A. There are two general types of retirement plans—defined benefit plans and defined contribution plans.
i. How do these two types of plans differ? Which does Johnson &
Johnson have?
In a defined benefit plan, retirement benefits are based on a formula that takes various factors into account, such as number of years worked and salary level. This is typically called a pension plan. On the other hand, a defined contribution plan specifies how much the employer would contribute into the plan. The contribution amount is based on either the employee’s salary or a specific amount. Johnson &
Johnson uses a defined benefit retirement plan, as seen in the notes to the financial statements.
ii. Explain why retirement plan obligations are liabilities.
Retirement plan obligations are liabilities because they represent the amount that the companies owe past and current employees. Since these plans are typically included in the contract signed when the employee begins work, there is an evident obligation the company must meet, so long as the employee meets all of the requirements.
Some people argue that these are not completely liabilities because they are based on estimates, otherwise called assumptions.
iii. List some of the assumptions that are necessary in order to account for retirement plan obligations.
Some of the assumptions necessary in order to account for retirement plan obligations include predicting employees’ lifespans, average retirement age, future salary levels, length of time with the company, and even the disability rate.
B. In General, companies’ pension obligations are influenced each year by four main types of activities: service cost, interest cost, actuarial gains or losses, and benefits paid to retirees. Explain each of the four activities in your own words.
Service costs are expenses caused by the increase in the projected benefit obligation due to services rendered during the current year. Interest cost is the rate that the employee’s benefits accrue, and, therefore, creates additional expenses and obligations for the company. Actuarial gains and losses occur when the assumptions used to calculate the pension plan change and result in an increase or decrease in liability. Lastly, benefits paid to retirees decrease the pension obligation, because they are obligations that have already been paid.
C. In general, companies’ pension assets are influenced each year by three main types of activities: actual return on pension investments, company contributions to the plan, and benefits paid to retirees.
Explain each of the three items in your own words.
179 Actual return on pension investments increases the plan assets of the pension plan. The actual return on pension investments can be computed by taking the difference between the beginning and ending balances of the plan assets account and adjusting it for contributions and benefits. Company contributions to the plan also increase the plan assets, since the company pays cash into the plan. Benefits decrease the plan assets as well as plan obligations. The company does not make an adjusting journal entry to its balance sheet when benefits are paid to employees.
D. In general, companies’ pension expense and pension plan assets both have a “return on plan assets” component. How do the two returns differ? Explain the rationale for this difference.
The portion of “return on assets” that affects pension plan assets is the actual return on plan assets. The portion mentioned earlier is the unexpected gain or loss on plan assets. Both of these, when combined, equals expected return on plan assets. The company wants the expected return on assets to affect the plan assets account; however, we can still see the actual and unexpected returns thanks to the accounting system.
E. Johnson & Johnson provides other benefits to retirees including health-care and insurance benefits. What is the primary difference between the company’s other-benefits plans and its retirement plans?
The primary difference between other benefits plans and retirement plans is that the other benefits plans deal primarily with health care and is available to all U.S. retired employees and their dependents. The retirement plans, on the other hand, cover most employees worldwide.
F. Consider Johnson & Johnson’s pension expense detailed on page 61 of the company’s annual report. Note that the company uses the term “net periodic benefit cost” to refer to pension expense.
i. How much pension expense did Johnson & Johnson report on its 2007 income statement?
In 2007, Johnson & Johnson reported pension expense of $646 million.
ii. Prepare the journal entry to record the service cost and interest cost portion of the 2007 pension expense.
See Figure 13.1.
G. Consider Johnson & Johnson’s retirement plan obligations, that is, the pension liability, as detailed on page 62 of the company’s annual report.
i. What is the value at December 31, 2007, of the company’s retirement plan obligation? What does this value represent?
How reliable is this number?
The value of Johnson & Johnson’s retirement plan obligation equals
$12,002 million at the end of 2007. This value represents the amount of benefits the company will pay to employees. This number changes based on actuarial assumptions; however, it is usually computed by an actuary and is rather reliable.
ii. What is the pension-related interest cost for the year?
Compute the average interest rate the company must have used to calculate interest cost during 2007. Does this rate seem reasonable? Explain.
The pension related interest cost for the 2007 was $656 million.
Johnson & Johnson used an average interest rate of 5.63 percent.
According to the IRS website, the average interest rate on pension obligations for U.S. companies equaled 5.85 percent. Thus, Johnson &
Johnson’s rate is extremely reasonable as there is only a 0.22 percent difference in these rates.
iii. What amount of pension benefits were paid to retirees during the year? Did Johnson & Johnson pay cash for these benefits?
How do the benefits paid affect the retirement plan obligation and the retirement plan assets?
Johnson & Johnson paid pension benefits of $481 million for 2007.
Johnson & Johnson did not pay cash for these benefits. The benefits paid affect the memo record by reducing the plan obligation as well as the plan assets, because the benefits are being paid using the plan assets.
H. Consider Johnson & Johnson’s retirement plan assets, that is, the pension plan asset, as detailed on page 62 of the company’s annual report.
i. What is the value at December 31, 2007, of the retirement plan assets held by Johnson & Johnson’s retirement plan?
What “value” is this?
Johnson & Johnson’s retirement plan assets were valued at $10,469 million on December 31, 2007. This is the fair value of the assets at the end of the year.
ii. Compare the amount of the expected return on plan assets to the amount of the actual return during 2006 and 2007. Are these differences significant? In your opinion, which return better reflects the economics of the company’s pension expense?
The expected returns during 2006 and 2007 were $809 and $701 respectively. However, actual returns for 2006 and 2007 equaled
$743 and $966. The difference was not significant in 2007 as it was only an 8 percent difference, however the difference of 27 percent in 2006 was very significant. This significant difference may have changed Johnson & Johnson’s expected return for 2007, leading to an