Employee Compensation – Payroll, Pensions, and Other
Compensation Issues
Chapter 17 Review Notes
Salaries and wages of officers and other employees accrue
daily, but normally no entry is made for these expenses until
payment is made. At the end of the accounting period an
adjusting entry for the unpaid salaries and wages is record in
order to match revenues and expenses. Allocation of
withholding amounts is reserved until actual payment.
Legislation, including the Federal Insurance Contributions
Act (FICA), the Federal Unemployment tax Act (FUTA), and
federal and state income tax laws, imposes five taxes on
payrolls:
1. Federal old-age, survivors’ and disability tax on both
employer and employee (OASDI, or Social Security),
levied on a taxable wage base specified by the law and
typically changing each year.
2. Federal hospital insurance tax on both employer and
employee (HI, or Medicare), levied on the entire wage.
3. Federal unemployment insurance tax on employer only
(FUTA). A standard credit is allowed for the
corresponding state tax.
4. State unemployment insurance tax on employer only in
most states (SUTA)
5. Individual income tax on employee only, but withheld
and paid by employer to the Federal government and to
some states
The payroll and related withholdings are typically debited to
a salaries or wages expense account and credited to payables
for the withholdings and to cash for the payroll. The accrued
employer’s payroll tax liability is debited to payroll tax
expense and credited to various tax payables. Upon payment
of the taxes the tax payables are debited and cash is
credited. See page 1009 for typical payroll and payroll tax
journal entries. End-of-period adjusting entries will normally
be required for accrued but unpaid liabilities. Other
deductions, for group insurance, pension plans, union dues,
and other items, may be made in accordance with agreements
with employees and are similarly accounted for.
Compensated absences, for vacations, holidays, illness, family
leave, and others, generate a liability for earned but unused
compensated absences. In accordance with the matching
principle, at the end of each accounting period the amount
accrued during the period is charged to wage expense and
credited to the liability. FASB Statement No. 43 provides
guidance for estimating the accrual: it should be earned
through services already rendered, be vested or capable of
being carried forward to subsequent years, and be estimable
and probable. The vesting requirement implies that sick pay
should only be accrued if the employee is entitled to
compensation regardless of whether he/she was actually
absent for the period; otherwise sick pay is recorded as an
expense only when paid. See page 1010.
Compensation expense includes the value of stock options and
performance bonuses. The value of the stock options is
calculated from the number of options awarded, the fair
value of each option as of the grant date, and the type of
stock-based compensation plan. The expense is allocated over
the period of time the employees must stay with the company
to earn the options. See Chapter 13 for details of the
calculations. Performance bonuses are reported on the
income statement as an operating expense, with any payable
remaining reported on the balance sheet as a current
liability.
Post-employment benefits include severance benefits,
supplemental unemployment benefits, disability-related
benefits job training and counseling, and continuation of life
and health insurance coverage. They are incurred by the
company during employment but accrue to the employee after
termination of employment but before retirement. FASB
Statement No. 112 specifies the accounting. As with
compensated absences, the benefits recognized must relate
to services already provided by the employee, must vest, and
must be estimable and probable. See page 1012.
FASB Statements Nos. 87 and 88 set forth the accounting
and reporting requirements for employer pension plans. Such
plans must be funded as required by the Employee
Retirement Income Security Act of 1974 (ERISA). The
funding may be provided entirely by the employer in a
noncontributory pension plan or by both employer and
employee in a contributory plan.
There are two basic types of employer pension plans: defined
contribution plans and defined benefit plans. Defined
contribution plan are relatively simple: the contributions are
deposited in a trust fund and the employee’s benefit at
retirement is determined by the amount accumulated to date.
The employer’s contributions are charged to pension expense.
The employee effectively bears the investment risk.
Defined benefit plans are much more complicated. The
retirement benefit is specified by the employment contract,
usually in terms of length of employment and average salary
over the period. The employer must then contribute
periodically an amount sufficient to accumulate to the
present value at retirement of the defined benefit. The
difficulties are that the amount of the retirement benefit,
though defined in principle, depends on future events such as
length of future service, employee turnover, vesting
provisions, and future salary levels which can only be
estimated; but more importantly, the present value of the
benefits over the employee’s remaining lifetime requires an
actuarial calculation. The employer bears the investment risk
and is liable for any additional amounts needed to top up the
pension fund to the amount required to fund the benefits.
See pages 1013 -1015.
The valuation of pension plans depends strongly on their
vesting provisions: that is, the conditions to be met by the
employee (mostly in terms of length of employment) in order
to qualify for receiving pension benefits. These provisions
have been greatly liberalized by federal regulation.
Nonvested benefits may be forfeited by the employee if
he/she changes employment.
The amounts to be regularly contributed by the employer to
fund the pension benefits are determined by the plan and
vary widely. Their purpose is to accumulate a fund sufficient
to pay the benefits as they fall due, but the amount of the
contribution may exceed or fall short of the present value of
the additional benefits earned for the period. This generates
either an underfunded obligation or an over-funded
obligation.
The Pension Benefit Guarantee Corporation (PBGC) if a
federally supported pension plan insurer which oversees the
funding status of defined benefit plans and collects
premiums from employers to insure their employees against
loss of their pension rights through the bankruptcy of the
employer.
The textbook presents the accounting for defined benefit
pension plans through two examples. Thakkar Company
discussed on pages 1018 - 1023 involves the pension
obligation for a single employee. (I strongly recommend that
you download and read the web based material relating to the
present value calculations used in this example.)
Thornton Electronics, discussed on pages 1024 - 1041 is a
more comprehensive example and involves multiple employees
and multiple years.
Accounting for a defined benefit pension plan begins with
estimating the benefit obligation, which is the employer’s
liability for the amount to be paid in future pension benefits.
One measure of this obligation is the accumulated benefit
obligation (ABO). This is the actuarial present value of the
expected future pension payments, using the current salary
as the basis for forecasting the amount of the pension
benefit payments; it ignores the impact of expected future
salary increases on the amount of the benefit payments. It is
based on the employee’s current length of service and the
current salary; on actuarial calculations of the probabilities
of the employee living to retirement age and the life
expectancy at that age; and on the time value of money at a
discount rate – the settlement interest rate -representing
the rate of interest the employer would have to pay in
purchasing an annuity for the pension obligation.
An alternative measure of the pension obligation that takes
account of the impact of future salary increases is the
projected benefit obligation (PBO). In calculating the PBO,
instead of using the employee’s current salary the maximum
future salary is estimated. The FASB in Statement No. 87
specifies the PBO as the preferred measure for most
purposes, but the ABO also is to be disclosed and may
become involved in the calculation of future pension
obligation, as is explained later in the chapter.
FASB requires that the fair value of the pension fund
(FVPF), which is the current accumulated value of the
invested contributions, and the pension obligation (PBO) be
offset against each other on the balance sheet, as a net
pension asset or a net pension liability. The separate asset
(prepaid pension cost) and liability (accrued pension liability)
are disclosed in the notes to the financial statements.
As discussed in the Thakkar Company example, the
measurement of pension expense for the accounting period
involves three factors. First is the interest cost, which is
the implied interest (or the settlement interest rate) on the
beginning-of-the-period pension obligation. The second is the
service cost, or new pension benefits earned by the
employees through service during the period. Finally there is
the investment return on the pension fund, consisting of
interest revenue, dividends, rentals, and changes (possibly
negative) in the market value of the assets. According to the
FASB the expected long-term rate of return should be used
rather than the actual rate of return, so as to minimize
fluctuations that could distort the income statement
earnings. The interest cost and the service cost increase the
PBO and the return on investment increases the fair value of
the pension fund. Contributions to the plan and benefits paid
from the plan, if any, also enter into the measurement. The
effect of these factors is to update the value of the PBO
and the fair value of the pension fund, thus:
End-of-period PBO = Beginning-of-period PBO + Interest
cost + Service cost – Benefits paid + or – Effect of changes
in actuarial assumptions
End-of-period FVPF = Beginning-of-period FVPF + Employer
contributions – Benefits paid + or – Actual return on the
pension fund.
The pension expense for the period is then = Interest cost +
Service cost – Expected return on the pension fund. The
amount of contributions does not appear on the income
statement. It is disclosed as a cash outflow on the statement
of cash flows.
To account for defined benefit pensions an entry is made to
accrue the pension expense and another entry to record the
contribution to the pension fund. A single account, the
prepaid/accrued pension cost, may be used to reflect
changes in the net pension asset or liability. See page 1023.
In the second pension example, Thornton Electronics, two
additional components of net periodic pension expense are
introduced: amortization of unrecognized prior service cost;
and deferral of current period gain or loss and amortization
of unrecognized net gain or loss.
Prior service cost (PSC) is the value of additional benefits
earned by services performed in years prior to the plan’s
adoption or amendment; it is determined by actuaries. This
cost is not charged immediately upon the date of adoption or
amendment, but rather amortized over future periods, as
required by FASB Statement No. 87, by “assigning an equal
amount to each future period of service of each employee
active at the date of the amendment who is expected to
receive benefits under the plan”. The future period of
service is called the expected service period. See page 1027
for more details of the calculation.
Because so many assumptions are made, actuarial and
otherwise, in the calculation of pension assets, liabilities, and
expenses, pension gain or loss may result from differences
appearing between expected results and actual experiences.
Immediate recognition of such gains and losses could cause
volatility in pension expense: to avoid this, the FASB allows
deferral of some gains and losses and amortization over
future periods instead. Immediate recognition is permitted,
but must be disclosed and applied consistently. There are
several reasons why actuarial estimates may change: two
examples are discussed in the text, differences between the
actual and expected return on the pension fund (page 1030)
and differences in actuarial estimates of PBO (page 1031).
Amortization of unrecognized net pension gain or loss may be
included in the net period pension expense if it accumulates
to more than the corridor amount defined by the FASB: 10%
of the greater of the PBO or the market-related value of
the pension fund at the beginning of the period. This allows
the discrepancy to be ignored if it is small enough to indicate
that the actuarial assumptions are close to being correct.
The balance sheet does not disclose the unfunded pension
liability. To compensate for this, the FASB prescribes
reporting a minimum pension liability at least equal to the
unfunded accumulated benefit obligation which equals ABO –
FVPF. This is done by recognizing an additional pension
liability, if the accrued pension costs are less than the
minimum pension liability, equal to the difference. The
offsetting entry, if an additional pension liability is required,
is to a deferred pension cost account (intangible asset) to
the extent of any unrecognized prior service cost, with any
remaining liability charged to a separate contra equity
account, with the adjustment included as a component of
Other Comprehensive Income. See pages 1034 - 1036 for
examples and further details.
A worksheet is shown for the accounting for the accrual of
the pension expense and the updating of the prepaid/accrued
pension cost. See pages 1026, 1029, and 1032.
Disclosure requirements relating to pensions are in FASB
Statement No. 132 (revised 2003). For most publicly traded
companies they are:
1. Reconciliation of beginning and ending balances of PBO
2. Reconciliation of beginning and ending balances of
FVPF
3. Disclosure of ABO
4. Funded status of plans, amounts not recognized in the
balance sheet, and amounts recognized in the balance
sheet, including:
a. Amount of unamortized PSC
b. Amount of unrecognized net gains and losses
c. Net pension asset or liability
5. Components of pension expense for period
6. Effect on other comprehensive income of changes in
additional pension liability
7. Assumptions used for discount rate, rate of
compensation increase, and expected long-term rate of
return on the pension fund
8. Percentages of different types of investments in the
pension fund with narrative description of investment
strategy
9. For each of the next five years, estimates of cash to
be paid as benefits and to be contributed by the
company
10. For postretirement benefits, assumed initial health
care cost trend rates with effect on service and
interest costs and the ABO if the trend rates were
one percent higher
FASB Statement No. 88 addresses the issue of what
previously unrecognized pension amounts should be
recognized in the event of pension settlements and
curtailments. See pages 1040 – 1041.
In 1998 the IASB revised IAS 19 dealing with pensions to
make international accounting standards much more similar to
U.S. GAAP. The two major remaining differences are (1) no
provision for an additional minimum liability and (2) no
recognition of a net pension asset unless, in effect, the
company expects to be able to get its hands on the excess
amount in the pension fund. See page 1042.
Postretirement benefits other than pensions are covered in
FASB Statement No. 106. They include health care, life
insurance, legal assistance, and tuition assistance. Generally
they are to be accounted for on an accrual basis similarly to
pension costs. There are differences, however:
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Many postretirement plans are informal
Most are not funded: ERISA not applicable, no
minimum liability
Formerly, pay-as-you-go rather than accrual
accounting, but since 1993 accrual accounting
Greater uncertainty of future benefits; larger recordkeeping costs
Less or no relation to pay level; benefits earned from
hire date to full eligibility date, not to retirement date