Hubbard, Inc. received the following information from its pension plan trustee concerning the operation of the company's defined-benefit pension plan for the year ended December 31, 2015. The service cost component of pension expense for 2015 is $890,000 and the amortization of prior service cost due to an increase in benefits is $180,000. The settlement rate is 10% and the expected rate of return is 8%. What is the amount of pension expense for 2015?

Question

Hubbard, Inc. received the following information from its pension plan trustee concerning the operation of the company's defined-benefit pension plan for the year ended December 31, 2015.  The service cost component of pension expense for 2015 is $890,000 and the amortization of prior service cost due to an increase in benefits is $180,000. The settlement rate is 10% and the expected rate of return is 8%. What is the amount of pension expense for 2015?

Quizplus · Accepted Answer

Pension Expense = Service Cost + Interest Cost + Expected Return on Plan Assets + Amortization of Prior Service Cost - Amortization of Net Loss

Given:
Service Cost = $890,000
Amortization of Prior Service Cost = $180,000
Settlement Rate = 10%
Expected Rate of Return = 8%

To calculate Interest cost:
Interest Cost = Beginning PBO x Settlement rate
Beginning PBO = (Service Cost + Interest Cost - Expected Return on Plan Assets - Amortization of Prior Service Cost + Amortization of Net Loss) / Settlement rate
Assuming no Amortization of Net Loss:
Beginning PBO = ($890,000 + Interest Cost - $0 - $180,000) / 10% = ($710,000 + Interest Cost) / 10%
Interest Cost = Beginning PBO x Settlement rate = [($710,000 + Interest Cost) / 10%] x 10%
Interest Cost = $710,000 + Interest Cost
Interest Cost = $710,000

To calculate Expected Return on Plan Assets:
Expected Return on Plan Assets = Fair Value of Plan Assets x Expected Rate of Return
Given no information about Fair Value of Plan Assets, we assume it is the same as the market-related value, which is the fair value of the plan assets smoothed over a period of time. Therefore, we assume that the fair value of plan assets at the beginning of the period is the same as the market-related value at the beginning of the period.
Assuming no contributions and benefit payments during the year:
Fair Value of Plan Assets at the end of the period = Fair Value of Plan Assets at the beginning of the period x (1 + Expected Rate of Return) = Fair Value of Plan Assets at the beginning of the period x 1.08
Expected Return on Plan Assets = Fair Value of Plan Assets at the end of the period - Fair Value of Plan Assets at the beginning of the period = Fair Value of Plan Assets at the beginning of the period x 1.08 - Fair Value of Plan Assets at the beginning of the period = Fair Value of Plan Assets at the beginning of the period x 0.08 = ($710,000 + Fair Value of Plan Assets) x 0.08
Fair Value of Plan Assets = $710,000 / 0.08 = $8,875,000
Expected Return on Plan Assets = $8,875,000 x 8% = $710,000

To calculate Amortization of Net Loss:
Since there is no information about the net loss, we assume that there is no net loss to be amortized.

Therefore:
Pension Expense = $890,000 + $710,000 + $710,000 + $180,000 - $0 = $2,490,000

However, we need to deduct the amortization of prior service cost due to a decrease in benefits from pension expense, because it is a gain to the plan:
Pension Expense = $2,490,000 - $180,000 = $2,310,000

Therefore, the answer is B) $1,730,000 (which is the closest option to $2,310,000).