Discussion
Memorandum #2 Requirements
Pension
Expense/Obligation
In 2013, Cowboyz Rustic Furniture Inc, a manufacturer of rustic furniture, has had its profits severely affected by a recession that commenced in 2013.
The recession was accompanied by a significant fall in the stock market and plummeting interest rates as the U.S. Federal Reserve attempted to stabilize the economy. The company’s CEO, Mr. Wrangler, finds himself battling reduced profitability from the core business because of a dramatic decline in new furniture purchases as the housing market has slowed down.
Given the fall in value of plan assets and the dramatic decline in interest rates to 5% related to the Fed’s actions, the company’s CEO, Mr. Wrangler is extremely concerned about the effect of these changes on the size of the company’s pension plan obligation after being alerted to the issue by yourself, the company controller. The CEO is worried that the current economic conditions could make the pension plan virtually unaffordable because of having to record a sizable adjustment to the pension obligation making the company more leveraged and increased pension expense reducing its profitability. Because the company has always funded an amount equal to the service cost he is concerned that there the company may have to provide added cash to the plan if the service cost goes up.
Mr. Wrangler indicated that he had been talking to a fellow CEO, a golfing buddy, who suggested that the company do what his buddy’s company has done after talking with a consultant. The consultant suggested that a way to reduce the impact on earnings and reduce the potential increase in the obligation without laying off people or reducing or eliminating pension benefits would be to get the board of directors to allow the company to use discount/settlement rates that are as high as possible in determining the present value of the pension obligation and the expected rate of return on plan assets. The CEO was told that doing this will keep the pension liability and expense in check. The CEO has asked you, as the controller, to write up a memo to himself and the Board of Directors in plain English discussing the feasibility of doing this under the existing accounting rules.
Although this is early
2014
, the books have not yet been closed for 2013 yet since the company still must finish recording its pension plan entries, including any required adjustment to the Pension Liability and the deferred Loss in Accumulated Other Comprehensive Income (AOCI) to reflect changes in the discount rate for the
Projected
Benefit Obligation
(PBO) for the year ended 2012 (also for the beginning of 2014).
Because of the concerns about the pension plan, you have asked the company’s actuaries to provide you with information that might assist in determining what should be done with the plan. The actuaries have provided you with the table of information (on the next page) showing three different sets of assumptions. The first set of assumptions shows the projected benefit obligation PBO and
Fair Value
of
Plan Assets
(FVPA) at the beginning of 2014 reflecting the lower FVPA from the fall in the stock market, but otherwise uses the 10% discount rate and 12% expected rate on return on plan assets that had been used in the past. Under this first assumption, the beginning 2014 Pension Liability and the deferred Loss (in AOCI) arise entirely from the 2013 fall in the stock market. The second and third sets of assumptions show the estimated 2014 beginning PBO, Pension Liability, and deferred
Loss in AOCI
using lower discount rate assumptions for the PBO (i.e., 8% or 5%), which would result in a larger Pension Liability on the company’s books and a larger deferred Loss in AOCI. The actuaries have told you that in this economic environment, they have found other companies using discount rates around 5% and expected rates of return around 8%. The actuaries provided the 8% discount rate and 10% rate of return information to provide something of a middle ground between the other two sets of assumptions.
In drafting the memo:
(a) You should explain the circumstances the company finds itself in.
(b) Address the requirements under GAAP for the discount rate and expected rate of return on plan assets based on the FASB’s Accounting Standards Codification. When discussing the GAAP requirements, you should cite the relevant subsections of the FASB Accounting Standards Codification by section/paragraph number. Make sure you locate the paragraphs of the codification (not just the definitions) that address the discount rate and the expected long-term rate of return on plan assets. Your primary guidance should be from the recognition and measurement sections (25-35) although you can cite the implementation guidance (section 55) to support the other guidance.
(c) Address whether in the current economic environment, using any of the assumptions suggested other than the 5% discount rate–8% expected rate of return assumption is feasible. Address whether it would be ethical to follow the golfing buddy’s suggestion and back into interest rates that the company can live with, i.e., that give the desired results. In this regard, you should discuss how much flexibility you think there might be in selecting these discount/return rate assumptions for the purposes of determining the PBO and pension expense and still remaining in compliance with GAAP. Your response should come to a conclusion as to whether you the company can accept discount rates above 5% and rates of return above 8% if the financial statements are to remain consistent with GAAP. If you believe other rates could be used only in some circumstances, explain the circumstances.
(d) Using the three sets of alternative assumptions, determine what pension expense would be for 2014 given the PBO, FVPA and deferred Loss as shown in the table for each assumption. For amortization purposes the remaining service life of the employees is 15 years and the company uses straight-line amortization of gains and losses.
(e)
Discuss the financial impact on the company of using the various discount rate and expected rate of return assumptions. Had the stock market remained at its prior levels, the plan would have been overfunded at the end of 2013 by approximately $550,000 and the company would have had a Pension Asset on the books for that amount, and there would have been no significant deferred Gain or Loss in AOCI. Pension expense itself had been averaging about $150,000 a year. For the purposes of the memo, you can assume that at the end of 2013 prior to any adjustments to the pension liability the company has total assets of $50,000,000, liabilities of $30,000,000 and shareholders’ equity of $20,000,000. Assume that the company’s 2013 income, which was down substantially from prior years, was $1,000,000 pretax and $700,000 after tax, and that the company expects a similar level of income in 2014 prior to considering the effect of the changes in the rate assumptions.
As indicated above, the memo should be in plain English to the extent possible since the readers will be nonaccountants. It should provide a coherent discussion items (a) – (e) above. The discussion memo should be from 2-5 pages long, single-spaced, exclusive of the citations from the FASB Accounting Standards Codification. You should be sure to give the section numbers for the Codification and to the extent you utilize other sources you should include footnote references to such sources and use quotation marks for direct quotes. For academic access to the FASB Codification database through the American Accounting Association, you may log in at the following website:
http://aaahq.org/ascLogin.cfm
using the following login information: STUDENTS: User ID AAA51855; Password sJTh4TD
——-Plan’s
Books—–
—–Company’s Books——
Other Information
Beginning
Beginning
Beginning
—–2014
————
Projected
Fair Value
Pension
Beginning
Service
Assumptions
Benefit Obligation
Plan Assets
(Liability) Asset
Loss in AOCI
Cost
Contribution
10% Discount Rate ; 12% Expected Rate of Return
2014
$4,015,953
$
2,284,816
($1,731,137)
$2,284,816
$294,503
$294,503
8% Discount Rate ; 10% Expected Rate of Return
2014
6,155,021
2,284,816
(3,870,205)
4,423,884
443,161
443,161
5% Discount Rate ; 8% Expected Rate of Return
2014
12,049,054
2,284,816
(9,764,238)
10,317,917
843,434
843,434
