1. Financial Statement Analysis K.R. Subramanyam
K.R. Subramanyam
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. Analyzing Financing Activities3
CHAPTER
Pensions

3. Pension Overview

4. Postretirement Benefits
Two kinds of Retirement Plans
Defined Pension Plan -- Employer-promises monetary benefits to employees after retirement, e.g., monthly stipend until death.
Defined Contribution Plan – Plan specify the amount of pension contribution that the employer makes to the plan.

5. Post Retirement Benefits
Who are the three “Parties” to a pension plan?

6. Postretirement Benefits
Elements of the Pension Process
Employer
Employee
Pension Fund
Benefits
(Disbursements)
Contributions
Investment and returns

7. Post Retirement Benefits
How does a company determine the annual cost of a defined contribution plan compared to a defined benefit plan?

8. Post Retirement Benefits
How does a company determine the annual cost of a defined contribution pension plan?

9. Post Retirement Benefits
Most common type of defined contribution pension plan is a 401-K.

10. Post Retirement Benefits
How does a company determine the annual cost of a defined benefit pension plan?

11. Post Retirement Benefits
Three steps:
Determine how much is the annual benefit and for how many years.
Determine the PV of the above payments.
Determine how many years to “spread” the cost.

12. Postretirement Benefits
Illustration of Pension Accumulation and Disbursement for a Defined Benefits Plan
Step 1
Annual payments into the
Fund required to accumulate
to $134,200 in 15
years with a discount
rate of 8%per
annum
Funds required at employees’ retirement:
Present value of 10 payments of $20,000 per annum with a discount rate of 8% per annum
$134,200
Annual benefits of
$20,000 paid to
employee for 10 years
Contributions =
$4,942 per annum
Benefits =
$20,000 per annum
15 years
10 years
Preretirement
Retirement
Postretirement

13. Determining Future Annual Benefit Cost
Step 1
Need to determine the following related to each employee:
Life expectancy
Employee turnover
Compensation growth
Expected rates of return
Interest rates

14. Determining Future Annual Benefit Cost
Who can assist with determining and calculating the needed information?

15. Determining Future Annual Benefit Cost
Who can assist with determining and calculating the needed information?
Answer: An Actuary

16. Determining Future Annual Benefit Cost
Step 2
How much needs to be “accrued” at the time of an employee’s retirement?

17. Postretirement Benefits
Illustration of Pension Accumulation and Disbursement for a Defined Benefits Plan
Step 2
Annual payments into the
Fund required to accumulate
to $134,200 in 15
years with a discount
rate of 8%per
annum
Funds required at employees’ retirement:
Present value of 10 payments of $20,000 per annum with a discount rate of 8% per annum
$134,200
Annual benefits of
$20,000 paid to
employee for 10 years
Contributions =
$4,942 per annum
Benefits =
$20,000 per annum
15 years
10 years
Preretirement
Retirement
Postretirement

18. Determining Future Annual Benefit Cost
Step 3
How much is required to be expensed each year so that the amount needed to be “accrued” at the time of an employee’s retirement is achieved?
How do we determine the number of years?

19. Determining Future Annual Benefit Cost
Step 3
How much is required to be expensed each year so that the amount needed to be “accrued” at the time of an employee’s retirement is achieved?
Answer – PV of an Annuity

20. Determining Future Annual Benefit Cost
Step 3 - continued
How do we determine the number of years in which to accrue the expense?

21. Determining Future Annual Benefit Cost
Step 3 - continued
How do we determine the number of years in which to accrue the expense?
Answer - The estimated remaining years of employment.

22. Postretirement Benefits
Illustration of Pension Accumulation and Disbursement for a Defined Benefits Plan
Step 3
Annual payments into the
Fund required to accumulate
to $134,200 in 15
years with a discount
rate of 8%per
annum
Funds required at employees’ retirement:
Present value of 10 payments of $20,000 per annum with a discount rate of 8% per annum
$134,200
Annual benefits of
$20,000 paid to
employee for 10 years
Contributions =
$4,942 per annum
Benefits =
$20,000 per annum
15 years
10 years
Preretirement
Retirement
Postretirement

23. Postretirement Benefits
Pension Basics
Pension Plan – agreement by the employer to provide pension benefits involving 3entities: employer-who contributes to the plan; employee-who derives benefits; and pension fund
Pension Fund – account administered by a trustee, independent of employer, entrusted with responsibility of receiving contributions, investing them in a proper manner, & disbursing pension benefits to employees
Vesting – specifies employee’s right to pension benefits regardless of whether employee remains with the company or not; usually conferred after employee has
served some minimum period with the employer
Pension Plan Categories
Defined benefit – a plan specifying amount of pension benefits that employer promises to provide retirees; employer bears risk of pension fund performance
Defined contribution – a plan specifying amount of pension contributions that employers make to the pension plan; employee bears risk of pension fund performance   
Focus of Pension Analysis
Defined benefit plans constitutes the major share of pension plans and are the focus of analysis given their implications to future company performance and financial position

24. Managing Pension Plan
Company’s prefer defined contribution plans since the amount of expense can be modified each year and the expense amount can easily be determined.
The expense amount of a defined benefit plan is much more difficult to determine and the amount in future period can fluctuate significantly.

25. Managing Pension Plan CFO desired goals: Steady earnings.
Limited disclosure
Footnote only if possible
Least impact on earnings
Least fluctuation in earnings
Least recorded amount of a liability

26. Postretirement Benefits
Pension Accounting Requirements
Recognized Pension Cost
The recognized pension cost included in net income (i.e., the net periodic pension cost) is a smoothed version (smoothing process, defers volatile, one-time items) of the actual economic pension cost for the period.
Expected return on plan assets is recognized in reported pension expense.
Difference between the actual and expected return is deferred. These deferred amounts are gradually recognized through a process of amortization.
Thus, net periodic pension cost includes service cost, interest cost, expected return on plan assets and amortization of deferred items.
Articulation of Balance Sheet and Income Statement Effects
The net deferral for the period is included in other comprehensive income for the period
The cumulative net deferral is included in accumulated other comprehensive income, a component of shareholders’ equity.

27. Pension Costs Recurring: Service cost Interest cost
Expected return on assets
Changes in assumptions and economics:
Actual return on assets different than expected.
Prior service cost (additional benefits)
Actuarial gain / losses due to change in assumptions

28. Pension Plan Example
Why is interest cost a portion of pension expense?
Why is return on plan assets considered a negative expense?

29. Pension Plan Example
Why is interest cost a portion of pension expense?
To compensate for the liability amount being discounted.
Why is return on plan assets considered a negative expense?
The earnings from plan assets is a source of funding the plan.

30. Pension Plan Example
What would be the company’s pension expense given the following:
Service cost is $125,000
Interest cost is $ 25,000
Expected return on assets $50,000

31. Pension Plan Example
What would be the company’s pension expense given the following:
Service cost is 125,000
Interest cost is ,000
Expected ROA (50,000)
Total expense $100,000

32. Pension Costs Recurring: Service cost Interest cost
Expected return on assets
Changes in assumptions and economics:
Actual return on assets different than expected.
Prior service cost (additional benefits)
Actuarial gain / losses due to change in assumptions

33. Impact on Plan Expense
What is the impact on the plan if we have any of the following:
Change in discount rate
Change in expected return on assets
Change in compensation growth rate

34. Impact on Plan Expense Change in discount rate
Higher rate lower liability
Change in expected return on assets
Higher return lower cost
Change in compensation growth rate
Increase in rate higher liability

35. Impact on Plan Expense
What is the impact on the plan if we have any of the following:
Additional pension benefits
Increase in life expectancy
Increase in expected employee turnover

36. Impact on Plan Expense Additional pension benefits
Increase liability and future expense
Increase in life expectancy
Increase in expected employee turnover
Decrease liability and future expense

37. Expected vs Actual Return on Plan Assets
How would you account for the following change?
Plan assets $1,000,000
Expected return %
Expected earnings $80,000 (Reduction of pension expense)
Actual return %
Actual earnings $30,000
Average life of plan assets 10 years

38. Expected vs Actual Return on Plan Assets
Accounting Entries:
Year 1
Cash $30,000
Expected return $80,000 (Reduction of current pension expense)
Deferred asset $50,000
(An amount that will be amortized in future periods that will increase pension expense.)
Year 2
Amortization of deferred asset $5,000 (Expense)
Deferred asset $5,000

39. Change in Actuarial Assumptions
How would you account for the following change?
Increase in life expectancy $40,000
Higher employee turnover $20,000
Increase in expected compensation $30,000
Lower expected discount rate $100,000
Average remain years of service for employee - 15 years

40. Change in Actuarial Assumptions
How would you account for the following change?
Year 1
Deferred assets $150,000
Projected benefit obligations $150,000
Year 2
Amortization of deferred asset $10,000 (Expense)
Deferred assets $10,000

41. Postretirement Benefits
Economic Pension Cost
Economic pension cost -- net cost arising from changes in net economic position (or funded status) for a period; includes both recurring and nonrecurring components along with return on plan assets.
Recurring pension costs consist of two components:
Service cost – actuarial present value of pension benefit earned by employees
Interest Cost – increase in projected benefit obligation arising when pension payments are one period closer to being made; computed by multiplying beginning-period PBO by the discount rate
Return on plan assets:
Actual return on plan assets – pension plan’s earnings, consisting
of investment income—capital appreciation and dividend and interest
received, less management fees; plus realized and unrealized
appreciation (or minus depreciation) of other plan assets; Used to offset cost
to arrive at a net economic pension cost.
Nonrecurring pension costs consist of two components:
Actuarial Gain or Loss – change in PBO that occurs when one or more actuarial assumptions are revised in estimating PBO
Prior Service Cost – effect of changes in pension plan rules on PBO

42. Evaluation of the following assumptions:
Compensation increases 5.5% per year
(Average for the last ten years)
Employee turnover 7.2% per year
(Average for the last five years)
Expected asset yield 7.5% per year
(Average for the last twenty years)
Expected discount rate 8.0% per year

43. Practice Exercise

44. Practice Exercise

45. Practice Exercise

46. Practice Exercise

47. Practice Exercise

48. Expected Return on Assets
What is a reasonable rate of return on assets with the following mix?
Short term bonds 45%
Long term bonds %
Equities 30%

49. Funding Considerations
Minimum requirements (ERISA) Employee retirement Income Security Act
No current deductions for over funded plans

50. Postretirement Benefits
Alternative Definitions of Pension Obligation
Accumulated benefit obligation (ABO) – actuarial present value of future pension benefits payable to employees at retirement based on their current compensation and service to-date
Project benefit obligation (PBO) – actuarial estimate of future pension benefits payable to employees on retirement based on expected future compensation and service to-date
Plan Assets – The funds contributed to the plan are called plan assets because these are invested in capital markets
Funded Status of the Plan – Difference between the value of the plan assets and the PBO which represents the net economic position of the plan
** Note: Plan is overfunded (underfunded) when value of plan assets exceeds (is less than) PBO***
Relation between Plan Assets and Funded Status

51. Postretirement Benefits
Two kinds of Postretirement Benefits
Pension benefits -- Employer-promises monetary benefits to employees after retirement, e.g., monthly stipend until death
Other Postretirement Employee Benefits (OPEB) -- Employer-provided non-pension (usually nonmonetary) benefits after retirement, e.g., health care and life insurance

52. Postretirement Benefits
Pension Accounting Requirements
Recognized Status on the Balance Sheet
Recognizes the funded status of the pension plans on the balance sheet.
Pension assets and obligations are netted against each other (as funded status) rather than separately reported both as an asset and a corresponding liability.
Companies do not report the funded status of pension plans as a separate line item on the balance sheet, instead, it is embedded in various assets and liabilities.

53. Postretirement Benefits
Pension Accounting Requirements

54. Postretirement Benefits
Features of OPEB Accounting
(similar to pension accounting)
Other Pension Employee Benefits (“OPEB”) costs are recognized when incurred rather than when actually paid out.
Assets of the OPEB plan are offset against the OPEB obligation, and returns from these assets are offset against OPEB costs.
(3) Actuarial gains and losses, prior service costs, and the excess of actual return over expected return on plan assets are deferred and subsequently amortized.

55. Postretirement Benefits
Analyzing Postretirement Benefits
Five-step procedure for analyzing postretirement benefits:
Determine and reconcile the reported and economic benefit cost and liability (or asset).
Make necessary adjustments to financial statements.
Evaluate actuarial assumptions (discount rate, expected return, growth rate) and their effects on financial statements.
Examine pension risk exposure (arises to the extent to which plan assets have a different risk profile than the pension obligation).
Consider the cash flow implications of postretirement
benefit plans.