I have completely updated my document on pension accounting (there are a number of changes between the 2009 and 2010 curriculum). I am posting the new version below. I recommend the pdf version I created. It is much easier to read as I have highlighted and underlined many important components. I have posted the pdf version on my linkedin profile. Feel free to add me and then download it directly. My name is Jean-Francois Saine, I don’t share my name with any other Linked In member.
Pensions are easy 2010 Complete document written by Jean-Francois Saine Introduction CFAI materials read like reference books and the FSA section is worst than most. I cannot stress how poor this section is. The CFAI accounting writers should be fired and shunned from our industry. These guys redefine the meaning of the word incompetence. I’m a fan of Schweser, but the books and videos are a disaster when it comes to pensions. Both manuals and videos display a total lack of structure, the items aren’t presented in logical order and they suffer from cryptic/inconsistent terminology. The CFAI curriculum is presented in a nightmarish fashion, and the guys at Schweser just haven’t been capable of re-writing it in an intuitive fashion. (Disclosure: I haven’t seen the 2010 Schweser materials) I have written this little dissertation on pension accounting. I suggest reading this first, the Schweser second, and then jumping into problems. I have written this as a help in understanding the material, mastering it will take practice. I am presenting the information below “out of CFAI order.” I am using the order in which it should be taught. This won’t affect the way you use this information to solve problems and you may actually get a shot at understanding what is going on. Outline I. Pension Expense (Income Statement) II. Pension Related Assets and Liabilities (Balance Sheet) III. Other Important Issues Note: this material is strictly meant for Defined Benefit plans and I will not discuss the share compensation material. This reading is a comprehensive overview of what you need to understand. You should also read up on: Share based compensation, Defined benefits vs. defined contribution, Vested status, Etc. I – Pension Expense I begin with the income statement because the yearly costs will drive the balance sheet entries. Pensions will affect a company’s income and cash flows at some point in the future. But we account for the PV of those costs today. Of course we all know that the Income Statement is an attempt to represent the year’s operations, not cash flows, so this all makes perfect sense. (It is important to keep this in mind, since the actual pension payoff may occur far in the future, but a portion will occur as a result of the current years operations, so we must account for the PV of that portion this year.) The Pension Expense Components: + Current Service cost – PV of future payments to employees. + Interest Expense – The interest that must be earned on the assets already aside. - Expected Return on Plan Assets – The return that we expect to get from assets aside. +/- Other Costs – (There is a bag of other costs here) Some of these components may seem strange at first, but they all make perfect sense. Here are the details. Current service cost Employees just worked for a year. We will at some point owe them money over what was paid this year. This entry represents the PV of this cost. We don’t account for the full cost of what we will owe them for this year’s work, we only account for the PV of that future cost. Note: This entry will add to the expense. Interest expense – “What should be earned on the assets already aside” This represents what we need to earn on the assets already aside. Remember that the previous entry was only the present value, meaning that the liability should grow every year in order to represent the passage of time and the fact that we are getting closer to paying out these expenses. Interest expense represents how we need to earn on the assets that were (or should have been) set aside each year to cover future pension costs. Note: This entry will add to the expense. Expected Return on plan assets These are the returns you expect to get from the assets you have set aside. If you’re liability is fully funded, this should cancel out the previous entry. It is only the expected returns, not actual returns. Note: This entry decreases the expense. Other Costs There are a few things here but the major two will be Past Service Cost and Actuarial Gains and Losses. Other entries such as settlement or curtailment may show up. Note These all can either increase or decrease the total expense. Past service cost: Should be named: “Changes arising from changes to pension terms.” If the company changes the terms, then this will change how much money you will owe in the future. Actuarial gains and losses: If the accountants change their minds as to how much they expect to get back from their current investments, we will account for this here. Also, if there is a large difference between the actual and expected returns on plan assets, we should account for this here. Conclusion First you add the current year’s expense. Then you add the difference between interest cost and expected returns (in a perfect world this number would be zero). Lastly you take into account changes in assumptions or modifications to the terms. I look at it as a three step process. And it really is that simple. II. Pension Related Assets and Liabilities (Balance Sheet) The balance sheet entry for pension is called Funded Status. Funded Status = Fair Value of Planned Assets – Projected Benefit Obligation (PBO). The Fair Value of Planned Assets is what we currently have aside. The PBO is the PV of what we will have to pay in the future. One is an asset and one a liability, valued at time 0. Of course, funded Status can be positive (overfunded) or negative (underfunded). I’m presenting the following items as the difference between one period and another. Fair Value of Planned Assets: Beg Value of Planned Assets + Contributions (Service and Interest for the period) + Actual Return on Assets - Benefit Paid - Expenses for Running the Fund = Ending Value of Pension Asset This is pretty straight forward. It is all tangible; there are no accounting assumptions here. The following section includes a number actuarial assumptions and estimates. PBO: Beg Value of PBO + Service Cost for the Period + Interest Cost for the Period +/- Actuarial G/L on PV of Future Liabilities +/- Prior Service Cost - Benefits Paid this Period = Ending Value of Current Pension Liability Many of these entries we have already seen twice. Actuarial G/L is an important new topic. The future PBO liability is an estimate. Actuarial accountants have to make a number of assumptions in terms of the Rate of Compensation Growth and the appropriate Discount Rate used to discount the future liabilities. If these change they will affect PBO. This entry accounts for these changes, which can be positive or negative. Same concept goes for Prior Service Costs. Benefits Paid are not longer a liability, and must be subtracted. There is an important note on using this process for IFRS in the next section. Don’t miss it. III. Other Important Issues IFRS and GAAP (Must read): IFRS is generally a superior and more conservative set of rules than GAAP. Unfortunately, they are behind GAAP on pension accounting. There are a number of small inconsequential differences and one extremely important one. The Funded Status on the Balance Sheet will be handled differently under IFRS. And remember that unless stated we use the IFRS set of rules. If assumptions change (discount rate, employee compensation growth, etc) or if we find differences between actual and expected returns, we may not wish to expense the full difference in the current year. We may smooth these differences over a few years, which is fine. GAAP obliges companies to account for these costs on the Balance Sheet as part of the funded status. IFRS does the opposite. After calculating the funded status, you will need to back out Unrecognized Actuarial G/L as well as Unrecognized Prior Service Costs from the Funded Status. You will lower the liabilities and balance with a component of equity named other comprehensive income. The end result will be perverse: It will lower the company’s Liabilities and increase Equity. Economic Pension Expense: In attempt to starve off a brain aneurism, I will refrain from commenting on the way this is explained in the manual. Here is all you need to know: Economic Pension Expense = (Change in Funded Status) – Employer Contribution The change is between two periods. The equation represents how much the liabilities or assets changed between two years, excluding contribution by the firm. Effects on Cash Flow: When a company contributes to a plan (Employer Contribution) it is accounted as a cash expense and will go into Cash Flow from Operations. (If you were calculating the CFO using the indirect method you would add back pension expense and subtract employer contribution, as it is a cash payment to a fund) From an analysis point of view, if the Employer Contribution differs from the Economic Pension Expense during any given period, you would want to move the difference from Cash Flow from Operations to Cash Flow from Financing. Theoretically, you are no longer paying for this period’s pension costs; you are now “paying down debt” or “borrowing,” which is a Cash Flow from Financing.
Thanks for updating this, really appreciate it. Contributions like yours are what makes AF such a great resource. I have had your original post on pensions bookmarked for several months, and will now replace it with this new version.
Thanks for the info.
Bump - To give a chance for everyone to see this updated version.
Very nice- I’ve suspected that pensions aren’t that difficult, you just need them to be laid out in a logical manner. This is great for getting the basics. Thanks!
Johnny, EE pension expense is “Contributions - Change Funded Status”, not the other way around.
davidyoung@sitkapacific.com Wrote: ------------------------------------------------------- > Johnny, > > EE pension expense is “Contributions - Change > Funded Status”, not the other way around. My formula is for Economic Position. Your formula is for Economic Expense. I know that CFAI has an example where they use you’re order of things, but it is very misleading. Like I’ve said: “Shunned from our industry.” Both formulas will yield the same answer if the overall FS increases. But only mine will yield the right answer if overall FS decreases. Now, I haven’t seen a questionwhere it decreases, but it is clearly a possibility. My formula will derive the economic position whatever the case. Example 1: Contributions are 8 and FS goes from 15 to 20. Your formula: 8-20-15=3 My formula : 20-15-8=-3 So, same anwer, you’re expense is 3, my economic position is -3. Example 2: Contributions are 8 but FS goes from 20 to 15. Your forumla: 8-15-20=-27 My forumla : 15-20-8=-13 The economic expense is 13, not 27 here. You’re formula makes this error. In any case, think about it, if your FS decreases by 5, that is an expense, if you take into account that it would have decreased by 8 more had you not contributed, that is an expense. Total is 13. Cheers, JFS
Super.
If anyone has questions on the way the information is presented, please contact me. Sometimes things that sound clear to one person aren’t to everyone, so I would be happy to discuss any parts of this document.
bump
hey i dont understand… u say there is significant amnt of changes in pension from 2009 to 2010… i dont see ne… can u pls highlight few???
Great notes. Thanks. Is Interest cost — the increase in the PBO due to the passage of time?
Bump!
So just to make it concrete, the econ pension expense is what the net pension liability would have increased by (or what the net pension asset would have fallen by) if the firm had made zero contribution to the pension fund… does that sound right?
sorry… its the funded status that we’re interested in not the net asset / liability… how about, the econ pension expense is the amount that the funded status would have declined by (smaller positive number or larger negative number) if the firm made no contributions to the pension fund…
Pensions are GRRRRREEEEEEEAAAAAAT!!!
whats a pension? like a pen mansion or something why would anyone care about that