Hi - Anyone knows why amortization of past service cost is not included as part of the operating expense?
It is one of the qbank questions on CFA website.
Cited from CFA website:
Atlantic Preserves Case Scenario
Jim Loris is the Food and Beverage analyst at Eastern Trust & Investments. Jeremy Paul is an intern under Loris’s supervision. Loris is planning on reviewing the financial statements of Atlantic Preserves, Inc., in the next few days. The company has recently signed a new collective agreement with its workers, and Loris is interested in seeing how the company’s employment costs have been affected. The company prepares its financial statements in accordance with US GAAP, and the new collective agreement became effective 1 January 2018.
Paul extracts portions of the new collective agreement related to the pension plan and mentions to Loris that there have been two changes related to the plan:
- The benefit formula has been changed to 1.75% × Final year’s salary × Number of years of service under the plan. Previously, the same formula was used, but with a factor of 1.65%.
- The vesting period has been changed from four years to three years.
Paul makes the following two comments about these changes to the pension plan:
- The new formula will have a big impact on income because the past service costs that arise will be expensed immediately.
- The change to a shorter vesting period will give rise to an actuarial gain.
Loris responds: “The past service costs that arise will be reported in other comprehensive income and amortized on the profit and loss statement over the average service lives of the employees.”
Loris provides Paul with the information in Exhibit 1 about John Smith, an employee who has just started working for Atlantic, and other information taken from the company’s pension plan disclosures. Loris asks Paul to calculate the pension liability arising from Smith.
EXHIBIT 1
ASSUMPTIONS RELATING TO THE LIABILITY ARISING FROM JOHN SMITH’S PENSION
Pension Plan Details and Assumptions** Employee Details Annual wage increase 3.50% Current salary $60,000 Discount rate 7.50% Date hired 1 Jan. 2018 Pension Plan Benefit Payments** Expected retirement date 31 Dec. 2023 Annual payments are paid at year end and continue for the remainder of the retiree’s life Estimated final salary $71,261 Estimated years in retirement 25
Following his calculation of the pension plan liability, Paul asks Loris two questions about the discount rate that is used:
- Exhibit 1 does not mention how you determined the discount rate that was used. What rate is the most appropriate rate to use?
- What would be the effect of using a higher discount rate on various components of the company’s pension plan obligation?
Loris answers Paul’s questions and then provides him with selected information from Note F of the 2017 Annual Report of Atlantic Preserves, shown in Exhibit 2. He mentions to Paul that he is aware that the company’s actual return on pension plan assets exceeds its expected return, and asks him to use the information in Exhibit 2 to calculate the periodic pension cost included in Atlantic’s 2017 income statement.
EXHIBIT 2
ATLANTIC PRESERVES, INC. SELECTED INFORMATION FROM NOTE F OF THE 2017 ANNUAL FINANCIAL STATEMENTS RELATING TO THE COMPANY’S DEFINED BENEFIT PENSION PLAN (IN $-THOUSANDS)
Start of year net pension liability 12,448 End of year net pension liability 12,265 Current service cost 1,151 Interest cost 5,441 Actual return on plan assets 5,888 Expected return on plan assets 4,597 Benefits paid to retired employees 5,059 Contributions 887 Amortisation of past service costs 272
Finally, Loris tells Paul that he intends to adjust Atlantic’s operating income so that it excludes the non-operating components of the reported pension expense. Paul asks what portion of Atlantic’s reported pension expense should be considered as an operating expense?
Q. The best answer to Paul’s question about the operating portion of the pension expense is (in $000s):
- 1,151.
- 1,423.
- 6,592.
Solution
A is correct. Conceptually speaking, only the current service cost component is considered an operating expense. Atlantic’s 2017 current service cost is $1,151. Both the interest expense and asset returns components of pension expense are non-operating.