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Tim Gresham, CFO of Alpha Logistics is concerned about changes in the business environment which could lead to Alpha violating some of the covenants of their outstanding debentures. Specifically Gresham is concerned about leverage and profitability ratios. Gresham reviews Alpha’s most recent financial statements and decides that changing the assumptions for the company’s defined benefit pension plan may provide some relief in the short-run. Alpha reports under U.S. GAAP.
Which of the following changes in the pension plan’s assumptions would most likely lead to lower reported leverage and higher reported profitability?

A) Increasing expected return on plan assets.

B) Increasing the discount rate.

C) Increasing the growth rate in compensation expense.

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Increasing discount rate leads to lower present values and reduces reported pension liability in the balance sheet and also reduces pension expense by reducing the service cost component. Increasing expected return on plan assets does reduce pension expense but does not affect reported assets or liabilities. Increasing the growth rate in compensation expense increases service cost as well as reported pension liability.

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Under current U.S. GAAP, the assets and liabilities of a defined benefit pension plan are:

A) reported in the appropriate section of the balance sheet, with pension obligations shown under liabilities and plan assets shown under assets.

B) off balance sheet items which are shown only in the footnotes.

C) netted against each other, and only the net asset or liability amount is reported on the company’s balance sheet.

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Under current U.S. GAAP, companies are required to report only the net asset or liability amount. They cannot show assets and liabilities separately. Although some smoothing details are still disclosed in the footnotes, all major components of pension assets and liabilities are now required to be shown on the balance sheet.

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Which of the following statements regarding pension accounting under U.S. GAAP standards is most accurate?

A) Changes in actuarial assumptions and past service costs fully and immediately affect the income statement.

B) A reconciliation between the funded status and the net pension asset (liability) reported on the balance is required.

C) Changes in the projected benefit obligation (PBO) and plan assets fully and immediately affect the balance sheet.

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Changes in the projected benefit obligation (PBO) and plan assets immediately affect the funded status (difference in PBO and plan assets) and the full amount of the changes is reflected on the balance sheet when the change occurs.

Changes in actuarial assumptions and past service costs are recognized in the income statement over time thereby smoothing pension expense.

Since the funded status is equal to the net pension asset (liability) reported on the balance sheet under U.S. GAAP, then no reconciliation is required. Note: However, the reconciliation (as illustrated below) is required under current IFRS.

Funded status (Fair value of plan assets – PBO)
Unrecognized deferred (gains) and losses
+ Unrecognized past service cost
Unrecognized transition (asset) or liability
=Net pension asset (liability) reported on the balance sheet

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Which of the following statements regarding the projected benefit obligation (PBO) and the value of the pension plan assets is most accurate?

A) Plan amendments during the year generally result in a decrease of the PBO at the end of the year.

B) The fair value of plan assets is increased by the amount of the expected return on assets.

C) If the PBO and the plan assets are the same, then nothing needs to be reported on the balance sheet.

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Neither the PBO nor the plan assets are separately reported on the balance sheet. The funded status is the difference in the PBO and the plan assets. If the PBO exceeds the plan assets, the difference is reported as a liability. If the plan assets exceed the PBO, the difference is reported as an asset. If the amounts are the same, then neither a liability nor asset needs to be reported.

Plan amendments (i.e. additional benefits provided that increase the amount of the employer’s obligation to plan participants) generally result in an increase of the PBO.

The fair value of plan assets at the beginning of the period is increased by the actual return on plan assets as well as any employer contributions. It is reduced by the amount of benefits paid.

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Which of the following statements regarding pension accounting under current U.S. GAAP standards and International Financial Reporting Standards (IFRS) is most accurate?

A) Under IFRS, the funded status (difference in the PBO and the plan assets) is now reported on the balance sheet.

B) Under U.S. GAAP, firms are required to provide a reconciliation of the funded status and the reported net pension asset or liability.

C) Under IFRS and U.S. GAAP, the calculation of pension expense is the same.

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The calculation of pension expense is not affected by the new standard. Pension expense still includes the smoothing effects of the amortization of deferred gains and losses and the amortization of past (prior) service costs.

Under current U.S. GAAP, the net pension asset or liability reported on the balance sheet is equal to the funded status, without adjustment for unrecognized items. However, under IFRS, the net pension asset or liability reported on the balance sheet represents the funded status adjusted for unrecognized items.

Under current IFRS, firms are required to provide a reconciliation of the funded status and the reported net pension asset or liability. The reconciliation can be used to make an adjustment to the new standard for comparison purposes

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Straight Elements, Inc. (SE) is a discount manufacturer of parts and supplies for the railroad industry, and uses U.S. GAAP. The following information is from SE’s financial statements and accompanying notes:

(Figures in millions)
PBO	$435
Service Cost	39
ABO	370
Actual Return on Plan Assets	39
Benefits Paid	22
Unamortized Past Service Cost	39
FMV of Plan Assets	295

If SE reported under IFRS instead of US GAAP, the liability reported on the balance sheet would be:

A) higher.

B) lower.

C) the same.

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Under IFRS the pension liability would be lower because of the $39 million in unamortized past service costs. Under IFRS, the balance sheet entry (funded status) excludes amounts that have not been recognized in the income statement (e.g., deferred gains and losses, and past service cost). Note that the question is asking for the liability vs. the examples in the Notes work with assets. Hence, the logic reverses.

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Paul Roberts, CPA, is a partner in Roberts & Smith, an accounting firm that is located in Chicago. The firm has recently been retained by Midwest Manufacturing, a major producer of heavy machinery and tractor parts in the U.S. Midwest has been in operation since 1965, and currently has approximately 700 full-time employees. The company had its initial public offering in 1986. The company has hired Roberts’s firm to ensure that the accounting for Midwest’s employee pension plan is fully in compliance with the new GAAP standards that changed in December 2006. Select year-end pension plan information for Midwest Manufacturing

	2006	2007
PBO	$21 million	$23 million
Discount Rate	6.0%	7.5%
Rate of Compensation Increase	4.0%	4.0%

Roberts will educate Midwest’s accounting department on changes in pension plan accounting that would be relevant to their situation. Also, Roberts will assist them in applying the new standards retroactively to prior years’ financial statements. In accordance with U.S. GAAP, distinguish which of the following events are classified as “actual” events and which ones are “smoothed” events.

Actual

Smoothed

A) interest cost reported pension expense

B) service cost expected return on plan assets

C) service cost interest cost

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Service cost and interest cost are considered to be actual events. Expected return on plan assets, amortization of unrecognized prior service costs, amortization of transition asset or liability, and amortization and deferral of actuarial gains and losses are classified as smoothed events. Together, these six components are used to calculate a plan’s reported pension expense or income on the income statement.

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The most likely result of the change in the assumed discount rate from 2006 to 2007 for Midwest’s pension plan is:

A) a decrease in PBO and an increase in ABO.

B) a decrease in ABO and an increase in PBO.

C) a decrease in PBO and a decrease in VBO.

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A higher discount rate will result in lower present values, which in turn produce lower pension liabilities (PBO and VBO).

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As of January 1st, 2007, the fair value of plan assets was $19 million. Which three components are necessary to calculate the fair value of the plan assets at the end of the year?

A) service cost, interest cost, and benefits paid.

B) expected return on plan assets, employer and participant contributions, and benefits paid.

C) actual return on assets, employer contributions, and benefits paid.

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Companies are required to disclose a reconciliation of the beginning and ending balances of the fair value of plan assets, which can be calculated as follows:

Fair value of plan assets at the beginning of the year
+ Actual return on assets
+ Employer contributions
− Benefits paid
= Fair value of plan assets at the end of the year

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A major change in U.S. GAAP pension accounting standards, effective as of December 2006, resulted in public companies now being required to report which of the following?

A) The pension liability adjusted for unrecognized items.

B) The funded status of the plan.

C) The expected return on plan assets.

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The current standard requires companies to report the funded status of the plan, which is the difference between the PBO and the fair value of plan assets.

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As of December 31st, 2007, the fair value of plan assets was $21 million. The sum of the unrecognized prior service cost and the unrecognized actuarial losses equals $1.5 million. Calculate the funded status of Midwest’s pension as of December 31st, 2007 that must be reported under the new U.S. GAAP pension accounting standards.

A) −$2.0 million.

B) −$500,000.

C) $2.0 million.

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The funded status is the difference between the PBO and the fair value of plan assets as of the reporting date. For Midwest’s plan, $21,000,000 − 23,000,000 = −$2,000,000. The new accounting standards differ from the old standards’ calculation, which reported the funded status net of an adjustment for unrecognized items.

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Which of the following statements regarding the new U.S. GAAP pension accounting standards is most accurate?

A) The balance sheet will now reflect the true economic position of the pension plan, but the income statement will not necessarily reflect a true measure of economic pension expense.

B) For most companies, the pension liability will increase while financial leverage may increase or decrease as a result of applying the new standard.

C) The changes in GAAP now cause U.S. standards to be consistent with the International Financial Reporting Standards (IFRS) for pension plans.

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Because deferred and unrecognized items are required to be reported on the balance sheet but not the income statement, the balance sheet will now reflect the true economic position of the pension plan, but the income statement will not necessarily reflect a true measure of economic pension expense.

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The following information relates to Nazarali Inc. (Nazarali) and its defined-benefit pension plan for the year:

Contributions	$3.0 million
Reported pension expense	$2.8 million
Economic pension expense	$3.1 million

Based on the information above, which of the following statements is most accurate?

A) There is a reduction in the overall pension obligation of $100,000.

B) There is a reduction in the overall pension obligation of $200,000.

C) There is a source of borrowing of $100,000.

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The economic pension expense represents the true cost of the pension. The reported pension expense is irrelevant in this case.

Since the economic pension expense ($3.1 million) exceeds the contributions ($3.0 million), the $100,000 difference can be viewed as a source of borrowing. Alternatively, if the firm’s contributions exceed the economic pension expense, the difference can be viewed as a reduction in the overall pension obligation, similar to an excess principal payment on a loan.

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Consider a situation at a firm where the differences in its cash flow and economic pension expense are considered material to the financial statements. The relevant tax rate is 30%. The expected return on plan assets is $120,000, interest cost is $85,000, employer’s contribution is $215,000, service cost is $450,000, and the actual return on plan assets is $50,000. Based on the information provided and for analytical purposes only, which of the following statements is most appropriate?

A) There is a reclassification of $189,000 from operating cash flow to financing cash flow.

B) There is a reclassification of $270,000 from operating cash flow to financing cash flow.

C) There is a reclassification of $140,000 from operating cash flow to financing cash flow.

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The economic pension expense = service cost + interest cost − actual return on plan assets = $450,000 + $85,000 − $50,000 = $485,000.

Since the differences in cash flow and economic pension expense are considered material, for analysis purposes we should consider reclassifying the difference from operating activities to financing activities in the cash flow statement.

The employer’s contribution was only $215,000. Since the economic pension expense exceeds the cash flow, the difference, net of tax, is treated as a borrowing in the cash flow statement for analytical purposes. Assuming a tax rate of 30%, $189,000 is reclassified from operating cash flow to financing cash flow [($485,000 economic pension expense − $215,000 employer contribution) ((1 − 30% tax rate)].

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With regard to a firm’s post-retirement healthcare plan, which of the following statements about its cash flows is least accurate?

A) Cash flows occur when the benefits are paid.

B) Cash flows occur when the firm makes contributions to the plan.

C) Cash flows are reported as operating activities.

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A post-retirement healthcare plan is an example of an unfunded plan. In a funded plan, the cash flows occur when the company makes contributions to the plan. In an unfunded plan, the cash flows occur when the benefits are paid. In either case, the cash flows are reported as operating activities in the cash flow statement.