service cost is the increase in the present value of the defi ned benefi t obligation from employee service in the current period. Past service cost is the change in the present value of the defi ned benefi t obligation for employee service for prior periods—generally resulting from a plan amendment (e.g., changes to the plan). This component is reported in the statement of comprehensive income in the operating section of the statement and affects net income. • Net interest. Net interest is computed by multiplying the discount rate by the funded status of the plan (defi ned benefi t obligation minus plan assets). If the plan has a net defi ned benefi t obligation at the end of the period, the company reports interest

expense. Conversely, if it has a net defi ned benefi t asset, it reports interest revenue. This approach is justifi ed on the basis of its simplicity and that any fi nancing costs should be based on the funded status of the plan. This amount is often shown below the oper- ating section of the income statement in the fi nancing section and affects net income. • Remeasurements. Remeasurements are gains and losses related to the defi ned benefi t obligation (changes in discount rate or other actuarial assumptions) and gains or losses on the fair value of the plan assets (actual rate of return less interest revenue included in the fi nance component). This component is reported in other comprehensive in- come, net of tax. These remeasurement gains or losses therefore affect comprehen- sive income but not net income. Illustration IFRS20-2 shows the components of changes in the pension liability (asset) and their placement on the statement of comprehensive income. ILLUSTRATION IFRS20-2 Reporting Changes in the Service Cost Pension Obligation (Assets) Net Income Net Interest Interest expense greater than interest revenue or Interest expense less than interest revenue Remeasurements Other Comprehensive Income IFRS Insights 1253 As indicated in Illustration IFRS20-2, service cost and net interest are reported in net income. We discuss determination of each of these components in the following section. Remeasurements, which are reported in other comprehensive income, are discussed in a later section. Service Cost. To determine current service cost and the related increase in the defined benefit obligation, companies must: 1. Apply an actuarial valuation method. 2. Assign benefi ts to period of service. 3. Make actuarial assumptions.29 In applying an actuarial valuation method, the IASB concluded that companies must consider future compensation levels in measuring the present obligation and periodic pension expense if the plan benefit formula incorporates them. In other words, the present obligation resulting from a promise to pay a benefit of 1 percent of an employee’s final pay differs from the promise to pay 1 percent of current pay. To over- look this fact is to ignore an important aspect of pension expense. Thus, the Board adopts the projected unit credit method (often referred to as the benefits/years-of-service method), which determines pension expense based on future salary levels. Some object to this determination, arguing that a company should have more free- dom to select an expense recognition pattern. Others believe that incorporating future salary increases into current pension expense is accounting for events that have not yet happened. They argue that if a company terminates the plan today, it pays only liabili- ties for accumulated benefits. Nevertheless, the IASB indicates that the defined ben- efit obligation provides a more realistic measure of the employer’s obligation under the plan on a going concern basis and, therefore, companies should use it as the basis for determining service cost. The assignment of benefits to periods of service is based on the actuarial valuation method. The actuary then allocates the cost of the pension benefits over the expected service life of the company’s employees. In determining the proper service cost for a period, the actuary makes actuarial assumptions related to such factors as mortality; rates of employee turnover, disability, and early retirement; discount rate; benefit levels; and future salary levels. While IAS 19 does not require use of an actuary, given the com- plexity of these estimates, just about all companies rely on an actuary to determine service cost and related other defined benefit measures. Net Interest. In computing net interest, companies assume that the discount rate, the net defined benefit obligation, and the pension asset are determined at the beginning of the year.30 The discount rate is based on the yields of high-quality bonds with terms consis- tent with the company’s pension obligation. Net interest is then computed as indicated

in the following equation. Net Interest 5 (Defined Benefit Obligation 3 Discount Rate) 2 (Plan Assets 3 Discount Rate) 29As indicated earlier, service cost is comprised of current and past service cost. Determination of past service cost is based on the same actuarial valuation model as that used for current service cost. We discuss recognition of past service cost in a later section. 30The IASB indicates that if the beginning of the year amount changes materially (due to contributions to or payments out of the plan), an adjustment to the beginning balances should be made. For homework purposes, unless information indicates that balances have changed materially, use the beginning of the year balances. 1254 Chapter 20 Accounting for Pensions and Postretirement Benefi ts That is, net interest is determined by multiplying the net defined pension obligation (asset) by the discount rate. Because payment of the pension obligation is deferred, companies record the pen- sion liability on a discounted basis. As a result, the liability accrues interest over the service life of the employee (passage of time), which is essentially interest expense (interest on the liability). Similarly, companies earn a return on their plan assets. That is, a company assumes that it earns interest based on multiplying the discount rate by the plan assets. While the IASB recognizes that the actual return on plan assets may differ from the assumed interest revenue computed, it believes that the change in plan assets can be divided into an amount that arises from the passage of time and amounts that arise from other changes. As we discuss in the next section, changes not related to the passage of time are reported in other comprehensive income as remeasurements. Thus, the growth in the plan assets should mirror the growth in the defined benefit obligation. In other words, the assumed interest revenue on the plan assets based on the passage of time offsets the interest expense on the defined benefit obligation. In summary, pension expense is comprised of two components: (1) service cost and (2) net interest. Companies report each of these components in the statement of compre- hensive income. In some cases, companies may choose to report these components in one section of the statement of comprehensive income and report total pension expense. Other companies may choose to report the service cost component in operating income and the net interest in a separate section related to financing.31 Plan Assets and Actual Return Pension plan assets are usually investments in shares, bonds, other securities, and real estate that a company holds to earn a reasonable rate of return. Plan assets are reported at fair value. Companies generally hold these assets in a separate legal entity (a pension fund) that exists only to administer the employee benefit plan. These assets held by the pension fund are therefore not available to the company’s own creditors (even in bank- ruptcy). Employer contributions and the actual return on plan assets increase pension plan assets. Actual return on plan assets is the increase in the pension fund assets aris- ing from interest, dividends, and realized and unrealized changes in the fair value of the plan. Benefits paid to retired employees decrease plan assets. To illustrate, assume that Hasbro Company has pension plan assets of $4,200,000 on January 1, 2014. During 2014, Hasbro contributed $300,000 to the plan and paid out re- tirement benefits of $250,000. Its actual return on plan assets was $210,000 for the year. Hasbro’s plan assets at December 31, 2014, are $4,460,000, computed as shown in Illus- tration IFRS20-3. ILLUSTRATION Plan assets, January 1, 2014 $4,200,000 IFRS20-3 Contributions by Hasbro to plan 300,000 Determination of Pension Actual return 210,000 Assets Benefits paid to employees (250,000) Plan assets, December 31, 2014 $4,460,000 In some cases, companies compute the actual return by adjusting the change in plan assets for the effect of contributions during the year and benefits paid during the year.

The equation in Illustration IFRS20-4, or a variation thereof, can be used to compute the actual return. 31The IASB does not provide guidance on which of these two approaches is preferred. For homework purposes, report pension expense as a single total in income from operations in the statement of comprehensive income. IFRS Insights 1255 ILLUSTRATION Plan Plan IFRS20-4 Actual Assets Assets Return5 Ending 2 Beginning 2 (Contributions 2 Benefits Paid) Equation for Computing gBalance Balance h Actual Return Stated another way, the actual return on plan assets is the difference between the fair value of the plan assets at the beginning of the period and at the end of the period, ad- justed for contributions and benefit payments. Illustration IFRS20-5 uses the equation above to compute actual return, using the information provided in Illustration IFRS20-3. ILLUSTRATION Plan assets, December 31, 2014 $4,460,000 IFRS20-5 Plan assets, January 1, 2014 (4,200,000) Computation of Actual Increase in fair value of plan assets 260,000 Return on Plan Assets Deduct: Contributions to plan $300,000 Add: Benefit payments to employees 250,000 (50,000) Actual return $ 210,000 In this case, Hasbro has a positive actual return on plan assets. Recently, some pension plans have experienced negative actual returns due to the increased volatility in global securities markets. Using a Pension Worksheet We will now illustrate the basic computation of pension expense using the first two components: (1) service cost and (2) net interest. We discuss remeasurements in later sections. Companies often use a worksheet to record pension-related information. As its name suggests, the worksheet is a working tool. A worksheet is not a permanent ac- counting record: It is neither a journal nor part of the general ledger. The worksheet is merely a device to make it easier to prepare entries and the financial statements.32 Illus- tration IFRS20-6 shows the format of the pension worksheet. PPeennssiioonn WWoorrkksshheeeett..xxllss ILLUSTRATION IFRS20-6 Home Insert Page Layout Formulas Data Review View P18 fx Basic Format of Pension A B C D E F Worksheet 1 2 General Journal Entries Memo Record 3 Annual Pension Defined 4 Pension Asset/ Benefit 5 Items Expense Cash Liability Obliga!on Plan Assets 6 7 8 9 10 The “General Journal Entries” columns of the worksheet (near the left side) determine the entries to record in the formal general ledger accounts. The “Memo Record” columns 32The use of a pension entry worksheet is recommended and illustrated by Paul B. W. Miller, “The New Pension Accounting (Part 2),” Journal of Accountancy (February 1987), pp. 86–94. 1256 Chapter 20 Accounting for Pensions and Postretirement Benefi ts (on the right side) maintain balances in the defined benefit obligation and the plan assets. The difference between the defined benefit obligation and the fair value of the plan assets is the pension asset/liability, which is shown in the statement of financial position. If the defined benefit obligation is greater than the plan assets, a pension liability occurs. If the defined benefit obligation is less than the plan assets, a pension asset occurs. On the first line of the worksheet, a company enters the beginning balances (if any). It then records subsequent transactions and events related to the pension plan using debits and credits, using both sets of columns as if they were one. For each transaction or event, the debits must equal the credits. The ending balance in the Pension Asset/ Liability column should equal the net balance in the memo record. 2014 Entries and Worksheet To illustrate the use of a worksheet and how it helps in accounting for a pension plan, assume that on January 1, 2014, Zarle Company provides the following information related to its pension plan for the year 2014. Plan assets, January 1, 2014, are $100,000. Defi ned benefi t obligation, January 1, 2014, is $100,000. Annual service cost is $9,000. Discount rate is 10 percent. Funding contributions are $8,000. Benefi ts paid to retirees during the year are $7,000.

Using the data presented above, the worksheet in Illustration IFRS20-7 presents the beginning balances and all of the pension entries recorded by Zarle in 2014. Zarle records the beginning balances for the defined benefit obligation and the pension plan assets on the first line of the worksheet in the memo record. Because the defined benefit obligation and the plan assets are the same at January 1, 2014, the Pension Asset/Liabil- ity account has a zero balance at January 1, 2014. Entry (a) in Illustration IFRS20-7 records the service cost component, which in- creases pension expense by $9,000 and increases the liability (defined benefit obligation) ILLUSTRATION PPeennssiioonn WWoorrkksshheeeett——22001144..xxllss IFRS20-7 Home Insert Page Layout Formulas Data Review View Pension P18 fx Worksheet—2014 A B C D E F 1 2 General Journal Entries Memo Record 3 Annual Pension Defined 4 Pension Asset/ Benefit 5 Items Expense Cash Liability Obliga!on Plan Assets 6 Balance, Jan. 1, 2014 — 100,000 Cr. 100,000 Dr. 7 (a) Service cost 9,000 Dr. 9,000 Cr. 8 (b) Interest expense 10,000 Dr. 10,000 Cr. 9 (c) Interest revenue 10,000 Cr. 10,000 Dr. 10 (d) Contribu!ons 8,000 Cr. 8,000 Dr. 11 (e) Benefits 7,000 Dr. 7,000 Cr. 12 13 Journal entry for 2014 9,000 Dr. 8,000 Cr. 1,000 Cr.* 14 Balance, Dec. 31, 2014 1,000 Cr.** 112,000 Cr. 111,000 Dr. 15 16 *$9,000 – $8,000 = $1,000 17 **$112,000 – $111,000 = $1.000 IFRS Insights 1257 by $9,000. Entry (b) accrues the interest expense component, which increases both the liability and the pension expense by $10,000 (the beginning defined benefit obligation multiplied by the discount rate of 10 percent). Entry (c) records the interest revenue component, which increases plan assets and decreases pension expense by $10,000. This is computed by multiplying the beginning plan assets by the discount rate of 10 percent. As a result, net interest expense (income) is zero in 2014. Entry (d) records Zarle’s con- tribution (funding) of assets to the pension fund, thereby decreasing cash by $8,000 and increasing plan assets by $8,000. Entry (e) records the benefit payments made to retirees, which results in equal $7,000 decreases to the plan assets and the defined benefit obligation. Zarle makes the “formal journal entry” on December 31, which records the pension expense in 2014, as follows. 2014 Pension Expense 9,000 Cash 8,000 Pension Asset/Liability 1,000 The credit to Pension Asset/Liability for $1,000 represents the difference between the 2014 pension expense of $9,000 and the amount funded of $8,000. Pension Asset/ Liability (credit) is a liability because Zarle underfunds the plan by $1,000. The Pension Asset/Liability account balance of $1,000 also equals the net of the balances in the memo accounts. Illustration IFRS20-8 shows that the defined benefit obligation exceeds the plan assets by $1,000, which reconciles to the pension liability reported in the statement of financial position. ILLUSTRATION Defined benefit obligation (Credit) $(112,000) IFRS20-8 Plan assets at fair value (Debit) 111,000 Pension Reconciliation Pension asset/liability (Credit) $ (1,000) Schedule—December 31, 2014 If the net of the memo record balances is a credit, the reconciling amount in the Pension Asset/Liability column will be a credit equal in amount. If the net of the memo record balances is a debit, the Pension Asset/Liability amount will be a debit equal in amount. The worksheet is designed to produce this reconciling feature, which is useful later in the preparation of the financial statements and required note disclosure related to pensions. In this illustration (for 2014), the debit to Pension Expense exceeds the credit to Cash, resulting in a credit to Pension Asset/Liability—the recognition of a liability. If the credit to Cash exceeded the debit to Pension Expense, Zarle would debit Pension Asset/ Liability—the recognition of an asset.33 Past Service Cost Past service cost is the change in the present value of the defined benefit obligation resulting from a plan amendment or a curtailment.34 For example, a plan amendment

arises when a company decides to provide additional benefits to existing employees 33The IASB in IAS 19 limits the amount of a pension asset that is recognized, based on a recover- ability test. This test, which has been further clarified in IFRIC 14, limits the amount of the pension asset to the sum of unrecognized actuarial gains and losses (discussed later) and amounts that will be received by the company in the form of refunds or reduction of future contributions. For purposes of homework, assume that a pension asset, if present, meets the criteria for full recognition. 34The IASB also indicates that gains and losses on non-routine settlements are considered past service costs. A settlement is a payment of benefits that is not set out in the terms of the plan. 1258 Chapter 20 Accounting for Pensions and Postretirement Benefi ts for past service. Conversely, the company may decide that it is necessary to reduce its benefit package retroactively for existing employees, thereby reducing their pension benefit. A curtailment occurs when the company has a significant reduction in the number of employees covered by the plan. Because a curtailment has the same effect as a reduction in benefits due to an amendment to the plan, these situations are accounted for in the same way. Illustration IFRS20-9 summarizes the nature of past service costs. ILLUSTRATION PAST SERVICE COSTS IFRS20-9 (EXPENSE IN CURRENT PERIOD) Types of Past Service Costs Plan Amendments Curtailments • Introduction of a plan. • Significant reduction in the • Withdrawal of a plan. number of employees covered • Changes to a plan. by the plan. The accounting for past service cost is straightforward—expense past service cost in the period of the amendment or curtailment. As a result, a substantial increase (decrease) in pension expense and the defined benefit obligation often results when a plan amendment or curtailment occurs. Because current and past service costs relate directly to employment, they are reported in the operating section of the statement of comprehensive income. Some disagree with the IASB position of expensing these costs in the year a plan is amended or curtailed. They argue that a company would not provide these additional benefits for past years of service unless it expects to receive benefits in the future. Ac- cording to this reasoning, a company should not recognize the full past service cost in the year of the amendment. Instead, the past service cost should be spread out over the remaining service life of employees who are expected to benefit from the changes in the plan. Others believe that if they are truly past service costs, they should be treated retro- actively as an adjustment made to prior periods. However, the IASB decided that any changes in the defined benefit obligation or plan assets should be recognized in the current period. To do otherwise is not informa- tive and leads to delayed recognition of costs or reduced benefits which are neither as- sets nor liabilities. It is also possible to decrease past service costs by decreasing the defined benefit obligation (referred to as negative past service cost). Negative past service cost arises when an entity changes the benefits attributable to past service cost so that the present value of the defined benefit obligation decreases. In that case, pension expense is de- creased. Both positive (increased pension expense) and negative (decreased pension ex- pense) past service cost adjustments are handled in the same manner; that is, adjust pension expense immediately. 2015 Entries and Worksheet Continuing the Zarle Company illustration into 2015, we note that the company amends the pension plan on January 1, 2015, to grant employees past service benefits with a present value of $81,600. The following additional facts apply to the pension plan for the year 2015. Annual service cost is $9,500. Discount rate is 10 percent. Annual funding contributions are $20,000. Benefi ts paid to retirees during the year are $8,000. IFRS Insights 1259 Illustration IFRS20-10 presents a worksheet of all the pension entries and informa-

tion recorded by Zarle in 2015. PPeennssiioonn WWoorrkksshheeeett——22001155..xxllss ILLUSTRATION IFRS20-10 Home Insert Page Layout Formulas Data Review View Pension P18 fx A B C D E F Worksheet—2015 1 2 General Journal Entries Memo Record 3 Annual Pension Defined 4 Pension Asset/ Benefit 5 Items Expense Cash Liability Obliga!on Plan Assets 6 Balance, Dec. 31, 2014 1,000 Cr. 112,000 Cr. 111,000 Dr. 7 (f) Addi!onal PSC, 1/1/2015 81,600 Dr. 81,600 Cr. 8 Balance, Jan. 1, 2015 193,600 Cr. 9 (g) Service cost 9,500 Dr. 9,500 Cr. 10 (h) Interest expense 19,360 Dr. 19,360 Cr. 11 (i) Interest revenue 11,100 Cr. 11,100 Dr. 12 (j) Contribu!ons 20,000 Cr. 20,000 Dr. 13 (k) Benefits 8,000 Dr. 8,000 Cr. 14 Journal entry for 2015 99,360 Dr. 20,000 Cr. 79,360 Cr. 15 Balance, Dec. 31, 2015 80,360 Cr. 214,460 Cr. 134,100 Dr. 16 The first line of the worksheet shows the beginning balances of the Pension Asset/ Liability account and the memo accounts. Entry (f) records Zarle’s granting of past ser- vice cost, by adding $81,600 to the defined benefit obligation and to Pension Expense. Entry (g) records the current service cost; entry (h) records interest expense for the pe- riod. Because the past service cost occurred at the beginning of the year, interest is com- puted on the January 1, 2015, balance of the defined benefit obligation, adjusted for the past service cost. Interest expense is therefore $19,360 ($193,600 3 10%). Entry (i) records interest revenue for the period of $11,100 ($111,000 3 10%). Entries (j) and (k) are similar to the corresponding entries in 2014. Zarle makes the following journal entry on December 31 to formally record the 2015 pension expense—the sum of the annual pension expense column. 2015 Pension Expense 99,360 Cash 20,000 Pension Asset/Liability 79,360 Because the expense exceeds the funding, Zarle credits the Pension Asset/Liability account for the $79,360 difference. That account is a liability. In 2015, as in 2014, the balance of the Pension Asset/Liability account ($80,360) is equal to the net of the balances in the memo accounts, as shown in Illustration IFRS20-11. ILLUSTRATION Defined benefit obligation (Credit) $(214,460) IFRS20-11 Plan assets at fair value (Debit) 134,100 Pension Reconciliation Pension asset/liability (Credit) $ (80,360) Schedule—December 31, 2015 The reconciliation is the formula that makes the worksheet work. It relates the com- ponents of pension accounting, recorded and unrecorded, to one another. 1260 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Remeasurements Of great concern to companies that have pension plans are the uncontrollable and unex- pected swings that can result from (1) sudden and large changes in the fair value of plan assets and (2) changes in actuarial assumptions that affect the amount of the defined benefit obligation. How should these changes (referred to as remeasurements) affect the financial statements, most notably pension expense? The IASB believes that the most informative way is to recognize the remeasurement in other comprehensive income. The rationale for this reporting is that the predictive nature of remeasurements is much different than the other two components of pension benefit cost—service cost and net interest. Remeasurements are generally of two types: 1. Gains and losses on plan assets. 2. Gains and losses on the defi ned benefi t obligation. Asset Gains and Losses. The gains and losses on plan assets (referred to as asset gains and losses) is the difference between the actual return and the interest revenue computed in determining net interest. Asset gains occur when actual returns exceed the interest reve- nue. Asset losses occur when the actual returns are less than interest revenue. To illustrate, assume that Shopbob Company has plan assets at January 1, 2014, of $100,000. The discount rate for the year is 6 percent, and the actual return on the plan assets for 2014 is $8,000. In 2014, Shopbob should record an asset gain of $2,000, computed as follows. ILLUSTRATION Actual return $8,000 IFRS20-12 Less: Interest revenue ($100,000 3 6%) 6,000

Computation of Asset Asset gain $2,000 Gain Shopbob therefore debits plan assets for the asset gain of $2,000 and credits Other Com- prehensive Income (G/L) for the same amount. If interest revenue exceeds the actual return, Shopbob debits Other Comprehensive Income (G/L) for the asset loss and credits plan assets. Liability Gains and Losses. In estimating the defined benefit obligation (the liability), actuaries make assumptions about such items as mortality rate, retirement rate, turn- over rate, disability rate, and salary amounts. Any change in these actuarial assump- tions affects the amount of the defined benefit obligation. Seldom does actual experi- ence coincide exactly with actuarial predictions. These gains or losses from changes in the defined benefit obligation are called liability gains and losses. Companies report liability gains (resulting from unexpected decreases in the liability balance) and liability losses (resulting from unexpected increases in the liability balance) in Other Comprehensive Income (G/L). Companies combine the liability gains and losses in the same Other Comprehensive Income (G/L) account used for asset gains and losses. They accumulate the asset and liability gains and losses from year to year in Ac- cumulated Other Comprehensive Income.35 This amount is reported on the statement of financial position in the equity section. 35The IASB is silent as to whether the account “Accumulated Other Comprehensive Income” should be used instead of another equity account, like Retained Earnings. For homework purposes, use an Accumulated Other Comprehensive Income account. The IASB also permits the transfer of the balance in the Accumulated Other Comprehensive Income account to other equity accounts at a later date. IFRS Insights 1261 2016 Entries and Worksheet Continuing the Zarle Company illustration, the following facts apply to the pension plan for 2016. Annual service cost is $13,000. Discount rate is 10 percent. Actual return on plan assets is $12,000. Annual funding contributions are $24,000. Benefi ts paid to retirees during the year are $10,500. Changes in actuarial assumptions establish the end-of-year defi ned benefi t obliga- tion at $265,000. The worksheet in Illustration IFRS20-13 presents all of Zarle’s 2016 pension entries and related information. The first line of the worksheet records the beginning balances that relate to the pension plan. In this case, Zarle’s beginning balances are the ending balances from its 2015 pension worksheet in Illustration IFRS20-10. PPeennssiioonn WWoorrkksshheeeett——22001166..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G 1 2 General Journal Entries Memo Record 3 Annual Pension Defined 4 Pension OCI— Asset/ Benefit 5 Items Expense Cash Gain/Loss Liability Obliga!on Plan Assets 6 Balance, Jan. 1, 2016 80,360 Cr. 214,460 Cr. 134,100 Dr. 7 (l) Service cost 13,000 Dr. 13,000 Cr. 8 (m) Interest expense 21,446 Dr. 21,446 Cr. 9 (n) Interest revenue 13,410 Cr. 13,410 Dr. 10 (o) Contribu!ons 24,000 Cr. 24,000 Dr. 11 (p) Benefits 10,500 Dr. 10,500 Cr. 12 (q) Asset loss 1,410 Dr. 1,410 Cr. 13 (r) Liability loss 26,594 Dr. 26,594 Cr. 14 Journal entry for 2016 21,036 Dr. 24,000 Cr. 28,004 Dr. 25,040 Cr. 15 16 Accumulated OCI, Dec. 31, 2015 0 17 Balance, Dec. 31, 2016 28,004 Dr. 105,400 Cr. 265,000 Cr. 159,600 Dr. 18 ILLUSTRATION IFRS20-13 Entries (l), (m), (n), (o), and (p) are similar to the corresponding entries in 2014 or Pension Worksheet—2016 2015. Entries (m) and (n) are related. Entry (m) records the interest expense of $21,446 ($214,460 3 10%). Entry (n) records interest revenue of $13,410 ($134,100 3 10%). There- fore, net interest expense is $8,036 ($21,446 2 $13,410). Entries (o) and (p) are recorded similarly in 2016 as those in 2014 and 2015. Entries (q) and (r) need additional explanation. As indicated, the actual return on plan assets for 2016 was $12,000. However, as indicated in entry (n), pension expense was decreased $13,410 as a result of multiplying the beginning plan assets by the discount

rate to arrive at an assumed interest revenue of $13,410. As a result, Zarle has an asset loss of $1,410 ($13,410 2 $12,000) because the assumed interest revenue is greater than the actual return. This asset loss is debited to Other Comprehensive Income (G/L) and cred- ited to plan assets. Pension plan assets are then properly stated at their fair value. 1262 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Entry (r) records the change in the defined benefit obligation resulting from the changes in the actuarial assumptions related to this obligation. As indicated in the facts on page 1261, the actuary has determined that the ending balance in the defined benefit obligation should be $265,000 at December 31, 2016. However, the balance at December 31, 2016, before any adjustment for actuarial gains and losses related to the defined benefit obligation is $238,406, as shown in Illustration IFRS20-14. ILLUSTRATION December 31, 2015, DBO balance $214,460 IFRS20-14 Service cost [entry (l)] 13,000 Defi ned Benefi t Interest expense [entry (m)] 21,446 Obligation Balance Benefits paid [entry (p)] (10,500) (Unadjusted) December 31, 2016, DBO balance (before liability increases) $238,406 The difference between the ending balance of $265,000 as determined by the ac- tuary and the present balance of $238,406 is $26,594 (a liability loss on the defined benefit liability). This liability loss is debited to Other Comprehensive Income (G/L) and credited to the defined benefit obligation. After this worksheet adjustment, the defined benefit obligation is stated at its actuarial value of $265,000. The journal en- try to record the information related to the pension plan at December 31, 2016, based on the pension worksheet in Illustration IFRS20-13, is as follows. Pension Expense 21,036 Other Comprehensive Income (G/L) 28,004 Cash 24,000 Pension Asset/Liability 25,040 As the 2016 worksheet indicates, the $105,400 balance in the Pension Asset/Liability account at December 31, 2016, is equal to the net of the balances in the memo accounts. Illustration IFRS20-15 shows this computation. ILLUSTRATION Defined benefit obligation (Credit) $(265,000) IFRS20-15 Plan assets at fair value (Debit) 159,600 Pension Reconciliation Pension asset/liability $(105,400) Schedule—December 31, 2016 Zarle carries the 2016 ending balances for Pension Asset/Liability and Accumu- lated Other Comprehensive Income forward as the beginning balances for pension plan accounting in 2017. These balances will be adjusted by changes in the defined benefit obligation and plan assets as shown in the prior examples. For example, assume that Zarle’s pension plan had the following activity in 2017: Service cost $10,072 Contributions $32,000 Pension expense 17,450 Benefits 11,000 Asset gain 13,150 Decrease in Pension Asset/Liability 27,700 Discount rate 7% The ending balances for the defined benefit obligation and plan assets are $282,622 and $204,922, respectively. These elements are summarized in the partial 2017 pension work- sheet shown in Illustration IFRS20-16. IFRS Insights 1263 PPaarrttiiaall PPeennssiioonn WWoorrkksshheeeett——22001177..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G 1 2 General Journal Entries Memo Record 3 Annual Pension Defined 4 Pension OCI— Asset/ Benefit 5 Items Expense Cash Gain/Loss Liability Obliga!on Plan Assets 6 Balance, Jan. 1, 2017 28,004 Dr. 105,400 Cr. 265,000 Cr. 159,600 Dr. 7 8 9 Journal entry for 2017 17,450 Dr. 32,000 Cr. 13,150 Cr. 27,700 Dr. 10 11 Accumulated OCI, Jan. 1, 2017 28,004 Dr. 12 Balance, Dec. 31, 2017 14,854 Dr. 77,700 Cr. 282,622 Cr. 204,922 Dr. 13 ILLUSTRATION IFRS20-16 Partial Pension Focusing on the “Journal Entry” row, in 2017 Zarle records pension expense of $17,450 Worksheet—2017 and a decrease in Pension Asset/Liability of $27,700. The reduction in Pension Asset/ Liability is due in part to the asset gain of $13,150 recorded in 2017. As a result, Zarle’s 2017 ending balances (which become the 2018 beginning balances) are $77,700 for Pen- sion Asset/Liability and Accumulated Other Comprehensive Income $14,854 (begin-

ning Accumulated OCI of $28,004 2 gain of $13,150). ON THE HORIZON The IASB and the FASB have been working collaboratively on a postretirement benefit project. The recent amendments issued by the IASB moves IFRS closer to GAAP with respect to recognition of the funded status on the statement of financial position. How- ever, as illustrated in the About the Numbers section above, significant differences remain in the components of pension expense. The FASB is expected to begin work on a project that will reexamine expense measurement of postretirement benefit plans. The FASB likely will consider the recent IASB amendments in this area, which could lead to a con- verged standard. IFRS SELF-TEST QUESTIONS 1. At the end of the current period, Oxford Ltd. has a defined benefit obligation of $195,000 and pension plan assets with a fair value of $110,000. The amount of the vested benefits for the plan is $105,000. What amount related to its pension plan will be reported on the company’s statement of financial position? (a) $5,000. (c) $85,000. (b) $90,000. (d) $20,000. 2. At the end of the current year, Kennedy Co. has a defined benefit obligation of $335,000 and pension plan assets with a fair value of $245,000. The amount of the vested benefits for the plan is $225,000. Kennedy has an actuarial gain of $8,300. What account and amount(s) related to its pension plan will be reported on the company’s statement of financial position? (a) Pension Liability and $74,300. (c) Pension Asset and $233,300. (b) Pension Liability and $90,000. (d) Pension Asset and $110,000. 1264 Chapter 20 Accounting for Pensions and Postretirement Benefi ts 3. For 2014, Carson Majors Inc. had pension expense of $77 million and contributed $55 million to the pension fund. Which of the following is the journal entry that Carson Majors would make to record pension expense and funding? (a) Pension Expense 77,000,000 Pension Asset/Liability 22,000,000 Cash 55,000,000 (b) Pension Expense 77,000,000 Pension Asset/Liability 22,000,000 Cash 99,000,000 (c) Pension Expense 55,000,000 Pension Asset/Liability 22,000,000 Cash 77,000,000 (d) Pension Expense 22,000,000 Pension Asset/Liability 55,000,000 Cash 77,000,000 4. At January 1, 2014, Wembley Company had plan assets of $250,000 and a defined benefit obligation of the same amount. During 2014, service cost was $27,500, the discount rate was 10%, actual return on plan assets was $25,000, contributions were $20,000, and benefits paid were $17,500. Based on this information, what would be the defined benefit obliga- tion for Wembley Company at December 31, 2014? (a) $277,500. (c) $27,500. (b) $285,000. (d) $302,500. 5. Towson Company has experienced tough competition for its talented workforce, lead- ing it to enhance the pension benefits provided to employees. As a result, Towson amended its pension plan on January 1, 2014, and granted past service costs of $250,000. Current service cost for 2014 is $52,000. Interest expense is $18,000, and in- terest revenue is $5,000. Actual return on assets in 2014 is $3,000. What is Towson’s pension expense for 2014? (a) $65,000. (c) $317,000. (b) $302,000. (d) $315,000. IFRS CONCEPTS AND APPLICATION IFRS20-1 What is net interest? Identify the elements of net interest and explain how they are computed. IFRS20-2 What is service cost, and what is the basis of its measurement? IFRS20-3 What is meant by “past service cost”? When is past service cost recognized as pension expense? IFRS20-4 Bill Haley is learning about pension accounting. He is convinced that in years when companies record liability gains and losses, total comprehensive income will not be affected. Is Bill correct? Explain. IFRS20-5 At the end of the current year, Joshua Co. has a defined benefit obligation of $335,000 and pension plan assets with a fair value of $345,000. The amount of the vested benefits for the plan is $225,000. Joshua has a liability gain of $8,300 (beginning accumulated OCI is zero). What amount and account(s) related to its pension plan will be reported on the company’s statement of financial position?

IFRS20-6 Villa Company has experienced tough competition, leading it to seek concessions from its em- ployees in the company’s pension plan. In exchange for promises to avoid layoffs and wage cuts, the em- ployees agreed to receive lower pension benefits in the future. As a result, Villa amended its pension plan on January 1, 2014, and recorded negative past service cost of $125,000. Current service cost for 2014 is $26,000. Interest expense is $9,000, and interest revenue is $2,500. Actual return on assets in 2012 is $1,500. Compute Villa’s pension expense in 2014. IFRS20-7 Tevez Company experienced an actuarial loss of $750 in its defined benefit plan in 2014. For 2014, Tevez’s revenues are $125,000, and expenses (excluding pension expense of $14,000, which does not include the actuarial loss) are $85,000. Prepare Tevez’s statement of comprehensive income for 2014. IFRS20-8 The following defined pension data of Doreen Corp. apply to the year 2014. IFRS Insights 1265 Defi ned benefi t obligation, 1/1/14 (before amendment) $560,000 Plan assets, 1/1/14 546,200 Pension asset/liability 13,800 Cr. On January 1, 2014, Doreen Corp., through plan amendment, grants past service benefi ts having a present value of 120,000 Discount rate 9% Service cost 58,000 Contributions (funding) 65,000 Actual return on plan assets 49,158 Benefi ts paid to retirees 40,000 Instructions For 2014, prepare a pension worksheet for Doreen Corp. that shows the journal entry for pension expense and the year-end balances in the related pension accounts. IFRS20-9 Buhl Corp. sponsors a defined benefit pension plan for its employees. On January 1, 2014, the following balances relate to this plan. Plan assets $480,000 Defi ned benefi t obligation 600,000 Pension asset/liability 120,000 As a result of the operation of the plan during 2014, the following additional data are provided by the actuary. Service cost for 2014 $90,000 Discount rate, 6% Actual return on plan assets in 2014 55,000 Unexpected loss from change in defi ned benefi t obligation, due to change in actuarial predictions 76,000 Contributions in 2014 99,000 Benefi ts paid retirees in 2014 85,000 Instructions (a) Using the data above, compute pension expense for Buhl Corp. for the year 2014 by preparing a pension worksheet. (b) Prepare the journal entry for pension expense for 2014. IFRS20-10 Linda Berstler Company sponsors a defined benefit pension plan. The corporation’s actuary provides the following information about the plan. January 1, December 31, 2014 2014 Defi ned benefi t obligation $2,500 $3,300 Plan assets (fair value) 1,700 2,620 Discount rate 10% Pension asset/liability 800 ? Service cost for the year 2014 400 Contributions (funding in 2014) 700 Benefi ts paid in 2014 200 Instructions (a) Compute the actual return on the plan assets in 2014. (b) Compute the amount of other comprehensive income (G/L) as of December 31, 2014. (Assume the January 1, 2014, balance was zero.) Professional Research IFRS20-11 Jack Kelly Company has grown rapidly since its founding in 2004. To instill loyalty in its em- ployees, Kelly is contemplating establishment of a defined benefit plan. Kelly knows that lenders and po- tential investors will pay close attention to the impact of the pension plan on the company’s financial statements, particularly any gains or losses that develop in the plan. Kelly has asked you to conduct some research on the accounting for gains and losses in a defined benefit plan. 1266 Chapter 20 Accounting for Pensions and Postretirement Benefi ts Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) Briefly describe how pension gains and losses are accounted for. (b) Explain the rationale behind the accounting method described in part (a). (c) What is the related pension asset or liability that may show up on the statement of financial posi-

tion? When will each of these situations occur? International Financial Reporting Problem Marks and Spencer plc IFRS20-12 The financial statements of Marks and Spencer plc (M&S) are available at the book’s companion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/ Marks-and-Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What kind of pension plan does M&S provide its employees? (b) What was M&S’s pension expense for 2012 and 2011? (c) What is the impact of M&S’s pension plans for 2012 on its financial statements? (d) What information does M&S provide on the target allocation of its pension assets? How do the allocations relate to the expected returns on these assets? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. c 2. b 3. a 4. b 5. d Remember to check the book’s companion website to fi nd additional resources for this chapter. This page is intentionally left blank Accounting for Leases 1 Explain the nature, economic substance, 5 Describe the lessor’s accounting for direct-financing and advantages of lease transactions. leases. 2 Describe the accounting criteria and procedures 6 Identify special features of lease arrangements that for capitalizing leases by the lessee. cause unique accounting problems. 3 Contrast the operating and capitalization methods 7 Describe the effect of residual values, guaranteed of recording leases. and unguaranteed, on lease accounting. 4 Explain the advantages and economics of leasing 8 Describe the lessor’s accounting for sales-type leases. to lessors and identify the classifications of leases 9 List the disclosure requirements for leases. for the lessor. More Companies Ask, “Why Buy?” Leasing has grown tremendously in popularity. Today, it is the fastest growing form of capital investment. Instead of borrowing money to buy an airplane, computer, nuclear core, or satellite, a company makes periodic payments to lease these assets. Even gambling casinos lease their slot machines. Of the 500 companies surveyed by the AICPA in 2011, more than half dis- closed lease data.* A classic example is the airline industry. Many travelers on airlines such as United, Delta, and Southwest believe these airlines own the planes on which they are flying. Often, this is not the case. Airlines lease many of their airplanes due to the favorable accounting treatment they receive if they lease rather than purchase. Presented below are the lease percentages for the major U.S. airlines. What about other companies? They are also exploiting the existing lease accounting rules to keep assets and liabilities off the books. For example, Krispy Kreme, a chain of 217 doughnut shops, had been showing good growth and profitability using a relatively small bit of capital. That’s an impressive feat if you care about return on capital. But there’s a hole in this doughnut. The company explained that it was building a $30 million new mixing plant and warehouse in Effingham, Illinois. RETPAHC 21 LEARNING OBJECTIVES After studying this chapter, you should be able to: The Phantom Fleets: Number of Aircraft and Percent Carried Off the Balance Sheet 26% American 12% UAL 12% Delta 28% Fleet Under Southwest Operating Leases 43% Republic Fleet Owned Number of planes: 200 400 600 800 1000 Source: Company reports, 2011. *AICPA, Accounting Trends and Techniques—2011. 277 out of 500 surveyed companies reported leased assets. Companies that lease tend to be smaller, are high growth, and are in technology-oriented industries (see www.techlease.com). CONCEPTUAL FOCUS > See the Underlying Concepts on Yet the financial statements failed to disclose the investments pages 1274 and 1307. and obligations associated with that $30 million. By financing > Read the Evolving Issues on pages 1283 through a synthetic lease, Krispy Kreme kept the investment and and 1303 for discussions of off-balance-sheet obligation off the books. reporting of leases. In a synthetic lease, a financial institution like Bank of America

sets up a special-purpose entity (SPE) that borrows money to build INTERNATIONAL FOCUS the plant and then leases it to Krispy Kreme. For accounting pur- poses, Krispy Kreme reports only rent expense. For tax purposes, however, Krispy Kreme can be considered the owner of the asset > See the International Perspectives and gets depreciation tax deductions. This is a pretty good deal for on pages 1272, 1276, 1285, and 1303. Krispy Kreme. But for investors? Not so good. This is because the > Read the IFRS Insights on pages 1331–1341 Krispy Kreme financial statements failed to disclose the invest- for a discussion of: ments and obligations associated with that $30 million. — Lessee accounting Another example is struggling drug store chain Rite Aid. Its — Lessor accounting balance sheet is in shambles. While its current assets exceed current liabilities, that’s the end of any good news in the balance sheet. Total assets are $7,364 million, while total liabilities are $9,951 million, thereby yielding a shareholders’ deficit of $(2,587) million. Things are even worse once you consider Rite Aid’s large off-balance-sheet lease obligations. Using the data in note 10 of the financial statements, analysts estimate the company’s lease liabilities to be $5,939 million. This adjustment increases total liabilities to $15,890 million, causing the stockholders’ deficit to worsen to $(8,526) million. As you will learn in this chapter, due to lease accounting rules, users of financial statements must make an educated guess on the real-but-hidden leverage of leasing only by using the information disclosed in the notes and by applying a rule-of-thumb multiple. As the chairperson for the IASB noted, “It seems odd to expect an analyst to guess the liabilities associated with leases when management already has this information at its fingertips.” This concern explains why the FASB and IASB are working on a new standard on leasing, so that assets and liabilities avoid on-balance-sheet treatment simply by calling a loan a “lease.” Sources: Adapted from Seth Lubore and Elizabeth MacDonald, “Debt? Who, Me?” Forbes (February 18, 2002), p. 56; A. Catanach and E. Ketz, “Still Searching for the ‘Rite’ Stuff,” Grumpy Old Accountants (April 30, 2012), at http://blogs.smeal.psu.edu/grumpyoldaccountants/ archives/643; and Hans Hoogervorst, “Harmonisation and Global Economic Consequences,” Public lecture at the London School of Economics (November 6, 2012). Our opening story indicates the increased significance and prevalence PREVIEW OF CHAPTER 21 of lease arrangements. As a result, the need for uniform accounting and informative reporting of these transactions has intensified. In this chapter, we look at the accounting issues related to leasing. The content and organization of this chapter are as follows. Accounting for Leases Special Lease Accounting Leasing Environment Accounting by Lessee Accounting by Lessor Problems • Who are players? • Capitalization criteria • Economics of leasing • Residual values • Advantages of leasing • Accounting differences • Classification • Sales-type leases • Conceptual nature • Capital lease method • Direct-financing method • Bargain-purchase option of a lease • Operating method • Operating method • Initial direct costs • Comparison • Current versus noncurrent • Disclosure • Unresolved problems 1269 1270 Chapter 21 Accounting for Leases THE LEASING ENVIRONMENT Aristotle once said, “Wealth does not lie in ownership but in the use of things”! LEARNING OBJECTIVE 1 Clearly, many U.S. companies have decided that Aristotle is right, as they have Explain the nature, economic become heavily involved in leasing assets rather than owning them. For example, substance, and advantages of lease transactions. according to the Equipment Leasing Association (ELA), the global equipment- leasing market is a $600–$700 billion business, with the United States accounting for about one-third of the global market. The ELA estimates that of the $1.3 trillion in total fixed investment expected from domestic businesses in 2012, $654 billion (50 percent)

will be financed through leasing. Remember that these statistics are just for equipment leasing. Add in real estate leasing, which is probably larger, and we are talking about a very large and growing business, one that is at least in part driven by the accounting. What types of assets are being leased? As the opening story indicated, any type of equipment can be leased, such as railcars, helicopters, bulldozers, barges, CT scanners, computers, and so on. Illustration 21-1 summarizes, in their own words, what several major companies are leasing. ILLUSTRATION 21-1 Company (Ticker) Description What Do Companies Gap (GPS) “We lease most of our store premises and some of our headquarters Lease? facilities and distribution centers.” ExxonMobil Corp. (XOM) “Minimum commitments for operating leases, shown on an undiscounted basis, cover drilling equipment, tankers, service stations, and other properties.” JPMorgan Chase (JPM) “JPMorgan Chase and its subsidiaries were obligated under a number of noncancelable operating leases for premises and equipment used primarily for banking purposes.” Maytag Corp. (MYG) “The Company leases real estate, machinery, equipment, and automobiles under operating leases, some of which have renewal options.” McDonald’s Corp. (MCD) “The Company was the lessee at 15,235 restaurant locations through ground leases (the Company leases the land and the Company or franchisee owns the building) and through improved leases (the Company leases land and buildings).” Starbucks Corp. (SBUX) “Starbucks leases retail stores, roasting and distribution facilities, and office space under operating leases.” TXU Corp. (TXU) “TXU Energy Holdings and TXU Electric Delivery have entered into operating leases covering various facilities and properties including generation plant facilities, combustion turbines, transportation equipment, mining equipment, data processing equipment, and office space.” Viacom Inc. (VIA.B) “ The Company has long-term non-cancelable operating lease commitments for office space and equipment, transponders, studio facilities, and vehicles. The Company also enters into capital leases for satellite transponders.” S ource: Company 10-K filings. The largest group of leased equipment involves information technology equipment, followed by assets in the transportation area (trucks, aircraft, rail), and then construction and agriculture. Who Are the Players? A lease is a contractual agreement between a lessor and a lessee. This arrangement gives the lessee the right to use specific property, owned by the lessor, for a specified period The Leasing Environment 1271 of time. In return for the use of the property, the lessee makes rental payments over the lease term to the lessor. Who are the lessors that own this property? They generally fall into one of three categories: 1. Banks. 2. Captive leasing companies. 3. Independents. Banks Banks are the largest players in the leasing business. They have low-cost funds, which give them the advantage of being able to purchase assets at less cost than their competi- tors. Banks also have been more aggressive in the leasing markets. Deciding that there is money to be made in leasing, banks have expanded their product lines in this area. Finally, leasing transactions are now more standardized, which gives banks an advantage because they do not have to be as innovative in structuring lease arrangements. Thus, banks like Wells Fargo, Chase, Citigroup, and PNC have substantial leasing subsidiaries. Captive Leasing Companies Captive leasing companies are subsidiaries whose primary business is to perform leasing operations for the parent company. Companies like Caterpillar Financial Services Corp. (for Caterpillar), Ford Motor Credit (for Ford), and IBM Global Financing (for IBM) facilitate the sale of products to consumers. For example, suppose that Sterling Construction Co. wants to acquire a number of earthmovers from Caterpillar. In this case, Caterpillar Financial Services Corp. will offer to structure the transaction as a lease rather than as a purchase. Thus, Caterpillar Financial provides the financing rather than

an outside financial institution. Captive leasing companies have the point-of-sale advantage in finding leasing customers. That is, as soon as Caterpillar receives a possible order, its leasing subsidiary can quickly develop a lease-financing arrangement. Furthermore, the captive lessor has product knowledge that gives it an advantage when financing the parent’s product. The current trend is for captives to focus primarily on their companies’ products rather than do general lease financing. For example, Boeing Capital and UPS Capital are two captives that have left the general finance business to focus exclusively on their parent companies’ products. Independents Independents are the final category of lessors. Independents have not done well over the last few years. Their market share has dropped fairly dramatically as banks and captive leasing companies have become more aggressive in the lease-financing area. Independents do not have point-of-sale access, nor do they have a low cost of funds advantage. What they are often good at is developing innovative contracts for lessees. In addition, they are starting to act as captive finance companies for some companies that do not have a leasing subsidiary. For example, International Lease Finance Corp. is one of the world’s largest independent lessors. According to recent data at www.ficinc.com on new business volume by lessor type, banks hold about 49 percent of the market, followed by captives at 32 percent. Indepen- dents had the remaining 19 percent of new business. Data on changes in market share show that both captives and independents have increased business at the expense of the banks. That is, from 2009 to 2010, captives’ and independents’ market shares had grown by 11.3 percent and 5.3 percent, respectively, while the banks’ market share declined by 0.9 percent. 1272 Chapter 21 Accounting for Leases Advantages of Leasing The growth in leasing indicates that it often has some genuine advantages over owning property, such as: 1. 100% fi nancing at fi xed rates. Leases are often signed without requiring any money down from the lessee. This helps the lessee conserve scarce cash—an especially desirable feature for new and developing companies. In addition, lease payments often remain fi xed, which protects the lessee against infl ation and increases in the cost of money. The following comment explains why companies choose a lease instead of a conventional loan: “Our local bank fi nally came up to 80 percent of the purchase price but wouldn’t go any higher, and they wanted a fl oating interest rate. We just couldn’t afford the down payment, and we needed to lock in a fi nal payment rate we knew we could live with.” 2. Protection against obsolescence. Leasing equipment reduces risk of obsolescence to the lessee and in many cases passes the risk of residual value to the lessor. For exam- ple, Merck (a pharmaceutical maker) leases computers. Under the lease agreement, Merck may turn in an old computer for a new model at any time, canceling the old lease and writing a new one. The lessor adds the cost of the new lease to the balance due on the old lease, less the old computer’s trade-in value. As one treasurer re- marked, “Our instinct is to purchase.” But if a new computer is likely to come along in a short time, “then leasing is just a heck of a lot more convenient than purchasing.” Naturally, the lessor also protects itself by requiring the lessee to pay higher rental payments or provide additional payments if the lessee does not maintain the asset. 3. Flexibility. Lease agreements may contain less restrictive provisions than other debt agreements. Innovative lessors can tailor a lease agreement to the lessee’s special needs. For instance, the duration of the lease—the lease term—may be anything from a short period of time to the entire expected economic life of the asset. The rental payments may be level from year to year, or they may increase or decrease in amount. The payment amount may be predetermined or may vary with sales, the prime interest rate, the

Consumer Price Index, or some other factor. In most cases, the rent is set to enable the lessor to recover the cost of the asset plus a fair return over the life of the lease. 4. Less costly fi nancing. Some companies fi nd leasing cheaper than other forms of fi nancing. For example, start-up companies in depressed industries or companies in low tax brackets may lease to claim tax benefi ts that they might otherwise lose. Depreciation deductions offer no benefi t to companies that have little if any taxable income. Through leasing, the leasing companies or fi nancial institutions use these tax benefi ts. They can then pass some of these tax benefi ts back to the user of the asset in the form of lower rental payments. International 5. Tax advantages. In some cases, companies can “have their cake and eat it too” Perspective with tax advantages that leases offer. That is, for fi nancial reporting purposes, Some companies “double dip” companies do not report an asset or a liability for the lease arrangement. For tax on the international level too. purposes, however, companies can capitalize and depreciate the leased asset. As The leasing rules of the lessor’s a result, a company takes deductions earlier rather than later and also reduces and lessee’s countries may differ, its taxes. A common vehicle for this type of transaction is a “synthetic lease” permitting both parties to own arrangement, such as that described in the opening story for Krispy Kreme. the asset. Thus, both lessor and 6. Off-balance-sheet fi nancing. Certain leases do not add debt on a balance lessee receive the tax benefi ts sheet or affect fi nancial ratios. In fact, they may add to borrowing capacity.1 related to depreciation. Such off-balance-sheet fi nancing is critical to some companies. 1As demonstrated later in this chapter, certain types of lease arrangements are not capitalized on the balance sheet. The liabilities section is thereby relieved of large future lease commitments that, if recorded, would adversely affect the debt to equity ratio. The reluctance to record lease obligations as liabilities is one of the primary reasons some companies resist capitalized lease accounting. The Leasing Environment 1273 What do the numbers mean? OFF-BALANCE-SHEET FINANCING As shown in our opening story, airlines use lease arrangements fi nancing. The following chart indicates that many airlines that extensively. This results in a great deal of off-balance-sheet lease aircraft understate debt levels by a substantial amount. Additional Debt from Capitalizing Leases Reported Debt UAL Source: Company reports, 2011. Airlines are not the only ones playing the off-balance- the effects of non-capitalized leases. A methodology for sheet game. A recent study estimates that for S&P 500 com- making this adjustment is discussed in Eugene A. Imhoff, panies, off-balance-sheet lease obligations total more than Jr., Robert C. Lipe, and David W. Wright, “Operating Leases: one-half trillion dollars, or roughly three percent of market Impact of Constructive Capitalization,” Accounting Horizons value. Thus, analysts must adjust reported debt levels for (March 1991). Source: D. Zion and A. Varshney, “Leases Landing on Balance Sheets,” Credit Suisse Equity Research (August 17, 2010). Conceptual Nature of a Lease If Delta borrows $47 million on a 10-year note from Bank of America to purchase a Boeing 737 jet plane, Delta should clearly report an asset and related liability at that amount on its balance sheet. Similarly, if Delta purchases the 737 for $47 million directly from Boeing through an installment purchase over 10 years, it should obviously report an asset and related liability (i.e., it should “capitalize” the installment transaction). However, what if Delta leases the Boeing 737 for 10 years from International Lease Finance Corp. (ILFC)—the world’s largest lessor of airplanes—through a noncancelable lease transaction with payments of the same amount as the installment purchase trans- action? In that case, opinion differs over how to report this transaction. The various

views on capitalization of leases are as follows. 1. Do not capitalize any leased assets. This view considers capitalization inappropri- ate because Delta does not own the property. Furthermore, a lease is an “executory” contract requiring continuing performance by both parties. Because companies do not currently capitalize other executory contracts (such as purchase commitments and employment contracts), they should not capitalize leases either. 2. Capitalize leases that are similar to installment purchases. This view holds that companies should report transactions in accordance with their economic substance. Therefore, if companies capitalize installment purchases, they should also capitalize leases that have similar characteristics. For example, Delta makes the same payments over a 10-year period for either a lease or an installment purchase. Lessees make rental payments, whereas owners make mortgage payments. snoillim ni $ Net Reported Debt and Additional Debt from Leases 60,000 50,000 40,000 30,000 20,000 10,000 0 American Southwest Delta Republic 1274 Chapter 21 Accounting for Leases W hy should the fi nancial statements not report these transactions in the Underlying Concepts same manner? The issue of how to report 3. Capitalize all long-term leases. This approach requires only the long-term leases is the classic case of right to use the property in order to capitalize. This property-rights approach substance versus form. Although capitalizes all long-term leases.2 legal title does not technically 4. Capitalize fi rm leases where the penalty for nonperformance is substantial. pass in lease transactions, the A fi nal approach advocates capitalizing only “fi rm” (noncancelable) contrac- benefi ts from the use of the tual rights and obligations. “Firm” means that it is unlikely to avoid perfor- property do transfer. mance under the lease without a severe penalty. In short, the various viewpoints range from no capitalization to capitalization of all leases. The FASB apparently agrees with the capitalization approach when the lease is similar to an installment purchase. It notes that Delta should capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is noncancelable. Noncancelable means that Delta can cancel the lease con- tract only upon the outcome of some remote contingency, or that the cancellation provi- sions and penalties of the contract are so costly to Delta that cancellation probably will not occur. This viewpoint leads to three basic conclusions. (1) Companies must identify the characteristics that indicate the transfer of substantially all of the benefits and risks of ownership. (2) The same characteristics should apply consistently to the lessee and the lessor. (3) Those leases that do not transfer substantially all the benefits and risks of ownership are operating leases. Companies should not capitalize operating leases. Instead, companies should account for them as rental payments and receipts. ACCOUNTING BY THE LESSEE If Delta Airlines (the lessee) capitalizes a lease, it records an asset and a liability LEARNING OBJECTIVE 2 generally equal to the present value of the rental payments. ILFC (the lessor), Describe the accounting criteria and having transferred substantially all the benefits and risks of ownership, recognizes procedures for capitalizing leases by the lessee. a sale by removing the asset from the balance sheet and replacing it with a receivable. The typical journal entries for Delta and ILFC, assuming leased and capitalized equipment, appear as shown in Illustration 21-2. ILLUSTRATION 21-2 Delta ILFC Journal Entries for (Lessee) (Lessor) Capitalized Lease Leased Equipment XXX Lease Receivable XXX Lease Liability XXX Equipment XXX Having capitalized the asset, Delta records depreciation on the leased asset. Both ILFC and Delta treat the lease rental payments as consisting of interest and principal. If Delta does not capitalize the lease, it does not record an asset, nor does ILFC re- move one from its books. When Delta makes a lease payment, it records rental expense;

ILFC recognizes rental revenue. 2Capitalization of most leases (based on either a right of use or on noncancelable rights and obligations) has the support of financial analysts. See Peter H. Knutson, “Financial Reporting in the 1990s and Beyond,” Position Paper (Charlottesville, Va.: AIMR, 1993); and Warren McGregor, “Accounting for Leases: A New Approach,” Special Report (Norwalk, Conn.: FASB, 1996). The joint FASB/IASB project on lease accounting is based on a right-of-use model, which will require expanded capitalization of lease assets and liabilities. See http://www.fasb.org (click on the “Projects” tab). Accounting by the Lessee 1275 In order to record a lease as a capital lease, the lease must be noncancelable. Further, it must meet one or more of the four criteria listed in Illustration 21-3. ILLUSTRATION 21-3 Capitalization Criteria (Lessee) Capitalization Criteria • The lease transfers ownership of the property to the lessee. for Lessee • The lease contains a bargain-purchase option.3 • The lease term is equal to 75 percent or more of the estimated economic life of the leased property. See the FASB • The present value of the minimum lease payments (excluding executory costs) equals or exceeds Codification section 90 percent of the fair value of the leased property. [1] (page 1313). Delta classifies and accounts for leases that do not meet any of the four criteria as operating leases. Illustration 21-4 shows that a lease meeting any one of the four criteria results in the lessee having a capital lease. Lease Agreement Is Is Is Is Present There a There a Lease Value of Bargain- Transfer of No Purchase No Term ≥ 75% No Payments ≥ 90% No Ownership? of Economic of Fair Option? Life? Value? Operating Yes Yes Yes Yes Lease Capital Lease ILLUSTRATION 21-4 Diagram of Lessee’s In keeping with the FASB’s reasoning that a company consumes a significant Criteria for Lease portion of the value of the asset in the first 75 percent of its life, the lessee applies neither Classifi cation the third nor the fourth criterion when the inception of the lease occurs during the last 25 percent of the asset’s life. Capitalization Criteria Three of the four capitalization criteria that apply to lessees are controversial and can be difficult to apply in practice. We discuss each of the criteria in detail on the following pages. Transfer of Ownership Test If the lease transfers ownership of the asset to the lessee, it is a capital lease. This crite- rion is not controversial and easily implemented in practice. Bargain-Purchase Option Test A bargain-purchase option allows the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the option becomes exercisable. At the inception of the lease, the difference between the option price and the expected fair value must be large enough to make exercise of the option reasonably assured. 3We define a bargain-purchase option in the next section. 1276 Chapter 21 Accounting for Leases For example, assume that Brett’s Delivery Service was to lease a Honda Accord for $599 per month for 40 months, with an option to purchase for $100 at the end of the 40-month period. If the estimated fair value of the Honda Accord is $3,000 at the end of the 40 months, the $100 option to purchase is clearly a bargain. Therefore, Brett must capitalize the lease. In other cases, the criterion may not be as easy to apply, and deter- mining now that a certain future price is a bargain can be difficult. Economic Life Test (75% Test) If the lease period equals or exceeds 75 percent of the asset’s economic life, the lessor transfers most of the risks and rewards of ownership to the lessee. Capitalization is therefore appropriate. However, determining the lease term and the economic life of the asset can be troublesome. The lease term is generally considered to be the fixed, noncancelable term of the lease. However, a bargain-renewal option, if provided in the lease agreement, can extend this period. A bargain-renewal option allows the lessee to renew the lease for a rental

that is lower than the expected fair rental at the date the option becomes exercisable. At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. For example, assume that Home Depot leases Dell PCs for two years at a rental of $100 per month per computer and subsequently can lease them for $10 per month per computer for another two years. The lease clearly offers a bargain-renewal option; the lease term is considered to be four years. However, with bargain-renewal options, as with bargain-purchase options, it is sometimes difficult to determine what is a bargain.4 Determining estimated economic life can also pose problems, especially if the leased item is a specialized item or has been used for a significant period of time. For example, determining the economic life of a nuclear core is extremely difficult. It is subject to much more than normal “wear and tear.” As indicated earlier, the FASB takes the posi- tion that if the lease starts during the last 25 percent of the life of the asset, companies cannot use the economic life test to classify a lease as a capital lease. International Perspective Recovery of Investment Test (90% Test) If the present value of the minimum lease payments equals or exceeds 90 percent IFRS does not specify an exact percentage, such as 90%. of the fair value of the asset, then a lessee like Delta should capitalize the leased Instead, it uses the term asset. Why? If the present value of the minimum lease payments is reasonably “substantially all.” This difference close to the fair value of the aircraft, Delta is effectively purchasing the asset. illustrates the distinction Determining the present value of the minimum lease payments involves between rules-based and three important concepts: (1) minimum lease payments, (2) executory costs, and principles-based standards. (3) discount rate. Minimum Lease Payments. Delta is obligated to make, or expected to make, minimum lease payments in connection with the leased property. These payments include the following. 1. Minimum rental payments. Minimum rental payments are those that Delta must make to ILFC under the lease agreement. In some cases, the minimum rental payments may equal the minimum lease payments. However, the minimum lease payments may also include a guaranteed residual value (if any), penalty for failure to renew, or a bargain-purchase option (if any), as we note on the next page. 4The original lease term is also extended for leases having the following: substantial penalties for nonrenewal, periods for which the lessor has the option to renew or extend the lease, renewal periods preceding the date a bargain-purchase option becomes exercisable, and renewal periods in which any lessee guarantees of the lessor’s debt are expected to be in effect or in which there will be a loan outstanding from the lessee to the lessor. The lease term, however, can never extend beyond the time a bargain-purchase option becomes exercisable. [2] Accounting by the Lessee 1277 2. Guaranteed residual value. The residual value is the estimated fair (market) value of the leased property at the end of the lease term. ILFC may transfer the risk of loss to Delta or to a third party by obtaining a guarantee of the estimated residual value. The guaranteed residual value is either (1) the certain or determinable amount that Delta will pay ILFC at the end of the lease to purchase the aircraft at the end of the lease, or (2) the amount Delta or the third party guarantees that ILFC will realize if the aircraft is returned. (Third-party guarantors are, in essence, insurers who for a fee assume the risk of defi ciencies in leased asset residual value.) If not guaranteed in full, the unguaranteed residual value is the estimated residual value exclusive of any portion guaranteed.5 3. Penalty for failure to renew or extend the lease. The amount Delta must pay if the agreement specifi es that it must extend or renew the lease, and it fails to do so.

4. Bargain-purchase option. As we indicated earlier (in item 1), an option given to Delta to purchase the aircraft at the end of the lease term at a price that is fi xed suffi ciently below the expected fair value, so that, at the inception of the lease, purchase is reasonably assured. Delta excludes executory costs (defined below) from its computation of the present value of the minimum lease payments. Executory Costs. Like most assets, leased tangible assets incur insurance, maintenance, and tax expenses—called executory costs—during their economic life. If ILFC retains responsibility for the payment of these “ownership-type costs,” it should exclude, in computing the present value of the minimum lease payments, a portion of each lease payment that represents executory costs. Executory costs do not represent payment on or reduction of the obligation. Many lease agreements specify that the lessee directly pays executory costs to the appropriate third parties. In these cases, the lessor can use the rental payment without adjustment in the present value computation. Discount Rate. A lessee like Delta generally computes the present value of the mini- mum lease payments using its incremental borrowing rate. This rate is defined as: “The rate that, at the inception of the lease, the lessee would have incurred to borrow the funds necessary to buy the leased asset on a secured loan with repayment terms similar to the payment schedule called for in the lease.” [4] To determine whether the present value of these payments is less than 90 percent of the fair value of the property, Delta discounts the payments using its incremental borrowing rate. Determining the incremental borrowing rate often requires judgment because the lessee bases it on a hypothetical purchase of the property. However, there is one exception to this rule. If (1) Delta knows the implicit interest rate computed by ILFC and (2) it is less than Delta’s incremental borrowing rate, then Delta must use ILFC’s implicit rate. What is the interest rate implicit in the lease? It is the discount rate that, when applied to the minimum lease payments and any unguar- anteed residual value accruing to the lessor, causes the aggregate present value to equal the fair value of the leased property to the lessor. [5] The purpose of this exception is twofold. First, the implicit rate of ILFC is generally a more realistic rate to use in determining the amount (if any) to report as the asset and related liability for Delta. Second, the guideline ensures that Delta does not use an artifi- cially high incremental borrowing rate that would cause the present value of the mini- mum lease payments to be less than 90 percent of the fair value of the aircraft. Use of such a rate would thus make it possible to avoid capitalization of the asset and related liability. 5A lease provision requiring the lessee to make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage is not included in the minimum lease payments. Lessees recognize such costs as period costs when incurred. [3] 1278 Chapter 21 Accounting for Leases Delta may argue that it cannot determine the implicit rate of the lessor and therefore should use the higher rate. However, in most cases, Delta can approximate the implicit rate used by ILFC. The determination of whether or not a reasonable estimate could be made will require judgment, particularly where the result from using the incremental borrowing rate comes close to meeting the 90 percent test. Because Delta may not capi- talize the leased property at more than its fair value (as we discuss later), it cannot use an excessively low discount rate. Asset and Liability Accounted for Differently In a capital lease transaction, Delta uses the lease as a source of financing. ILFC finances the transaction (provides the investment capital) through the leased asset. Delta makes rent payments, which actually are installment payments. Therefore, over the life of the aircraft rented, the rental payments to ILFC constitute a payment of principal plus interest.

Asset and Liability Recorded Under the capital lease method, Delta treats the lease transaction as if it purchases the aircraft in a financing transaction. That is, Delta acquires the aircraft and creates an obligation. Therefore, it records a capital lease as an asset and a liability at the lower of (1) the present value of the minimum lease payments (excluding executory costs) or (2) the fair value of the leased asset at the inception of the lease. The rationale for this approach is that companies should not record a leased asset for more than its fair value. Depreciation Period One troublesome aspect of accounting for the depreciation of the capitalized leased asset relates to the period of depreciation. If the lease agreement transfers ownership of the asset to Delta (criterion 1) or contains a bargain-purchase option (criterion 2), Delta depreciates the aircraft consistent with its normal depreciation policy for other aircraft, using the economic life of the asset. On the other hand, if the lease does not transfer ownership or does not contain a bargain-purchase option, then Delta depreciates it over the term of the lease. In this case, the aircraft reverts to ILFC after a certain period of time. Effective-Interest Method Throughout the term of the lease, Delta uses the effective-interest method to allocate each lease payment between principal and interest. This method produces a periodic interest expense equal to a constant percentage of the carrying value of the lease obliga- tion. When applying the effective-interest method to capital leases, Delta must use the same discount rate that determines the present value of the minimum lease payments. Depreciation Concept Although Delta computes the amounts initially capitalized as an asset and recorded as an obligation at the same present value, the depreciation of the aircraft and the dis- charge of the obligation are independent accounting processes during the term of the lease. It should depreciate the leased asset by applying conventional depreciation meth- ods: straight-line, sum-of-the-years’-digits, declining-balance, units of production, etc. The FASB uses the term “amortization” more frequently than “depreciation” to recog- nize intangible leased property rights. We prefer “depreciation” to describe the write-off of a tangible asset’s expired services. Capital Lease Method (Lessee) To illustrate a capital lease, assume that Caterpillar Financial Services Corp. (a subsidiary of Caterpillar) and Sterling Construction Corp. sign a lease agreement dated January 1, Accounting by the Lessee 1279 2014, that calls for Caterpillar to lease a front-end loader to Sterling beginning January 1, 2014. The terms and provisions of the lease agreement, and other pertinent data, are as follows. • The term of the lease is five years. The lease agreement is noncancelable, requiring equal rental payments of $25,981.62 at the beginning of each year (annuity-due basis). • The loader has a fair value at the inception of the lease of $100,000, an estimated economic life of five years, and no residual value. • Sterling pays all of the executory costs directly to third parties except for the prop- erty taxes of $2,000 per year, which is included as part of its annual payments to Caterpillar. • The lease contains no renewal options. The loader reverts to Caterpillar at the termi- nation of the lease. • Sterling’s incremental borrowing rate is 11 percent per year. • Sterling depreciates, on a straight-line basis, similar equipment that it owns. • Caterpillar sets the annual rental to earn a rate of return on its investment of 10 per- cent per year; Sterling knows this fact. The lease meets the criteria for classification as a capital lease for the following reasons. 1. The lease term of fi ve years, being equal to the equipment’s estimated economic life of fi ve years, satisfi es the 75 percent test. 2. The present value of the minimum lease payments ($100,000 as computed below) exceeds 90 percent of the fair value of the loader ($100,000). The minimum lease payments are $119,908.10 ($23,981.62 3 5). Sterling computes

the amount capitalized as leased assets as the present value of the minimum lease payments (excluding executory costs—property taxes of $2,000) as shown in Illustration 21-5. ILLUSTRATION 21-5 Capitalized amount 5 ($25,981.62 2 $2,000) 3 Present value of an annuity due of 1 for Computation of 5 periods at 10% (Table 6-5) Capitalized Lease 5 $23,981.62 3 4.16986 5 $100,000 Payments Sterling uses Caterpillar’s implicit interest rate of 10 percent instead of its incremen- tal borrowing rate of 11 percent because (1) it is lower and (2) it knows about it.6 Calculator Solution for Lease Payment Sterling records the capital lease on its books on January 1, 2014, as: Inputs Answer Leased Equipment (under capital leases) 100,000 Lease Liability 100,000 N 5 Note that the entry records the obligation at the net amount of $100,000 (the present value of the future rental payments) rather than at the gross amount of $119,908.10 I 10 ($23,981.62 3 5). Sterling records the first lease payment on January 1, 2014, as follows. PV ? 100,000 Property Tax Expense 2,000.00 Lease Liability 23,981.62 Cash 25,981.62 PMT –23,981.59* 6If Sterling has an incremental borrowing rate of, say, 9 percent (lower than the 10 percent rate used by Caterpillar) and it did not know the rate used by Caterpillar, the present value compu- FV 0 tation would yield a capitalized amount of $101,675.35 ($23,981.62 3 4.23972). And, because this amount exceeds the $100,000 fair value of the equipment, Sterling should capitalize the $100,000 *Set payments at beginning of period. and use 10 percent as its effective rate for amortization of the lease obligation. 1280 Chapter 21 Accounting for Leases Each lease payment of $25,981.62 consists of three elements: (1) a reduction in the lease liability, (2) a financing cost (interest expense), and (3) executory costs (property taxes). The total financing cost (interest expense) over the term of the lease is $19,908.10. This amount is the difference between the present value of the lease payments ($100,000) and the actual cash disbursed, net of executory costs ($119,908.10). Therefore, the annual interest expense, applying the effective-interest method, is a function of the outstanding liability, as Illustration 21-6 shows. ILLUSTRATION 21-6 STERLING CONSTRUCTION Lease Amortization LEASE AMORTIZATION SCHEDULE Schedule for Lessee— ANNUITY-DUE BASIS Annuity-Due Basis Annual Reduction Lease Executory Interest (10%) of Lease Lease Date Payment Costs on Liability Liability Liability (a) (b) (c) (d) (e) 1/1/14 $100,000.00 1/1/14 $ 25,981.62 $ 2,000 $ –0– $ 23,981.62 76,018.38 1/1/15 25,981.62 2,000 7,601.84 16,379.78 59,638.60 1/1/16 25,981.62 2,000 5,963.86 18,017.76 41,620.84 1/1/17 25,981.62 2,000 4,162.08 19,819.54 21,801.30 1/1/18 25,981.62 2,000 2,180.32* 21,801.30 –0– $129,908.10 $10,000 $19,908.10 $100,000.00 (a) Lease payment as required by lease. (b) Executory costs included in rental payment. (c) Ten percent of the preceding balance of (e) except for 1/1/14; since this is an annuity due, no time has elapsed at the date of the first payment and no interest has accrued. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 19 cents. At the end of its fiscal year, December 31, 2014, Sterling records accrued interest as follows. Interest Expense 7,601.84 Interest Payable 7,601.84 Depreciation of the leased equipment over its five-year lease term, applying Sterling’s normal depreciation policy (straight-line method), results in the following entry on December 31, 2014. Depreciation Expense (capital leases) 20,000 Accumulated Depreciation—Capital Leases 20,000 ($100,000 4 5 years) At December 31, 2014, Sterling separately identifies the assets recorded under capital leases on its balance sheet. Similarly, it separately identifies the related obligations. Ster- ling classifies the portion due within one year or the operating cycle, whichever is longer, with current liabilities, and the rest with noncurrent liabilities. For example, the current portion of the December 31, 2014, total obligation of $76,018.38 in Sterling’s amortization

schedule is the amount of the reduction in the obligation in 2015, or $16,379.78. Illustration 21-7 shows the liabilities section as it relates to lease transactions at December 31, 2014. ILLUSTRATION 21-7 Current liabilities Reporting Current and Interest payable $ 7,601.84 Noncurrent Lease Lease liability 16,379.78 Liabilities Noncurrent liabilities Lease liability 59,638.60 Accounting by the Lessee 1281 Sterling records the lease payment of January 1, 2015, as follows. Property Tax Expense 2,000.00 Interest Payable 7,601.84 Lease Liability 16,379.78 Cash 25,981.62 Entries through 2018 follow the pattern above. Sterling records its other executory costs (insurance and maintenance) in a manner similar to how it records any other operating costs incurred on assets it owns. Upon expiration of the lease, Sterling has fully amortized the amount capitalized as leased equipment. It also has fully discharged its lease obligation. If Sterling does not purchase the loader, it returns the equipment to Caterpillar. Sterling then removes the leased equipment and related accumulated depreciation accounts from its books.7 If Sterling purchases the equipment at termination of the lease, at a price of $5,000, and the estimated life of the equipment changes from five to seven years, it makes the following entry. Equipment ($100,000 1 $5,000) 105,000 Accumulated Depreciation—Capital Leases 100,000 Leased Equipment (under capital leases) 100,000 Accumulated Depreciation—Equipment 100,000 Cash 5,000 Operating Method (Lessee) Under the operating method, rent expense (and the associated liability) accrues day by day to the lessee as it uses the property. The lessee assigns rent to the periods benefit- ing from the use of the asset and ignores, in the accounting, any commitments to make future payments. The lessee makes appropriate accruals or deferrals if the ac- counting period ends between cash payment dates. For example, assume that the capital lease illustrated in the previous section did not qualify as a capital lease. Sterling therefore accounts for it as an operating lease. The first-year charge to operations is now $25,981.62, the amount of the rental payment. Sterling records this payment on January 1, 2014, as follows. Rent Expense 25,981.62 Cash 25,981.62 Sterling does not report the loader, as well as any long-term liability for future rental payments, on the balance sheet. Sterling reports rent expense on the income statement. And, as discussed later in the chapter, Sterling must disclose all operating leases that have noncancelable lease terms in excess of one year. What do the numbers mean? RESTATEMENTS ON THE MENU Accounting for operating leases would appear routine, so The problem stems from the way most property (and it is unusual for a bevy of companies in a single industry— equipment) leases cover a specific number of years (the restaurants—to get caught up in the accounting rules for so-called primary lease term) as well as renewal periods operating leases. Getting the accounting right is particularly (sometimes referred to as the option term). In some cases, important for restaurant chains because they make extensive companies were calculating their lease expense for the use of leases for their restaurants and equipment. primary term but depreciating lease-related assets over 7If Sterling purchases the front-end loader during the term of a “capital lease,” it accounts for it like a renewal or extension of a capital lease. “Any difference between the purchase price and the carrying amount of the lease obligation shall be recorded as an adjustment of the carrying amount of the asset.” [6] 1282 Chapter 21 Accounting for Leases both the primary and option terms. This practice resulted calculating both lease expense and depreciation. The change in understating the total cost of the lease and thus boosted increases depreciation annually, which in turn decreases earnings. total assets. For example, the CFO at CKE Restaurants Inc., owner of CKE was not alone in improper operating lease account- the Hardee’s and Carl’s Jr. chains, noted that CKE ran into ing. Notable restaurateurs who ran afoul of the lease rules

trouble because it was not consistent in calculating the lease included Brinker International Inc., operator of Chili’s; and depreciation expense. Correcting the error at CKE reduced Darden Restaurants Inc., which operates Red Lobster and earnings by nine cents a share in fi scal 2002, nine cents a Olive Garden; and Jack in the Box. To correct their operating share in fiscal 2003, and 10 cents a share in fiscal 2004. lease accounting, these restaurants reported restatements The company now uses the shorter, primary lease terms for that resulted in lower earnings and assets. Source: Steven D. Jones and Richard Gibson, Wall Street Journal (January 26, 2005), p. C3. Comparison of Capital Lease with Operating Lease As we indicated, if accounting for the lease as an operating lease, the first-year LEARNING OBJECTIVE 3 charge to operations is $25,981.62, the amount of the rental payment. Treating Contrast the operating and the transaction as a capital lease, however, results in a first-year charge of capitalization methods of recording leases. $29,601.84: depreciation of $20,000 (assuming straight-line), interest expense of $7,601.84 (per Illustration 21-6), and executory costs of $2,000. Illustration 21-8 shows that while the total charges to operations are the same over the lease term whether accounting for the lease as a capital lease or as an operating lease, under the capital lease treatment the charges are higher in the earlier years and lower in the later years.8 ILLUSTRATION 21-8 STERLING CONSTRUCTION Comparison of Charges SCHEDULE OF CHARGES TO OPERATIONS to Operations—Capital CAPITAL LEASE VERSUS OPERATING LEASE vs. Operating Leases Capital Lease Operating Executory Total Lease Year Depreciation Costs Interest Charge Charge Difference 2014 $ 20,000 $ 2,000 $ 7,601.84 $ 29,601.84 $ 25,981.62 $3,620.22 2015 20,000 2,000 5,963.86 27,963.86 25,981.62 1,982.24 2016 20,000 2,000 4,162.08 26,162.08 25,981.62 180.46 2017 20,000 2,000 2,180.32 24,180.32 25,981.62 (1,801.30) 2018 20,000 2,000 — 22,000.00 25,981.62 (3,981.62) $100,000 $10,000 $19,908.10 $129,908.10 $129,908.10 $ –0– If using an accelerated method of depreciation, the differences between the amounts charged to operations under the two methods would be even larger in the earlier and later years. In addition, using the capital lease approach results in an asset and related liability of $100,000 initially reported on the balance sheet. The lessee would not report any asset 8The higher charges in the early years is one reason lessees are reluctant to adopt the capital lease accounting method. Lessees (especially those of real estate) claim that it is really no more costly to operate the leased asset in the early years than in the later years. Thus, they advocate an even charge similar to that provided by the operating method. Accounting by the Lessee 1283 or liability under the operating method. Therefore, the following differences occur if using a capital lease instead of an operating lease. 1. An increase in the amount of reported debt (both short-term and long-term). 2. An increase in the amount of total assets (specifi cally long-lived assets). 3. A lower income early in the life of the lease and, therefore, lower retained earnings. Thus, many companies believe that capital leases negatively impact their financial position: Their debt to total equity ratio increases, and their rate of return on total assets decreases. As a result, the business community resists capitalizing leases. Whether this resistance is well founded is debatable. From a cash flow point of view, the company is in the same position whether accounting for the lease as an operating or a capital lease. Managers often argue against capitalization for several reasons. First, capitalization can more easily lead to violation of loan covenants. It also can affect the amount of compensation received by owners (for example, a stock compensation plan tied to earnings). Finally, capitalization can lower rates of return and increase debt to equity relationships, making the company less attractive to present and potential

investors.9 Evolving Issue ARE YOU LIABLE? Under current accounting rules, companies can keep the And it is not just retailers who would be impacted. A obligations associated with operating leases off the balance PricewaterhouseCoopers survey of 3,000 international com- sheet. (For example, see the “What Do the Numbers Mean?” panies indicated the following impacts for several industries. box on page 1273 for the effects of this approach for airlines.) This approach may change if the FASB and IASB are able to Average craft a new lease accounting rule. The current plans for a new Increase in Companies Average Interest- with over Increase in rule in this area should result in many more operating leases Bearing Debt 25% Increase Leverage on balance sheets. Analysts are beginning to estimate the Retail and trade 213% 71% 64% expected impact of a new rule. As shown in the table below, Other services 51 35 34 if the FASB (and IASB) issue a new rule on operating leases, Transportation and a company like Walgreen could see its liabilities jump a warehousing 95 38 31 whopping 216 percent. Professional services 158 52 19 Accommodation 101 41 18 Estimated Off- Jump in Liabilities All companies 58 24 13 Balance-Sheet If They Were on Retailer Lease Liabilities the Balance Sheet As indicated, the expected effects are signifi cant, with all McDonald’s $ 7.996 billion 149% companies expecting a 58 percent increase in their debt levels Walgreen 23.212 216 and a 13 percent increase in leverage ratios. Home Depot 5.846 27 Starbucks 3.685 146 This is not a pretty picture, but investors need to see it if CVS 26.913 104 they are to fully understand a company’s lease obligations. Sources: Nanette Byrnes, “You May Be Liable for That Lease,” BusinessWeek (June 5, 2006), p. 76; PricewaterhouseCoopers, The Future of Leasing: Research of Impact on Companies’ Financial Ratios (2009); and J. E. Ketz, “Operating Lease Obligations to Be Capitalized,” Smartpros (August 2010), http://accounting.smartpros.com/x70304.xml. 9One study indicates that management’s behavior did change as a result of the leasing rules. For example, many companies restructure their leases to avoid capitalization. Others increase their purchases of assets instead of leasing. Still others, faced with capitalization, postpone their debt offerings or issue stock instead. However, note that the study found no significant effect on stock or bond prices as a result of capitalization of leases. See A. Rashad Abdel-khalik, “The Economic Effects on Lessees of FASB Statement No. 13, Accounting for Leases,” Research Report (Stamford, Conn.: FASB, 1981). 1284 Chapter 21 Accounting for Leases ACCOUNTING BY THE LESSOR Earlier in this chapter, we discussed leasing’s advantages to the lessee. Three LEARNING OBJECTIVE 4 important benefits are available to the lessor: Explain the advantages and economics of leasing to lessors and identify the 1. Interest revenue. Leasing is a form of fi nancing. Banks, captives, and indepen- classifications of leases for the lessor. dent leasing companies fi nd leasing attractive because it provides competitive interest margins. 2. Tax incentives. In many cases, companies that lease cannot use the tax benefi t of the asset, but leasing allows them to transfer such tax benefi ts to another party (the lessor) in return for a lower rental rate on the leased asset. To illustrate, Boeing Aircraft might sell one of its 737 jet planes to a wealthy investor who needed only the tax benefi t. The investor then leased the plane to a foreign airline, for whom the tax benefi t was of no use. Everyone gained. Boeing sold its airplane, the investor received the tax benefi t, and the foreign airline cheaply acquired a 737.10 3. High residual value. Another advantage to the lessor is the return of the property at the end of the lease term. Residual values can produce very large profi ts. Citigroup at one time estimated that the commercial aircraft it was leasing to the airline industry would have a residual value of 5 percent of their purchase price. It turned out that

they were worth 150 percent of their cost—a handsome profi t. At the same time, if residual values decline, lessors can suffer losses when less-valuable leased assets are returned at the conclusion of the lease. At one time, automaker Ford took a $2.1 billion write-down on its lease portfolio, when rising gas prices spurred dramatic declines in the resale values of leased trucks and SUVs. Such residual value losses led Chrysler to get out of the leasing business altogether. Economics of Leasing A lessor, such as Caterpillar Financial in our earlier example, determines the amount of the rental, basing it on the rate of return—the implicit rate—needed to justify leasing the front-end loader. In establishing the rate of return, Caterpillar considers the credit stand- ing of Sterling Construction, the length of the lease, and the status of the residual value (guaranteed versus unguaranteed). In the Caterpillar/Sterling example on pages 1278–1281, Caterpillar’s implicit rate was 10 percent, the cost of the equipment to Caterpillar was $100,000 (also fair value), and the estimated residual value was zero. Caterpillar determines the amount of the lease payment as follows. ILLUSTRATION 21-9 Fair value of leased equipment $100,000.00 Computation of Lease Less: Present value of the residual value –0– Payments Amount to be recovered by lessor through lease payments $100,000.00 Five beginning-of-the-year lease payments to yield a 10% return ($100,000 4 4.16986a) $ 23,981.62 aPV of an annuity due of 1 for 5 years at 10% (Table 6-5). If a residual value is involved (whether guaranteed or not), Caterpillar would not have to recover as much from the lease payments. Therefore, the lease payments would be less. (Illustration 21-16, on page 1291, shows this situation.) 10Some would argue that there is a loser—the U.S. government. The tax benefits enable the profitable investor to reduce or eliminate taxable income. Accounting by the Lessor 1285 Classifi cation of Leases by the Lessor For accounting purposes, the lessor may classify leases as one of the following: 1. Operating leases. 2. Direct-fi nancing leases. 3. Sales-type leases. Illustration 21-10 presents two groups of capitalization criteria for the lessor. If at the date of inception the lessor agrees to a lease that meets one or more of the Group I criteria (1, 2, 3, and 4) and both of the Group II criteria (1 and 2), the lessor shall classify and account for the arrangement as a direct-financing lease or as a sales-type lease. [7] Note that the Group I criteria are identical to the criteria that must be met in order for a lessee to classify a lease as a capital lease, as shown in Illustration 21-3 (on page 1275). ILLUSTRATION 21-10 Capitalization Criteria (Lessor) Capitalization Criteria Group I for Lessor 1. The lease transfers ownership of the property to the lessee. 2. The lease contains a bargain-purchase option. 3. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. 4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property. Group II 1. Collectibility of the payments required from the lessee is reasonably predictable. 2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease (lessor’s performance is substantially complete or future costs are reasonably predictable). International Why the Group II requirements? The profession wants to ensure that the Perspective lessor has really transferred the risks and benefits of ownership. If collectibility of payments is not predictable or if performance by the lessor is incomplete, GAAP is consistent with then the criteria for revenue recognition have not been met. The lessor should International Accounting therefore account for the lease as an operating lease. Standard No. 17 (Accounting For example, computer leasing companies at one time used to buy IBM for Leases). However, the equipment, lease the equipment, and remove the leased assets from their international standard is a

relatively simple statement of balance sheets. In leasing the assets, the computer lessors stated that they would basic principles, whereas the substitute new IBM equipment if obsolescence occurred. However, when IBM U.S. rules on leases are more introduced a new computer line, IBM refused to sell it to the computer leasing prescriptive and detailed. companies. As a result, a number of the lessors could not meet their contracts with their customers and had to take back the old equipment. The computer leasing companies therefore had to reinstate the assets they had taken off the books. Such a case demonstrates one reason for the Group II requirements. The distinction for the lessor between a direct-financing lease and a sales-type lease is the presence or absence of a manufacturer’s or dealer’s profit (or loss). A sales- type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not. The profit (or loss) to the lessor is evidenced by the difference between the fair value of the leased property at the inception of the lease and the lessor’s cost or carrying amount (book value). Normally, sales-type leases arise when manufacturers or dealers use leasing as a means of marketing their products. For example, a computer manufacturer will lease its computer equipment (possibly through a captive) to businesses and institutions. Direct-financing leases generally result from arrangements with lessors that are primarily 1286 Chapter 21 Accounting for Leases engaged in financing operations (e.g., banks). However, a lessor need not be a manufac- turer or dealer to recognize a profit (or loss) at the inception of a lease that requires application of sales-type lease accounting. Lessors classify and account for all leases that do not qualify as direct-financing or sales-type leases as operating leases. Illustration 21-11 shows the circumstances under which a lessor classifies a lease as operating, direct-financing, or sales-type. Lease Agreement AnL (ye C S a o r aD s if t me o eG e r eM r is ao ae ?u se pt I Yes of LC Reo a e Cl sl a ee e s rc I o tPts ani a ib a nyi b ?l mi lt yey nts Yes SP CueL b orf me so ts rI a ps ms no lea tr ti' ns a ec l ?le y Yes LV eA a sls s VusD o aee ro l 't usEe eF s q B ?a u oi ar ol k Yes Lessee's) Direct- No No No No Financing Lease Operating Sales-Type Lease Lease ILLUSTRATION 21-11 Diagram of Lessor’s As a consequence of the additional Group II criteria for lessors, a lessor may classify Criteria for Lease a lease as an operating lease but the lessee may classify the same lease as a capital lease. Classifi cation In such an event, both the lessor and lessee will carry the asset on their books, and both will depreciate the capitalized asset. For purposes of comparison with the lessee’s accounting, we will illustrate only the operating and direct-financing leases in the following section. We will discuss the more complex sales-type lease later in the chapter. Direct-Financing Method (Lessor) Direct-financing leases are in substance the financing of an asset purchase by the LEARNING OBJECTIVE 5 lessee. In this type of lease, the lessor records a lease receivable instead of a leased Describe the lessor’s accounting asset. The lease receivable is the present value of the minimum lease payments. for direct-financing leases. Remember that “minimum lease payments” include: 1. Rental payments (excluding executory costs). 2. Bargain-purchase option (if any). 3. Guaranteed residual value (if any). 4. Penalty for failure to renew (if any). Thus, the lessor records the residual value, whether guaranteed or not. Also, recall that if the lessor pays any executory costs, then it should reduce the rental payment by that amount in computing minimum lease payments. The following presentation, using the data from the preceding Caterpillar/Sterling example on page 1279, illustrates the accounting treatment for a direct-financing lease. We repeat here the information relevant to Caterpillar in accounting for this lease trans- action. 1. The term of the lease is fi ve years beginning January 1, 2014, noncancelable, and

requires equal rental payments of $25,981.62 at the beginning of each year. Payments include $2,000 of executory costs (property taxes). Accounting by the Lessor 1287 2. The equipment (front-end loader) has a cost of $100,000 to Caterpillar, a fair value at the inception of the lease of $100,000, an estimated economic life of fi ve years, and no residual value. 3. Caterpillar incurred no initial direct costs in negotiating and closing the lease transaction. 4. The lease contains no renewal options. The equipment reverts to Caterpillar at the termination of the lease. 5. Collectibility is reasonably assured and Caterpillar incurs no additional costs (with the exception of the property taxes being collected from Sterling). 6. Caterpillar sets the annual lease payments to ensure a rate of return of 10 percent (implicit rate) on its investment as shown in Illustration 21-12. ILLUSTRATION 21-12 Fair value of leased equipment $100,000.00 Computation of Lease Less: Present value of residual value –0– Payments Amount to be recovered by lessor through lease payments $100,000.00 Five beginning-of-the-year lease payments to yield a 10% return ($100,000 4 4.16986a) $ 23,981.62 aPV of an annuity due of 1 for 5 years at 10% (Table 6-5). The lease meets the criteria for classification as a direct-financing lease for several reasons. (1) The lease term exceeds 75 percent of the equipment’s estimated economic life. (2) The present value of the minimum lease payments exceeds 90 percent of the equipment’s fair value. (3) Collectibility of the payments is reasonably assured. (4) Caterpillar incurs no further costs. It is not a sales-type lease because there is no dif- ference between the fair value ($100,000) of the loader and Caterpillar’s cost ($100,000). The Lease Receivable is the present value of the minimum lease payments (excluding executory costs which are property taxes of $2,000). Caterpillar computes it as follows. ILLUSTRATION 21-13 Lease receivable 5 ($25,981.62 2 $2,000) 3 Present value of an annuity due of 1 for 5 Computation of Lease periods at 10% (Table 6-5) Receivable 5 $23,981.62 3 4.16986 5 $100,000 Caterpillar records the lease of the asset and the resulting receivable on January 1, 2014 (the inception of the lease), as follows. Lease Receivable 100,000 Equipment 100,000 Companies often report the lease receivable in the balance sheet as “Net investment in capital leases.” Companies classify it either as current or noncurrent, depending on when they recover the net investment.11 Caterpillar replaces its investment (the leased front-end loader, a cost of $100,000), with a lease receivable. In a manner similar to Sterling’s treatment of interest, Caterpil- lar applies the effective-interest method and recognizes interest revenue as a function of the lease receivable balance, as Illustration 21-14 (page 1288) shows. 11In the notes to the financial statements (see Illustration 21-32, pages 1301–1302, for lessor disclosures by Hewlett-Packard), the lease receivable is reported at its gross amount (minimum lease payments plus the unguaranteed residual value). In addition, the lessor also reports total unearned interest related to the lease. As a result, some lessors record lease receivable on a gross basis and record the unearned interest in a separate account. We illustrate the net approach here because it is consistent with the accounting for the lessee. 1288 Chapter 21 Accounting for Leases ILLUSTRATION 21-14 CATERPILLAR FINANCIAL Lease Amortization LEASE AMORTIZATION SCHEDULE Schedule for Lessor— ANNUITY-DUE BASIS Annuity-Due Basis Annual Interest Lease Lease Executory (10%) on Receivable Lease Date Payment Costs Lease Receivable Recovery Receivable (a) (b) (c) (d) (e) 1/1/14 $100,000.00 1/1/14 $ 25,981.62 $ 2,000.00 $ –0– $ 23,981.62 76,018.38 1/1/15 25,981.62 2,000.00 7,601.84 16,379.78 59,638.60 1/1/16 25,981.62 2,000.00 5,963.86 18,017.76 41,620.84 1/1/17 25,981.62 2,000.00 4,162.08 19,819.54 21,801.30 1/1/18 25,981.62 2,000.00 2,180.32* 21,801.30 –0– $129,908.10 $10,000.00 $19,908.10 $100,000.00

(a) Annual rental that provides a 10% return on net investment. (b) Executory costs included in rental payment. (c) Ten percent of the preceding balance of (e) except for 1/1/14. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 19 cents. On January 1, 2014, Caterpillar records receipt of the first year’s lease payment as follows. Cash 25,981.62 Lease Receivable 23,981.62 Property Tax Expense/Property Taxes Payable 2,000.00 On December 31, 2014, Caterpillar recognizes the interest revenue during the first year through the following entry. Interest Receivable 7,601.84 Interest Revenue (leases) 7,601.84 At December 31, 2014, Caterpillar reports the lease receivable in its balance sheet among current assets or noncurrent assets, or both. It classifies the portion due within one year or the operating cycle, whichever is longer, as a current asset, and the rest with noncurrent assets. Illustration 21-15 shows the assets section as it relates to lease transactions at December 31, 2014. ILLUSTRATION 21-15 Current assets Reporting Lease Interest receivable $ 7,601.84 Transactions by Lessor Lease receivable 16,379.78 Noncurrent assets (investments) Lease receivable $59,638.60 The following entries record receipt of the second year’s lease payment and recog- nition of the interest. January 1, 2015 Cash 25,981.62 Lease Receivable 16,379.78 Interest Receivable 7,601.84 Property Tax Expense/Property Taxes Payable 2,000.00 Special Lease Accounting Problems 1289 December 31, 2015 Interest Receivable 5,963.86 Interest Revenue (leases) 5,963.86 Journal entries through 2018 follow the same pattern except that Caterpillar records no entry in 2018 (the last year) for interest revenue. Because it fully collects the receiv- able by January 1, 2018, no balance (investment) is outstanding during 2018. Caterpillar recorded no depreciation. If Sterling buys the loader for $5,000 upon expiration of the lease, Caterpillar recognizes disposition of the equipment as follows. Cash 5,000 Gain on Disposal of Equipment 5,000 Operating Method (Lessor) Under the operating method, the lessor records each rental receipt as rental revenue. It depreciates the leased asset in the normal manner, with the depreciation expense of the period matched against the rental revenue. The amount of revenue recognized in each accounting period is a level amount (straight-line basis) regardless of the lease provisions, unless another systematic and rational basis better represents the time pat- tern in which the lessor derives benefit from the leased asset. In addition to the depreciation charge, the lessor expenses maintenance costs and the cost of any other services performed under the provisions of the lease that pertain to the current accounting period. The lessor amortizes over the life of the lease any costs paid to independent third parties, such as appraisal fees, finder’s fees, and costs of credit checks, usually on a straight-line basis. To illustrate the operating method, assume that the direct-financing lease illustrated in the previous section does not qualify as a capital lease. Therefore, Caterpillar ac- counts for it as an operating lease. It records the cash rental receipt, assuming the $2,000 was for property tax expense, as follows. Cash 25,981.62 Rent Revenue 25,981.62 Caterpillar records depreciation as follows (assuming a straight-line method, a cost basis of $100,000, and a five-year life). Depreciation Expense (leased equipment) 20,000 Accumulated Depreciation—Equipment 20,000 If Caterpillar pays property taxes, insurance, maintenance, and other operating costs during the year, it records them as expenses chargeable against the gross rental revenues. If Caterpillar owns plant assets that it uses in addition to those leased to others, the company separately classifies the leased equipment and accompanying accumulated depreciation as Equipment Leased to Others or Investment in Leased Property. If signifi- cant in amount or in terms of activity, Caterpillar separates the rental revenues and accompanying expenses in the income statement from sales revenue and cost of goods sold.

SPECIAL LEASE ACCOUNTING PROBLEMS The features of lease arrangements that cause unique accounting problems are: 6 LEARNING OBJECTIVE Identify special features of lease 1. Residual values. arrangements that cause unique 2. Sales-type leases (lessor). accounting problems. 3. Bargain-purchase options. 1290 Chapter 21 Accounting for Leases 4. Initial direct costs. 5. Current versus noncurrent classifi cation. 6. Disclosure. We discuss each of these features on the following pages. Residual Values Up to this point, in order to develop the basic accounting issues related to lessee LEARNING OBJECTIVE 7 and lessor accounting, we have generally ignored residual values. Accounting Describe the effect of residual values, for residual values is complex and will probably provide you with the greatest guaranteed and unguaranteed, on lease challenge in understanding lease accounting. accounting. Meaning of Residual Value The residual value is the estimated fair value of the leased asset at the end of the lease term. Frequently, a significant residual value exists at the end of the lease term, espe- cially when the economic life of the leased asset exceeds the lease term. If title does not pass automatically to the lessee (criterion 1) and if a bargain-purchase option does not exist (criterion 2), the lessee returns physical custody of the asset to the lessor at the end of the lease term.12 Guaranteed versus Unguaranteed The residual value may be unguaranteed or guaranteed by the lessee. Sometimes the lessee agrees to make up any deficiency below a stated amount that the lessor realizes in residual value at the end of the lease term. In such a case, that stated amount is the guaranteed residual value. The parties to a lease use guaranteed residual value in lease arrangements for two reasons. The first is a business reason: It protects the lessor against any loss in estimated residual value, thereby ensuring the lessor of the desired rate of return on investment. The second reason is an accounting benefit that you will learn from the discussion at the end of this chapter. Lease Payments A guaranteed residual value—by definition—has more assurance of realization than does an unguaranteed residual value. As a result, the lessor may adjust lease payments because of the increased certainty of recovery. After the lessor establishes this rate, it makes no difference from an accounting point of view whether the residual value is guaranteed or unguaranteed. The net investment that the lessor records (once the rate is set) will be the same. Assume the same data as in the Caterpillar/Sterling illustrations except that Caterpillar estimates a residual value of $5,000 at the end of the five-year lease term. In addition, Caterpillar assumes a 10 percent return on investment (ROI),13 whether the residual value is guaranteed or unguaranteed. Caterpillar would compute the amount of the lease payments as follows. 12When the lease term and the economic life are not the same, the residual value and the salvage value of the asset will probably differ. For simplicity, we will assume that residual value and salvage value are the same, even when the economic life and lease term vary. 13Technically, the rate of return Caterpillar demands would differ depending upon whether the residual value was guaranteed or unguaranteed. To simplify the illustrations, we are ignoring this difference in subsequent sections. Special Lease Accounting Problems 1291 ILLUSTRATION 21-16 CATERPILLAR’S COMPUTATION OF LEASE PAYMENTS (10% ROI) Lessor’s Computation of GUARANTEED OR UNGUARANTEED RESIDUAL VALUE Lease Payments ANNUITY-DUE BASIS, INCLUDING RESIDUAL VALUE Fair value of leased asset to lessor $100,000.00 Less: Present value of residual value ($5,000 3 .62092, Table 6-2) 3,104.60 Amount to be recovered by lessor through lease payments $ 96,895.40 Five periodic lease payments ($96,895.40 4 4.16986, Table 6-5) $ 23,237.09 Contrast the foregoing lease payment amount to the lease payments of $23,981.62 as computed in Illustration 21-9 (on page 1284), where no residual value existed.

In the second example, the payments are less, because the present value of the residual value reduces Caterpillar’s total recoverable amount from $100,000 to $96,895.40. Lessee Accounting for Residual Value Whether the estimated residual value is guaranteed or unguaranteed has both economic and accounting consequence to the lessee. We saw the economic consequence—lower lease payments—in the preceding example. The accounting consequence is that the minimum lease payments, the basis for capitalization, include the guaranteed residual value but exclude the unguaranteed residual value. Guaranteed Residual Value (Lessee Accounting). A guaranteed residual value affects the lessee’s computation of minimum lease payments. Therefore, it also affects the amounts capitalized as a leased asset and a lease obligation. In effect, the guaranteed residual value is an additional lease payment that the lessee will pay in property or cash, or both, at the end of the lease term. Using the rental payments as computed by the lessor in Illustration 21-16, the mini- mum lease payments are $121,185.45 ([$23,237.09 3 5] 1 $5,000). Illustration 21-17 shows the capitalized present value of the minimum lease payments (excluding execu- tory costs) for Sterling Construction. ILLUSTRATION 21-17 STERLING’S CAPITALIZED AMOUNT (10% RATE) Computation of Lessee’s ANNUITY-DUE BASIS, INCLUDING GUARANTEED RESIDUAL VALUE Capitalized Amount— Present value of fi ve annual rental payments Guaranteed Residual ($23,237.09 3 4.16986, Table 6-5) $ 96,895.40 Value Present value of guaranteed residual value of $5,000 due fi ve years after date of inception: ($5,000 3 .62092, Table 6-2) 3,104.60 Lessee’s capitalized amount $100,000.00 Sterling prepares a schedule of interest expense and amortization of the $100,000 lease liability. That schedule, shown in Illustration 21-18 (page 1292), is based on a $5,000 final guaranteed residual value payment at the end of five years. Sterling records the leased asset (front-end loader) and liability, depreciation, inter- est, property tax, and lease payments on the basis of a guaranteed residual value. (These journal entries are shown in Illustration 21-23, on page 1294.) The format of these entries is the same as illustrated earlier, although the amounts are different because of the guaranteed residual value. Sterling records the loader at $100,000 and depreciates it over five years. To compute depreciation, it subtracts the guaranteed 1292 Chapter 21 Accounting for Leases ILLUSTRATION 21-18 STERLING CONSTRUCTION Lease Amortization LEASE AMORTIZATION SCHEDULE Schedule for Lessee— ANNUITY-DUE BASIS, GUARANTEED RESIDUAL VALUE—GRV Guaranteed Residual Value Lease Reduction Payment Executory Interest (10%) of Lease Lease Date Plus GRV Costs on Liability Liability Liability (a) (b) (c) (d) (e) 1/1/14 $100,000.00 1/1/14 $ 25,237.09 $ 2,000 –0– $ 23,237.09 76,762.91 1/1/15 25,237.09 2,000 $ 7,676.29 15,560.80 61,202.11 1/1/16 25,237.09 2,000 6,120.21 17,116.88 44,085.23 1/1/17 25,237.09 2,000 4,408.52 18,828.57 25,256.66 1/1/18 25,237.09 2,000 2,525.67 20,711.42 4,545.24 12/31/18 5,000.00* 454.76** 4,545.24 –0– $131,185.45 $10,000 $21,185.45 $100,000.00 (a) Annual lease payment as required by lease. *Represents the guaranteed residual value. (b) Executory costs included in rental payment. **Rounded by 24 cents. (c) Preceding balance of (e) 3 10%, except 1/1/14. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). residual value from the cost of the loader. Assuming that Sterling uses the straight-line method, the depreciation expense each year is $19,000 ([$100,000 2 $5,000] 4 5 years). At the end of the lease term, before the lessee transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances. ILLUSTRATION 21-19 Leased equipment (under capital leases) $100,000.00 Interest payable $ 454.76 Account Balances on Less: Accumulated depreciation— Lease liability 4,545.24 Lessee’s Books at End of capital leases 95,000.00 Lease Term—Guaranteed $ 5,000.00 $5,000.00 Residual Value

If at the end of the lease the fair value of the residual value is less than $5,000, Ster- ling will have to record a loss. Assume that Sterling depreciated the leased asset down to its residual value of $5,000 but that the fair value of the residual value at December 31, 2018, was $3,000. In this case, Sterling would have to report a loss of $2,000. Assum- ing that it pays cash to make up the residual value deficiency, Sterling would make the following journal entry. Loss on Capital Lease 2,000.00 Interest Expense (or Interest Payable) 454.76 Lease Liability 4,545.24 Accumulated Depreciation—Capital Leases 95,000.00 Leased Equipment (under capital leases) 100,000.00 Cash 2,000.00 If the fair value exceeds $5,000, a gain may be recognized. Caterpillar and Sterling may apportion gains on guaranteed residual values in whatever ratio the parties initially agree. When there is a guaranteed residual value, the lessee must be careful not to depreciate the total cost of the asset. For example, if Sterling mistakenly depreciated the total cost of the loader ($100,000), a misstatement would occur. That is, the carrying amount of the asset at the end of the lease term would be zero, but Sterling would show the liability under the capital lease at $5,000. In that case, if the asset was worth $5,000, Sterling would end up reporting a gain of $5,000 when it transferred the asset back to Special Lease Accounting Problems 1293 Caterpillar. As a result, Sterling would overstate depreciation and would understate net income in 2014–2017; in the last year (2018) net income would be overstated. Unguaranteed Residual Value (Lessee Accounting). From the lessee’s viewpoint, an unguaranteed residual value is the same as no residual value in terms of its effect upon the lessee’s method of computing the minimum lease payments and the capitalization of the leased asset and the lease liability. Assume the same facts as those above except that the $5,000 residual value is unguaranteed instead of guaranteed. The amount of the annual lease payments would be the same—$23,237.09. Whether the residual value is guaranteed or unguaranteed, Caterpillar will recover the same amount through lease rentals—that is, $96,895.40. The minimum lease payments are $116,185.45 ($23,237.09 3 5). Sterling would capitalize the amount shown in Illustration 21-20. ILLUSTRATION 21-20 STERLING’S CAPITALIZED AMOUNT (10% RATE) Computation of Lessee’s ANNUITY-DUE BASIS, INCLUDING UNGUARANTEED RESIDUAL VALUE Capitalized Amount— Present value of 5 annual rental payments of $23,237.09 3 4.16986 Unguaranteed Residual (Table 6-5) $96,895.40 Value Unguaranteed residual value of $5,000 (not capitalized by lessee) –0– Lessee’s capitalized amount $96,895.40 Illustration 21-21 shows Sterling’s schedule of interest expense and amortization of the lease liability of $96,895.40, assuming an unguaranteed residual value of $5,000 at the end of five years. ILLUSTRATION 21-21 STERLING CONSTRUCTION Lease Amortization LEASE AMORTIZATION SCHEDULE (10%) Schedule for Lessee— ANNUITY-DUE BASIS, UNGUARANTEED RESIDUAL VALUE Unguaranteed Residual Annual Reduction Value Lease Executory Interest (10%) of Lease Lease Date Payments Costs on Liability Liability Liability (a) (b) (c) (d) (e) 1/1/14 $96,895.40 1/1/14 $ 25,237.09 $ 2,000 –0– $23,237.09 73,658.31 1/1/15 25,237.09 2,000 $ 7,365.83 15,871.26 57,787.05 1/1/16 25,237.09 2,000 5,778.71 17,458.38 40,328.67 1/1/17 25,237.09 2,000 4,032.87 19,204.22 21,124.45 1/1/18 25,237.09 2,000 2,112.64* 21,124.45 –0– $126,185.45 $10,000 $19,290.05 $96,895.40 (a) Annual lease payment as required by lease. (b) Executory costs included in rental payment. (c) Preceding balance of (e) 3 10%. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 19 cents. Sterling records the leased asset and liability, depreciation, interest, property tax, and lease payments on the basis of an unguaranteed residual value. (These journal entries are shown in Illustration 21-23 on page 1294.) The format of these capital lease entries is the same as illustrated earlier. Note that Sterling records the leased asset at $96,895.40 and depreciates

it over five years. Assuming that it uses the straight-line method, the depreciation expense each year is $19,379.08 ($96,895.40 4 5 years). At the end of the lease term, before Sterling transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances. 1294 Chapter 21 Accounting for Leases ILLUSTRATION 21-22 Leased equipment (under capital Lease liability $–0– Account Balances on leases) $96,895 Lessee’s Books at Less: Accumulated depreciation— End of Lease Term— capital leases 96,895 Unguaranteed Residual $ –0– Value Assuming that Sterling has fully depreciated the leased asset and has fully amor- tized the lease liability, no entry is required at the end of the lease term, except to remove the asset from the books. If Sterling depreciated the asset down to its unguaranteed residual value, a mis- statement would occur. That is, the carrying amount of the leased asset would be $5,000 at the end of the lease, but the liability under the capital lease would be stated at zero before the transfer of the asset. Thus, Sterling would end up reporting a loss of $5,000 when it transferred the asset back to Caterpillar. Sterling would understate depreciation and would overstate net income in 2014–2017; in the last year (2018), net income would be understated because of the recorded loss. ILLUSTRATION 21-23 Comparative Entries Lessee Entries Involving Residual Values. Illustration 21-23 shows, in comparative for Guaranteed and Unguaranteed Residual form, Sterling’s entries for both a guaranteed and an unguaranteed residual value. Values, Lessee Company Guaranteed Residual Value Unguaranteed Residual Value Capitalization of lease (January 1, 2014): Leased Equipment Leased Equipment (under capital leases) 100,000.00 (under capital leases) 96,895.40 Lease Liability 100,000.00 Lease Liability 96,895.40 First payment (January 1, 2014): Property Tax Expense 2,000.00 Property Tax Expense 2,000.00 Lease Liability 23,237.09 Lease Liability 23,237.09 Cash 25,237.09 Cash 25,237.09 Adjusting entry for accrued interest (December 31, 2014): Interest Expense 7,676.29 Interest Expense 7,365.83 Interest Payable 7,676.29 Interest Payable 7,365.83 Entry to record depreciation (December 31, 2014): Depreciation Expense Depreciation Expense (capital leases) 19,000.00 (capital leases) 19,379.08 Accumulated Depreciation— Accumulated Depreciation— Capital Leases 19,000.00 Capital Leases 19,379.08 ([$100,000 2 $5,000] 4 5 years) ($96,895.40 4 5 years) Second payment (January 1, 2015): Property Tax Expense 2,000.00 Property Tax Expense 2,000.00 Lease Liability 15,560.80 Lease Liability 15,871.26 Interest Expense Interest Expense (or Interest Payable) 7,676.29 (or Interest Payable) 7,365.83 Cash 25,237.09 Cash 25,237.09 Lessor Accounting for Residual Value As we indicated earlier, the lessor will recover the same net investment whether the residual value is guaranteed or unguaranteed. That is, the lessor works on the assumption that it will realize the residual value at the end of the lease term whether guaranteed or unguaranteed. The lease payments required in order for the company to earn a certain Special Lease Accounting Problems 1295 return on investment are the same (e.g., $23,237.09 in our example) whether the residual value is guaranteed or unguaranteed. To illustrate, we again use the Caterpillar/Sterling data and assume classification of the lease as a direct-financing lease. With a residual value (either guaranteed or unguar- anteed) of $5,000, Caterpillar determines the payments as shown in Illustration 21-24. ILLUSTRATION 21-24 Fair value of leased equipment $100,000.00 Computation of Direct- Less: Present value of residual value ($5,000 3 .62092, Table 6-2) 3,104.60 Financing Lease Amount to be recovered by lessor through lease payments $ 96,895.40 Payments Five beginning-of-the-year lease payments to yield a 10% return ($96,895.40 4 4.16986, Table 6-5) $ 23,237.09 The amortization schedule is the same for guaranteed or unguaranteed residual value, as Illustration 21-25 shows. ILLUSTRATION 21-25

CATERPILLAR FINANCIAL Lease Amortization LEASE AMORTIZATION SCHEDULE Schedule, for Lessor— ANNUITY-DUE BASIS, GUARANTEED OR UNGUARANTEED RESIDUAL VALUE Guaranteed or Annual Lease Interest Unguaranteed Residual Payment Plus (10%) on Lease Value Residual Executory Lease Receivable Lease Date Value Costs Receivable Recovery Receivable (a) (b) (c) (d) (e) 1/1/14 $100,000.00 1/1/14 $ 25,237.09 $ 2,000.00 $ –0– $ 23,237.09 76,762.91 1/1/15 25,237.09 2,000.00 7,676.29 15,560.80 61,202.11 1/1/16 25,237.09 2,000.00 6,120.21 17,116.88 44,085.23 1/1/17 25,237.09 2,000.00 4,408.52 18,828.57 25,256.66 1/1/18 25,237.09 2,000.00 2,525.67 20,711.42 4,545.24 12/31/18 5,000.00 –0– 454.76* 4,545.24 –0– $131,185.45 $10,000.00 $21,185.45 $100,000.00 (a) Annual lease payment as required by lease. (b) Executory costs included in rental payment. (c) Preceding balance of (e) 3 10%, except 1/1/14. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 24 cents. Using the amounts computed above, Caterpillar would make the following entries for this direct-financing lease in the first year. Note the similarity to Sterling’s entries in Illustration 21-23. ILLUSTRATION 21-26 Inception of lease (January 1, 2014): Entries for Either Lease Receivable 100,000.00 Guaranteed or Equipment 100,000.00 Unguaranteed Residual Value, Lessor Company First payment received (January 1, 2014): Cash 25,237.09 Lease Receivable 23,237.09 Property Tax Expense/Property Taxes Payable 2,000.00 Adjusting entry for accrued interest (December 31, 2014): Interest Receivable 7,676.29 Interest Revenue 7,676.29 1296 Chapter 21 Accounting for Leases Sales-Type Leases (Lessor) As already indicated, the primary difference between a direct-financing lease LEARNING OBJECTIVE 8 and a sales-type lease is the manufacturer’s or dealer’s gross profit (or loss). The Describe the lessor’s accounting for diagram in Illustration 21-27 presents the distinctions between direct-financing sale-type leases. and sales-type leases. Direct-Financing Lease Equals Fair Value Total Payments Cost of (Interest and Asset Principal) Interest Revenue Sales-Type Lease Does Not Equal Fair Value Total Payments Cost of Sales Price (Interest and Asset of Asset Principal) Gross Profit Interest Revenue ILLUSTRATION 21-27 In a sales-type lease, the lessor records the sales price of the asset, the cost of goods Direct-Financing versus sold and related inventory reduction, and the lease receivable. The information neces- Sales-Type Leases sary to record the sales-type lease is as follows. SALES-TYPE LEASE TERMS LEASE RECEIVABLE (also referred to as NET INVESTMENT). The present value of the minimum lease payments plus the present value of any unguaranteed residual value. The lease receivable therefore includes the present value of the residual value, whether guaran- teed or not. SALES PRICE OF THE ASSET. The present value of the minimum lease payments. COST OF GOODS SOLD. The cost of the asset to the lessor, less the present value of any unguaranteed residual value. When recording sales revenue and cost of goods sold, there is a difference in the ac- counting for guaranteed and unguaranteed residual values. The guaranteed residual value can be considered part of sales revenue because the lessor knows that the entire asset has been sold. But there is less certainty that the unguaranteed residual portion of the asset has been “sold” (i.e., will be realized). Therefore, the lessor recognizes sales and cost of goods sold only for the portion of the asset for which realization is assured. However, the gross profit amount on the sale of the asset is the same whether a guar- anteed or unguaranteed residual value is involved. To illustrate a sales-type lease with a guaranteed residual value and with an unguar- anteed residual value, assume the same facts as in the preceding direct-financing lease situation (pages 1286–1287). The estimated residual value is $5,000 (the present value of which is $3,104.60), and the leased equipment has an $85,000 cost to the dealer, Caterpil- lar. Assume that the fair value of the residual value is $3,000 at the end of the lease term.

Special Lease Accounting Problems 1297 Illustration 21-28 shows computation of the amounts relevant to a sales-type lease. ILLUSTRATION 21-28 Sales-Type Lease Computation of Lease Guaranteed Unguaranteed Amounts by Caterpillar Residual Value Residual Value Financial—Sales-Type Lease receivable $100,000 Lease [$23,237.09 3 4.16986 (Table 6-5) Same 1 $5,000 3.62092 (Table 6-2)] Sales price of the asset $100,000 $96,895.40 ($100,000 2 $3,104.60) Cost of goods sold $85,000 $81,895.40 ($85,000 2 $3,104.60) Gross profit $15,000 $15,000 ($100,000 2 $85,000) ($96,895.40 2 $81,895.40) Caterpillar records the same profit ($15,000) at the point of sale whether the residual value is guaranteed or unguaranteed. The difference between the two is that the sales revenue and cost of goods sold amounts are different. In making this computation, we deduct the present value of the unguaranteed re- sidual value from sales revenue and cost of goods sold for two reasons. (1) The criteria for revenue recognition have not been met. (2) It is improper to record an expense against revenue not yet recognized. The revenue recognition criteria have not been met because ILLUSTRATION 21-29 of the uncertainty surrounding the realization of the unguaranteed residual value. Entries for Guaranteed and Unguaranteed Caterpillar makes the following entries to record this transaction on January 1, 2014, Residual Values, Lessor and the receipt of the residual value at the end of the lease term. Company—Sales-Type Lease Guaranteed Residual Value Unguaranteed Residual Value To record sales-type lease at inception (January 1, 2014): Cost of Goods Sold 85,000.00 Cost of Goods Sold 81,895.40 Lease Receivable 100,000.00 Lease Receivable 100,000.00 Sales Revenue 100,000.00 Sales Revenue 96,895.40 Inventory 85,000.00 Inventory 85,000.00 To record receipt of the first lease payment (January 1, 2014): Cash 25,237.09 Cash 25,237.09 Lease Receivable 23,237.09 Lease Receivable 23,237.09 Property Tax Exp./Pay. 2,000.00 Property Tax Exp./Pay. 2,000.00 To recognize interest revenue during the first year (December 31, 2014): Interest Receivable 7,676.29 Interest Receivable 7,676.29 Interest Revenue 7,676.29 Interest Revenue 7,676.29 (See lease amortization schedule, Illustration 21-25 on page 1295) To record receipt of the second lease payment (January 1, 2015): Cash 25,237.09 Cash 25,237.09 Interest Receivable 7,676.29 Interest Receivable 7,676.29 Lease Receivable 15,560.80 Lease Receivable 15,560.80 Property Tax Exp./Pay. 2,000.00 Property Tax Exp./Pay. 2,000.00 To recognize interest revenue during the second year (December 31, 2015): Interest Receivable 6,120.21 Interest Receivable 6,120.21 Interest Revenue 6,120.21 Interest Revenue 6,120.21 To record receipt of residual value at end of lease term (December 31, 2018): Inventory 3,000 Inventory 3,000 Cash 2,000 Loss on Capital Lease 2,000 Lease Receivable 5,000 Lease Receivable 5,000 1298 Chapter 21 Accounting for Leases Gateway to Companies must periodically review the estimated unguaranteed residual value the Profession in a sales-type lease. If the estimate of the unguaranteed residual value declines, the Expanded Discussion of company must revise the accounting for the transaction using the changed estimate. Real Estate Leases and The decline represents a reduction in the lessor’s lease receivable (net investment). The Leveraged Leases lessor recognizes the decline as a loss in the period in which it reduces the residual esti- mate. Companies do not recognize upward adjustments in estimated residual value. What do the numbers mean? XEROX TAKES ON THE SEC Xerox derives much of its income from leasing equipment. bottom line is the same using either the SEC’s recommended Reporting such leases as sales leases, Xerox records a lease allocation method or its current method. contract as a sale, thereby recognizing income immediately. Although Xerox can refuse to change its method, the SEC has One problem is that each lease receipt consists of payments for the right to prevent a company from selling stock or bonds to

items such as supplies, services, fi nancing, and equipment. the public if the agency rejects fi nancial fi lings of the company. The SEC accused Xerox of inappropriately allocating lease Apparently, being able to access public markets is very receipts, which affects the timing of income that it reports. valuable to Xerox. The company agreed to change its account- If Xerox applied SEC guidelines, it would report income in ing according to SEC wishes, and Xerox will pay $670 million different time periods. Xerox contended that its methods to settle a shareholder lawsuit related to its lease transactions. were correct. It also noted that when the lease term is up, the Its former auditor, KPMG LLP, will pay $80 million. Sources: Adapted from “Xerox Takes on the SEC,” Accounting Web (January 9, 2002), www.account-ingweb.com; and K. Shwiff and M. Maremont, “Xerox, KPMG Settle Shareholder Lawsuit,” Wall Street Journal Online (March 28, 2008), p. B3. Bargain-Purchase Option (Lessee) As stated earlier, a bargain-purchase option allows the lessee to purchase the leased property for a future price that is substantially lower than the property’s expected future fair value. The price is so favorable at the lease’s inception that the future exercise of the option appears to be reasonably assured. If a bargain-purchase option exists, the lessee must increase the present value of the minimum lease payments by the present value of the option price. For example, assume that Sterling Construction (see Illustration 21-18 on page 1292) had an option to buy the leased equipment for $5,000 at the end of the five-year lease term. At that point, Sterling and Caterpillar expect the fair value to be $18,000. The significant difference between the option price and the fair value creates a bargain- purchase option, and the exercise of that option is reasonably assured. A bargain-purchase option affects the accounting for leases in essentially the same way as a guaranteed residual value. In other words, with a guaranteed residual value, the lessee must pay the residual value at the end of the lease. Similarly, a purchase option that is a bargain will almost certainly be paid by the lessee. Therefore, the com- putations, amortization schedule, and entries that would be prepared for this $5,000 bargain-purchase option are identical to those shown for the $5,000 guaranteed residual value (see Illustrations 21-16, 21-17, and 21-18 on pages 1291 and 1292). The only difference between the accounting treatment for a bargain-purchase option and a guaranteed residual value of identical amounts and circumstances is in the computation of the annual depreciation. In the case of a guaranteed residual value, Sterling depreciates the asset over the lease term. In the case of a bargain-purchase option, it uses the economic life of the asset. Initial Direct Costs (Lessor) Initial direct costs are of two types: incremental and internal. [8] Incremental direct costs are paid to independent third parties for originating a lease arrangement. Examples Special Lease Accounting Problems 1299 include the cost of independent appraisal of collateral used to secure a lease, the cost of an outside credit check of the lessee, or a broker’s fee for finding the lessee. Internal direct costs are directly related to specified activities performed by the lessor on a given lease. Examples are evaluating the prospective lessee’s financial condition; evaluating and recording guarantees, collateral, and other security arrangements; nego- tiating lease terms and preparing and processing lease documents; and closing the transaction. The costs directly related to an employee’s time spent on a specific lease transaction are also considered initial direct costs. However, initial direct costs should not include internal indirect costs. Such costs are related to activities the lessor performs for advertising, servicing existing leases, and establishing and monitoring credit policies. Nor should the lessor include the costs for supervision and administration or for expenses such as rent and depreciation.

The accounting for initial direct costs depends on the type of lease: • For operating leases, the lessor should defer initial direct costs and allocate them over the lease term in proportion to the recognition of rental revenue. • For sales-type leases, the lessor expenses the initial direct costs in the period in which it recognizes the profit on the sale. • For a direct-financing lease, the lessor adds initial direct costs to the net investment in the lease and amortizes them over the life of the lease as a yield adjustment. In a direct-financing lease, the lessor must disclose the unamortized deferred initial direct costs that are part of its investment in the direct-financing lease. For example, if the carrying value of the asset in the lease is $4,000,000 and the lessor incurs initial direct costs of $35,000, then the lease receivable (net investment in the lease) would be $4,035,000. The yield would be lower than the initial rate of return, and the lessor would adjust the yield to ensure proper amortization of the amount over the life of the lease. Current versus Noncurrent Earlier in the chapter, we presented the classification of the lease liability/receivable in an annuity-due situation. Illustration 21-7 (on page 1280) indicated that Sterling’s current liability is the payment of $23,981.62 (excluding $2,000 of executory costs) to be made on January 1 of the next year. Similarly, as shown in Illustration 21-15 (on page 1288), Caterpillar’s current asset is the $23,981.62 (excluding $2,000 of executory costs) it will collect on January 1 of the next year. In these annuity-due instances, the balance sheet date is December 31 and the due date of the lease payment is January 1 (less than one year), so the present value ($23,981.62) of the payment due the following January 1 is the same as the rental payment ($23,981.62). What happens if the situation is an ordinary annuity rather than an annuity due? For example, assume that the rent is due at the end of the year (December 31) rather than at the beginning (January 1). GAAP does not indicate how to measure the current and noncurrent amounts. It requires that for the lessee the “obligations shall be sepa- rately identified on the balance sheet as obligations under capital leases and shall be subject to the same considerations as other obligations in classifying them with current and noncurrent liabilities in classified balance sheets.” [9] The most common method of measuring the current liability portion in ordinary annuity leases is the change- in-the-present-value method.14 14For additional discussion on this approach and possible alternatives, see R. J. Swieringa, “When Current Is Noncurrent and Vice Versa!” The Accounting Review (January 1984), pp. 123–30; and A. W. Richardson, “The Measurement of the Current Portion of the Long-Term Lease Obligations— Some Evidence from Practice,” The Accounting Review (October 1985), pp. 744–52. 1300 Chapter 21 Accounting for Leases To illustrate the change-in-the-present-value method, assume an ordinary-annuity situation with the same facts as the Caterpillar/Sterling case, excluding the $2,000 of executory costs. Because Sterling pays the rents at the end of the period instead of at the beginning, Caterpillar sets the five rents at $26,379.73, to have an effective-interest rate of 10 percent. Illustration 21-30 shows the ordinary-annuity amortization schedule. ILLUSTRATION 21-30 STERLING/CATERPILLAR Lease Amortization LEASE AMORTIZATION SCHEDULE Schedule—Ordinary- ORDINARY-ANNUITY BASIS Annuity Basis Annual Reduction Lease Interest of Lease Balance of Lease Date Payment 10% Liability/Receivable Liability/Receivable 1/1/14 $100,000.00 12/31/14 $ 26,379.73 $10,000.00 $ 16,379.73 83,620.27 12/31/15 26,379.73 8,362.03 18,017.70 65,602.57 12/31/16 26,379.73 6,560.26 19,819.47 45,783.10 12/31/17 26,379.73 4,578.31 21,801.42 23,981.68 12/31/18 26,379.73 2,398.05* 23,981.68 –0– $131,898.65 $31,898.65 $100,000.00 *Rounded by 12 cents. The current portion of the lease liability/receivable under the change-in-the-present-

value method as of December 31, 2014, would be $18,017.70 ($83,620.27 2 $65,602.57). At December 31, 2014, Caterpillar classifies $65,602.57 of the receivable as noncurrent. As of December 31, 2015, the current portion would be $19,819.47 ($65,602.57 2 $45,783.10). Thus, both the annuity-due and the ordinary-annuity situations report the reduc- tion of principal for the next period as a current liability/current asset. In the annuity- due situation, Caterpillar accrues interest during the year but is not paid until the next period. As a result, a current asset arises for the receivable reduction and for the interest that was recognized in the preceding period. In the ordinary-annuity situation, the interest accrued during the period is also paid in the same period. Consequently, the lessor shows as a current asset only the principal reduction. Disclosing Lease Data The FASB requires lessees and lessors to disclose certain information about leases LEARNING OBJECTIVE 9 in their financial statements or in the notes. These requirements vary based upon List the disclosure requirements the type of lease (capital or operating) and whether the issuer is the lessor or lessee. for leases. These disclosure requirements provide investors with the following information. • General description of the nature of leasing arrangements. • The nature, timing, and amount of cash inflows and outflows associated with leases, including payments to be paid or received for each of the five succeeding years. • The amount of lease revenues and expenses reported in the income statement each period. • Description and amounts of leased assets by major balance sheet classification and related liabilities. • Amounts receivable and unearned revenues under lease agreements. [10] Illustration 21-31 presents financial statement excerpts from the annual report of Wal-Mart Stores, Inc. dated January 31, 2012. These excerpts represent the statement and note disclosures typical of a lessee having both capital leases and operating leases. Special Lease Accounting Problems 1301 ILLUSTRATION 21-31 Wal-Mart Stores, Inc. Disclosure of Leases (dollar amounts in millions) Jan. 31, 2012 Jan. 31, 2011 by Lessee Current Liabilities Obligations under capital leases due within one year $ 326 $ 336 Description and amount of lease obligations Noncurrent Liabilities Long-term obligations under capital leases $3,009 $3,150 Note 12: Commitments The Company and certain of its subsidiaries have long-term leases for stores and equipment. Aggregate General description minimum annual rentals at January 31, 2012, under non-cancelable leases are as follows (dollar amounts in millions): Operating Leases Capital Leases 2013 $1,644 $ 608 Description and amounts 2014 1,590 580 of leased assets 2015 1,525 532 2016 1,428 497 2017 1,312 457 Thereafter 8,916 3,261 Total minimum rentals $5,935 Less estimated executory costs 50 Net minimum lease payments $5,885 Less imputed interest 2,550 Present value of minimum lease payments $3,335 Nature, timing, and Rental expense was approximately $2.4 billion in 2012 and $2 billion in 2011. amounts of cash outflows Certain of the Company’s leases provide for the payment of contingent rentals based on a percentage of sales. Such contingent rentals were immaterial for fiscal 2012 and 2011. Substantially all of the Company’s store leases have renewal options, some of which may trigger an escalation in rentals. The Company has future lease commitments for land and buildings for approximately 425 future locations. These lease commitments have lease terms ranging from 4 to 50 years and provide for certain minimum rentals. If executed, payments under operating leases would increase by $92 million for fiscal 2013, Amount of lease rental based on current cost estimates. expense Illustration 21-32 presents the lease note disclosure from the 2011 annual report of Hewlett-Packard Company. The disclosure highlights required lessor disclosures. ILLUSTRATION 21-32 Hewlett-Packard Company Disclosure of Leases by Notes to Financial Statements Lessor (in millions)

Note 11: Financing Receivables and Operating Leases Financing receivables represent sales-type and direct-financing leases resulting from the marketing of HP’s and third-party products. These receivables typically have terms from two to five years and are usually collateralized by a security interest in the underlying assets. Financing receivables also include General description billed receivables from operating leases. The components of net financing receivables, which are included in financing receivables and long-term financing receivables and other assets, were as follows for the following fiscal years ended October 31: 2011 2010 Minimum lease payments receivable $7,721 $7,094 Allowance for doubtful accounts (130) (140) Unguaranteed residual value 233 212 Unearned income (647) (596) Amount receivable and unearned revenues Financing receivables, net 7,177 6,570 Less current portion (3,162) (2,986) Amounts due after one year, net $4,015 $3,584 1302 Chapter 21 Accounting for Leases ILLUSTRATION 21-32 As of October 31, 2011, scheduled maturities of HP’s minimum lease payments receivable were as (Continued) follows for the following fiscal years ended October 31: Nature, timing, and 2012 2013 2014 2015 Thereafter Total amounts of cash inflows Scheduled maturities of minimum lease payments receivable $3,518 $2,256 $1,257 $517 $173 $7,721 Equipment leased to customers under operating leases was $4.0 billion at October 31, 2011 and $3.5 billion at October 31, 2010 and is included in machinery and equipment. Accumulated depreciation on Description of leased equipment under lease was $1.3 billion at October 31, 2011 and $1.0 billion at October 31, 2010. As of assets October 31, 2011, minimum future rentals on non-cancelable operating leases related to leased equipment were as follows for the following fiscal years ended October 31: 2012 2013 2014 2015 Thereafter Total Minimum future rentals on Amount of future non-cancelable operating leases $1,273 $801 $414 $152 $42 $2,682 rentals Unresolved Lease Accounting Problems As we indicated at the beginning of this chapter, lease accounting is subject to abuse. Companies make strenuous efforts to circumvent GAAP in this area. In practice, the strong desires of lessees to resist capitalization have rendered the accounting rules for capitalizing leases partially ineffective. Leasing generally involves large dollar amounts that, when capitalized, materially increase reported liabilities and adversely affect the debt to equity ratio. Lessees also resist lease capitalization because charges to expense made in the early years of the lease term are higher under the capital lease method than under the operating method, frequently without tax benefit. As a consequence, “let’s beat the lease standard” is one of the most popular games in town.15 To avoid leased asset capitalization, companies design, write, and interpret lease agreements to prevent satisfying any of the four capitalized lease criteria. Companies can easily devise lease agreements in such a way, by meeting the following specifications. 1. Ensure that the lease does not specify the transfer of title of the property to the lessee. 2. Do not write in a bargain-purchase option. 3. Set the lease term at something less than 75 percent of the estimated economic life of the leased property. 4. Arrange for the present value of the minimum lease payments to be less than 90 percent of the fair value of the leased property. The real challenge lies in disqualifying the lease as a capital lease to the lessee, while having the same lease qualify as a capital (sales or financing) lease to the lessor. Unlike lessees, lessors try to avoid having lease arrangements classified as operating leases.16 Avoiding the first three criteria is relatively simple, but it takes a little ingenuity to avoid the “90 percent recovery test” for the lessee while satisfying it for the lessor. Two of the factors involved in this effort are (1) the use of the incremental borrowing rate by the lessee when it is higher than the implicit interest rate of the lessor, by making information