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					Pensions

 RCJ Chapter 14
 Key Issues
1. Types of pension plans: defined benefit vs. defined contribution
2. Pension liability: PBO, ABO, VBO
3. Assumptions: discount rate%, salary growth rate%, E(ROA)%, actuarial
4. PENSION assets
5. Primary (ongoing) factors
6. Journal entries
7. Smoothing of transitory gains and losses 12. Corridor amortization
8. Types of transitory gains and losses        13. Pension worksheet
9. Additional factors                          14. Footnote disclosures
10. Funded status reconciliation               15. Correction JE
                                               16. OPEB’s
11. Minimum liability


                                Paul Zarowin                        2
Structure of Pension Plan

firm or employee  pension fund  retiree
               Cash                  Pay benefits




                      Paul Zarowin                  3
Types of Pension Plans
1. Defined contribution:
   employee bears risk, no firm liability

2. Defined benefit:
   firm bears risk and has liability (our focus)




                             Paul Zarowin          4
Ex. Defined Benefit Plan
 worker’s age = 60
 service = 30 yrs so far

 retire @ 65 (5 more years)

 current salary = $50,000

Pension contract:
  X% per year * final salary
  (X = # of years of service @ retirement)
  Example: 35% x $50,000 = $17,500




                          Paul Zarowin       5
 Pension Liabilities
Pension liability: discounted PV of expected future cash payments
- like any other non-current liability (effective interest method).
compare to other non-current liabilities:
                           r%                        E(CF)
            Bonds        known                      known
            Leases       known?                     known
            Pensions         ?                         ?

Both discount rate and expected cash flows are subjective




                                    Paul Zarowin                      6
3 Definitions of Liabilities
   PBO = PV of expected payments, given expected future salaries
   ABO= PV of expected payments, given current salaries
   VBO =PV of vested portion of expected payments, given current
    salaries
                            PBO  ABO  VBO


    Which definition is appropriate for which case?
    1. valuing a going concern
    2. Takeover
    3. Firm in bankruptcy


    We’ll use PBO, unless otherwise stated.
                                 Paul Zarowin                       7
Key Assumptions
   discount rate = r%                              What are
   salary growth rate = g% (for PBO)               management’s
                                                    incentives?
   actuarial (life span, tenure, turnover, etc.)
   EROA% (expected rate of return on pension assets),
    see below




Q: Is liability bigger for older or younger workers?



                              Paul Zarowin                  8
Ex. Defined Benefit Plan, Continued
   Assumptions
      Expected salary growth rate = 5%

      Discount rate = 10%

      Life expectancy = 80 years (15 years in retirement)



   Expected final salary = 50,000 * (1.05)5 = 63,814
   30% * 63,814 = 19,144 = amount he’ll receive per year in
    retirement (based on service so far)
   PV of annuity factor, 10%, 15 yrs = 7.606
   19,144 * 7.606 = 145,611 = PV @ retirement

PBO = 145,611/(1.10)5 = 90,413 = PV of annuity now
ABO = (30% * 50,000 * 7.606)/1.105 = 70,841
PBO > ABO due to expected salary growth
                                 Paul Zarowin                  9
Primary (Ongoing) Factors Affecting PBO
                               PBO
                -                         +
              DR                         CR
           pay benefits              Interest cost
                                     Service cost

def: interest cost = r% * PBO @ beginning of year
(remember: effective interest method)
[debt accretion, like zero coupon bond]

def: service cost = PV of future benefits earned this year

Ex. E14-1, E14-13

                                    Paul Zarowin             10
Ex. Defined Benefit Plan, Continued
Interest cost = 90413*.10 = 9041
Service cost = (1% * 63,814 * 7.606)/1.105 = 3014

Q: how does a higher or lower r% affect interest cost?
Q: how does an employee’s age affect his service cost?




        E14-1,13


                          Paul Zarowin                   11
Pension Assets
   Pension assets: FMV of assets (stocks, bonds, etc.)

   Funded status (true, economic position):
                     Pension assets – PBO
      Overfunded: assets > PBO

      Underfunded: assets < PBO

      Severely underfunded: assets < ABO




                            Paul Zarowin                  12
Primary (Ongoing) Factors Affecting
Pensions Assets
                            Assets
           +                                         -
          DR                                        CR
     Funding (contribution)                   Pay benefits
    (ROA)Return on assets#

# note: this is actual ROA; ROA is shown as +, but could be –


Ex. E14-6, E14-13



                               Paul Zarowin                     13
Primary Journal Entries
                               DR                          CR
service, interest      Pension expense                    PBO

Funding                      Assets                       Cash
(contributions)

benefits                      PBO                        Assets
ROA                    Assets(actual              Pension Expense
                          ROA)*                    (expected ROA=
                                               EROA%*beginning assets)
                             UNL              or        UNG
* note: actual ROA is shown as +, but could be –

UNL = unexpected net loss (if actual ROA < expected ROA)
UNG = unexpected net gain (if actual ROA > expected ROA)
                                    Paul Zarowin                         14
Ex. Defined Benefit Plan, Continued
Assume:
  pension assets = 100,000
  E(ROA)% = 10%
  actual ROA = 15,000


  DR assets 15,000
     CR     Pension expense 10,000
     CR     UNGain           5,000

Q: How does assumed EROA% affect FMV of assets?


                              Paul Zarowin        15
Primary Factors Affecting Pension
Expense
                  Pension Expense
               +                            -
              DR                           CR
           Service                       E(ROA)
           Interest



Q: What is the effect of funding on expense?




                          Paul Zarowin            16
Ex. Defined Benefit Plan, Continued
Service              3,014

Interest              9,041

E(ROA)              (10,000)
pension expense       2,055



Ex. E14-12 without amortization and unexpected loss
P 14-1, Parts 1-3 in Summary So Far

                             Paul Zarowin             17
Smoothing of Transitory Gains and Losses
def: unrecognized = deferred (in footnotes)
def: recognized = amortized (into pension expense on I/S)

   Transitory gains, losses are CR’d (gains) or DR’d (losses)
    to unrecognized (footnote) accounts, rather than
    recognized as gain or loss on I/S. The unrecognized
    balances are amortized onto I/S. This smooths NI and
    keeps assets and PBO off of B/S.


Full Exp For E14-13

                             Paul Zarowin                  18
Smoothing (cont’d): Intuition
   Loss in DR, Gain in CR
                DR                           CR
Loss:     Unrecognized loss             Asset or liab.

Amort’n: Exp.(recorded)                 Unrecognized loss



Gain:     Asset or liab.                Unrecognized gain


Amort’n: Unrecognized gain              Exp.(recorded)


                              Paul Zarowin                  19
Types of Transitory Gains, Losses
                                                          DR               CR
asset gain: actual ROA > expected ROA                    Assets    Pension expense
                                                                         UNG
asset loss: actual ROA < expected ROA                    Assets    Pension expense
                                                          UNL
* assets are DR’d (or CR’d) for actual ROA; pension expense is CR’d for expected ROA;
difference is UNG or UNL (see slide #15)
liability loss (due to  assumption r%, g%, etc.)         UNL             PBO
liability gain (due to  assumption r%, g%, etc.)         PBO             UNG
note: asset and liability gains and losses are all aggregated into one UNG/L
account
note: liability gains and losses are also called actuarial gains and losses
Q: What happens if EROA% is set too high (higher than true average
ROA%)?                                                                              20
2 Types of Liability Gain/Loss
1. Change in assumptions
2. Change in contracts

Intuition: What affects r% and E(CF)’s




                           Paul Zarowin   21
Types of Transitory Gains, Losses (cont’d)

                                                DR            CR
Change in pension contract: sweetening          UPSC         PBO

Change in pension contract: souring             PBO         UPSC




def: UPSC = unrecognized prior service cost (retroactive benefits)




                                 Paul Zarowin                        22
Ex. Defined Benefit Plan, Continued
1. assume benefits are sweetened to pay 1.1% * final
   salary per year (increased by 10%)
   increase in PBO = 10% * 90,413 = 9041
   DR UPSC 9041
        CR    PBO 9041
2. assume salary growth rate is increased to 6% (final
   salary = 66,912), so PBO = 94,802 and increase in
   PBO = 4389 (94,802 – 90,413)
  DR UNLoss 4389
     CR   PBO 4389

                           Paul Zarowin                  23
Additional Factors Affecting PBO
                                      PBO
                         DR (+)                  CR (-)
                     Pay benefits           Interest cost
   Primary factors
                                            Service cost
                     Liability gain         Liability loss ( assumptions)
   Additional
   factors           Souring                Sweetening ( contracts)




                             Paul Zarowin                            24
Additional Factors Affecting Pension
Expense

                                        Expense
                           DR (+)                      CR (-)
                     Interest cost            E(ROA)
Primary factors
                     Service cost

Additional factors   loss amortization Gain amortization




                               Paul Zarowin                     25
Additional Factors Affecting Pension Expense (cont’d)
Loss amortization:
  DR Pension expense
       CR     UPSC or UNL or UTL
Gain amortization:
  DR UPSC or UNG or UTA
       CR     Pension expense
UTA, UTL = unrecognized transition asset, liability =
            net position (assets - PBO) @ adoption of SFAS #87
   remember: amortization = recognized into expense
   amortization is generally SL over average remaining service life of
    employees


                                  Paul Zarowin                            26
Ex. Defined Benefit Plan, Continued
Amortize UPSC over 5 years: 9041/5 = 1808
  DR pension expense 1808
       CR      UPSC 1808

service              3,014
interest             9,041
E(ROA)             (10,000)
UPSC Amort.          1,808
pension expense      3,863


Ex. E14-13 GM disclosure
E 14-12 w/o Loss              Paul Zarowin   27
Funded Status Reconciliation
Reconcile true vs. recognized position
       assets
    - PBO
       funded status (can be net asset or net liability): ‘true position’
    + UNL (or - UNG)
                             Unrecognized
    + UPSC                   Gains/Losses
    + UTL (or - UTA)
    recognized (on B/S) position: prepaid pension cost (asset) or
    deferred pension cost (liab)
   note: funded status (true economic position) vs. recognized position
   unrecognized losses & liab’s make the recognized position better
    than the true position
   unrecognized gains & assets make the recognized position worse
    than the true position
Ex. E14-14, 19
                                   Paul Zarowin                             28
Minimum Liability
   if ABO > assets the pension plan is considered ‘severely
    underfunded’ and a liab.  (ABO - assets) must be
    recognized.
   if recognized position is asset (prepaid cost) or liab
    (accrued cost) < (ABO-assets), additional entry is needed
    to bring recognized position to minimum level:
    DR Intangible asset*
        CR      Additional liability
    * should be DR to a loss account
   additional liab can be shown separately or aggregated with
    accrued pension cost on B/S
Ex. E14-2, E14-5                Paul Zarowin              29
 Corridor (Minimum) Amortization
     UNL or UNG must be amortized only if it > “corridor”
     corridor = 10% of bigger (PBO, assets) @BOY
     amortization is down to corridor, not zero
     if amort’n is required one year, it might or might not be the
      next year, and vice versa
                     UNG/L
           DR                  CR
     *BOY net loss        *BOY net gain (* for current year amort’n test)
     Current year loss    Current year gain
     gain amort’n         loss amort’n    (amort’n only if required)
     #EOY net loss        #EOY net gain (# for next year’s amort’n test)

Ex. P14-1, sec 1-6 E14-18                                              30
    Pension Worksheet -                                                    put it all
    together - relate to funded status reconciliation
                                      Recognized (on FS) bal.        Unrecognized (footnote) balances
                                 Pen. exp   Cash    pp’d/acc cost   Pen Ass    Pen Liab UNGL       UPSC
 Service cost                       DR                                            CR
 Interest cost                      DR                                            CR
 ROA                                 CR                               DR                   plug
 Funding (contribution)                       CR                      DR
 Benefits                                                             CR          DR
 liability loss6                                                                  CR        DR
 Sweetening7                                                                      CR                  DR
 Amortization UNL8                  DR                                                      CR
 Amortization of UPSC
                                    DR                                                                CR
 (from sweetening)9
 Summary JE; only
                                    DR        CR      CR or DR
 recognized (on FS) JE
6. reverse DR and CR for a liability gain              8. reverse DR and CR for amort’n of unrecognized gain
7. reverse DR and CR for souring                       9. reverse DR and CR for amort’n from souring
Note: recognized asset/liab (prepaid/accrued pension cost) is net of all unrecognized accounts
Exercise problems
   E14-3, E14-4, E14-7 E14-17, 20
   P14-2, P14-3
   P14-13




                           Paul Zarowin   32
Footnote Disclosures
The pension footnote includes:
1. total pension expense and its components

2. reconciliation of BOY vs EOY PBO and asset
   accounts (like t-accounts)

3. funded status reconciliation

4. assumptions (r%, g%, EROA%)


   C 14-2,3

                           Paul Zarowin         33
Correction JE
(to put assets and liabs on B/S)
   using information in pension footnote, put pension assets and liab
    on B/S; replace recognized position with true position

                DR                                CR
          pension assets                         PBO
     accrued pension cost         or            Prepaid pension cost
                R/E               or             R/E

1. put pension assets and PBO on B/S
2. remove accrued or prepaid pension cost from B/S
3. plug: DR or CR R/E = cumulative unrecognized gains/losses (sum of
   UNGL, UPSC, UTAL)
note: DR or CR to R/E rather than current year gain or loss


                                 Paul Zarowin                          34
Other Post-Employment Benefits (OPEB’s)
Same accounting as pensions, with minor differences
1. ABO instead of PBO (OPEB’s not tied to salary)
2. significance of (TL) transition liability (no incentive to fund, so
   ABO > assets) firms can: amortize TL over <= 20 years
  DR OPEB expense
       CR       Accrued OPEB cost
 or take loss as change in accounting principle (below the line):
  DR loss due to change in acct principle
       CR       Accrued OPEB cost
    most firms chose latter: why?
3. service cost is accrued (earned) over short (vesting) period,
   since benefits don’t increase with tenure


                                   Paul Zarowin                          35

				
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