I just read the schweser chapter of this and I find the second half of the reading quite confusing after my first read through. This typically does not happen. Has anyone else shared similar views? Also does anyone suggest reading the CFAI reading on this topic? It seems like its going to be an important reading. Thanks
This chapter is not fun. If you don’t understand it from Schweser then read the CFAI. CFAI is more thorough. I read both, and then re-read Schweser to make it stick.
I luckily had access to schweser Video. The prof uses a great example in part 3 and that makes life much easier.
The example of the defined-benefit plan is fairly easy to grasp. The second part is more difficult. This is a summary of the first part… A person has some 29 years left to retirement and is expected to live for 20 years afterwards. 35 85 Between 35 and 65 there are 29 years. Between 65 and 85 there are 20 years, pension paid out at the beginning of each year. Salary is 60000 to start with, increases with 3% each year, expected to end in 30000*(1.03)^29 = 141394. That amount forms basis for the size of each monthly payment: pay * 3% * years_of_employment which right now is 141394 * 3% * 1 = 4242 per year for 20 years. This is equivalent to a 20 year annuity equal to the amount of 48086. [BEG mode, n=20, i=7%, PMT=4242, FV=0]. Those 48086 are worth 6759 today [48086 / 1.07^29] The liability is worth 6759 today. Put it up as a liability (PBO, projected benefit obligation) with the contra account service cost (roughly speaking). Next year salary is 60000*1.03 = 61800 with 28 years left. Ending salary still 141394 but with two (2) years of service: 141394 * 3% * 2 = 8484. Pensioner to receive 8484 for 20 years is equivalent to the amount of 96171 [same as above but with PMT=8484]. “Today” is now one year later so is worth 14464 today [96171 / 1.07^28]. Liability is 14464, but part of it is already on the balance sheet: 6759. Remains 7705 to be accounted for. The “old” part is increased with 7% interest, 473 [6759 * 7%]. Remaining increase is 7705 - 473 = 7232 to be taken as cost this year. The liability increases, company contributes a random amount 10000 to the plan, and so lifts it off the PBO amount. 10000 in plan and 14464 - 10000 = 4464 on balance sheet, reported as net pension liability, the 10000 reported as “plan assets”. Next year both salary and plan assets have increased. Salary with 3% to 63654 (27 years left) and assets with 1000 in actual return so the assets are now worth 11000 in total. Ending salary still 141394 with three (3) years of service: 141394 * 3% * 3 = 12725 to be paid out each year for 20 years. This is equivalent to the amount of 144245 [n=20, i=7, FV=0, PMT=12725]. “Today” (27 years earlier) this is worth 23213. Of the liability of 23213 some of it has been taken as “service cost” in earlier years. PBO of last year was 14464 with interest 1012 [14464*7%]. Remains: 23213 - 14464 - 1012 = 7737 as “new service cost” of this year. Gross pension liability is 23213 but part of it (11000) is offset by the plan assets. Remaining as net pension liability is 12213. How much to be taken as pension expense? Reconciliation: Service cost 7737 + Interest cost 1012 - increase in pension assets 1000 = 7749. The higher the actual return on the assets, the lower the pension expense. The ABO (Accumulated benefit obligation) is the present value of the sum of salaries excluding the increases: 60000 ==> 60000*3% = PMT=1800 ==> PV=2868 (which means pensions settled at current basis while company being liquidated). The VBO (vested benefit obligation) is determined by the vesting schedule, for instance receiving 20% of the accumulated balance for each employment year until 5 years of employment have passed, after which the person is fully vested. If the ABO is 2868, 20% of it is 574, and this is indeed the amount of the VBO. Discussion of two assumptions: discount rate and expected rate of compensation increase. A higher discount rate results in the PV of the obligation being smaller, which is to say a lower pension expense. Since actual return varies over the years, it is allowed to make assumptions on e-x-p-e-c-t-e-d return on plan assets. If the true actual return is 10% but expected is 8%, the pension expense is 7749 in the first case but 7949 in the second; the difference of 200 is kept “off of the financial statements”. These amounts are amortized into the financial statements in future years. THREE principal assumptions are reported in footnotes: discount rate, compensation rate, expected return on plan assets. In addition “hidden” assumptions exist on e.g. mortality rates, actuarial formulas etc not accounted for in the footnotes of the financial statements, but has effect as “actuarial gains/losses”… The second part of the reading concerns accounting standards and is indeed a bit tricky… *sigh*
Yeah, this reading stinks. Why is the deferred tax liability reduced as a result of an adjustment to post-2006 accounting? It makes my head hurt to think about it…
There’s a pretty good illustration of it on page 206 in the current Schweser notes. If you think about the balance sheet and the relation A = L + E you’ll see why you’ll have that effect. I also realise I must try to find my Level I notes again… to look up that part about deferred income taxes…
Adding this link (for my own future reference…) http://www.us.kpmg.com/microsite/attachments/us_accounting_bulletin_2007/02%20KARG%20Chapter%20on%20Pension%20Costs%20-%20123.100.pdf
Will you have time to go through this?
I already have. It did explain a few things that weren’t obvious (to me) in the Schweser notes, like that thing about corridor amortization. I hope that answers your question, Clama.
WAWA: I don’t know if Wawa is your name or you are using it for other personal reason but in Hindi it means VERY NICE =) Thanks for that post.