Pensions as an important financial instruments - Essay Example

? Connie Johnson Week Five Individual Assignment ACC 541 – Valerie Turnbow of Phoenix September 11, Pensions are important financial instruments that provide economic security to employees once they retire. A pension is a fixed payment that the beneficiary receives on a monthly basis once they reach retirement age. The use of pension plans by corporations became a mainstream practice in corporate America after World War II. In the United States pension plans have become more important than ever particularly for younger people due to the fact that the social security system is not going to be able to help younger adults. The most likely outcome is that generation X will not receive a social security check 30 years from now. This paper discusses the require reporting for defined contribution, defined benefit, and other postretirement plans. A defined contribution plan is a pension plan in which the employer contributes a fixed amount of money each period. For instance a company can contribute 7% of the annual salary of the employees towards the pension plan. One of the uncertainties associated with defined contribution plans is that the employee does not know the pension benefits he or she will receive upon retirement age. The amount of benefits depends on the return the pension fund manager obtains from the investment of the money in the fund. In contrast defined benefit plans provide beneficiaries’ greater certainty since the person will know how much his benefit will be once the individual reaches retirement age. “The terms of a defined benefit plan specify the amount of pension benefits to be paid out to plan recipients in the future” (Clark & Cathey, 2011, pg. 456). ERISA imposes minimum funding requirements for defined benefit plans. Defined contribution plans must be disclosed in the financial statements of an organization. The things that must be reported in the financial statements in regards to pensions include the existence of the plan, the employee groups covered, the basis for determining contributions, and any significant matters affecting comparability from period to period (Clark & Cathey, 2011). The accounting treatment for defined benefit plans is a bit more complex. It is imperative that corporations make pension contributions that are sufficient to cover the benefits that are promised by the plan. Due to the fluctuating nature of the stock market, which is an investment mechanism used by pension managers to obtain a greater return for the beneficiaries, on many occasions pension funds are underfunded. The Pension Protection Act of 2006 stipulated that all corporate pension funds must be fully funded by the year 2013. Pension fund accounting requires the use of actuarial tools to estimate the future value of pension benefits. Two benefit approaches that can be used by accountants are accumulated benefits approach and years of service approach. The difference between the two methods is that one estimates annual pension cost and liability based on existing salary levels, while the other is based on the estimated final pay at retirement. The liability for pension benefits under the accumulated benefits approach is called accumulated benefits obligation, while the liability computed under the benefits/years of service approach is called projected benefit obligation (Clark & Cathey, 2011). The proliferation of the use of pension plans occurred after World War II. The accounting profession immediately took notice of the tendency. In 1956 the Committee on Accounting Procedures released Accounting Bulleting No. 47, Accounting for Costs of Pension Plans. ARB-47 required disclosure of unfunded vested benefits on the balance sheet (Duangplov & Pence, 2007). Pension funds were considered a legal liability after the inception of APB No. 8 in 1966. APB No. 8 also discusses the different components of pension costs. The three components of pension costs are normal costs, past service costs, and prior service costs. The underfunded pension cost became a liability in the balance sheet. In 1980 an amendment was made to APB No. 8 under FAS-36. FAS-36, Disclosure of Pension Information, requires disclosure of accumulated benefit obligation (ABO), plan assets and the two components of ABO (Duangplov, et. al. 2007). In 1985 SFAS No. 87 changed pension accounting by adopting an economic liability approach. The three major changes associated with FAS-87 are: expanded disclosures, recognition of pension liability when the accumulated benefit obligation exceeds the fair value of the pension assets, and creation of a standardized method to calculate net pension costs. FASB ASB 715 changed the guidelines to determine the components of net pension costs for defined pension plans. The six components are service cost, interest cost, return on plan assets, amortization of unrecognized prior service costs, amortization of gain and losses, amortization of unrecognized net asset or unrecognized net obligation. Employees have been protected by ERISA since 1974. ERISA created standards for the operation of pension funds to protect workers from abuses by corporations that did not properly manage pension funds. SFAS No. 106, Employers’ Accounting for Postretirement Benefits Other than Pension requires companies to switch from cash based accounting to accrued based accounting for non pension post retirement benefits often referred to as OPRB. The implementation of SFAS No. 106 when it became effective increased the cost of the benefits owed by corporations to retirees. Some OPRB offered by companies include healthcare plan, life insurance, dental plan, day care, tuition, gym membership, housing subsidy, and legal services. There is no minimum liability disclosure in the balance sheet for other postretirement benefits. Other postretirement benefits have the same six costs components as pensions, but they may be measured differently. Employees who are not working for a company due to injury can also receive post-employment benefits. These types of benefits are covered by SFAS No. 112, Employers Accounting for Post Employment Benefits. The elimination of a segment of a pension plan is not a simple process. The reason is not that simple is because pensions are legal liabilities. If the firm uses both defined contribution and defined benefit plans instead of eliminating both segments it could theoretically switch from one system to another. Even when an employee leaves a company the pension benefit are transferred to his / her next employer or the employee must receive a lump sum payment equivalent to the money accumulated in the pension fund. The accounting profession and governing bodies have done a great job of creating regulations to protect employees from fraudulent activity associated with pension fund mismanagement. Two years from now all pension funds must be fully funded. References Duangploy, O., Pence, D. (2007). SFAS No. 158: a reform of pension liability recognition: what will be the effect on pension cost of the implementation of SFAS No. 158? (Statement of Financial Standard). Bank Accounting & Finance, 20(4), pg. 23. Retrieved September 11, 2011 from http://www.austincc.edu/njacobs/Acct_Theory/Articles/SFAS_158_Pensions.htm Schroeder, R.G., J.M., Cathey (2011). Financial Accounting Theory and Analysis (10th ed.). New Jersey: John Wiley & Sons. Read More