ACCT 400B Exam 2 - Pensions

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Defined Contribution Plan

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  • plan states fixed amount company should contribute but total depends on how you invest your money

  • employee bears the risk

  • During service period: employee can see, control, manage, invest but can’t withdraw

  • Interim: invest and manage benefits

  • Retirement: employee accesses and withdraws benefits

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Defined Benefit Plan

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  • plan states the future benefits that the employee will receive

  • company bears the risk

  • companies contributions depend on actuarial projections

  • During service period: employer/company makes contributions to Pension Plan Admin (PPA)

  • Interim: PPA invests/manages plan assets on behalf of company

  • Retirement: PPA pays benefits to employee

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26 Terms

1
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Defined Contribution Plan

  • plan states fixed amount company should contribute but total depends on how you invest your money

  • employee bears the risk

  • During service period: employee can see, control, manage, invest but can’t withdraw

  • Interim: invest and manage benefits

  • Retirement: employee accesses and withdraws benefits

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Defined Benefit Plan

  • plan states the future benefits that the employee will receive

  • company bears the risk

  • companies contributions depend on actuarial projections

  • During service period: employer/company makes contributions to Pension Plan Admin (PPA)

  • Interim: PPA invests/manages plan assets on behalf of company

  • Retirement: PPA pays benefits to employee

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Role of Actuaries for Pensions

  • take large amounts of data and make projections out of it that help us estimate future cash outflows

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Net Funded Status

the difference between the PBO and PA

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Overfunded

PBO < PA

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Underfunded

PBO > PA

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Fully Funded

PBO = PA

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Why fully fund the pension? Who’s in favor?

  • Incentive for employees to work for the company because increases security on retirement plan

  • Employees and Labor Unions

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Why NOT fully fund/contribute voluntarily to pension? Who’s NOT in favor?

  • Ties up liquidity

  • Management - they want to have cash for other opportunities

  • Creditors - they want the company to be liquid so they get paid back

  • Suppliers - they want the company to be liquid so they get paid back

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Service Cost

  • Increase PBO, No affect on PA

  • Increase Pension Expense

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Incur Interest

  • Increase PBO, No affect on PA

  • Increase Pension Expense

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Return on Plan Assets

  • No affect on PBO, Increases PA

  • If expect more and receive less = unrealized loss

  • If expect less and receive more = unrealized gain

  • Decrease pension expense

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Contributions

  • No affect on PBO, Increase PA

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Benefits Paid

  • Decrease PBO, Decrease PA

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OCI and AOCI

  • items that have a lot of volatility, fluctuate/dramatic changes all the time

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Main purpose of OCI/AOCI?

  • Keep earnings smoothness and predictability

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Why are OCI/AOCI NOT included in Net Income?

  • Because they fluctuate so much they don’t represent a companies regular earnings

  • These items would make a companies Net Income NOT predictable

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Amortization of Prior Service Cost

  • comes from changes/amendments to the pension plan (always an increase)

  • total amount is recorded and held in AOCI and increase PBO

  • gradually expense to pension expense overtime through credit

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Journal Entry for Total Plan Amendment

Dr. AOCI - PSC

Cr. PBO

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Why do we NOT expense all of Amendment of Prior Service Cost at once?

  • We don’t want a big spike in pension expense because we want to keep net income smooth

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2 other sources of gains/losses

  1. Changes in market value of plan assets → difference between Expected ROPA and Actual ROPA → Actual is More = Unrealized Gain ; Actual is Less = Unrealized Loss

  2. Changes in actuarial assumptions that affect PBO → adjust the PBO but put the changes in AOCI to keep volatility out of pension expense → Actuarial Loss = Increase PBO ; Actuarial Gain = Decrease PBO

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Corridor Approach

  • done at beginning of each period to calc min amortization required for upcoming period

  • beg balance of PBO or PA (whichever largest) x .10

  • If less than Beg. AOCI = Min amortization required

  • If more than Beg. AOCI = No amortization required

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How to Calc Min Amount of Amortization

AOCI - Corridor / Remaining Years of Employee Service

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Equity Investor incentives for fully funded pension?

  • aren’t directly affected because they care about net income, since we expense pension expense overtime it dosent affect Net income

  • might be in favor for funding to appeal to employees to grow the business

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How would Pension Policy affect Net Income and Cash Flows?

  • Net Income - dosent affect

  • Cash Flows - Increases cash flows which decreases liquidity

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What could be an alternative to fully funding a pension to make appeal to all stakeholders?

The company could commit to a certain threshold of funding the pension