1. Pensions
RCJ Chapter 14

2. Key Issues
1. Types of pension plans: defined benefit vs. defined contribution
2. Pension liability: PBO, ABO, VBO
3. Assumptions: discount rate%, salary growth rate%, E(ROA)%, actuarial
4. PENSION assets
5. Primary (ongoing) factors
6. Journal entries
7. Smoothing of transitory gains and losses 12. Corridor amortization
8. Types of transitory gains and losses 13. Pension worksheet
9. Additional factors 14. Footnote disclosures
10. Funded status reconciliation 15. Correction JE
16. OPEB’s
11. Minimum liability
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3. Structure of Pension Plan
firm or employee  pension fund  retiree
Cash Pay benefits
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4. Types of Pension Plans
1. Defined contribution:
employee bears risk, no firm liability
2. Defined benefit:
firm bears risk and has liability (our focus)
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5. Ex. Defined Benefit Plan
 worker’s age = 60
 service = 30 yrs so far
 retire @ 65 (5 more years)
 current salary = $50,000
Pension contract:
X% per year * final salary
(X = # of years of service @ retirement)
Example: 35% x $50,000 = $17,500
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6. Pension Liabilities
Pension liability : discounted PV of expected future cash
payments - like any other non-current liability (effective interest
method).
compare to other non-current liabilities:
r% E(CF)
Bonds known known
Leases known? known
Pensions ? ?
Both discount rate and expected cash flows are subjective
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7. 3 Definitions of Liabilities
 PBO = PV of expected payments, given expected future salaries
 ABO= PV of expected payments, given current salaries
 VBO =PV of vested portion of expected payments, given current
salaries
PBO ≥ ABO ≥ VBO
Which definition is appropriate for which case?
1. valuing a going concern
2. Takeover
3. Firm in bankruptcy
We’ll use PBO, unless otherwise stated.
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8. Key Assumptions
 discount rate = r% What are
 salary growth rate = g% (for PBO) management’s
incentives?
 actuarial (life span, tenure, turnover, etc.)
 EROA% (expected rate of return on pension assets),
see below
Q: Is liability bigger for older or younger workers?
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9. Ex. Defined Benefit Plan, Continued
 Assumptions
 Expected salary growth rate = 5%
 Discount rate = 10%
 Life expectancy = 80 years (15 years in retirement)
 Expected final salary = 50,000 * (1.05)5 = 63,814
 30% * 63,814 = 19,144 = amount he’ll receive per year in
retirement (based on service so far)
 PV of annuity factor, 10%, 15 yrs = 7.606
 19,144 * 7.606 = 145,611 = PV @ retirement
PBO = 145,611/(1.10)5 = 90,413 = PV of annuity now
ABO = (30% * 50,000 * 7.606)/1.105 = 70,841
PBO > ABO due to expected salary growth
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10. Primary (Ongoing) Factors Affecting PBO
PBO
- +
DR CR
pay benefits Interest cost
Service cost
def: interest cost = r% * PBO @ beginning of year
(remember: effective interest method)
[debt accretion, like zero coupon bond]
def: service cost = PV of future benefits earned this year
Ex. E14-1, E14-13
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11. Ex. Defined Benefit Plan, Continued
Interest cost = 90413*.10 = 9041
Service cost = (1% * 63,814 * 7.606)/1.105 = 3014
Q: how does a higher or lower r% affect interest cost?
Q: how does an employee’s age affect his service cost?
E14-1,13
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12. Pension Assets
 Pension assets: FMV of assets (stocks, bonds, etc.)
 Funded status (true, economic position):
Pension assets – PBO
 Overfunded: assets > PBO
 Underfunded: assets < PBO
 Severely underfunded: assets < ABO
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13. Primary (Ongoing) Factors Affecting
Pensions Assets
Assets
+ -
DR CR
Funding (contribution) Pay benefits
(ROA)Return on assets#
# note: this is actual ROA; ROA is shown as +, but could be –
Ex. E14-6, E14-13
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14. Primary Journal Entries
DR CR
service, interest Pension expense PBO
Funding Assets Cash
(contributions)
benefits PBO Assets
ROA Assets(actual Pension Expense
ROA)* (expected ROA= EROA
%*beginning assets)
UNL or UNG
* note: actual ROA is shown as +, but could be –
UNL = unexpected net loss (if actual ROA < expected ROA)
UNG = unexpected net gain (if actual ROA > expected ROA)
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15. Ex. Defined Benefit Plan, Continued
Assume:
 pension assets = 100,000
 E(ROA)% = 10%
 actual ROA = 15,000
DR assets 15,000
CR Pension expense 10,000
CR UNGain 5,000
Q: How does assumed EROA% affect FMV of assets?
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16. Primary Factors Affecting Pension
Expense
Pension Expense
+ -
DR CR
Service E(ROA)
Interest
Q: What is the effect of funding on expense?
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17. Ex. Defined Benefit Plan, Continued
Service 3,014
Interest 9,041
E(ROA) (10,000)
pension expense 2,055
Ex. E14-12 without amortization and unexpected loss
P 14-1, Parts 1-3 in Summary So Far
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18. Smoothing of Transitory Gains and Losses
def: unrecognized = deferred (in footnotes)
def: recognized = amortized (into pension expense on I/S)
 Transitory gains, losses are CR’d (gains) or DR’d (losses)
to unrecognized (footnote) accounts, rather than
recognized as gain or loss on I/S. The unrecognized
balances are amortized onto I/S. This smooths NI and
keeps assets and PBO off of B/S.
Full Exp For E14-13
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19. Smoothing (cont’d): Intuition
 Loss in DR, Gain in CR
DR CR
Loss: Unrecognized loss Asset or liab.
Amort’n: Exp.(recorded) Unrecognized loss
Gain: Asset or liab. Unrecognized gain
Amort’n: Unrecognized gain Exp.(recorded)
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20. Types of Transitory Gains,
Losses
DR CR
asset gain: actual ROA > expected ROA Assets Pension expense
UNG
asset loss: actual ROA < expected ROA Assets Pension expense
UNL
* assets are DR’d (or CR’d) for actual ROA; pension expense is CR’d for expected ROA;
difference is UNG or UNL (see slide #15)
liability loss (due to ∆ assumption r%, g%, etc.) UNL PBO
liability gain (due to ∆ assumption r%, g%, etc.) PBO UNG
note: asset and liability gains and losses are all aggregated into one UNG/L
account
note: liability gains and losses are also called actuarial gains and losses
Q: What happens if EROA% is set too high (higher than true average
ROA%)? 20

21. 2 Types of Liability Gain/Loss
1. Change in assumptions
2. Change in contracts
Intuition: What affects r% and E(CF)’s
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22. Types of Transitory Gains, Losses
(cont’d)
DR CR
Change in pension contract: sweetening UPSC PBO
Change in pension contract: souring PBO UPSC
def: UPSC = unrecognized prior service cost (retroactive benefits)
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23. Ex. Defined Benefit Plan, Continued
1. assume benefits are sweetened to pay 1.1% * final
salary per year (increased by 10%)
increase in PBO = 10% * 90,413 = 9041
DR UPSC 9041
CR PBO 9041
2. assume salary growth rate is increased to 6% (final
salary = 66,912), so PBO = 94,802 and increase in
PBO = 4389 (94,802 – 90,413)
DR UNLoss 4389
CR PBO 4389
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24. Additional Factors Affecting PBO
PBO
DR (+) CR (-)
Pay benefits Interest cost
Primary factors
Service cost
Liability gain Liability loss (∆ assumptions)
Additional
factors Souring Sweetening (∆ contracts)
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25. Additional Factors Affecting Pension
Expense
Expense
DR (+) CR (-)
Interest cost E(ROA)
Primary factors
Service cost
loss
Additional factors Gain amortization
amortization
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26. Additional Factors Affecting Pension Expense
(cont’d)
Loss amortization:
DR Pension expense
CR UPSC or UNL or UTL
Gain amortization:
DR UPSC or UNG or UTA
CR Pension expense
UTA, UTL = unrecognized transition asset, liability =
net position (assets - PBO) @ adoption of SFAS #87
 remember: amortization = recognized into expense
 amortization is generally SL over average remaining service life of
employees
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27. Ex. Defined Benefit Plan, Continued
Amortize UPSC over 5 years: 9041/5 = 1808
DR pension expense 1808
CR UPSC 1808
service 3,014
interest 9,041
E(ROA) (10,000)
UPSC Amort. 1,808
pension expense 3,863
Ex. E14-13 GM disclosure
E 14-12 w/o Loss Paul Zarowin 27

28. Funded Status Reconciliation
Reconcile true vs. recognized position
assets
- PBO
funded status (can be net asset or net liability): ‘true position’
+ UNL (or - UNG)
Unrecognized
+ UPSC Gains/Losses
+ UTL (or - UTA)
recognized (on B/S) position: prepaid pension cost (asset) or
deferred pension cost (liab)
 note: funded status (true economic position) vs. recognized position
 unrecognized losses & liab’s make the recognized position better
than the true position
 unrecognized gains & assets make the recognized position worse
than the true position
Ex. E14-14, 19 Paul Zarowin 28

29. Minimum Liability
 if ABO > assets the pension plan is considered ‘severely
underfunded’ and a liab. ≥ (ABO - assets) must be
recognized.
 if recognized position is asset (prepaid cost) or liab
(accrued cost) < (ABO-assets), additional entry is needed
to bring recognized position to minimum level:
DR Intangible asset*
CR Additional liability
* should be DR to a loss account
 additional liab can be shown separately or aggregated with
accrued pension cost on B/S
Ex. E14-2, E14-5 Paul Zarowin 29

30. Corridor (Minimum) Amortization
 UNL or UNG must be amortized only if it > “corridor”
 corridor = 10% of bigger (PBO, assets) @BOY
 amortization is down to corridor, not zero
 if amort’n is required one year, it might or might not be the next
year, and vice versa
UNG/L
DR CR
*BOY net loss *BOY net gain (* for current year amort’n test)
Current year loss Current year gain
gain amort’n loss amort’n (amort’n only if required)
#EOY net loss #EOY net gain (# for next year’s amort’n test)
Ex. P14-1, sec 1-6 E14-18 30

31. Pension Worksheet - put it all
together - relate to funded status reconciliation
Recognized (on FS) bal. Unrecognized (footnote) balances
Pen. exp Cash pp’d/acc cost Pen Pen UNGL UPSC
Ass Liab
Service cost DR CR
Interest cost DR CR
ROA CR DR plug
Funding (contribution) CR DR
Benefits CR DR
liability loss6 CR DR
Sweetening7 CR DR
Amortization UNL8 DR CR
Amortization of UPSC
DR CR
(from sweetening)9
Summary JE; only
DR CR CR or DR
recognized (on FS) for a liability gain
6. reverse DR and CR JE 8. reverse DR and CR for amort’n of unrecognized gain
7. reverse DR and CR for souring 9. reverse DR and CR for amort’n from souring
Note: recognized asset/liab (prepaid/accrued pension cost) is net of all unrecognized accounts

32. Exercise problems
 E14-3, E14-4, E14-7 E14-17, 20
 P14-2, P14-3
 P14-13
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33. Footnote Disclosures
The pension footnote includes:
1. total pension expense and its components
2. reconciliation of BOY vs EOY PBO and asset
accounts (like t-accounts)
3. funded status reconciliation
4. assumptions (r%, g%, EROA%)
C 14-2,3
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34. Correction JE
(to put assets and liabs on B/S)
 using information in pension footnote, put pension assets and liab
on B/S; replace recognized position with true position
DR CR
pension assets PBO
accrued pension cost or Prepaid pension cost
R/E or R/E
1. put pension assets and PBO on B/S
2. remove accrued or prepaid pension cost from B/S
3. plug: DR or CR R/E = cumulative unrecognized gains/losses (sum
of UNGL, UPSC, UTAL)
note: DR or CR to R/E rather than current year gain or loss
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35. Other Post-Employment Benefits (OPEB’s)
Same accounting as pensions, with minor differences
1. ABO instead of PBO (OPEB’s not tied to salary)
2. significance of (TL) transition liability (no incentive to fund, so
ABO > assets) firms can: amortize TL over <= 20 years
DR OPEB expense
CR Accrued OPEB cost
or take loss as change in accounting principle (below the line):
DR loss due to change in acct principle
CR Accrued OPEB cost
? most firms chose latter: why?
3. service cost is accrued (earned) over short (vesting) period,
since benefits don’t increase with tenure
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