Adjusting Cash Flow - Contributions vs. Total Pension Cost

CFA Level II FRA
#1

Good Morning!!

I’m having a little difficulty grasping Adjusting Cash Flow as it relates to Total Pension Costs.

I think I get the basic idea; just having trouble applying it at times.

Contributions > Total Pension Cost

*reduction in PO; similar to excess principal payment

*add the excess to CFO and subtract same amount form CFF (how are taxes applicable here as I know from other posts it seems to apply???)

* Kaplan Book 2 (pg. 119 #9) is an example of this but the solution DOESNT ADDRESS taxes (why is that and why is the answer not A?)

Contributions < Total Pension Cost (Kaplan text is stating " pension expense" but isn’t that incorrect bc that’s not the same thing and expense is one reported on I/S?) (cost and expense are not interchangeable in this full reading section are they???)

*increase in PO (???); similar to source of borrowing.

*add the after tax shortfall to CFF and subtract same amount form CFO (this is how Kaplan explains via example on pg.113)

SO… I guess my main questions are:

  1. the distinction throughout the whole reading and curriculum regarding “cost” vs. “expense” terms as it relates to employee beneifts?

* Cost (e.g. Total period pension cost, total economic pension cost) - Use ACTUAL return when calculating

* EXPENSE (e.g. Reported pension expense, pension expense) - use EXPECTED return when calculating and report to I/S

  1. Can someone in common sense terms explain the rationale on why the CF adjustment is necessary? I believe I get the basics but couldn’t teach a class on it…

  2. Please explain the rationale and steps regarding making additional adjustments for taxes

Please feel free to interject and correct/clarify anything above. I will take no offense to any criticism or advice!

Thank you in advance for all the insight and time!! GOOD LUCK to all!!!

#2

Can anyone provide me with clarity on this??? I’m actually starting to get the hang of this section and this is my last part of uncertainty?

THANK YOU in advance for any guidance!

#3

The terms and wacky accounting around pensions are enough to drive a person crazy.

  1. Cost = the economic cost of pensions during the period = TPPC

Expense = what’s reported on the I/S. The rest of the cost goes to OCI.

  1. The CF adjustment is necessary because it accurately reflects what’s happening. If the funded status of the plan decreases, or becomes more negative (larger liability), the company is effectively borrowing from itself. The funded status has to be positive in order to pay the employees (simplify it here and think it’s only for one employee.) So, as the company will have to put money back into the plan, it has to count it as a source of financing, not as a cash flow from operations. Otherwise, the CFO will be inflated.

  2. I’m not sure I follow you on the taxes bit. I wouldnt’ worry as it likely wont’ come up. If it does, choose A.

#4

With regards to taxes. For eg. If tax rate = .3

Total pension costs = 400 Contribution = 500

Then contributions exceed pension costs and therefor a CFF outflow. CFF outflow would be (500 - 100) * .7 = 70

Would also be a CFO inflow of the same amout and thats how taxes works. I didnt read the rest of your post.

#5

CFAI uses “total periodic pension cost” to represent the ENTIRE pension cost incurred during the period and “periodic pension cost” as the PART of the total pension cost that you report on I.S (pension expense),

Total pension cost under GAAP and IFRS are the same while pension expenses are different.

Pension expense under IFRS =

Current/past service cost + discount % (PBO - Asset) and under GAAP =

Current service cost + discount % (PBO) - expected return % (Asset) + amortized past service cost

The reason y total pension cost is the same under both GAAP and IFRS is that in the remeasurement component as OCI will adjust for the actual return on asset and cancel out both discount % (asset) and expected return % (asset) and leaving your total pension cost as

  1. change in funded status + employer contribution or

  2. service cost + interest cost - actual return - acturial gain + acturial loss

note that benefits paid reduce both PBL and asset by the same amount, it has no effects on your total pension cost.

If contribution is greater than total pension cost (not pension expense), your net PBO will decrease and therefore, the excess portion of the contribution is considered as outflow of CFF (think of it like the principal pmt you make toward your debt because PBO is afterall a liability/debt you owe) instead of an outflow of CFO so your CFO goes up.