 Hello and welcome to this session in which we would look at the amortization of a prior service cost as it relates to pension expense. In this session I'm going to focus specifically on prior service cost. There are five components for the pension expense. The service cost, the amortization of a prior service cost, interest on liability, actual return, gain slash losses. In the prior session we covered the service cost, interest on liability and actual return on plan asset. Again, I will discuss gains and losses and work in example in the next session. In this session I'm going to focus specifically on how do we amortize prior service cost, which in turn increases the pension expense. So let's see what is a prior service cost? Well it's a retroactive benefits for employee. What does that mean? So let's assume for a particular company they started business in 2020 and nine years later, in year 2029, let's assume that's the case nine years later, the company decided to start a pension plan for their employees. They wanted to give their employee benefits, the company is doing well, so on and so forth. So they started in 2020, but now it's 2029. What they want to do? They want to go back and reward all those employees that worked for them starting in 2020, assuming they are still with the company by 2029. So this is what we mean by retroactive benefits. Going back and they will basically do a study and say, okay, it's going to cost us for example, $5 million to have in order to reward those employees with this benefit plan. Well, what does that mean? It means out of nowhere in 2029, now you have $5 million in additional expenditure that you're going to have to somehow put on your books and we're going to see how we're going to deal with this. But that's the point of a prior service cost. Or let's assume in 2029, the company decided to amend their plan. They wanted to give more benefit to their old and current employees. They want to give more benefit. If that's the case, well, that's going to be listed under prior service cost because let's assume right now your total liability is $10 million. Then you decided to give more benefits to your employee. Your actuary is going to tell you, well, bump it up to $12 million. Well, if that's the case, you made an amendment, then you have your rewarding employees for prior service. It's a prior service cost. The question is what do we do with this $5 million? Well, expense related to the prior service cost parked first in OCI and other comprehensive income. So what's going to happen is this, once we come up with that number, $5 million, this is going to be our cost to start this pension plan and reward all the employees. Well, we're going to park that $5 million. We're not going to expense it yet. We're going to park it in OCI. Then we are going to expense amortize. We're going to go into amortize either using the straight line method over the remaining useful life over the remaining useful life of the employees or years of service method, which is preferable. So simply put, initially what we do is when we decide that it's going to be $5 million, we're going to debit OCI, which is an equity account. We're going to reduce OCI by $5 million, increase our PBO by $5 million. Now we have additional obligation. Then over the years, what's going to happen? We're going to amortize this OCI to expense. So over the years, that's some five years. So we're going to debit $1 million in expense and remove $1 million from OCI, starting to reduce OCI over five years. So this is the idea. The idea is not to let the $5 million head the expense all at once. And how did I am amortize that here? I assume it's five years. So let's take a look at years of service method because the straight line is pretty straightforward how to do this. Let's look at how years of service method is used. Assume Adam Company's defined benefit plan covers 170 employees. Adam amends expansion plan on January 1, X1 and grant an additional $80,000 of a prior service cost to its employee. Simply put, Adam Company wants to reward their employees a little bit more. They said, okay, amend the plan and I'm going to add an additional $80,000 in benefits. Well, let's take a look at their employee structure. Well, this is I broke them down by division. It doesn't have to. It could be broken down by sections, groups, so on and so forth. Here's what's going to happen. They have 40 staff and those 40 staff expected to retire 20X1, which is the end of the year, 40 staff. Administrative people, we have 20 of them. They're going to expect it to retire by the end of 20X2. They're going to be with us for two years. IT group, we have 40 employees and they're expected to be with us for three years. Factory workers, we have 50 employees and they're expected to be with us 20X1, 20X2, 20X3, 20X4, four years and the high level employees. We have 20 of them and they're expected to be with us for until 20X5, for five years. So how do we do? How do we figure out how to amortize if we have how to amortize this $80,000 using years of service method? What's going to happen is this. We're going to break it down by year, we're going to break it down by year in position and the staff will be with us for one year only, right? After that, they retire, expected to retire by December 31X1. The administrative group, we have 20 employees. Those 20 employees, they're going to be with us in year one, so they're going to be with us in X1 and they're going to be with us for X2 because they retire in 20X2. The third group, IT, well, they're going to be with us for year X1, they're going to be with us for year X2 and they're going to be with us for year X3, then basically the assumption is they're retired, so on and so forth. So what we do is we can compute the total of years. The total of years is 500 years and this is the number of employee by staff, but the total of years is 500 years for all the employee broken down this way. So now we're going to take the $80,000 which is the prior service cost and amortize it divided by 500 and that's going to be our cost per one single year. So basically what's going to happen is this, in 20X1 we had 170 years. Well, how did we come up with 170? It's right here, year X1. Now don't confuse the 170 with the total employees of 170 and if we take $80,000 divided by $80,000 divided by 500, it's going to give us $160 cost per year. In X1, 170, this is the amount that we will amortize. In year X2, we're going to have 130 service years again times 160 equal to the amortization amount. All in all, this is the $80,000 that's going to be amortized. So simply put, as we amortize it, this number will go down. Now the best way to illustrate this is to actually look at a comprehensive example. Before we look at the example, I'm glad you are watching. You're most likely students taken an intermediate accounting course. That's great. I'm glad you are. Farhatlectures.com. I have accounting courses including intermediate accounting that's going to give you detailed explanation, practice multiple choice questions, practice through false exercises that's going to help you reinforce the concept that you learned. Don't shortchange yourself. Farhatlectures will help you do better in your accounting class and if you're studying for your CPA exam or other courses, I do have resources. Please connect with me on LinkedIn, like this recording. If you're watching, it's helping you. Please like it. It will help others as well. Connect with me on Instagram, Facebook, Twitter and Reddit. So let's take a look at this example starting with the projected benefit obligation before the amendment $570,000. So this is one year X1. So this is what they expect to have an obligation as of this date. They have planned asset for the same date, $556,200. And if you notice, we have more obligation than assets. At this time, the plan is underfunded and it's underfunded by $13,800. Now, how do we use the worksheet? Well, the worksheet on the worksheet, the PBO goes right here, $570, the plan asset, $556,200. And the difference is starting the liability on the balance sheet. On January 1st, 2020 X1, Adam went through a plan amendment and they increased their cost, their prior service cost to $130,000. So this is what we're going to be dealing with. How are we going to deal with this prior service cost? We'll see. Service cost for the year is $60,000. There are other elements to this exercise, but I'm going to first work those. Then on the next slide, on the next slide, I will have a complete worksheet. So I would like to go through this step by step. In addition to that, we have a settlement rate of 9% for the debt. Starting, we're going to post the PBO, the beginning PBO, $570,000, the beginning plan asset, $556,200. The difference is a pension liability because the difference is $13,800 of underfunded liability. Now we introduce under the prior service cost, the beginning prior service cost is $130,000. Then we're going to increase our projected benefit obligation by $130,000. So simply put, the journal entry specifically for this $130,000. Let me show you the journal entry specifically for $130,000. We're going to debit OCI and keep that in mind because we're going to see a different entry later, debit OCI and credit PBO. So what we did is we reduce our equity, increase our liability specifically for this entry. Now you're going to see later that we debited OCI. We're going to credit OCI something else, but just make a note of this. Now our PBO, our adjusted PBO is $700,000. Now the liability increased further, right? Because we have $700,000, only we have $556,200 of assets. Now the employee worked for us one additional year and we said the prior service cost for this example is $60,000. Now we're going to start to keep track of our pension expense. We're going to debit, I'm sorry, we're going to increase pension expense by $60,000, which we will debit pension expense and we will increase our obligation by 60 because now the pension expense for this year it increases our obligation. Now our obligation is $760,000. Now interest cost, well we have to compute the interest cost on the liability. The liability is $700,000. This liability here and the settlement rate is 9%. So that's going to give us interest cost of $63,000. So the interest cost will be debited to pension expense, will increase pension expense and obviously it's going to increase our PBO, projected benefit obligation, projected benefit obligation. So those are the entries I'm going to work on this slide. On the next slide I'm going to keep going with this example, so just bear in mind if you want to take a picture of this otherwise it's right here. So I'm going to keep going. Actual and expected return on the plan assets were $50,000. What does that mean? It means the plan assets that we invested earned $50,000. How is that going to help us? Well it's going to reduce our pension expense. So notice it's a negative pension expense and it's going to increase our plan assets. It's going to increase our plan asset. The company made a contribution of $60,000. Well if the company wrote a check to the administration of the pension plan to the bank, to the financial institution, their cash is going to go down by 60, right? But they're going to have more plan asset. Their plan asset will go up by 60 because they put that $60,000 cash in the account. Then benefit paid to retiree. Who pays this benefit? The administration of the plan. This is outside the company. So we don't credit cash for this $30,000. If we pay $30,000 of our obligation, it's going to reduce our obligation. This is a plus. It's going to reduce our obligation by $30,000. But we pay the $30,000 out of the plan assets. It's going to reduce our plan asset by $30,000 as well. And we come up to the prior service amortization cost. We decided to amortize. We don't know how we come up with this. It just doesn't matter whether it's the straight line or the sums of year's digit or years of service digit. Now we're going to deal with the prior service cost and we happen to be given us the number at $17,000. We don't care how they come up with this amortization number. We are told you're going to amortize $17,000. How is that going to help? Well, now part of it, it's going to leave OCI, it's going to leave OCI and go to pension expense. Therefore, we're going to increase pension expense and we're going to start to reduce OCI, start to reduce OCI. And basically we accounted for everything that we need to account for except gains and losses, which we don't have in this example. I will work gain and losses in the next session. Now let's take a look at what we have when we add up all our pension expense. $60,000 plus $63,000 minus $50,000 plus $17,000, our pension expense is $90,000. Cash paid $60,000. The prior service cost, remember the prior service cost, this is an OCI. Remember what we did first, we debited OCI. Now we credited OCI. So what's left in OCI is $113,000. In a sense that we're going to have, now bear in mind, all what we did now is just we put it on the worksheet. So what's going to happen is you're going to see the net effect of it. You're going to see the net effect. In what sense? In a sense that I'm going to show you I'm debiting OCI for that amount, but you will see the net effect of it later. Okay? But this is the, because this is year one, simply put on a piece of paper I said, well, I started with $130,000 minus $17,000. I need to put on the books $113,000. Okay? Because at the end of the year you're doing this. Therefore, we're going to see this will be a debit to OCI. Why a debit? Well, because basically what happened is this. First, I debited OCI $130,000, credited PBO $130,000. Now I'm going to go ahead. I'm going to have to debit OCI. I'm going to, I'm sorry, I'm going to debit OCI. I'm going to credit OCI. I'm going to debit pension expense. I'm just going to put it as an expense $17,000 and credit OCI $17,000. So those are the two entries if you're going to go entry by entry. So notice if you debited OCI $130,000, credited OCI $130,000, this is a net of a debit. So that's why you're going to see later. I debited OCI for $113,000. Now am I done yet? Absolutely not. Now I'm going to compute, I'm going to add up all my plan asset at the end of the year, all my projected benefit obligation. And I find out now my pension underfunded balance actually increased further. So what's the difference between $793,000 and $636,200, $156,800. This is my new pension liability. This is my new liability. And hold on a second. How much do I have a liability as of the beginning of the year? $13,800. So I'm going to have to go from $13,800 as a liability balance underfunded to $156,800. What am I looking for? I'm looking for the difference. What is the difference? The difference is $143,000. The difference is a credit of $143,000. Now we are ready to process the journal entries. Now bear in mind, we're not assuming anything in the AOCI from the prior year. We're assuming zero accumulated other comprehensive income. If you had a balance, you have to take care of that balance, but we're assuming none. So now let's take a look at the journal entry that we will prepare for this example. Again, pension expense $90,000. We debit pension expense $90,000. Other comprehensive income, we're going to debit other comprehensive income $113,000. And explain to you why we are debiting this account $113,000. Because you said we're going to be reducing it. This is year one. This is year one. Okay? We debit OCI for $113,000. We're going to credit pension assets slash liability $143,000, which is, why are we doing this $143,000? Because in this pension asset slash liability, we started with $13,800. We end up with $156,800. What we're missing is this $143,000. And we paid cash of $60,000. Always make sure your debits are equal to your credits. And this is going to give us $203,000 and debits and $203,000 credits. Make sure those are equal to each other. What should you do now? Go to farhatlectures.com. 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