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.
Study together. Pass together.
Join the world's largest online community of CFA, CAIA and FRM candidates.