How to Account for Pension Benefits – Part 2… fun stuff!
CFA Level 2 – Financial Reporting & Analysis; Study Session 6, Reading 24 in 2011 textbook/Reading 22 in 2010 textbook.
Part 2 of 2 (longggish…)
This post talks about Pension Accounting (obligation, asset/liability, funded status & pension expense), which I find is very interesting and current…I think it helps to throw some perspective on the recent uproar in opposition to unions, governments & corporations switching from defined benefit to defined contribution pension benefits, resentment towards public sector compensation
It is widely assumed that this is a challenging topic but I think it is relatively easy…there are a few key points:
1. Understand terminology (make sure you have read Part 1)
2. Remember that Assets = Liabilities + Equity
3. Because we want to compare financials across 2 accounting standards, we need to make adjustments and ensure that results reconcile after adjustments…
4. Info to make adjustments appears in footnotes in both standards
Balance Sheet – Pension Asset/Liability
Reconciliation of PBO between start and end of year (disclosed in footnote)
Beginning PBO
+ Service Cost
+ Interest Cost
+ Plan Amendments
± Actuarial (gains)/losses
– Benefits Paid
= Ending PBO
Reconciliation of Fair Value (= Market Value) of Plan Assets (disclosed in footnote)
Fair Value of Plan Assets at Start of Year
± Actual Returns on Assets
+ Employer Contributions
– Benefits Paid
= Fair Value of Plan Assets at End of year
Funded Status of a Pension Plan:
- = True economic position of plan = Fair Value of Plan Assets – PBO
- ≠ Balance Sheet Asset/Liability under IFRS & old US GAAP.
- = Balance Sheet Asset/Liability under current US GAAP i.e. Fair Value of Plan Assets – PBO
- is overfunded if > 0 and underfunded if < 0
- Neither Fair Value Plan Assets nor PBO is reported on the balance sheet.
- US GAAP – Funded status is reported on B/S as an asset (PBO < Plan Assets) or a liability (PBO > Plan Assets)
- IFRS – Funded Status after eliminating gains/losses (due to prior service cost) not recognized in I/S
IFRS – Reconciliation of Funded Status to Net Pension Asset/Liability
This is the funded status adjusted for unrecognized gains/losses and as reported on the balance sheet under IFRS. Remember that under US GAAP, the ‘unadjusted’ or true funded status is reported on the balance sheet.
Funded Status (Fair Value of Plan Assets – PBO)
± Unrecognized Deferred (gains) & losses
+ Unrecognized past service costs
± Unrecognized transition (asset) or liability
= Net Pension Asset (Liability) reported on B/S
Balance Sheet Adjustments to convert from Old US GAAP/current IFRS to new US GAAP
- Adjust net pension asset/liability to reflect funded status i.e. difference in funded status & pension asset/liability (remember that under IFRS, the pension asset/liability is adjusted for unrecognized items).
- Adjust Other Comprehensive Income (OCI) for after-tax difference in #1 (this is necessary to balance the B/S)
- Adjust Deferred tax assets for taxes on difference in # 1
Income Statement – Pension Expense
Net Pension (or Periodic) Expense – as reported on Income Statement (SG&A) under both, IFRS & US GAAP
Recurring Costs (actual)
Current Service Cost
+ Interest Cost
- Expected return on plan assets
Smoothed Events
± Amortization of (gains) & losses
+ Amortization of prior service costs
± Amortization of transition (asset)/liability (rare)
= Pension Expense on Income Statement
As seen from the formula, the reported pension expense is a smoothed number (remember, whenever there is smoothing, there is an opportunity for manipulation).
Adjusting Reported Pension Expense to Economic Expense
Reclassifying Pension Expense to reflect economic or true expense
Pension expense is reported as part of SG&A… but it truly doesn’t belong there; so here are the adjustments:
- Remove pension expense from Operating Cost
- Add Service cost to Operating cost
- Add Interest cost to interest expense
- Add Actual Return on plan assets to non-operating income
- Ignore amortization
Total Income Statement Effect = Service Cost + Interest Cost – Actual Return
Economic Pension Expense (easy method) =
Service Cost
+ Interest Cost
+ Plan Amendments
– Actual Return on Assets
Economic Pension Expense (CFA method 1) =
Source: Schweser Level 2 2010
Economic Pension Expense (CFA method 2) =
Source: Schweser Level 2 2010
Pension Reconciliation for current US GAAP… (last reconciliation!)
Beginning Funded Status
– Economics Pension Expense
+ Contributions
= Ending Funded Status
Cash Flow Adjustment
- All pension related cash activity (e.g. contributions, benefits paid, taxes) is reported under CFO. (remember, all cash movement occurs through the cash flow statement)
- If Contribution > Economic Expense, the after tax difference is equivalent to paying off pension liability which means the excess contribution should flow through CFF not CFO…
- CFO increases, CFF decreases
- If Contribution < Economic Expense, the after tax difference is equivalent to borrowing which means the deficit in contribution should flow through CFF not CFO
- CFO decrease, CFF Increases
Phew… that’s it for Pension Accounting… now apply the above to real world… US Medicare, Public Pensions globally (especially Greece, France, US cities)
THANK YOU SOOOO MUCH!!! This was exactly the question I had. My “Intermediate” Accounting class gives us this “pension expense,” but I know that it is not on the Income Statement!
Excellent write-up. I certainly appreciate this website. Keep writing!