Comprehensive Pension and Post-Employment Benefits Accounting

What is a pension?

Deferred compensation earned over time through employee service.

What are the two most common pension arrangements?

Defined contribution plans and defined benefit plans.

What is a defined contribution plan?

The employer contributes a set amount each period to the employee's retirement account.

In a defined contribution plan, does the employer promise the future value of the retirement assets?

No.

In a defined contribution plan, who makes the investment decisions?

The employee.

In a defined contribution plan, who bears the investment risk?

The employee.

How is expense measured for a defined contribution plan?

Employer contribution for the period.

What balance sheet item is reported for a defined contribution plan?

Nothing.

What is a defined benefit plan?

The employer promises a future lump sum or periodic payment after retirement.

In a defined benefit plan, what is the future payment usually based on?

Years of service and compensation at retirement.

In a defined benefit plan, who bears the investment risk?

The employer.

Why is defined benefit accounting more complicated?

The employer must estimate future obligations using assumptions such as future compensation, turnover, retirement age, mortality rates, and the discount rate.

What does funded status measure?

The difference between plan assets and the pension obligation.

What is the formula for funded status?

Funded status = fair value of plan assets − PBO.

If plan assets are greater than the pension obligation, what is the plan called?

Overfunded.

If the pension obligation is greater than plan assets, what is the plan called?

Underfunded.

How is positive funded status reported?

Asset.

How is negative funded status reported?

Liability.

What is PBO?

Actuarial present value of all future benefits earned to date.

Does PBO include expected future salary increases?

Yes.

What discount rate is typically used to calculate PBO?

Yield on long-term investment-grade corporate bonds.

What is the formula for the pension balance sheet asset or liability?

Balance sheet asset or liability = funded status.

What are other post-employment benefits?

Benefits such as health care benefits for retired employees.

How are retiree health care benefits similar to defined benefit pensions?

The future benefit is specified today but depends on uncertain variables.

How do other post-employment benefit plans usually differ from pension plans?

They are usually unfunded.

For an unfunded post-employment benefit plan, when is expense recognized?

As benefits are earned.

For an unfunded post-employment benefit plan, when is cash flow affected?

When benefits are actually paid.

What is current service cost?

Present value of benefits earned by employees during the current period.

What causes current service cost?

Employees working one more period.

What does current service cost increase?

PBO.

Where is current service cost recognized?

Income statement above the line, before EBIT.

What are past service costs?

Costs from retroactively increasing benefits for prior years of employee service.

What happens to PBO when past service costs arise?

It increases by the present value of the additional benefits already earned.

Under U.S. GAAP, how are past service costs treated?

Reported in OCI initially and amortized over the remaining service life of affected employees.

Under IFRS, how are past service costs treated?

Recognized immediately in P&L and not amortized.

Are 'past service cost' and 'prior service cost' interchangeable?

Yes.

Under U.S. GAAP, what is the formula for interest cost?

Interest cost = beginning PBO × discount rate.

Under IFRS, what is the formula for net interest income or expense?

Net interest income/expense = beginning funded status × discount rate.

Under IFRS, if beginning funded status is negative, what is reported?

Expense.

Under IFRS, if beginning funded status is positive, what is reported?

Income.

Under U.S. GAAP, what is the formula for expected return on plan assets?

Expected return = expected rate of return × beginning plan assets.

Under U.S. GAAP, how does expected return affect reported pension expense?

It reduces it.

Under U.S. GAAP, does expected return affect PBO?

No.

Under U.S. GAAP, does expected return affect the fair value of plan assets?

No.

Under IFRS, what rate is assumed for expected return on plan assets?

The discount rate.

Under IFRS, is expected return reported separately?

No. It is netted against interest cost.

What are actuarial gains and losses caused by?

Changes in assumptions and differences between actual and expected return on plan assets.

What is the first component of actuarial gains and losses?

Change in PBO caused by changes in assumptions.

What is the second component of actuarial gains and losses?

Difference between actual and expected return on plan assets.

Under IFRS, where are actuarial gains and losses recognized?

OCI.

Under IFRS, are actuarial gains and losses amortized?

No.

Under U.S. GAAP, how are actuarial gains and losses treated?

They are recognized in the period incurred.

How are actuarial gains and losses treated under U.S. GAAP?

Amortized portion goes to income; unamortized portion remains in OCI.

What method is used for actuarial gains and losses under U.S. GAAP?

Corridor approach.

When is amortization required under the corridor approach?

When beginning actuarial gains or losses exceed 10% of the greater of beginning PBO or beginning plan assets.

What is the formula for the corridor threshold?

Corridor threshold = 10% × greater of beginning PBO or beginning plan assets.

What is the impact of amortizing an actuarial loss under U.S. GAAP?

Pension cost increases.

What is the impact of amortizing an actuarial gain under U.S. GAAP?

Pension cost decreases.

Where is current service cost recognized under U.S. GAAP?

Income statement.

Where is current service cost recognized under IFRS?

Income statement.

Where is past service cost recognized under U.S. GAAP?

OCI initially; then amortized over service life in later years.

Where is past service cost recognized under IFRS?

Income statement immediately.

Where is interest cost recognized under U.S. GAAP?

Income statement.

Where is interest cost recognized under IFRS?

Income statement as part of net interest expense or income.

Where is expected return recognized under U.S. GAAP?

Income statement as an offset to pension expense.

How is expected return treated under IFRS?

Equals the discount rate and is netted against interest cost.

Where are actuarial gains and losses recognized under U.S. GAAP?

Amortized portion in income; unamortized portion in OCI.

Where are actuarial gains and losses recognized under IFRS?

OCI only, with no amortization.

What is the formula for beginning funded status?

Beginning funded status = beginning plan assets − beginning PBO.

What is the formula for ending funded status?

Ending funded status = ending plan assets − ending PBO.

What is the formula for PBO reconciliation?

Ending PBO = beginning PBO + current service cost + interest cost + actuarial loss − benefits paid.

What is the formula for plan asset reconciliation?

Ending plan assets = beginning plan assets + employer contributions + actual return − benefits paid.

What is the formula for U.S. GAAP pension expense before actuarial amortization?

Pension expense = current service cost + interest cost − expected return on plan assets.

What is the formula for U.S. GAAP pension expense when actuarial loss amortization applies?

Pension expense = current service cost + interest cost − expected return on plan assets + amortization of actuarial loss.

What is the formula for U.S. GAAP pension expense when actuarial gain amortization applies?

Pension expense = current service cost + interest cost − expected return on plan assets − amortization of actuarial gain.

What is the formula for IFRS pension expense?

Pension expense = current service cost + net interest cost.

What is the formula for IFRS net interest cost?

Net interest cost = discount rate × beginning funded status.

How should a negative IFRS net interest amount be interpreted?

Expense.

How should a positive IFRS net interest amount be interpreted?

Income.

What is the formula for U.S. GAAP interest cost?

Interest cost = discount rate × beginning PBO.

What is the formula for U.S. GAAP expected return?

Expected return = expected rate of return × beginning plan assets.

What is the formula for the corridor threshold under U.S. GAAP?

Corridor threshold = 10% × greater of beginning PBO or beginning plan assets.

How do employer contributions affect plan assets?

Increase.

How does actual return affect plan assets?

Increase.

How do benefits paid affect PBO?

Decrease.

How do benefits paid affect plan assets?

Decrease.

What is the cash flow statement impact of pension plans?

Employer contributions are reported in operating activities.

What must firms disclose about pension plans under IFRS?

Main characteristics, risks involved, financial statement figures, and the amount, timing, and uncertainty of future cash flows.

Why should analysts compare pension assumptions over time and across firms?

To assess earnings quality.

What is the effect of aggressive accounting choices?

Lower reported pension expense and lower PBO.

What assumptions reduce reported pension expense and PBO?

Low life expectancy, low future inflation, low salary growth, and high discount rate.

What is the effect of a higher expected rate of return on plan assets under U.S. GAAP?

Lower reported pension expense.

Does a higher expected rate of return affect PBO or fair value of plan assets?

No.

What should be done with an underfunded pension liability for valuation purposes?

Deduct it from enterprise value.

Where are pension costs usually embedded in financial modeling?

SG&A or COGS.

How are pension costs typically modeled in financial modeling?

As a percentage of revenue.

Why is modeling pension costs as a percentage of revenue acceptable?

They usually vary systematically with wages and salaries.

When are separate pension forecasts needed?

When there are plan changes or the plan is closed or frozen.

Are detailed forecasts needed for smaller plans that are well funded or closed/frozen?

No.