Hi Brave Ones, In CFAI B2 (Question 9 EOC - employee compensation) P146, the reconciliation from NI to CFO is adding back reported pension expense (they consider it totally non-cash???) and subtracting contributions made. My question is, if contributions made are not part of pension expense nor in NI, why are they subtracting it? Hope can anyone share his/her insight. Thks t
equally as baffled! hopefully someone responds, wheres cpk123 when you need!
In L2 I’ve been finding schweser with more “gaps” to the CFAI than in L1…that’s why is taking me much longer…I am consulting more CFAI readings, by far.
im relying on cfai texts and using schwer for note cards, a lot better
I’ll take a stab here: What are the components of pension expense: Current service cost Interest cost Expected return on plan assets Amortization of actuarial gains/losses Amortization of prior service cost The only cash related components I see here are current service cost and interest costs, but these are added back. Interest cost can be reclassified as a financing outflow for analytical purposes and really has no bearing on operating cash flow. I can’t really pinpoint why current service cost is added back, but my assumption is since current service cost merely increases the DBO, there is no actual cash being disbursed. Contributions are subtracted since it is an outflow of cash in order to fund the pension plan.
Hi Brian, thanks for your post. I got your point regarding adding back all reported pension expense to NI to arrive at CFO (thanks!). My point is you usually conciliate (?) components of NI to CFO when they actually are part of NI and here I don’t see contributions made as part of NI. It is like if you wanted to add back some principal repayment of debt to NI to arrive CFO. You simply only deal with components of NI… Maybe I am stuck in something that has nothing to do with what they want to explain thks anyway t
tigas Wrote: ------------------------------------------------------- > Hi Brian, thanks for your post. > > I got your point regarding adding back all > reported pension expense to NI to arrive at CFO > (thanks!). > > My point is you usually conciliate (?) components > of NI to CFO when they actually are part of NI and > here I don’t see contributions made as part of NI. > It is like if you wanted to add back some > principal repayment of debt to NI to arrive CFO. > You simply only deal with components of NI… > > Maybe I am stuck in something that has nothing to > do with what they want to explain > > thks anyway > > t I understand your point, and you are right. The basic formula was taught in L1, but it ignored pension expense, which is introduced here in L2 and is a component of net income. I think what they’re trying to get at is this expense has no bearing on operating cash flow. However, cash does flow out when it makes a contribution to the plan. As analysts, we have to adjust these items to more accurately represent economic reality. By adding back these non cash expenses and subtracting the contribution, we can depict this reality more accurately.
Thks again, I will eventually dig a little more on it… t
This is what I understand. First of all - Net income has pension expense already deducted (as part of operating expense), so you need to add it back and only subtract employer’s contribution since it is cash-based expense, while the other expenses are only accrual-based expense (non-cash expense). Be careful: Current service cost and Interest cost are NOT cash-based. They are accrual calculations for the PBO. Interest cost here has nothing to do with real interest (like interest to you pay to some bank), thus not part of CFF. Specifically, Interest cost for pension= Last year of total PBO* discount rate, reflecting the time value of of the PBO. All of the above stuff has to do with standard accounting stuff, ALL firms have to do this whether they like it or not and is what Q9 is asking. Now, in addition to the standard accounting definition, the book is talking about economic pension cost. This is NOT standard accounting, but something CFA is advising the analysts should do to find out about the ECONOMIC cash flow (i.e., the cash flow that reflects the real economic foundation of the firm). Notice that this is CFA way of doing things. Practice varies. Here, the CFA advises that the analyst should adjust the CFO to take into consideration the fact that firms do not always contribute the pension as they should. Some time, they contribute too much, some time they contribute too little --> thus the CFO does not give the ‘correct’ number. Since CFO is normally used to judge the performance of the firm, the analyst should adjust. One first calculates the ECONOMIC pension cost. Notice this expense is NOT the standard accounting pension expense. The adjustment is that if - Cash Contribution > economic pension cost, the excess should be seen as principal payment of a loan --> take the excess and ADD it back since the firm has paid too much thus CFO is underestimated. The excess is then subtracted from CFF since it should be seen as financial cashflow. - Cash Contribution < economic pension cost, seen as borrowing and one should do the oppsite: subtract the excess from CFO and add it back to CFF. In this case, the adjustment can be seen as if the firm has given itself a loan to finance the underpayment of pension cost. Again, this adjustment is for analytical reason, and something the analyst should do based on the accounting CFO/CFF the firm gives.
I have not started with FSA yet, but I will attempt to answer this, based on the preview lecture I took by Peter Olinto in Singapore. Okay, first thing is, we are doing this for Defined Benefit plan and NOT for Defined Contribution plan. For Defined Contribution Plans, Pension Expense would be Contribution made by Employer in that period and would be all cash (so, no need to add that back to NI, as it is totally a cash component) For Defined Benefit plans, bpdulog has mentioned all components for Pension Expense. Value for all these components is based on various estimated parameters (e.g. avg number of employment years, employee avg life in yrs after retirement, discount rate etc…etc…). This derived pension expense is a non-cash expense. Then why do we report it in I/S? Because of the Matching Principal for reporting expenses. Each year an employee works, s/he earns some retirement benefits and though these benefits are not paid until in future, they need to be reported now as expense in the period, when they were earned. So, though these benefits are NOT paid NOW, but they need to be reported as expenses in the form of Pension Expense. So, for the current period, they are NON-CASH expenses and hence, should be added back to NI for CFO calculation. However, any cash contributions to the asset plan are cash expenses and would not be added back to NI for CFO calculation. Hope this helps.
elcfa Wrote: ------------------------------------------------------- > This is what I understand. > > First of all > - Net income has pension expense already deducted > (as part of operating expense), so you need to add > it back and only subtract employer’s contribution > since it is cash-based expense, while the other > expenses are only accrual-based expense (non-cash > expense). > > Be careful: Current service cost and Interest > cost are NOT cash-based. They are accrual > calculations for the PBO. Interest cost here has > nothing to do with real interest (like interest to > you pay to some bank), thus not part of CFF. > Specifically, Interest cost for pension= Last year > of total PBO* discount rate, reflecting the time > value of of the PBO. > > All of the above stuff has to do with standard > accounting stuff, ALL firms have to do this > whether they like it or not and is what Q9 is > asking. > > Now, in addition to the standard accounting > definition, the book is talking about economic > pension cost. This is NOT standard accounting, but > something CFA is advising the analysts should do > to find out about the ECONOMIC cash flow (i.e., > the cash flow that reflects the real economic > foundation of the firm). Notice that this is CFA > way of doing things. Practice varies. > > Here, the CFA advises that the analyst should > adjust the CFO to take into consideration the fact > that firms do not always contribute the pension as > they should. Some time, they contribute too much, > some time they contribute too little --> thus the > CFO does not give the ‘correct’ number. Since CFO > is normally used to judge the performance of the > firm, the analyst should adjust. One first > calculates the ECONOMIC pension cost. Notice this > expense is NOT the standard accounting pension > expense. > > The adjustment is that if > - Cash Contribution > economic pension cost, the > excess should be seen as principal payment of a > loan --> take the excess and ADD it back since the > firm has paid too much thus CFO is underestimated. > The excess is then subtracted from CFF since it > should be seen as financial cashflow. > - Cash Contribution < economic pension cost, seen > as borrowing and one should do the oppsite: > subtract the excess from CFO and add it back to > CFF. In this case, the adjustment can be seen as > if the firm has given itself a loan to finance the > underpayment of pension cost. > > > Again, this adjustment is for analytical reason, > and something the analyst should do based on the > accounting CFO/CFF the firm gives. Thanks for mentioning the interest piece! I forgot it was calculated using prior year #'s.
Brave ones, thank you ALL for your excellent contributions (I am far more clarified now than at the beginning of the thread). The thing that still strikes me is that Contributions are not part of pension expense. Are contributions part of net income? If they are so they are not considered CFO and must be subtracted. But if they are not part of net income why are we subtracting them to arrive at CFO? Sorry guys about this doubt…but simply can’t reach it. thks
But by the adjustments that are needed and referred above by elcfa I imply that they are including employer’s contribution in CFO. That’s why we need to reclassify it (the excess over the economic pension cost) to CFF. So I am forced to believe that contributions are part of net income. does this make any sense? won’t bother you more with this, must advance. thks ALL
Well It is a complex relationship. Contribution affects Plan assets only. “Expected Return (NB: it is Expected, not actual) of plan asset” component of pension expense which is again part of Net Income. Further more, difference between expected return and actual return (of plan assets) is recognized according to the corridor method as part of “Amortization of actuarial gains/losses” component of pension expense. (see bpdulog’s post above for overview of pension expense components) So indirectly, contributions is part of the pension cost, yes. Hope it answers your question.
Great explanations by elcfa in his 2 posts. Thanks. Tigas, somehow I got a feeling, your question is more fundamental in nature than being Pension specific. Expenses (cash or non-cash) are reported in the Income Statement based on the matching principle. And these reported expenses (both cash as well as non-cash) WILL affect NI (NI being the bottom line on Income Statement), right? Contributions are real cash flows, that is the money a firm has actually spent in that period. So, they are NOT added back to NI in CFO calculation. Whereas, Pension Expense is the money, which is not spent yet. It is the money, firm will actually spend later, upon retirement of its respective employees. It is the obligation that has accrued in this period, but actual cashflow will happen in future. So, these being non-cash expenses in current period will be added back to NI for CFO calculation. Please ignore, if you already understood it this way.
rus1bus, thks for your post. I will use your words to help me “Contributions are real cash flows, that is the money a firm has actually spent in that period. So, they are NOT added back to NI in CFO calculation”… I understand why they are not added, but why are they deducted? The only way I’ve seen so far some value being deducted from NI to arrive at CFO is another type of cash flow either than CFO, i.e. a gain in a sale of land, that increased the bottom line but was not part of CFO, so we would overstate CFO if we didn’t deduct that value. They are doing this same reasoning with the contributions made. To do the reconciliation they treat them as smthg that increased bottom line but as it is not a CFO must be deducted. Never mind guys…maybe some flash of light will hit my brain…I just don’t want to memorize it…but at this time I have already done it 
. I guess is smth really specific and I will try to understand it later. thks ALL I can only understand this deduction from
well, not sure I understand the question, but let me explain what I understand your question is in simpler form. Let say you work in IB. The firm you work for has very complex form of compensation, some cash, a lot of option, some shares,… and you meet someone who wants to know how much you get paid. “500K” you said. “Really, does you get paid all that?” she said. “No, not really”. “so you how much did they PAY you THIS YEAR” “IN CASH, it is 200K to me, and 10 contribution to my 401, 50K to my car rental so totally this year. in cash it is 300K” Well, think 500 K is the equivalent of the firm pension expense. 300K is their cash contribution. To get from 500K to 300K you need to do a lot calculation to bridge: e.g., take out the market value of your options which you have not vested, which they have not paid yet, but will cost them in the future,… If you want know how much the firm spends cashwise, you don’t want bother to bridge, you just forget the 500K and trace the cash. Similarly, to get the CFO to know how much CASH does the firm spends, it is easier just to forget about the pension expense (thus add it back) and just get straight to how much cash the firm ACTUALLY gives to the pension fund (subtract contribution, similar to the way you calculate CFO under the DEFINED CONTRIBUTION plan) Hope I have answered the question.
And that’s it, awesome example…consider it done elcfa & friends thks a lot for your patience and most of all, knowledge… you all look in good shape for the semifinals. I hope I can give back my contribution to your future questions thks 4 real t