Pensions are easy CFAI materials read like reference books. They just aren’t designed to be used as learning tools. I’m a big fan of Schweser, but the books and videos are a disaster when it comes to pensions. There’s a total lack of structure, the items aren’t presented in logical order and it also suffer from cryptic/inconsistent terminology. I have written a little dissertation on pension accounting. I suggest reading this first, the Schweser second, and then jumping into problems. I have written this as a help in understanding this materials, not mastering it. - Here are the bases: 1. Pension Expense (Income Statement) 2. Pension Related Assets and Liabilities (Balance Sheet) 3. GAAP vs. IFRS for Pensions, with a quip on Comprehensive Income. 1. Pension Expense (Income Statement) Pensions will affect a company’s income and cash flows at some point in the future. It’s therefore important to account for this on the Income Statement. Of course we all know that the Income Statement is an attempt to represent the year’s operation, not cash flows. It is important to keep this in mind, since the actual pension payoff will often occur far in the future, but a portion will occur as a result of the current year’s operations, so we must account for that portion this year. The components: • + Service cost for the period. This is the PV of future benefits the employer will have to pay due to work performed by employees this period • + Interest cost for the period. This is the interest that must be earned on the assets already put aside. • - Expected return on planned assets. The name says it all. • +/- Amortization of deferred G/L on assets. Will discuss this in a sec. • +/- Amortization of deferred changes in pension terms. (Actually called prior service costs). Will discuss in a sec. The first two components are pretty straight forward actually. Service cost represents what should be added to the fund in order to cover what will be owed to employees in the future for the work they performed this period. Interest cost for the year and expect return on planned assets are pretty similar really. These two entries should be pretty close to one another. Interest cost is the assets aside multiplied by the discount rate, so what should be earned on the assets. Expected returns on planned assets is the amount that is expected to be earned on the assets aside. Notice that we are talking about expected returns not actual returns. This is due to actuarial accounting. (Same with the two amortization entries.) This is the IS not the CF statement, so we want smooth numbers. The difference between expected and actual returns will go directly to Comprehensive Income on the Balance Sheet, so that the numbers can remain smooth on the IS. When the difference becomes significant in Comprehensive Income (10% of PBO) we will start amortizing the difference in Amortization of Deferred G/L on assets. When the employer makes changes to the pension terms, it will affect the PV of the amount to be paid in the future. This amount will be accounted for in Comprehensive Income (BS) and amortized over years on the IS in order to keep the pension expense smooth, this is the last entry (amortization of deferred changes in pension terms). So, there are a few items here, but remember that the goal is to present a number that represent the average cost of the pension. Taking out the yearly (or quarterly) ups and downs is crucial. Of course, it creates some complications in calculating the expense, and does give actuarial accountants some room to misrepresent expenses and earnings. 2. Pension Related Assets and Liabilities (Balance Sheet) The balance sheet entry for pension is called Funded Status. Funded Status = Fair Value of Planned Assets – Projected Benefit Obligation (PBO). The Fair Value of Planned Assets is what we currently have aside. The PBO is the PV of what we will have to pay in the future. One is an asset and one a liability, valued at time 0. Of course, funded Status can be positive (overfunded) or negative (underfunded). It’s interesting to note that only the difference in what we have, and what we will owe is represented on the Balance Sheet. (Dare I say “off balance sheet” items?). I’m presenting the following items as the difference between one period and another. This may be slightly more confusing than starting from scratch, but it is likely to be tested this way on the exam. Fair Value of Planned Assets: • Beg Value of Planned Assets • + Contributions (Service and Interest for the period) • + Actual Return on Assets • - Benefit Paid • - Expenses for running the fund This is pretty straight forward as it is all tangible. There are no accounting assumptions here. Whereas the next section includes actuarial assumptions. PBO: • Beg Value of PBO • + Service cost for the period. This is the PV of future benefits the employer will have to pay due to work performed by employees this period • + Interest cost for the period. This is the interest that must be earned on the assets already put aside. • +/- Actuarial G/L on PV of liabilities. Due to changes in discount rates, employee deaths, retirement age, etc. • +/- Changes on pension terms. (Called prior service costs). • - Paid benefits this period. This will lower our future liabilities as it’s just been paid. So there you go, the PV of the future liabilities. 3. GAAP vs. IFRS The best way to value pensions should go as follows: • Recognize a smoothed amount in the Income Statement. (So that Net Income doesn’t jump up and down every year based on market values and actuarial assumptions.) • Recognize an actual amount on the Balance Sheet. (So that we can look at the Balance Sheet and get a real sense of Assets and Liabilities). GAAP and IFRS used to present a smooth amount on both statements. GAAP woke up in 2006 (with a rule called SFAS 158) and decided to present an actual amount on the Balance Sheet. For companies with underfunded plans, the new standard will increase liabilities and decrease shareholder’s equity. A quip on Comprehensive Income: Let’s say we experience a loss on an asset, it usually flows through the income statement and ends up reducing equity. Another way to reduce equity is to forgo the income statement and reduce equity directly (through an entry called Comprehensive Income.) When we have an item that has little to do with operations, we may choose to reduce Comprehensive Income directly. We do quite a bit of this with changing values due to actuarial assumptions (pensions), because they have little to do with the period’s operations. We will often account for deferred losses in Comprehensive Income, and adjust for these over time, by putting them through the income statement. - This reading is an overview of what you need to understand. You should also read up on: • Share based compensation • Defined benefits vs. defined contribution • ABO and VBO • Etc.
This is easier to read in PDF version, the notes are clearer… If anyone would like to receive that, leave your email in the thread… All comments are welcomed.
thanks for taking the time out to write this. I’m in favor of expanding this to cover all sections of fsa!
Haha, definetely the weakest link for Schweser…
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This seems to be either a cut and paste error or a typo below: Fair Value of Planned Assets: • Beg Value of Planned Assets • + Contributions (Service and Interest for the period) • + Actual Return on Assets • - Benefit Paid • - Expenses for running the fund Why are contributions (Service and Interest for the period) being added to the Beginning Value of Plan Assets to arrive at the Fair Value of Plan Assets. These are truly liabilities … so should not be increasing the Fair Value of Plan Assets directly.
All help is appreciated, thanks for writing this up: jdane AT tadanet DOT com
thread bookmarked. Thanks Johnny
cpk123 Wrote: ------------------------------------------------------- > This seems to be either a cut and paste error or a > typo below: > > Fair Value of Planned Assets: > • Beg Value of Planned Assets > • + Contributions (Service and Interest for the > period) > • + Actual Return on Assets > • - Benefit Paid > • - Expenses for running the fund > > Why are contributions (Service and Interest for > the period) being added to the Beginning Value of > Plan Assets to arrive at the Fair Value of Plan > Assets. > > These are truly liabilities … so should not be > increasing the Fair Value of Plan Assets directly. Contributions flow through the income statement before they reach the Balance Sheet. Once on the balance sheet, they split in two: Asset and Liabilities (nothing in equity). So, at the same time these go into liabilities (since they represent the PV of future costs) and go into assets (since they represent money put aside to cover upcoming liabilities). It is correct. If you need proof go to p.169 in Schweser FSA and you will see the formula as follow: Beg Value + Actual return on asset + EMPLOYER CONTRIBUTION - Benefits paid = Fair Value of Plan Assets at End of Period.
However the fact is EMPLOYER CONTRIBUTION is not necessarily the “Service and Interest Cost” for the period. I am definite you have that part wrong. Employer Contribution is how much the employer decides to contribute. If he does not contribute the entire amount due for the period - he would have a higher liability because of the funded status.
cpk is right- service cost is the pv of benefits earned that year interest cost is the increase in PBO from interest owed on the current obligation employer contribution is how much the employer decides to contribute during the year to fund the plan. Beg Value + Actual return on asset + EMPLOYER CONTRIBUTION - Benefits paid = Fair Value of Plan Assets at End of Period that formula is right
cpk123 Wrote: ------------------------------------------------------- > However the fact is EMPLOYER CONTRIBUTION is not > necessarily the “Service and Interest Cost” for > the period. I am definite you have that part > wrong. > > Employer Contribution is how much the employer > decides to contribute. If he does not contribute > the entire amount due for the period - he would > have a higher liability because of the funded > status. It’s possible I have that wrong. I actually cant find any details on it in Schweser or CFAI which leads me to believe that it’s beyond the curricullum… On the exam, I would imagind that CFAI would just say “Employer Contributions” if you are correct. If you find some evidence backing up youre position, please post it… In the meanwhile I will take out that detail in the PDF I send out… Thank you for the scrutiny… I do appreciate it (no sarcasm)!
dan . lieb – gmail THANKS!