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My dumbed down Accounting for Pension Expense.

Here, i explain how i have come to understand the Pension Expense.  If it helps you great, if it doesn’t, please ignore.

First assume you have a mini balance sheet, seperately for your pension accounting.  Whatever the net outcome of your mini balance sheet is, will be recorded in your MAIN balance sheet as either an Asset or a Liability under a fancy account called Funded Status of Pension Plan.

Next, in your mini balance sheet, you’ve got the asset and the liability. ( Your Liability is also called PBO)

Your Liability is only one figure - it’s simply the present value of payments to be made in the future.  In lay man terms, this is a debt you owe to your hardworking employees and will have to pay back at some point in the future.

We all hate liabilities - at least, most of us do - so you decide on a nice plan to have some assets in place, to fund your liability whenever it comes due in the future.  This is simply some amount of cash you’ve invested and expect to earn some income on at some point in the future.

So all good!  Assets and Liabilities, equation balanced!  When you net your assets against your liability, whatever you get is your funded status.

But there is a caveat though.

Your liability, like all debt, is not static, for two reasons.  

1) Like all debts, you pay interest on it. - we will call this your interest expense

2) Each year your hardworking employees sweat hard for you, you owe them more – whatever you owe them in that year is what we will call the Current Cost.

At the end of the year, your liability will have increased by Interest Expense + Current cost.

So your ending PBO = Begining PBO + Interest expense + Current Cost.

Just in case you are mumbling and cursing beaneth your breathe at “Those d**n pigs bleeding their poor employer to death” …you might want to take a chill pill and look at your Assets!

Your Assets would have made some returns as well.  The total returns on your assets, as usual is in two components

1) Income component

2) Capital Gains component

If you are American, the income return component of your assets will simply be = Expected return * Plan Assets. (If you are british, you use interest rates instead of expected return)

So, Total Return on your assets = Income return Component + Capital Gains Component

and therefore, by simple mathematics, Capital Gains component = Total Actual Return - Income return, 

which is the same as writing [Actual return -(expected return * plan assets)]  

The Net periodic Pension cost is simply a net measure of the amount by which your Liability and your assets must have increased by the end of the year, after also factoring in employer contributions.

The amount is =[ Increase in Liability - Increase in Assets.] - Employer Contributions.

This is the same as

[ Current service cost + Interest Expense] - [Income Component + Capital Gains Component] - Employer Contributi

Also, remember that Liability - Assets = Funded status.

So, we can also re-write 

[ Increase in Liability - Increase in Assets.] - Employer Contributions 

as  Change in Funded status - Employer Contributions.

This is your Net Periodic Pension cost.  This is also your Periodic Pension Cost.  This is also your total Periodic Pension cost.  All three are the same just poor naming conventions.

So let’s talk a bit about how US GAAP differs from IFRS.

The first difference:

Rememeber that our asset return in each period is said to be made up of two components

1) Interest component

2) Capital Gains Component

The main significant difference is how interest component is defined.  Americans use Expected return * Asset (Americans like dreams and expectations), the british use Interest rates * Assets.

The second difference:

Remember our final derivation?

[ Current service cost + Interest Expense] - [Income Component of Returns + Capital Gains Component] - Employer Contributions

Under US GAAP, the equation is fine as it is.  Under IFRS, those two middle components are netted together in a single figure called NET INTEREST EXPENSE.

The third difference:

There are times, when you make ammends to your company’s pension plan to take into account some guys who may have come way back with you when you first started the company.  You call this Past Service Cost.—think of this as Loyalty Points.

Now look at that long equation again. The difference here is that under IFRS, this Past Service Cost is simply added to the Current Service cost…..but guess what the Americans do?  They toss it in the bin!  Yes you heard me right, so much for Loyalty.  Under GAAP, all that Loyalty Points are tossed into a big bin called OCI and then slowly amortised into the Income statement by dividing Past Service Cost by expected number of employee years.

Speaking of the big bin…..

What are the contents?  Well just about any s***ty stuffs you can think of really, mostly coded as “Actuarial Stuff”

Actuarial Stuffs are the randomn stuffs you were not expecting.  For instance, let’s say you change the assumptions you’ve made about your discount rates, the rate of compensation increase, or how long your employees are likely to live, these changes will affect the value of your liabilites and the increase or decrease is coded as “Actuarial Stuff”, tossed away in the big bin called OCI.

Additionally, if you are American, and had filed your statements using Expected returns, then you must also record the Capital Gains portion of your returns in the OCI.  

Recall that we agreed earlier on, that:

Capital Gains Component = Total Actual Return Component - Income Component

and Income Component = Expected return * Asset.

If you have manged to stay this far without getting confused, well thank you.  and here’s the final and fifth difference between IFRS and GAAP

- Under IFRS, you never amortize your bin bag!  You should say this to yourself over and over again!

- Under GAAP, you amortize Past service cost by dividing by expected number of years and you amortize the rest of your bin bag using the corridor approach.

That’s it!!!!

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How the h**l do you know this s**t so well!!!

Now … don’t you wish you’d started a 401(k) in 1978?

Simplify the complicated side; don't complify the simplicated side.

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Followed that pretty easily. Really appreciate the help bloodline. 

Printed this and will read it many many times.

Very much thank you!

Saved for future reference, thank you!

Fair value of planned assets= 1000
PBO- 980

A analyst wants to adjust Debt/assets ratio and will add pension assets and obligations to calculate adjusted Debt/assets ratio. Amount added to assets will be

a) 1000
b) 980
c) 20

Study Method

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Notes - KaplanSchweser

Never say Die
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D**n, dude! And I thought I knew the pension accounting well.

bloodline wrote:

as  Change in Funded status - Employer Contributions.

Elan’s notes and their formula sheet have PPC= change in funded status + Employer contributions…  I’ve also seen EOC problems using “+ Employer Contribution”

Am I missing something?

mwmischler wrote:

bloodline wrote:

as  Change in Funded status - Employer Contributions.

Elan’s notes and their formula sheet have PPC= change in funded status + Employer contributions…  I’ve also seen EOC problems using “+ Employer Contribution”

Am I missing something?

Straight from the horses mouth: “The total periodic cost of a company’s DB pension plan is the change in the net pension liability or asset - excluding the effect of the employers periodic contribution to the plan…Net Periodic Pension Cost = ending funded status - employer contributions - beginning funded status.”

It makes sense, why would a companys pension cost increase by an amount they are paying into it?

Also - beauty summary bloodline. i printed this off as well for later review.

mwmischler wrote:

bloodline wrote:

as  Change in Funded status - Employer Contributions.

Elan’s notes and their formula sheet have PPC= change in funded status + Employer contributions…  I’ve also seen EOC problems using “+ Employer Contribution”

Am I missing something?

No, you are not missing anything.  I think there’s been some confusion around this.

There are two ways of calculating the funded status

1)  Assets - Liability

If this is positive, your Funded status is a Net asset.  If this is negative, you have a net Liability.

2) Liability - Assets

If this is positive, your funded status is a Net liability, if this is negative, you have a net asset.

Both ways can then be used to calculate Net Periodic Pension Cost.

Under the first approach

[Change in Assets + Contribution] - Change in Liability

= Change in Assets - Change in Liability + Contribution

= Change in Funded Status + Contribution

Under the Second Approach

Change in Liability - [Change in Assets + Contribution]

= Change in Liability - Change in Assets - Contribution

= Change in Funded Status - Contribution.

You need to understand the difference betweeen this two.

 In the second approach you are saying “If Liability has increased by X amount and the fund’s asset has increased by Y amount, if the employer has also contributed Z amount, how much Liability will be left at the end of the day”

In the first approach, you are saying “If Assets have increased by X amount and the employer has contributed Y amount, if i have Z amount of Liability to fund, how much asset will i be left with”  

The first approach is more in line with the traditional principles of Assets - Liability.  The assumption here is that for a company to be a going concern, its position must always be Net Assets.  I think Elan’s guide follow this method

The CFAI uses the second approach, which assumes that the Pension account will always be a Liability to an employer, and an employer’s goal will be to gather as much assets as possible to fund this liability as they come due in the future. I will recommend this approach, as it leads to less tendencies for errors.

Whichever approach you use, what is most important is understanding the principles behind it.

Great explanation. Totally cleared things up for me.  Thanks bloodline.  Huge help!

Tears… real man tears are being shed. I love u bloodline.

I’m really glad you all found the explanation useful.  I have learnt a lot in the process as well.

This is awesome and a great help! I  am sure now bloodline that no one can stop you from beating this beast.

DK

so…. what was the 4th difference? hahaha. you seem to have either skipped it or mislabled how many there were.

bloodline wrote:

mwmischler wrote:

bloodline wrote:

as  Change in Funded status - Employer Contributions.

Elan’s notes and their formula sheet have PPC= change in funded status + Employer contributions…  I’ve also seen EOC problems using “+ Employer Contribution”

Am I missing something?

No, you are not missing anything.  I think there’s been some confusion around this.

There are two ways of calculating the funded status

1)  Assets - Liability

If this is positive, your Funded status is a Net asset.  If this is negative, you have a net Liability.

2) Liability - Assets

If this is positive, your funded status is a Net liability, if this is negative, you have a net asset.

Both ways can then be used to calculate Net Periodic Pension Cost.

Under the first approach

[Change in Assets + Contribution] - Change in Liability

= Change in Assets - Change in Liability + Contribution

= Change in Funded Status + Contribution

Under the Second Approach

Change in Liability - [Change in Assets + Contribution]

= Change in Liability - Change in Assets - Contribution

= Change in Funded Status - Contribution.

You need to understand the difference betweeen this two.

 In the second approach you are saying “If Liability has increased by X amount and the fund’s asset has increased by Y amount, if the employer has also contributed Z amount, how much Liability will be left at the end of the day”

In the first approach, you are saying “If Assets have increased by X amount and the employer has contributed Y amount, if i have Z amount of Liability to fund, how much asset will i be left with”  

The first approach is more in line with the traditional principles of Assets - Liability.  The assumption here is that for a company to be a going concern, its position must always be Net Assets.  I think Elan’s guide follow this method

The CFAI uses the second approach, which assumes that the Pension account will always be a Liability to an employer, and an employer’s goal will be to gather as much assets as possible to fund this liability as they come due in the future. I will recommend this approach, as it leads to less tendencies for errors.

Whichever approach you use, what is most important is understanding the principles behind it.

It’s easy to remeber (at least for me) in this way:

If funded status got worse, this essentialy means that your costs rose, which is an additional cost to what your employer contributed so you simply add both the change in funded status and contribution.

If, however, funded status got better (assets rose more than liabilities) this means it is gonna reduce your cost so you can subtract this change from employer contribution to decrease your total periodic pension cost (or how else you can all it:)) 

Thank you for the “plain language” explanation. 

I’m building a StumbleUpon Clone

Did I understand correct that under GAAP for pension expenses you add only the amortization of past service costs while under IFRS you add the whole past service costs (you do not put it into bin)?

so far I have seen only questions which asked you to calculate the expenses under IFRS or GAAP und you had to use only service costs, int costs and resp deducting expected return under GAAP. what else should I add under various methods when calculating expenses?

The examples above really helped, thanks guys!

I suggest Bloodline recieves a thousand AF points because of this post!

One more question guys!

Under GAAP, do we amortize the hole bin ie. OCI (actuarial G/L, past servise cost and difference between expected and actual return) using corridor approach or only acturial G/L and the rest just stays in the bin?

Dude! This is superb!!

Thanks alot!!!

plumber > stripper > experience > CFA > MBA

kobi wrote:

One more question guys!

Under GAAP, do we amortize the hole bin ie. OCI (actuarial G/L, past servise cost and difference between expected and actual return) using corridor approach or only acturial G/L and the rest just stays in the bin?

From what you wrote I guess we should amortize past servise cost over the life of employees and actuarial g/l using corridor approach. But do we amortize difference between actual and expected returt at all?

Great summary, great putting a little uplifting approach to a demoralizing subject!

kobi wrote:

One more question guys!

Under GAAP, do we amortize the hole bin ie. OCI (actuarial G/L, past servise cost and difference between expected and actual return) using corridor approach or only acturial G/L and the rest just stays in the bin?

My understanding of this is that under GAAP, past service cost is amortized into the income statement by dividing the amount of past service cost by the total number of employee years.  So in each period for the income statement, you will have a portion of your income expense relating to amortized portion of past service cost.

The rest of the OCI (gains/losses, expect minus actual, remeasurements)  get amortized based on the corridor approach. 

So corridor approach apllies to actualrial losses and difference between expected and actual return? 

It is not implicitly stated in CFAI text.

EDIT: ok

Appreciated a lot mate!

kobi wrote:

So corridor approach apllies to actualrial losses and difference between expected and actual return? 

It is not implicitly stated in CFAI text.

EDIT: ok

here’s what the book says

“thus, under U.S. GAAP, differences between the expected return and the actual return on plan assets represent another source of actuarial gains or losses.
 
As noted, actuarial gains and losses can also result from changes in the actuarial assumptions used in determining the benefit obligation. Under U.S. GAAP, all actuarial gains and losses are included in the net pension liability or net pension asset and can be reported either in P&L or in OCI
 
Typically, companies report actuarial gains and losses in OCI and recognise gains and losses in P&L only when certain conditions are met under a so-called corridor approach.
 (Institute 178)

kobi wrote:

Appreciated a lot mate!

No worries buddy.

yea, that cleared a lot! i owe you a large beer :)