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Professor Paul Zarowin - NYU Stern School of Business

Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes

Pensions and OPEB=s

 defined benefit vs defined contribution plans

 pension assets: FMV

 pension liabilities: VBO, ABO, PBO

 comparison to other liabilities (effective interest method)

 importance of assumptions: r%, g%, actuarial, E(ROA)%

 components of pension expense:

 permanent components: + service, + interest, - E(ROA)

 smoothing of transitory gains, losses: U(ROA), UNG/L, UPSC, Transition

 recognized (on B/S) vs unrecognized balances (Atrue@ vs reported@


position)

 Acorrecting@ the financial statements

 footnote disclosure: expense components, funded status reconciliation,


assumptions

 worksheet

 OPEB=s
Pensions and OPEB=s

In a pension plan, the employer puts assets into a (pension) fund; these assets are invested
and the funds are used to pay income to the retirees. Thus, assets flow from the employer into the
fund (funding the plan), and from the fund to the retirees (paying the pension benefits). There are
two types of pension plans, defined benefit and defined contribution plans. For a defined
contribution plan, the employer must put a certain amount into the employees= pension fund
each period (the defined contribution). After this contribution, the employer=s obligation is
finished. Employees bears all the risk of how much or little income they will have during
retirement, depending on how well the funds were invested. The employer=s accounting for a
defined contribution is a simple Apay as you go@ (de facto cash basis):
DR CR
pension expense
Cash
The entry is made for the amount of the defined contribution. The employer may put more or less
funding into the plan in a given period. If more, there is an asset Aprepaid pension cost@; if less,
there is a liability Aaccrued pension expense@. Otherwise, no asset or liability is recognized.

For a defined benefit plan, the employer guarantees the employee a certain pension income
during retirement (the defined benefit). Since there is an obligation of the employer, the
accounting for a defined benefit plan is much more involved than the accounting for a defined
contribution plan. This module focuses on the employer=s accounting for a defined benefit plan.

The accounts for a defined benefit plan are: (1) pension expense (I/S), (2) cash (which the
employer uses to fund the plan), (3) prepaid/accrued pension cost (B/S), (4) pension liability
(fn), (5) pension assets (fn), (6) Unrecognized Net Gain/Loss (UNGL, fn), (7) Unrecognized
Prior Service Cost (UPSC, fn), and (8) unrecognized transition asset or liability (UTA/L, fn).

Additionally, the firm must make 3 key assumptions about: (1) expected ROA% - the expected
rate of return on pension assets, (2) r% - interest rate used to discount the future payments, to
calculate the pension liability, and (3) g% - expected salary growth rate, to determine the future
payments to retirees.

For understandng pension journal entries, it is useful to show the eight accounts in a horizontal
grid. Firms actually prepare such a report, a pension worksheet for internal accounting purposes,
which simplifies the accounting process. As we=ll see, the reconciliation schedule in the
pension footnote (see RCJ=s GE example on page 708-709 and 711-714) shows the same
information vertically.

Pension exp. Cash pp=d/acc=d cost ▌ Pens. Assets Pens. Liab. UNGL UPSC
Trans.Ass/Liab
I have deliberately put the pension expense, cash, and prepaid/accrued pension cost, on the left
side of the hash mark, because these are the Aon financial statement@ accounts. The other 5
accounts are not on the financial statements, and must be found in the footnotes. In principle,
these 5 accounts could have been on the B/S, but firms lobbied against this, fearing that a large
pension liability on the B/S would make them appear too risky. As we will see, the prepaid
/accrued pension cost account is the net of the 5 accounts; since the DR and CR balances of these
5 accounts cancel each other out, the balance in the prepaid/accrued account tends to be small.

The simplest (and theoretically correct) accounting for a defined benefit pension plan would
have pension assets and pension liabilities on the B/S, and the net change in these accounts as a
CR or DR on the I/S. Assets would be measured at FMV and marked-to-market each year (in
fact they are), as they are primarily securities with known FMV=s. Liabilities are the NPV of
expected future cash payments to retirees, discounted at the assumed r%. Thus, the pension
liability is just like any other non-current liability, except 1. the future cash flows are not known
with certainty, but must be estimated based on various actuarial assumptions, and 2. A discount
rate is not market-determined but must be assumed, because the liability is not traded. For
example, assume that the assets (security portfolio) went up a lot (good stock market year), and
the liability also grew, but not as much. The je would be: DR CR
pension assets
Pension liability
Net pension gain (or revenue)

Alternatively, assume that the security portfolio fell in value (bad stock market year), and the
liability grew. The je would be: DR CR
Net pension loss (or expense)
Pension assets
Pension liability

In this simple accounting, all we would need to do is measure the assets and liability at the end of
the year, and record the changes. Unfortunately, pension accounting is not so simple, because:
1. firms wanted to keep the assets and liabilities off the B/S (relegated to the pension footnote),
in effect showing only the net; this keeps a large liability off the B/S - the net is the Aprepaid-
accrued pension cost@ account in the grid. If only the net asset or liability were shown on the
B/S, pension accounting would still be simple; but, 2. Recording the net change as a gain or loss
can make net income very volatile, which firms dislike because it makes them appear risky (e.g.,
the stock market has large swings, and big changes in the liability are induced by occasional
changes in the plan contract itself or in its assumptions.)
Thus, actual pension accounting has numerous devices that 1. Smooth pension expense (net
income), and 2. Make the net asset or liability on the B/S different from the true net asset or
liability. The difference between the true net asset or liability and the prepaid/accrued pension
cost (the on B/S asset or liability) is the sum of the UNGL, UPSC, and Trans.Ass/Liab in the
grid. This difference is shown as a reconciliation schedule in the pension footnote. In addition to
the reconciliation schedule, the pension footnote also shows pension expense and its
components, and the assumptions mentioned above.

Pension expense is the employer=s periodic expense on the I/S due to the pension plan and is
the sum of the following components:
(1) service cost - This is the present value of the benefits (liability) that are earned this period
(2) interest cost - This is the interest on the pension liability. It is computed as: r% x beginning of
period liability value. This is called accretion of the liability as it gets closer to ultimate payment.
It is analogous to interest expense on a zero coupon bond. The journal entry to recognize the
service and interest cost components of pension expense is:

DR CR
Pension expense
Pension liability

(3) return on assets - There are 2 important points here. First, positive ROA is a negative hit to
(reduction in) pension expense. The intuition is that the greater the growth in the assets from a
high return, the less that the firm has to fund the pension plan to pay the future benefits, because
the assets do it themselves. Second, the amount of the entry to pension expense is the expected
return on assets (not the actual return), which equals the expected ROA% x the beginning of
period balance of pension assets. Since pension assets increase or decrease by the actual return,
there may be a difference in the amount of the pension expense versus the amount of the change
in the pension assets. This difference is charged to the UNGL account so that the entry balances.

For example, assume that the firm has an expected ROA% of 9.5%, and that beginning of period
pension assets is 1,000,000. If the actual ROA% is 12%, the journal entry is:
DR CR
Pension assets 120,000
Pension expense 95,000
(3.1) Unrecognized net gain 25,000

If the actual ROA% is 5%, the journal entry is: DR CR


Pension assets 50,000
(3.2) Unrecognized net loss 45,000
Pension expense 95,000

If the actual ROA% is -4%, the journal entry is: DR CR


unrecognized net loss 135,000
(3.3) pension assets 40,000
Pension expense 95,000
If the actual ROA% is 9.5% (equal to the expected ROA%) the entry is:
(3.4) DR CR
pension assets 95,000
Pension expense 95,000

Note that the CR to pension expense in each case is 95,000, regardless of the actual ROA%.
Thus, the expected ROA% is an important assumption in the determination of pension expense.
The entry to pension expense is based on the expected ROA%, because actual ROA% is
extremely volatile (pension assets are usually invested in stocks). Basing pension expense on the
actual ROA% would induce extra volatility into pension expense, and thereby into net income.
Firms do not like this, because it makes them appear to be riskier. This example highlights the
smoothing of pension expense that is a key feature of pension accounting. We will see more
examples of smoothing, below. DR or CR entries to UNGL because expected and actual ROA%
differ are called asset gains and losses.

As long as the expected ROA% accurately reflects the long run average ROA%, the DR=s and
CR=s to the UNGL will cancel out and the net balance will stay small. In this case, there is no
need to amortize UNGL. If the UNGL gets too big, it must be amortized. An example of this
might occur if management opportunistically sets the expected ROA% too high, in order to get a
large CR (negative) entry to pension expense each period, in order to enhance net income. This is
shown in entry 3.2, above. In this case, a DR will build up in the UNGL account, and it will have
to be amortized. The entry is:
DR CR
pension expense
UNGL
Note that the amortization is a component of (increases) pension expense, so the too high
expected ROA% ultimately backfires.

The UNGL must be amortized at the end of a year if its beginning of year balance reaches a DR
or CR balance outside a Acorridor@, defined as the 10% of the greater of beginning of year
pension assets or pension liabilities. Note that firms must amortize down to the corridor, not to
zero. This is called corridor amortization. Note also that the need to amortize changes each year,
because both the 10% corridor changes and the amount of the UNGL balance changes. Thus,
amortization in one year does not tell you if there will be amortization the next year. If the
UNGL is inside the corridor, firms may elect to amortize it, but they do not have to. The
amortization is generally done SL over the expected remaining service life (average # of years
until retirement) of the employees. Amortization of the UNGL over many years (rather than
immediately) is an example of smoothing pension expense.

Pension assets are the assets in the pension fund that will be used to pay the employees=
retirement income, and are measured at FMV. The firm=s funding the plan and the assets
earning a (positive) return increases pension assets; using to assets to pay the retirees (honoring
the pension liability) decreases pension assets. The entry for funding the plan is:
DR CR
Pension assets
Cash
The entry for paying the retirees is: DR CR
Pension liability

Pension assets
Note that this entry reduces both pension assets and pension liability. See the entries for return
on assets, above.

Pension liability is the employer=s liability to pay the defined benefit; i.e., it is the present
discounted value of the cash expected to be paid to the retirees. In this way, it is like any other
non-current liability. The main difference is that with a monetary liability (bond or note), both
the future cash outflows and the discount rate are known. For a lease liability, the future cash
outflow are known, and a discount rate must be applied (to calculate the PV). For a pension
liability, it can only be estimated, based on the terms of the pension contract and actuarial
estimates about how long people will live. Pension contracts stipulate the monthly income that a
retiree will earn (usually based on years of service and final salary).

You can think of an employee=s pension as an annuity for a contracted amount for an
actuarially expected duration. To compute the firm=s pension liability to the employees, there
are 2 steps: first PV the annuity as of the workers= date of retirement, using the actuarially
determined retirement life; second, PV this value back to the present, using the average
remaining service life of the employees. The assumed interest rate (r%) is used to compute the
PV of the liability.

Note that a higher assumed interest rate will lower the liability, but this effect will be offset
somewhat by the effect of the higher interest rate in the calculation of the interest component of
pension expense (see above). In general, the lowering effect will dominate. Thus, along with the
assumed expected ROA%, the assumed interest rate is another way that firms can affect their
pension expense and pension liabilities. RCJ (pg. 697) show the range of rates that firms use.

There are 3 different definitions of the pension liability discussed in the text. The most important
one is the projected benefit obligation (PBO), which computes the liability based on expected
salaries when the workers retire, which is more realistic (for a going concern) than using current
salaries. This is where the expected salary growth rate (g%) comes in. The PBO is the liability
definition used in the interest expense component of pension expense, above. An alternative
definition of the pension liability is the accumulated benefit obligation (ABO). It is the same as
the PBO, but without the effect of salary growth. Additionally, the vested benefit obligation
(VBO) is the vested portion of the ABO. Thus, the PBO must be greater than the ABO (because g
% > 0) and the ABO > VBO (because all employees aren=t vested). If the pension assets are
greater (less) than the PBO, the plan is overfunded (underfunded).

Thus, the factors that affect the pension liability are: the assumed interest rate, the expected
duration of retirement, the periodic payment, and the time until retirement. If the actuarially
determined duration changes (for example, people live longer), the PBO increases. The entry is:
DR CR
UNGL
PBO

This is called a liability loss or actuarial loss (a liability gain or actuarial gain is the opposite).
Note that the DR is to the same account, UNGL, as the asset gains/losses, and either reduces or
increase the net balance in the account, thereby affecting the need for corridor amortization. The
DR to UNGL (rather than recording the loss by a DR to pension expense) is another example of
smoothing pension expense. Thus, occasional liability losses affect pension expense gradually
over time via amortization of UNGL (if it exceeds the corridor).

Unrecognized Prior Service Cost (UPSC) The PBO can also be changed by a contractual change
in the defined benefit. For example, assume that the pension plan is improved (sweetened)
thereby increasing the firm=s PBO. The entry is: DR CR
UPSC
PBO
UPSC has a DR (asset) balance, because it represents goodwill between the firm and employees.
The DR to the UPSC, (rather than recording the loss by a DR to pension expense) is another
example of smoothing pension expense. Thus, occasional contractual changes affect pension
expense gradually over time via amortization of UPSC. Unlike the UNGL however, the balance
in the UPSC account must be amortized. The amortization is also generally done SL over the
expected remaining service life.

Unrecognized Transition Asset or Obligation (UTA/L) At the date of a firm=s adoption of the
current pension accounting as described above (SFAS #87, 1985) firms with defined benefit
plans might have had a net underfunded (PBO < Pension Assets) or a net overfunded (Pension
Assets > PBO) pension plan. This difference between PBO and Assets at the date of adoption is
called transition obligation (asset). For most firms the net amount was small, because most plans
are adequately funded, both because of ERISA=s requirements and because funding is tax
deductible.

Any transition balance must be amortized into pension expense over the employees= average
remaining service life. This done by the je (shown for a transition asset, just reverse for a
transition liability):
DR CR
prepaid/accrued pension cost
pension expense
Note that the amortization of the unrecognized asset or liability effectively recognizes the asset
or liability by putting it on the B/S, in the prepaid/accrued pension cost account. Amortization of
a unrecognized transition asset (liability) increases the on B/S asset (liability) and lowers (raises)
pension expense. Amortizing this asset/liability is another example of smoothing, rather than
affecting pension expense in one shot. The balance in the grid (reconciliation schedule) is the
remaining unrecognized balance.
To summarize, we now repeat the worksheet and fill in entries for: (1) service cost (2) interest
cost (3) return on assets (4) funding (5) payment to retirees (6) liability loss (7) plan sweetening
(8) UNGL amortization (if necessary) (9) UPSC amortization. Note: for entry (3), the CR is for
E(ROA), the DR is for actual ROA, the plug is for the difference; for entry (6), a liability gain is
the opposite; for entry (8), the entry assumes a DR balance in UNGL that must be amortized.

Pension exp. Cash pp=d/acc=d cost ▌ Pension Assets Pension Liab. UNGL
UPSC
(1) DR CR
(2) DR CR
(3) CR DR Plug
(4) CR DR
(5) CR DR
(6) CR DR
(7) CR DR
(8) DR CR
(9) DR CR

Another way to summarize is by t accounts (I only show the three most important accounts):
* in between DR and CR means could be either

Pension expense Pension assets Pension liability


DR CR DR CR DR CR
service funding Service
interest ROA Interest
E(ROA) Pay Benefits Sweetening
Amort* Liab Loss
Pay Benefits
So far, we have discussed the entries to all the accounts except the prepaid/accrued pension cost
account. Note that there is no entry in its column, above. This is because there is no individual
entry that affects the prepaid/accrued account. The entry to this account is the net of all the
entries to the 5 accounts on the right side of the hash mark: pension assets, pension liability,
UNGL, UPSC. The entries to these 5 accounts are done in the pension worksheet, not directly on
the financial statements. When all of the worksheet entries are done, the one summary entry that
affects the financial statements is:
DR CR
Pension expense
Cash
Prepaid Or Accrued Pension Cost

Thus, the Prepaid/Accrued Pension Cost account Areplaces@ the other 5 accounts in the
financial statements. It is prepaid (asset) if a DR, and accrued (liability) if a CR. It is the
difference between pension expense and cash (funding) of the plan.

Some additional important points about pension accounting are:


Minimum Liability - If the ABO > pension assets (RCJ call this a severely underfunded plan),
the difference is called the minimum liability or unfunded ABO. Since the PBO > ABO, a plan
can be underfunded (PBO > assets), but the assets can still be greater than the ABO. If the
minimum liability exists, the excess (ABO-assets) must be shown as a liability on the B/S. This
may require an additional journal entry. If the accrued pension cost (liability on B/S) is already
greater than the minimum liability, no additional journal entry is necessary. In effect, a liability
greater than the minimum is already on the B/S. But, if the minimum liability is greater than the
accrued pension cost (or if there is a prepaid pension cost, DR balance), an additional entry is
necessary to establish the minimum liability on the B/S.
Case 1: Assume that PBO=10 million, pension assets=9 million, ABO=8 million. No minimum
liability exists.
Case 2: Assume that PBO=10 million, ABO=9 million, pension assets=8 million. A minimum
liability of 1 million exists.
(2A) If the accrued pension cost balance is 1.5 million, no additional entry is necessary.
(2B) If the accrued pension (CR) cost balance is 0.5 million, an additional entry is necessary:
DR CR
intangible asset - deferred pension cost 500,000
Additional pension liability 500,000
(2C) If the prepaid pension cost (DR) balance is 0.5 million, an additional entry is necessary:
DR CR
intangible asset - deferred pension cost 1,500,000
Additional pension liability 1,500,000
Entries 2B and 2C bring the B/S liability (accrued pension cost + additional liability) up to 1
million. The total balance of 1 million could be combined into one liability balance on the B/S,
or the 2 components could each be shown separately. The intangible asset is also a B/S account.

We now have all the tools to understand pension disclosures in financial statements.

Financial Statement Presentation


Only the aggregate pension expense and the net balance of the prepaid or accrued pension cost
appear on the I/S and the B/S. If the minimum liability condition is met, then the additional
pension liability also appears (or the 2 components are summed into one liability number). All
other information is in the footnotes. See RCJ=s GE example on page 708-709. There are 3 key
pieces of this footnote information.
(1) Components of Pension Expense: The firm must disclose the components of pension
expense, including any amortization. Usually, the actual ROA is shown along with the amount
deferred into UNGL (the difference is the current period expense).
(2) Funded Status of the Plan (called APension Reconciliation Schedule@):
Funded Status = Pension assets - pension liabilities  UNGL  UPSC  transition asset or
liability (- additional liability). [ means could be DR or CR]
This schedule usually appears vertically. Note that funded status equals the net balance of the
prepaid/accrued pension cost reported on the B/S. Thus, the right side of the pension worksheet
is the same as the footnote schedule, just in different form (vertical vs horizontal). This is why
understanding the worksheet is important.
In effect, the reconciliation schedule reconciles the difference between the true net asset or
liability (Pension Assets - PBO) vs the on B/S prepaid/accrued pension cost. Unrecognized assets
and gains cause the on B/S balance to be worse (lower asset or greater liability) than the true
balance. Unrecognized liabilities and losses cause the on B/S balance to be better (higher asset or
lower liability) than the true balance.

(3) Assumptions: The firm must disclose the expected ROA%, r%, and g%. This can be used for
cross-firm comparisons.

RCJ refer to the difference between PBO and Plan Assets as the plan=s Economic (Funded)
Status. PBO > Assets is called underfunded. PBO < Assets is called overfunded. This status is
the sum of the recognized + unrecognized amounts. The recognized amount is the prepaid or
accrued pension cost on the B/S. The unrecognized amount is the sum: UNGL + UPSC +
Trans.A/L +Add=l Liab. RCJ point out that funded status correlates with future CFO.

Although nowhere is the cash funding disclosed, it can be calculated. Note that the CR to cash in
the summary entry is the difference between pension expense and the change in the
prepaid/accrued pension cost, both of which are reported in the footnote.

The above accounting was prescribed in SFAS #87. SFAS #132 changed the format of some of
the footnote disclosures (but not the calculations) for pension expense. In particular, the service
and interest cost components of pension expense were unaffected; as shown in the t account
above, the remaining components are E(ROA) and amortization. These components had been
reported as actual ROA + net amortization and deferral. The new format discloses the expected
ROA and the amortizations separately.

Other Post-Employment Benefits (OPEB=s) In theory, OPEB=s are almost identical to


pensions, and the accounting is also virtually identical. There are three primary differences. (1)
Unlike pensions, many firms had large transition obligations at the date of adoption of the
current OPEB accounting standard. This is because funding of OPEB=s is not tax deductible
like pensions, so there is no incentive to have plan assets (fund the plan). The transition amount
must be written off either (a) immediately or (b) SL over the average remaining service life. (2)
The attribution period (the period over which the employee earns the benefits) to compute the
periodic service cost, is up to the vesting (eligibility) date, not up to the retirement date. In
practice, this means that periodic service cost is higher, because a given amount of benefits are
earned over fewer employment periods. (3) As a practical matter, actuarial calculation of the
(present value of the) benefits is harder than for pensions, because OPEB contracts do not state
amount of benefit per period, only the types of benefits (medical, dental, etc.). Since the
accounting is virtually identical, we focus on pensions, not OPEB=s.