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36.2 SPONSOR ACCOUNTING 36 5 • annual amount per year per participant plus a surcharge applicable to underfunded plans. Within specified time constraints, an employer can terminate a fully funded plan at will. A procedure is prescribed for notifying participants and the PBGC. Underfunded plans maintained by employers in financial distress can transfer responsibility to the PBGC for paying benefits guaranteed by the insurance program. (d) EVOLUTION OF PENSION ACCOUNTING STANDARDS. SFAS Nos. 35, 87, and 88 were the result of approximately 11 years of deliberations by the Financial Accounting Standards Board (FASB). However, the controversies concerning the accounting for pension plans well preceded that. As noted in the introduction to SFAS No. 87, since 1956 pension accounting literature has “expressed a preference for accounting in which cost would be systematically accrued during the expected period of actual service of the covered employees.” In 1966, APB Opinion No. 8, “Accounting for the Cost of Pension Plans,” was issued. Within broad limits, annual pension cost for accounting purposes under APB No. 8 was the same as cash contributions for prefunded plans. Over the years, however, actuarial funding methods have evolved that produce different patterns of accumulating ultimate costs; some are intended to produce level costs, other front-end load costs, and still others tend to back-load costs. In 1980, the FASB issued SFAS No. 35, which established standards of financial accounting and reporting for the annual financial statements of a defined benefit pension plan. The Statement was considered the FASB’s first step in the overall pension project. After SFAS No. 35 was issued, the FASB concluded that the contribution-driven standard prescribed by APB No. 8 was no longer acceptable for employer financial reporting purposes. The proliferation of plans and a total asset pool of nearly $1 trillion (and growing) argued for an accounting approach under which reported costs would be more consistent for a company from one period to the next and more comparable among companies. SFAS No. 87 and its companion SFAS No. 88 were issued in 1985. These Statements now govern the accounting for virtually all defined benefit pension plans. They prescribe a single method for accruing plan liabilities for future benefits that is independent from the way benefits are funded. Standards are prescribed for selecting actuarial assumptions used for calculating plan liability and expense components. Most importantly, the discount rate used to calculate the present value of future obligations is market-driven and follows prevailing yields in the bond markets. Taken together, these changes are intended to improve the quality of pension accounting information, but further refinements are possible. SFAS No. 87 states: This Statement continues the evolutionary search for more meaningful and useful pension accounting. The FASB believes that the conclusions it has reached are a worthwhile and significant step in that direction, but it also believes that those conclusions are not likely to be the final step in that evolution. 36.2 SPONSOR ACCOUNTING (a) SCOPE OF SFAS NO. 87. The goal of the FASB in issuing SFAS No. 87 was to establish objective standards of financial accounting and reporting for employers that sponsor pension benefit arrangements for their employees. The Statement applies equally to single-employer plans and multiemployer plans, as well as pension plans or similar benefit arrangements for employees outside the United States. Any arrangement that is similar in substance to a pension plan is covered by the Statement. The accounting specified in SFAS No. 87 does not supersede any of the plan accounting and reporting requirements of SFAS No. 35 (see “Plan Accounting”). It does, however, affect sponsor accounting by superseding the accounting requirements to calculate pension cost as described in APB No. 8, and the disclosure requirements as stated in SFAS No. 36, “Disclosure of Pension Information.” 36 6 • PENSION PLANS AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS The Statement does not apply to pension or other types of plans that provide life and/or health insurance benefits to retired employees, although the sponsor of a plan that provides such benefits may elect to account for them in accordance with the provisions of SFAS No. 87. The accounting for the obligations and cost of these other postretirement benefits is the subject of SFAS No. 106 (see “Accounting for Postretirement Benefits Other Than Pensions”). (b) APPLICABILITY OF SFAS NO. 87. In substance, there are two principal types of singleemployer pension plans—defined benefit plans and defined contribution plans. SFAS No. 87 applies to both kinds of plans; however, most of the provisions of the Statement are directed toward defined benefit plans. Appendix D of SFAS No. 87 defines these two types of pension plans: Defined benefit pension plan—A pension plan that defines an amount of pension benefit to be provided, usually as a function of one or more factors such as age, years of service, or compensation. Any pension plan that is not a defined contribution plan is, for purposes of this Statement, a defined benefit plan. Defined contribution pension plan—A plan that provides pension benefits in return for services rendered, provides an individual account for each participant, and specifies how contributions to the individual’s account are to be determined instead of specifying the amount of benefits the individual is to receive. Under a defined contribution pension plan, the benefits a participant will receive depend solely on the amount contributed to the participant’s account, the returns earned on investments of those contributions, and forfeitures of other participants’ benefits that may be allocated to such participant’s account. The paragraphs that immediately follow address the principal accounting and reporting requirements for a sponsor of a defined benefit pension plan. The provisions of SFAS No. 87 that provide standards for other types of pension plans—defined contribution, multiemployer, and multiple employer plans—are discussed in Subsections 36.2(j), 36.2(l), and 36.2(m). It should be noted that cash balance plans, which have characteristics of both defined benefit plans and defined contribution plans, are treated as defined benefit plans under SFAS No. 87. For employers with more than one pension plan, SFAS No. 87 generally applies to each plan separately, although the financial disclosures of the plans in the sponsor’s financial statements may be aggregated within certain limitations. (c) BASIC ELEMENTS OF PENSION ACCOUNTING. The intention of the FASB in adopting SFAS No. 87 was to specify accounting objectives and results rather than the specific computational means of obtaining those results. Accordingly, the Statement permits a certain amount of flexibility in choosing methods and approaches to the required pension calculations. One of the reasons for the flexibility is that in a defined benefit pension plan an employer promises to provide the employee with retirement income in future years after the employee retires or otherwise terminates employment. The actual amount of pension benefit to be paid usually is contingent on a number of future events, many of which the employer has no control over. These future events are incorporated into the defined benefit plan contract between the employer and employee, and form the basis of the plan’s benefit formula. The benefit formula within a pension plan generally describes the amount of retirement income an employee will receive for services performed during his employment. Since accounting and financial reporting are intended to mirror actual agreements and transactions, it is logical that sponsor accounting for pensions should follow this contract to pay future benefits—that is the plan’s benefit formula. However, two problems arise from this accounting premise: How will the amount and timing of benefit payments be determined, and over what years of service will the cost of those pension benefits be attributed? (i) Attribution. When drafting SFAS No. 87, the FASB considered whether the determination of net periodic pension cost should be based on a benefit approach or a cost approach. The benefit ap- 36.2 SPONSOR ACCOUNTING 36 7 • proach determines pension benefits attributed to service to date and calculates the present value of those benefits. The benefit approach recognizes costs equal to the present value of benefits earned for each period. Even when an equal amount of benefit is earned in each period, the cost being recognized will nevertheless increase as an employee approaches retirement. The cost approach, on the other hand, projects the present value of the total benefit at retirement and allocates that cost over the remaining years of service. Under the cost approach, the cost charged in the early years of an employee’s service is greater than the present value of benefits earned based on the plan’s benefit formula. In the later years of an employee’s service, the cost is less than the present value of benefits earned so that the cumulative cost by the time the employee retires will be the same as that under the benefits approach. As noted previously, accounting is intended to mirror actual agreements. In a defined benefit plan contract, the employer’s promise to the employee is specified in terms of how benefits are earned based on service. Accordingly, the benefit approach was selected by the FASB and is the single attribution approach permitted by SFAS No. 87. Specifically, the Statement requires: • • For flat benefit plans, the unit credit actuarial method For final-pay and career-average-pay plans, the projected unit credit method (ii) Actuarial Assumptions. The value of plan benefits that form the basis for determining net periodic pension cost are calculated through use of actuarial assumptions. The discount rate reflects the time value of money. Demographic assumptions help determine the probability and timing of benefit payments—for example, assumptions for mortality, termination of employment, and retirement incidence are used to develop expected payout streams. Demographic assumptions are also utilized to establish certain amortization schedules. Prior service costs attributable to plan amendments and experience gains and losses typically are spread over the expected remaining service of active employees. Paragraphs 43 to 45 of SFAS No. 87 establish standards for selecting assumptions. Each nonfinancial assumption must reflect the best estimate of future experience for that assumption. (iii) Interest Rates. Under SFAS No. 87, employers are required to apply two interest rates in measuring plan obligations and computing net periodic pension costs—an assumed discount rate and an expected long-term rate of return on plan assets. As implied by its name, the expected long-term rate of return on assets should reflect the expected long-term yield on plan assets available for investment during the ensuing year, as well as the reinvestment that yield in subsequent years. The discount rate is a “snapshot” rate determined on the measurement date used for financial reporting. Paragraph 44 of SFAS No. 87 states the following: Assumed discount rates shall reflect the rates at which the pension benefits could be effectively settled. It is appropriate in estimating those rates to look to available information about rates implicit in current prices of annuity contracts that could be used to effect settlement of the obligation (including information about available annuity rates currently published by the Pension Benefit Guaranty Corporation). In making those estimates, employers may also look to rates of return on high-quality fixed-income investments currently available and expected to be available during the period to maturity of the pension benefits. SFAS No. 87 was published in 1985. In December of 1990, SFAS No. 106 was issued, which said the following in Paragraph 186: The objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the accumulated benefits when due. Notionally, that single amount, the accumulated post-retirement benefit obligation, would equal the current market value of a portfolio of high-quality zero coupon bonds whose maturity dates and amounts would be the same as the timing and amount of the expected future benefit payments. 36 8 • PENSION PLANS AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS For SFAS No. 106, the concept of “settling” obligations using annuities is not usually applicable, so the method for selecting discount rates could not use exactly the same method as SFAS No. 87. But both refer to “high-quality” investments. The Chief Accountant of the Securities and Exchange Commission announced the following in a 1993 letter to the Chairman of the Emerging Issues Task Force at the FASB: The SEC staff believes that the guidance that is provided in paragraph 186 of FASB 106 for selecting discount rates to measure the post-retirement benefit obligation also is appropriate guidance for measuring the pension benefit obligation. Thus, the SEC suggests that SFAS No. 106’s method for estimating a discount rate should be used for SFAS No. 87 purposes. Paragraph 186 of SFAS No. 106 can be adapted easily for pension purposes by changing “accumulated post-retirement benefit obligation” to “projected benefit obligation” (PBO). The SEC also clarified the term “high quality” in this letter, indicating that any bond receiving one of two highest ratings given by a recognized rating agency (Moody’s Aaa and Aa for example) would be deemed to be high quality. (iv) Consistency. The Statement suggests some consistency among the assumptions used to calculate plan liabilities. In practice this means that identical components of financial assumptions generally should be used. For example, the rate of increase in assumed salary increases and the rate of increase in Social Security benefits both have an inflation component, so as one increases due to expected inflation, so should the other. Notwithstanding the preceding paragraph, the Statement does not require an employer to adopt any specific method of selecting the assumptions. Instead, SFAS No. 87 requires the assumptions to be the employer’s best estimates. Therefore, it is not deemed a change in accounting principle, as defined in APB Opinion No. 20, “Accounting Changes,” if an employer should change its basis of selecting the assumed discount rate, for example, from high-quality bond rates to annuity purchase rates. The change in liabilities due to a change in assumptions goes into “unrecognized net gain or loss,” hence the amount of unrecognized net gain or loss is one of the best indicators of the reasonableness of assumptions under the plan. If the assumptions are reasonable, the gains and losses should offset each other in the long term. Therefore, when a plan has a pattern of unrecognized gains or losses that does not appear to be self-correcting, the assumptions used to measure benefit obligations and net periodic pension cost may be unrealistic. Assumptions that do not appear on the surface to be unreasonable may still be unrealistic if not borne out by experience. (v) Actuarial Present Value of Benefits. As noted previously, the FASB determined the SFAS No. 87 accounting would be based on the plan’s contractual arrangement—that the projection of ultimate benefits to be paid under a pension plan should be based on the plan’s benefit formula. Accordingly, SFAS No. 87 utilizes two different measurements in estimating this ultimate pension liability—the accumulated benefit obligation (ABO) and the projected benefit obligation (PBO). The ABO comprises two components—vested and nonvested benefits—both of which are determined based on employee service and compensation amounts to date. Benefits are vested when they no longer depend on remaining in the service of the employer. The PBO is equal to the ABO plus an allowance for future compensation levels, that is, a projection of the actual salary upon which the pension benefit will be calculated and paid (i.e., projection of the final salary in a “final-pay” plan). The relationship of these two obligations is reflected in Exhibit 36.1. Consider the example of a plan that provides a retirement pension equal to 1% of an employee’s average final five-year compensation for each year of service. The PBO for an employee with five years of service is the actuarial present value of 5% of his projected average compensation at his expected retirement date; whereas his ABO is determined similarly but only taking into account his average compensation to date. Further, assume that this employee would be 60% vested in his accrued benefits if his service is terminated today; then his vested benefit obligation is equal to 60% of his ABO. 36.2 SPONSOR ACCOUNTING 36 9 • Effects of projected future compensation levels (for active employees) Projected benefit obligation Exhibit 36.1 Nonvested benefit obligation (for active employees) Vested benefit obligation (includes retirees, terminated employees with vested benefits not yet retired, and active employees with vested benefits) Accumulated benefit obligation Relationship of ABO and PBO. Unless there is evidence to the contrary, accounting is based on the going-concern concept. Accordingly, the PBO is utilized as the basis for computing the service and interest components of the net periodic pension cost since it is more representative of the ultimate pension benefits to be paid than the ABO. When evaluating a plan’s benefit formula to determine how the attribution method should be applied, SFAS No. 87 specifies that the substance of the plan and the sponsor’s history of plan amendments should be considered. For example, an employer that regularly increases the benefits payable under a flat-benefit plan may, in substance, be considered to have sponsored a plan with benefits primarily based on employees’ compensation. In such cases, the attribution method should reflect the plan’s substance, rather than simply conform to its written terms. Similarly, attribution of benefits (and, therefore, recognition of cost) for accounting purposes may differ from that called for in a plan’s benefit formula if the formula calls for deferred vesting (“backloading”) of benefits. This by far is one of the more subjective areas of SFAS No. 87. Obviously, the determination that there is a commitment by the sponsor to provide benefits beyond the written terms of the pension plan’s benefit formula requires careful evaluation and consideration. If an employer has committed to making certain plan amendments, these amendments should be reflected in the PBO even if they may not have been formally written into the plan or if some of the changes may not be effective until a later date. Collectively bargained pension plans often provide for benefit increases with staggered effective dates. Such a plan may provide a monthly pension equal to $20 per month for each year of service in the first year of a labor contract, $21 in the second year, and $22 in the third. Once the contract has been negotiated, the PBO should reflect the $21 and $22 benefit multipliers for participants assumed to terminate or retire after the first year of the labor contract. (vi) Measurement Date. The date as of which the plan’s PBO and assets are measured—for purposes of disclosure in the employer’s financial statements and determination of pension cost for the subsequent period—is known as the measurement date. Although SFAS No. 87 contemplates that the measurement date coincides with the date of the financial statements, an alternative date not more than three months prior may be used. However, a change in the measurement date, for example, from September 30 in one year to December 31 in the next year would constitute a change in accounting principle under APB No. 20. Although most employers have one measurement date each year, some employers remeasure their PBO and select the assumed discount rates on a more frequent basis. The frequency of measurement is part of the employer’s accounting methods and may not be changed without proper disclosure of the impact. Although the projected benefit obligation disclosed in the financial statements is as of the measurement date, it generally is not necessary to determine the PBO using participant data as of that date. Instead the PBO may be estimated from a prior measurement, provided that the result obtained does not differ materially from that if a new measurement is made using current participant data. The fair value of plan assets, on the other hand, should be as of the measurement date. 36 10 • PENSION PLANS AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS The period between consecutive measurement dates is known as the measurement period and is used for determining the net periodic pension cost. The cost thus determined is used for the related financial reporting period. Events that occur after the measurement date but still within the financial reporting period generally are excluded from the SFAS No. 87 disclosure requirement. If significant, the cost implications thereof should nevertheless be disclosed in a manner similar to other post-yearend events. (d) NET PERIODIC PENSION COST. Net periodic pension cost represents the accounting recognition of the consequences of events and transactions affecting a pension plan. The amount of pension cost for a specified period is reported as a single net amount in an employer’s financial statements. Under SFAS No. 87, net periodic pension cost comprises the following six components: • • • • • • Service cost Interest cost Expected return on plan assets Amount of gain or loss being recognized or deferred Amortization of unrecognized prior service cost Amortization of the unrecognized net obligation or net asset existing at the initial application of the Statement (i) Service Cost Component. A defined benefit pension plan contains a benefit formula that generally describes the amount of retirement income that an employee will receive for services performed during their employment. SFAS No. 87 requires the use of this benefit formula in the measurement of annual service cost. The service cost component of net periodic pension cost is defined by the Statement as the actuarial present value of pension benefits attributed by the pension benefit formula to employee service during a specified period. Under SFAS No. 87, attribution (the process of assigning pension benefits or cost to periods of employee service) generally is based on the benefit formula (i.e., the benefit attribution approach). A simplified example will help illustrate this concept. Assume that a pension plan’s benefit formula states that an employee shall receive, at the retirement age of 65, retirement income of $15 per month for life, for each year of credited service. Thus, a pension of $15 per month can be attributed to each year of employee service. The actuarial present value of the $15 monthly pension represents the service cost component of net periodic pension cost. Although it is customary to determine the service cost at the end of the year, an equally acceptable practice is to compute the service cost at the beginning of the year and to add the interest thereon at the assumed discount rate to the interest cost component. In certain circumstances the plan’s benefit formula does not indicate the manner in which a particular benefit relates to specific services performed by the employee. In this case, SFAS No. 87 specifies that the benefit shall be considered to be accumulated as follows: • • If the benefit is includable in vested benefits, the benefit shall be accumulated in proportion to the ratio of total completed years of service as of the present to the total completed years of service as of the date the benefit becomes fully vested. A vested benefit is a benefit that an employee has an irrevocable right to receive. For example, receipt of the pension benefit is not contingent on whether the employee continues to work for the employer. If the benefit is not includable in vested benefits, the benefit shall be accumulated in proportion to the ratio of completed years of service as of the present date to the total projected years of service. An example of a benefit that is not includable in vested benefits is a death or disability benefit that is payable only if death or disability occurs during the employee’s active service. Some pension plans require contributions by employees to cover part of the plan’s overall cost. SFAS No. 87 does not specify how the net periodic pension cost should be adjusted for employee 36.2 SPONSOR ACCOUNTING 36 11 • contributions. An often-used approach is to reduce the service cost component directly by the employee contributions, thus possibly resulting in a negative service cost. Under this approach the plan’s PBO encompasses both benefits to be financed by employee contributions and those financed by the employer. (ii) Interest Cost Component. In determining the PBO of a plan, SFAS No. 87 gives appropriate consideration to the time value of money, through the use of discounts for interest cost. Therefore, the Statement requires that an employer recognize, as a component of net periodic pension cost, interest on the projected benefit obligation. This interest cost component is equal to the increase in the amount of the PBO due to the passage of time. The accretion of interest on the PBO is based on the assumed discount rate. Since the assumed discount rate is intended to reflect the interest rate at which the PBO currently could be settled, it is imperative that the discount rate assumption be reevaluated each year to determine whether it reflects the best estimate of current settlement rates. As a rule of thumb, if interest rates are in a period of fluctuation, the discount rate generally should change. (iii) Expected Return on Plan Assets Component. SFAS No. 87 requires that an employer recognize, as a component of net periodic pension cost, the expected return on pension plan assets [see Subsection 36.2(e)]. (SFAS No. 87 actually describes an actual return on plan assets component in disclosing the net periodic pension cost. However, the difference between actual and expected return was then put into unrecognized gain or loss, so there is no difference between using expected return on assets versus using actual return on assets plus an offsetting recognized gain or loss. SFAS No. 132, which amended SFAS No. 87 disclosure requirements, states that expected return is to be disclosed, so that approach is followed here.) The expected return on plan assets is determined by multiplying the “market-related value of assets” (defined following) by the expected long-term rate of return assumption, and adjusting for interest on contributions and benefit payments expected to be made. The market-related value of plan assets is used in determining the expected return on pension plan assets. The market-related value of plan assets can be either the actual fair value of plan assets or a “calculated” value that recognizes the changes in the fair value of plan assets over a period of not more than five years. Employers are permitted great flexibility in selecting the method of calculating the market-related value of plan assets. Any method that averages gains and losses over not longer than a five-year period would be acceptable under the Statement, provided it meets two criteria: that the method be both systematic and rational. In fact, changes in the fair value of assets would not have to be averaged but could be recognized in full in the subsequent year’s net periodic pension cost, provided that the method is applied consistently to all gains and losses and is disclosed. An employer also may use different methods for determining the market-related values of plan assets in separate pension plans and in separate asset categories within each plan, provided that the differences can be supported. However, a change in calculating the market-related value of plan assets (e.g., going from using fair value of assets to a “smoothed” value, or going from one kind of smoothing to another) would be a change in accounting method under APB No. 20. The Statement makes no specific allowance for administrative or investment expenses paid directly from the pension fund. These expenses may be reflected in the net periodic pension cost as an offset to the expected return on plan assets, and in such case may also be considered in the selection of the expected long-term rate of return on plan assets. If deemed appropriate, administrative expenses may be treated differently from investment expenses and added to the plan’s service cost. (iv) Amortization of Unrecognized Net Gains and Losses Component. SFAS No. 87 broadly defines gains and losses as changes in the amount of either the PBO or pension plan assets that generally result from differences between the estimates or assumptions used and actual experience. Gains and losses may reflect both the refinement of estimates or assumptions and real changes in 36 12 • PENSION PLANS AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS economic conditions. Hence, the gain and loss component of SFAS No. 87 consists of the net difference between the estimates and actual results of two separate pension items: actuarial assumptions related to pension plan obligations (liability gains and losses) and return on plan assets (asset gains and losses). Liability gains and losses (increases or decreases in the PBO) stem from two types of events: changes in obligation-related assumptions (i.e., discount rate, assumed future compensation levels) and variances between actual and assumed experience (i.e., turnover, mortality). Liability gains and losses generally would be calculated at the end of each year as the difference between the projected value of the year-end pension obligation based on beginning of the year assumptions and the actual year-end value of the obligation based on the end-of-year assumptions. Asset gains and losses represent the difference between the actual and expected rate of return on plan assets during a period. These gains and losses are entirely experience-related. As noted in the previous section, the actual return on pension plan assets is equal to the difference between the fair value of pension plan assets at the beginning and end of a period, adjusted for any contributions and pension benefit payments made during that period. The expected return on pension plan assets is a computed amount determined by multiplying the market-related value of plan assets (as defined following) by the expected long-term rate of return. The expected long-term rate of return is an actuarial assumption of the average expected long-term interest rate that will be earned on plan assets available for investment during the period. In order to reduce the potentially volatile impact of gains and losses on net periodic pension cost from year to year, the FASB adopted various “smoothing” techniques in SFAS No. 87—the netting of gains and losses, the market-related value of plan assets, the initial deferral of net gains and losses, and the amortization of the net deferred amount. The impact of the first smoothing technique is obvious; the other techniques are discussed briefly in the following paragraphs. As noted previously, the market-related value of plan assets is utilized in the determination of the expected return on pension plan assets. The market-related value of plan assets can be either the actual fair value of plan assets or a “calculated” value that recognizes the changes in the fair value of plan assets over a period of not more than five years. Employers are permitted great flexibility in selecting the method of calculating the market-related value of plan assets. Any method that averages gains and losses over not longer than a five-year period would be acceptable under the Statement, provided it met two criteria: that the method be both systematic and rational. In fact, changes in the fair value of assets would not have to be averaged at all but could be recognized in full in the subsequent year’s net periodic pension cost provided that the method is applied consistently to all gains and losses (on both plan assets and obligations) and is disclosed. An employer also may use different methods for determining the market-related values of plan assets in separate pension plans and in separate asset categories within each plan, provided that the differences can be supported. SFAS No. 87 specifies that the net gain or loss resulting from the assumptions or estimates used differing from actual experience be deferred and amortized in future periods. Deferred gains and losses (excluding any asset gains and losses subsequent to the initial implementation of SFAS No. 87 that have not yet been reflected in the market-related value of assets) are amortized as a component of net periodic pension cost if they exceed the “corridor.” The corridor is defined as a range equal to plus or minus 10% of the greater of either the PBO or the market-related value of plan assets. If the cumulative gain or loss, as computed, does not lie outside the corridor, no amount of gain or loss needs to be reflected in net periodic cost for the current period. However, if the cumulative gain or loss does exceed the corridor, only the excess is subject to amortization. To visualize the concept of the corridor, refer to Exhibit 36.2. The minimum amortization that is required in net periodic pension cost is the excess amount described above, divided by the average remaining service period of the active employees expected to receive benefits under the plan. Unlike other amortization under SFAS No. 87, the average remaining service period is redetermined each year. The FASB does permit alternative methods of amortization. An employer may decide not to use the corridor method or substitute any alternative amortization method that amortizes an amount at least equal to the minimum. 36.2 SPONSOR ACCOUNTING 20x1 $ Amount 20x2 Cumulative net gain at 12/31/00 amortizable into 20x1 net periodic pension cost 36 13 • 20x3 Net gain 550 Net gain Net loss +10% Greater of PBO or market-related value of plan assets January 1, 20x1, 20x2, and 20x3 Net gain 300 −10% Not eligible for amortization into 20x1 net periodic pension cost 250 Cumulative net loss at 12/31/00 amortizable into 20x1 net periodic pension cost Net loss Net loss 0 Year Exhibit 36.2 20x1 20x2 20x3 Illustration of the corridor. Consequently, an alternative method could recognize the entire amount of the current period’s gain or loss in the ensuing period. Any alternative amortization method must be applied consistently from year to year and to both gains and losses, and must be disclosed in the employer’s financial statements. The 10% corridor is designed to avoid amortization of relatively small and temporary gains and losses arising in any one year that can be expected to offset each other in the long run. It is not intended to exclude a portion of gains and losses from ever being recognized in the sponsor’s income statement. If a substantial amount of net gain or loss remains unrecognized from year to year, or increases in size, it may imply that the PBO and net periodic pension cost have been overstated or understated. (v) Amortization of Unrecognized Prior Service Cost Component. Defined benefit pension plans are sometimes amended, usually to provide increased pension benefits to employees. An amendment to a pension plan (or initiation of a pension plan) that grants benefits to employees for services previously rendered generates an increase in the PBO under the plan. This additional PBO is referred to as prior service cost. Retroactive pension benefits generally are granted by the employer in the expectation that they will produce future economic benefits, such as increasing employee morale, reducing employee turnover, or improving employee productivity. Under SFAS No. 87, prior service cost is to be amortized and included as a component of net periodic pension cost. A separate amortization schedule is established for each prior service cost based on the expected future service by active employees who are expected to receive employer-provided benefits under the plan. Instead of a declining amortization schedule, a common practice is to amortize the prior service cost on a straight-line basis over the average future service period. Once this 36 14 • PENSION PLANS AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS amortization schedule has been established, it will generally not be changed unless the period during which the employer expects to realize future economic benefits has shortened or the future economic benefits have become impaired. Decelerating the amortization schedule is prohibited. If substantially all of the participants of a pension plan are inactive, the prior service cost from a retroactive amendment should be amortized over the remaining life expectancy of those plan participants. SFAS No. 87 permits the use of alternative amortization methods that more rapidly reduce the amount of unrecognized prior service cost, provided that the alternatives are used consistently. For example, straight-line amortization of unrecognized prior service cost over the average future service period of active employees who are expected to receive benefits under the plan is acceptable. The immediate recognition of prior service cost, however, generally is inappropriate. As noted previously, a plan amendment typically increases the cost of pension benefits and increases the amount of the PBO. However, there are situations where a plan amendment may decrease the cost of pension benefits, resulting in a decrease in the amount of the PBO. Any decrease resulting from a plan amendment should be applied to reduce the balance of any existing unrecognized prior service cost using a systematic and rational method [i.e., LIFO (last-in, first-out), FIFO (first-in, first out), or pro rata, unless such reduction can be related to any specific prior service cost]. Any excess is to be amortized on the same basis as increases in unrecognized prior service cost. Once the employer has committed to a plan amendment, the net periodic pension cost for the remainder of the year should reflect the additional service cost, interest cost, and amortization related to the amendment. Remeasurement based on the current discount rate may also be called for. Pension cost for any prior periods should not be restated merely on account of the amendment, even if the amendment may be effective retroactively to a prior date. (vi) Amortization of Unrecognized Net Obligation or Net Asset Component. The unrecognized net obligation or net asset of a pension plan was determined as of the first day of the fiscal year in which SFAS No. 87 was first applied or if applicable, the measurement date immediately preceding that day. The initial unrecognized net obligation or net asset was equal to the difference between the PBO and fair value of pension plan assets (plus previously recognized unfunded accrued pension cost or less previously recognized prepaid pension cost). A schedule was set up to amortize the initial unrecognized net obligation or net asset on a straight-line basis over the average remaining service period of employees expected to receive benefits under the plan, except under the following circumstances: • • If the average remaining service period was less than 15 years, an employer could elect to use 15 years. If the plan was composed of all or substantially all inactive participants, the employer should use those participants’ average remaining life expectancy as the amortization period. (e) PLAN ASSETS. Pension plan assets generally consist of equity or debt securities, real estate, or other investments, which may be sold or transferred by the plan, that typically have been segregated and restricted in a trust. In contrast to SFAS No. 35, for purposes of SFAS No. 87, plan assets exclude contributions due but unpaid by the plan sponsor. Also excluded are assets that are not restricted to provide plan benefits such as so-called rabbi trusts in which earmarked funds are available to satisfy judgment creditors. Pension plan assets that are held as an investment to provide pension benefits are to be measured at fair value as of the date of the financial statements or, if used consistently from year to year, as of a date not more than three months prior to that date (this date is defined by the Statement as the measurement date). In the context of SFAS No. 87, fair value is defined as the amount that a pension plan trustee could reasonably expect to receive from the sale of a plan asset between a willing and informed buyer and a willing and informed seller. The FASB believes that fair value is the appropriate mea-