Professor Paul Zarowin - NYU Stern School of Business
Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes
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 "pay as you go" (de facto cash basis):
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 "prepaid pension cost"; if less, there is a liability "accrued 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 (RCJ, pg. 692) 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 "on 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
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)
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 "prepaid-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:
(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:
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:
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 "corridor", 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:
The entry for paying the retirees is: DR CR
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). RCJ give an example on page 674.
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. 681) 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:
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 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):
prepaid/accrued pension cost
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
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:
Prepaid Or Accrued Pension Cost
Thus, the Prepaid/Accrued Pension Cost account "replaces" 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:
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:
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 the example on pg. 692 in RCJ. 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 "Pension 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. As shown in Exhibit 13.1 (pg. 692), 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.