1. Financial Statement Analysis 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. 3-2 Analyzing Financing Activities 3 CHAPTER Pensions

3. 3-3 Pension Overview

4. 3-4 Postretirement Benefits 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. Two kinds of Retirement Plans

5. 3-5 Post Retirement Benefits Who are the three “Parties” to a pension plan?

6. 3-6 Postretirement Benefits Elements of the Pension Process Employer Investment and returns Benefits (Disbursements) Contributions Pension Fund Employee

7. 3-7 Post Retirement Benefits How does a company determine the annual cost of a defined contribution plan compared to a defined benefit plan?

8. 3-8 Post Retirement Benefits How does a company determine the annual cost of a defined contribution pension plan?

9. 3-9 Post Retirement Benefits Most common type of defined contribution pension plan is a 401-K.

10. 3-10 Post Retirement Benefits How does a company determine the annual cost of a defined benefit pension plan?

11. 3-11 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. 3-12 Postretirement Benefits Illustration of Pension Accumulation and Disbursement for a Defined Benefits Plan 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 payments into the Fund required to accumulate to $134,200 in 15 years with a discount rate of 8%per annum 10 years Annual benefits of $20,000 paid to employee for 10 years PostretirementPreretirementRetirement Benefits = $20,000 per annum Contributions = $4,942 per annum 15 years Step 1

13. 3-13 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. 3-14 Determining Future Annual Benefit Cost Who can assist with determining and calculating the needed information?

15. 3-15 Determining Future Annual Benefit Cost Who can assist with determining and calculating the needed information? Answer: An Actuary

16. 3-16 Determining Future Annual Benefit Cost Step 2 How much needs to be “accrued” at the time of an employee’s retirement?

17. 3-17 Postretirement Benefits Illustration of Pension Accumulation and Disbursement for a Defined Benefits Plan 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 payments into the Fund required to accumulate to $134,200 in 15 years with a discount rate of 8%per annum 10 years Annual benefits of $20,000 paid to employee for 10 years PostretirementPreretirementRetirement Benefits = $20,000 per annum Contributions = $4,942 per annum 15 years Step 2

18. 3-18 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. 3-19 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. 3-20 Determining Future Annual Benefit Cost Step 3 - continued How do we determine the number of years in which to accrue the expense?

21. 3-21 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. 3-22 Postretirement Benefits Illustration of Pension Accumulation and Disbursement for a Defined Benefits Plan 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 payments into the Fund required to accumulate to $134,200 in 15 years with a discount rate of 8%per annum 10 years Annual benefits of $20,000 paid to employee for 10 years PostretirementPreretirementRetirement Benefits = $20,000 per annum Contributions = $4,942 per annum 15 years Step 3

23. 3-23 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. 3-24 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. 3-25 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. 3-26 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. Postretirement Benefits Pension Accounting Requirements

27. 3-27 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. 3-28 Pension Plan Example Why is interest cost a portion of pension expense? Why is return on plan assets considered a negative expense?

29. 3-29 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. 3-30 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. 3-31 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 ROA (50,000) Total expense $100,000

32. 3-32 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. 3-33 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. 3-34 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. 3-35 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. 3-36 Impact on Plan Expense Additional pension benefits Increase liability and future expense Increase in life expectancy Increase liability and future expense Increase in expected employee turnover Decrease liability and future expense

37. 3-37 Expected vs Actual Return on Plan Assets How would you account for the following change? Plan assets $1,000,000 Expected return 8% Expected earnings $80,000 (Reduction of pension expense) Actual return 3% Actual earnings $30,000 Average life of plan assets10 years

38. 3-38 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. 3-39 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. 3-40 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. 3-41 Postretirement Benefits 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 Economic Pension Cost

42. 3-42 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 (Average for the last twenty years)

43. 3-43 Practice Exercise

44. 3-44 Practice Exercise

45. 3-45 Practice Exercise

46. 3-46 Practice Exercise

47. 3-47 Practice Exercise

48. 3-48 Expected Return on Assets What is a reasonable rate of return on assets with the following mix? Short term bonds 45% Long term bonds 25% Equities30%

49. 3-49 Funding Considerations Minimum requirements (ERISA) Employee retirement Income Security Act No current deductions for over funded plans

50. 3-50 Postretirement Benefits 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*** Alternative Definitions of Pension Obligation Relation between Plan Assets and Funded Status

51. 3-51 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 Two kinds of Postretirement Benefits

52. 3-52 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. 3-53 Postretirement Benefits Pension Accounting Requirements

54. 3-54 Postretirement Benefits (similar to pension accounting) (1)Other Pension Employee Benefits (“OPEB”) costs are recognized when incurred rather than when actually paid out. (2)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. Features of OPEB Accounting

55. 3-55 Analyzing Postretirement Benefits Five-step procedure for analyzing postretirement benefits: (1)Determine and reconcile the reported and economic benefit cost and liability (or asset). (2)Make necessary adjustments to financial statements. (3)Evaluate actuarial assumptions (discount rate, expected return, growth rate) and their effects on financial statements. (4)Examine pension risk exposure (arises to the extent to which plan assets have a different risk profile than the pension obligation). (5)Consider the cash flow implications of postretirement benefit plans. Postretirement Benefits