Pension Expense

First assume you have a mini balance sheet, seperately for your pension accounting. Whatever the
net outcome of your mini balance sheet is, will be recorded in your MAIN balance sheet as either
an Asset or a Liability under a fancy account called Funded Status of Pension Plan.
Next, in your mini balance sheet, you’ve got the asset and the liability. (Your Liability is also called
PBO)
Your Liability is only one figure - it’s simply the present value of payments to be made in the
future. In lay man terms, this is a debt you owe to your hardworking employees and will have to
pay back at some point in the future.
We all hate liabilities - at least, most of us do - so you decide on a nice plan to have some assets in
place, to fund your liability whenever it comes due in the future. This is simply some amount of
cash you’ve invested and expect to earn some income on at some point in the future.
So all good! Assets and Liabilities, equation balanced! When you net your assets against your
liability, whatever you get is your funded status.
But there is a caveat though.
Your liability, like all debt, is not static, for two reasons.
1) Like all debts, you pay interest on it. - we will call this your interest expense
2) Each year your hardworking employees sweat hard for you, you owe them more – whatever you
owe them in that year is what we will call the Current Cost.
At the end of the year, your liability will have increased by Interest Expense + Current cost.
So your ending PBO = Begining PBO + Interest expense + Current Cost.
Just in case you are mumbling and cursing beaneth your breathe at “Those d**n pigs bleeding their
poor employer to death” …you might want to take a chill pill and look at your Assets!
Your Assets would have made some returns as well. The total returns on your assets, as usual is in
two components
1) Income component
2) Capital Gains component
If you are American, the income return component of your assets will simply be = Expected return
* Plan Assets. (If you are british, you use interest rates instead of expected return)
So, Total Return on your assets = Income return Component + Capital Gains Component
and therefore, by simple mathematics, Capital Gains component = Total Actual Return - Income
return,
which is the same as writing [Actual return -(expected return * plan assets)]
The Net periodic Pension cost is simply a net measure of the amount by which your Liability and
your assets must have increased by the end of the year, after also factoring in employer
contributions.
The amount is =[ Increase in Liability - Increase in Assets.] - Employer Contributions.
This is the same as
[ Current service cost + Interest Expense] - [Income Component + Capital Gains Component] -
Employer Contributi
Also, remember that Liability - Assets = Funded status.
So, we can also re-write
[ Increase in Liability - Increase in Assets.] - Employer Contributions
as Change in Funded status - Employer Contributions.
This is your Net Periodic Pension cost. This is also your Periodic Pension Cost. This is also your
total Periodic Pension cost. All three are the same just poor naming conventions.
So let’s talk a bit about how US GAAP differs from IFRS.
The first difference:
Rememeber that our asset return in each period is said to be made up of two components
1) Interest component
2) Capital Gains Component
The main significant difference is how interest component is defined. Americans use Expected
return * Asset (Americans like dreams and expectations), the british use Interest rates * Assets.
The second difference:
Remember our final derivation?
[ Current service cost + Interest Expense] - [Income Component of Returns + Capital Gains
Component] - Employer Contributions
Under US GAAP, the equation is fine as it is. Under IFRS, those two middle components are
netted together in a single figure called NET INTEREST EXPENSE.
The third difference:
There are times, when you make ammends to your company’s pension plan to take into account
some guys who may have come way back with you when you first started the company. You call
this Past Service Cost.—think of this as Loyalty Points.
Now look at that long equation again. The difference here is that under IFRS, this Past Service
Cost is simply added to the Current Service cost…..but guess what the Americans do? They toss it
in the bin! Yes you heard me right, so much for Loyalty. Under GAAP, all that Loyalty Points are
tossed into a big bin called OCI and then slowly amortised into the Income statement by dividing
Past Service Cost by expected number of employee years.
Speaking of the big bin…..
What are the contents? Well just about any s***ty stuffs you can think of really, mostly coded as
“Actuarial Stuff”
Actuarial Stuffs are the randomn stuffs you were not expecting. For instance, let’s say you change
the assumptions you’ve made about your discount rates, the rate of compensation increase, or
how long your employees are likely to live, these changes will affect the value of your liabilites and
the increase or decrease is coded as “Actuarial Stuff”, tossed away in the big bin called OCI.
Additionally, if you are American, and had filed your statements using Expected returns, then you
must also record the Capital Gains portion of your returns in the OCI.
Recall that we agreed earlier on, that:
Capital Gains Component = Total Actual Return Component - Income Component
and Income Component = Expected return * Asset.
If you have manged to stay this far without getting confused, well thank you. and here’s the final
and fifth difference between IFRS and GAAP
- Under IFRS, you never amortize your bin bag! You should say this to yourself over and over
again!
- Under GAAP, you amortize Past service cost by dividing by expected number of years and you
amortize the rest of your bin bag using the corridor approach.

There are two ways of calculating the funded status

1) Assets - Liability
If this is positive, your Funded status is a Net asset. If this is negative, you have a net Liability.
2) Liability - Assets
If this is positive, your funded status is a Net liability, if this is negative, you have a net asset.
Both ways can then be used to calculate Net Periodic Pension Cost.
Under the first approach
[Change in Assets + Contribution] - Change in Liability
= Change in Assets - Change in Liability + Contribution
= Change in Funded Status + Contribution
Under the Second Approach
Change in Liability - [Change in Assets + Contribution]
= Change in Liability - Change in Assets - Contribution
= Change in Funded Status - Contribution.
You need to understand the difference betweeen this two.
In the second approach you are saying “If Liability has increased by X amount and the fund’s asset
has increased by Y amount, if the employer has also contributed Z amount, how much Liability will
be left at the end of the day”
In the first approach, you are saying “If Assets have increased by X amount and the employer has
contributed Y amount, if i have Z amount of Liability to fund, how much asset will i be left with”
The first approach is more in line with the traditional principles of Assets - Liability. The
assumption here is that for a company to be a going concern, its position must always be Net
Assets. I think Elan’s guide follow this method
The CFAI uses the second approach, which assumes that the Pension account will always be a
Liability to an employer, and an employer’s goal will be to gather as much assets as possible to
fund this liability as they come due in the future. I will recommend this approach, as it leads to less
tendencies for errors.
Whichever approach you use, what is most important is understanding the principles behind it.

If funded status got worse, this essentialy means that your costs rose, which is an additional cost
to what your employer contributed so you simply add both the change in funded status and
contribution.
If, however, funded status got better (assets rose more than liabilities) this means it is gonna
reduce your cost so you can subtract this change from employer contribution to decrease your
total periodic pension cost (or how else you can all it:))

Americans Amortize

I still suck at the Held to Maturity, Held for Trading, and Available for Sale. The last two
sound kind of interchangeable dont they? Well here's how I think about it. As a kid, you had
the Magic cards (or Pokemon or baseball whatever) that you kept in a binder. Those were
for trading. You also had the ones that you used in decks and stuff, and sure you'd sell
them if the price was right, but that's not why you own them. It's like a couch. Yea, I mean
you'd sell it if the price was right, but in the mean time, youre still sitting on it.

Pardon me I cant be more help than that. Theres a great example in the Schweser notes
reading 16 about them that I keep trying and keep getting wrong tho.

Equity Method

This one is pretty simple. If you have between 20% and 50% and influence (that last part is
the more important part), then you use Equity Method. On you Income Statement (IS), your
income is...

NI = Net Income - Amortized Charges

Note: both proportional

Amortized Charges are basically the PPE falling apart. So the Fair Value (FV) of the PPE
minus the Book Value (BV) of the PPE get's amortized every year according to whatever
depreciation method they outline (typically straight-line, 10 years).

For your Balance Sheet (BS):

This Year's balance = Last year's balance + NI - Dividends.

Note: NI and Dividends are proportional

For your Cash Flow (CF):

Dividends

still proportional.

So let's say you pay $1,000 for 40%, and it gets $500 in NI and $150 in Dividends (Div). no
amortized charges in this example
IS NI = $500 * 40% = $200

CF Div = $150 * 40% = $60

BS Balance = $1000 + $200 - $60 = $1140

Goodwill
Goodwill = Paid - BV - (FVppe - BVppe)
Paid is what you paid. BV is what the book value was. FVppe - BVpee is basically saying
that the PPE's Book Value gets written up to Fair Value when you acquire a company, so it
doesn't contribute to Goodwill.

Example: You pay $80k for 30% and it has a total BV of $200k and the PPE has a FV of
$75k and a BV of $25.

Goodwill = $80k - $200(30%) - ($75k-$25)(30%) = $5k

Full Goodwill vs Partial Goodwill

Ok so let's say you only buy 80% of a company. Full Goodwill is what you'd have in
Goodwill if you had bought 100% instead. Partial Goodwill is just 80% of Full Goodwill.

Easy peasy.

Impairments

IFRS is 1 step.

USGAAP is 2 steps.

IFRS

Carry - FV = Impairment

Doesn't get much easier than that. Is the carrying value over the fair value? Then it's
impaired AND the impairment is equal to the different.

USGAAP

if Carry > FV

then FVo of Asset - FVt of Asset = Impairment

So if the Fair Value of the Asset was $100, and now it's $80, then the impairment is $20.

Edit: From TT Suburban: Under US GAAP, if the fair value of the investment falls below the
carrying amount, and assuming the decline is considered to be permanent (as Munroe
expects), the impairment loss is recognized on the income statement and the carrying
value of the investment is reduced to its fair value; the impairment loss is the difference
between the carrying amount and the fair value (i.e., $1,264.51 thousand – $940.00
thousand = $324.51 thousand).

Ok. Im gonna be hitting FRA hard the next few days cuz it's the one subject that's still
kicking my dick in, but hopefully we can help eachother ease the pain a bit.

edit: couple more

Minority Interested = Equity + NI - Div

All proportional

And with Joint Venture, ie 50/50, the equity method is required.

PBO
So you’re likely going to see a problem (Im assuming based on the Topic Tests) about
calculating the PBO for a company with one employee who just started working there.

Example:

2% annual payment of final salary. Starting salary $50k. Discount rate 8%. 4%
compensation growth. Will work for 25 years and retire for 15. (It’s worth mentioning that
the first retirement payment is at the end of the his first retired year.)
There are two sticky points that used to trip me up. 1) 25 years vs 24 years. Even though
he works for 25 years, you’re going to be using the number 24 for figuring out his final year
salary (i.e. 1.0424) and for discounting, (i.e. N = 24).

The first one makes sense, the second one I still don’t really understand, but whatever.

2) You assume he works 25 years, but at the same time assume he works only 1 year. And
then if he works another year, then you assume he works 2. Etc. I don’t know. It just
confuses me. If you don’t know what the hell I’m talking about, that’s fine. You’re better off.

Ok let’s dive into the problem.

First figure out his final salary = starting salary * 1.0424 = 128,165.21

Then figure out his benefit = final salary * 2% * 1 year = 2,563.30

Then set that as PMT and figure out the PV (like an annuity)= 21,940.55

Finally, find the present value of that annuity, discounted back 24 years = 3,460.01

And there you have it.

Remember, each year the PBO goes up by

Current Service Cost = PV of New Payments

And

Interest Cost USGAAP = PBObeg * Discount Rate

Interest Cost IFRS = Funded Status beg * Discount Rate

Now here’s just a shit load of formulas you’re gonna want to probably memorize (haven’t
double checked the TT’s yet to make sure theyre needs yet.)

Abbrevtiations

Funded Status (FS)

Change in Funded Status (ΔFS)

Fair Value of Plan Assets (FV of Plan Ass)

Total Periodic Pension Cost (TPPC)

Current Service Cost (Current)

Interest Cost (Int)

Actual Return on Plan Assets (Actual ROPA)

Past Service Cost (Past)

Periodic Pension Cost in P&L (PPCp&l)

Periodic Pension Cost in OCI (PPCoci)

Employer Contributions (Emp Cont)

Think that’s most of them.

Formulas

Funded Status = FV of Plan Ass - PBO

ΔFS = [(FV of Plan Ass end - PBO end) - (FV of Plan Ass beg - PBO beg)]

TPPC = Emp Cont - ΔFS

TPPC = Current + Int + Past +/- Actuarial LG - Actual ROPA

TPPC = PCCp&l + PPCoci

PPCp&l USGAAP = Current + Int + Past - Expected ROPA

Edit:: TT Atlantic makes it look like you have to add the amortized Past services charges.

Remember, only USGAAP allows for Expected ROPA. IFRS just uses the Discount Rate
for expected returns.

PPCp&l IFRS = Current + Net Int + Past

Remember that IFRS calculates Interest Expense differently.

PPCoci = TPPC - PPCp&l

After Tax Short Fall = (1-t)(TPPC - Emp Cont)

Then the answer is subtract (hence shortfall) from Cash Flows from Operations and added
to Cash Flows from Financing.

I believe this formula is correct:

FV Plan Ass end = FV Plan Ass beg + Actual ROPA + Contributions - Benefits

But Im not 100% sure.

Your way gets the correct answer, depending on WHAT the question is asking. Is the
question asking "what's the PBO at the START of the first year of employment?" or is is
asking "what's the PBO at the END of the employee's first year?". It's an important
distinction. If my understanding is correct, you wound up calculating the former (i.e. the
opening PBO of the first year). I found lots of my practice questions asked to find the
closing PBO of the first year. This stuff tripped me up too. I tackle it a slightly different way:

So firstly getting the final salary makes sense, since we expect a total of 24 salary
increases in total, assuming salary payments at the end of each year. 128,165.21 at the
end of year 25 is what I get too (december 31st). The annual compensation is 2% of that,
so 2,563.30 also the same as what I get. But this is where our methods differ. He gets his
first payment right after retirement, i.e. at the START (jan 1st) of year 26, and then the next
one a year later, and so on (a total of 15 payments, but paid at the BEGINNING). So when
calculating the present value of these payments (assuming you wish to PV it to the end of
year 25, i.e. his retirement time), you would need to put your calculator into BEGINNING
payment mode. Alternatively, you could keep it in ending mode, and then just multiply it by
(1+r): this gives you 23,695.75 at the end of year 25 (this is also the start of year 26). What
you calculated was actually the value at the end of year 24 (start of year 25). Now, if the
question is asking what the STARTING PBO of the first year was, you'd discount it back 25
years, and arrive at 3460 (you wound up getting the same answer, because you discounted
back 24 years instead of 25). If the question asked for the PBO at the END of the first year,
then we'd discount back by 24 years and get 3736.8. As long as you understood that you
were calculating the starting PBO and not the ending, then no worries, keep doing what
you're doing, because your method still gives you the correct result. I personally prefer my
method since it makes more intuitive sense to me.

Also, in calculating interest in PBOend, I'm fairly certain that it's the same regardless of
IFRS and US GAAP, in that you do PBObeg *r. Only on the income statement does
calculating for interest cost differ, where GAAP uses PBObeg *r and IFRS uses FSbeg *r.

I actually solve these things using the Cash Flow function on the BAII. I make a timeline
showing all the cash payments (obviously skipping over multiple years where the payment
is the same), and then enter those figures into the Cash Flow function.

If a payment is 25 years in the future, just enter CF1=0 F1=24 to "skip over" the first 24
years. Then CF2=X F2=15 for 15 years of $X pension payments. You end up with every
cash flow at just the right time, and then you can get your NPV or whatever.

It helps me avoid the stress of wondering whether I'm in BGN mode or END mode or if I left
a year out while discounting.
Ah my bad about the payment - I totally misread that. I'm so used to the questions telling
me it's at the start of the year.

I just double checked my notes from Fitch to confirm, it says that PBO is calculated the
same for both IFRS and GAAP, and only in the pension expense on the income statement
is calculated differently. If your notes go say otherwise tho, perhaps someone who is
reading this can do another fact check? :S I too want to get it right!