Pensions and Other Post-Employment Benefits. Pensions and other
post-employment benefits give rise to non current liabilities reported by many
companies. The question you might be wondering here is what is the link
between pension and liability? The point here is that we are talking about non-
current liabilities. If I am a company and I have lots of employees and I have
promised certain benefits to my employees, that is obligated on me, the
company, and obviously if it is an obligation, I need to record that
obligation. One of the most significant post employment benefits is pension and
the typical pension would be where a company says to its employees that when
you retire then a certain percentage of your income will be paid to you as
pension for the rest of your life or for X number of years, whatever the terms
might be, they will be defined in the contract between the employee and the
company, but these are obligations that the company has and therefore needs to
show it as a liability. We will focus on pension. With pensions you need to
recognize that there are two broad categories, you can either have a defined
contribution plan or a defined benefit plan. In a defined contribution plan, the
company contributes an agreed upon amount to the plan,
so agreed upon essentially is where the defined is coming in. From an accounting
standpoint, this is easy for the company, why? Because whatever the agreed upon
amount is, that is contributed every period and that amount is shown as
expense on the cash flow side that is shown as a operating outflow because
essentially this is a compensation, it's like a..just like salary is a
compensation, a pension contribution or a defined contribution is also considered an
operating cash flow. Sometimes, if the payment is not made in a given period,
it's made in the next period there might be a short term liability but by and
large whatever the contribution is needs to be
shown as an expense for the period. Accounting wise, very simple and
essentially, the risk is transferred to the employee over here because the
company is saying that I'm going to pay this much into your plan and then if the
plan does well that's good for the employee, if the plan does badly it's bad
for the employee, so the company is washing its hands of the risk, and just
as a general point these plans are becoming much more popular worldwide
relative to defined benefit. In a defined benefit plan the company makes promises
of a future benefit. So the company is saying that when you retire we will look
at your salary and give you a certain percentage of that salary, that's just
one example of a future benefit. So the company is promising the benefit and
here we don't know or the company doesn't know what that benefit will be
because we don't know what that final salary will be, we don't know how long
that person will live for after retirement, so you have these people
called actuaries who make lots of assumptions and they come up with
numbers. We don't need to go into the details but simplistically assumptions
are made and based on those assumptions the company calculates obligation so
that is called a pension obligation. It is essentially the present value of the
future payments that the company expects to make, okay that's called a
pension obligation. Now how does a company meet those obligations? What most
companies do is set up a pension fund, this pension fund is also called the
plan assets. Companies put money into this fund and then the pension
liabilities or obligations are paid from this fund. As you might imagine the
accounting for defined benefits is very difficult and from an analyst
perspective when you look at balance sheets and income statements you need to
be able to interpret what companies are doing, and in this
segment we will just very briefly cover the most important points, and as I've
said before, this will be covered in detail at level 2. An important concept
is that of Funded status. As I just said, plan assets--these represent the the fund
that the company creates in order to meet the future obligation. The value of
that fund, let's say, is 100 now that fund might consist of stocks bonds other
investments but it will have a certain value today, that value is the value of
the plan assets. Then you have the defined benefit obligation. This is the
present value of what the company believes all its obligations will be.
Let's say that the present value of those obligations is 110 and obviously
this 110 is based on several assumptions. This is giving you a
negative number, it is saying that the obligations are more than the plan asset.
So what we have here is a net pension liability, why? Because the liability or
the obligation is more than the asset so you have what's called an underfunded
plan or you have a net pension liability. Most companies that have pension plans
are in this situation. If the plan assets are greater than the obligation then you
say you have an overfunded plan or you have a net pension asset. Now this is an
asset or a liability so it is reported on your balance sheet dates. Let's say
you have a pension liability, that is...the liability is 10 at the start of the
period, end of the period the liability goes up. When the liability increases, is
that an expense? Yes, it is. Increase and liability is a expense. Now that expense
or that increase in liability needs to be shown either on the income statement
as a loss or an expense or in OCI. Remember when we were discussing
OCI, one of the components had something to do with pension, now this is a fairly
complicated area which we will discuss in level 2, but when your pension
obligation increases then some part is shown in the income statement, some part
is shown in OCI, and I really don't think you need to know the details right
now, just recognize the high-level picture. The pension expense under IFRS
has three components; employee service costs, net interest expense or income,
and re-measurements. Very briefly, if a company has a pension plan then most of
those pension plans have something to do with how long people work, and people
sort of earn their pension benefits based on their work, how much time they
spent with the company, so the change in the pension amount based on people
working, that is called the employee service cost. The interest expense is a
pension obligation at the start of a period multiplied by a rate, and if you
think about it how is interest expense calculated? It is the liability at the
start of a period multiplied by a rate. If pension obligation is a liability and
you multiply that by a rate you will get a certain expense. And re-measurements
I will skip, you really don't need to know that at this stage. Under US GAAP
you don't have three components, you have five components, so notice that I'm
skipping over a lot of details here because I know that you will have to
worry about them at level 2. Here you just need to know the basics and let's
see if you can do this example. What we have here is a pension
obligation = 100, the plan assets are equal to 90, so do we have a
net asset or a net liability? We have a net liability equal to 10, so under both
US GAAP and IFRS, on the balance sheet we will show a net pension liability of 10,
and then in the footnotes and disclosures there will be lots of detail
about where this 10 comes from. Okay coming close to the end of this reading,
Evaluating Solvency, now all these ratios should look
familiar. What is solvency? It is the ability of a company to meet long-term
obligations that's what we've been talking about over here. Long-term debt,
long-term obligations, long-term liabilities, how do you evaluate whether
a company will be able to meet those obligations? You look at two kinds of
ratios, solvency ratios and coverage ratios, and you've seen these before, debt
to assets, debt to capital, so all these ratios are given here, you've seen them
before, just memorize these ratios and recognize
that high is bad in the sense that a high debt to asset ratio means that you
have a lot of debt relative to your assets and these ratios as we've
discussed before need to be looked at in the context of the industry of that
particular company. And then coverage ratios; interest coverage is EBIT divided by
interest payments. Here you actually would want a high ratio because, so here
high is good, why? Because you want a high operating
income relative to interest payments. Earlier we had seen this expression, EBIT
plus lease payments divided by interest payments plus lease payments, and I sort
of went over it very fast, now this concept should make sense, because you
have studied leases. What is the concept? If you even take
this ratio over here the top line, what what is EBIT? It's your earnings before
interest so you are looking at how much money is a company generating before
making any interest payments and then you have to divide by interest payment
so it is saying how much money is the company making relative to interest
payments. If you think about these payments, these payments and obligation,
just the way interest payments are an obligation, they are, but is the lease
payment included in your operating expense? It is, alright, so what you want
to see is how much money are you making without counting that lease payment?
Without counting the lease payment, you then add back the lease payment to your
operating income and then you divide by our obligation.
What's your obligation? It is the interest payments plus the lease
payments, so conceptually both these ratios are very similar. You use this
ratio when you have a lot of lease payments. All right, that brings us to the
end of this reading. I'll just summarize the main points. We talked about bonds,
with bonds what are the most important points? You need to recognize what to do
when a bond is issued--you can either have a power bond the discount bond or
premium bond. The relationship between the coupon rate and the effective
interest rate is critical. If the coupon rate is high relative to the effective
interest rate then you have a premium bond because what is happening here is
the investor is getting more money relative to the effective interest rate
so he's willing to pay more for the bond, if this is less than, then we'll have a
discount bond. Amortization refers to the process where we bring the value of the
bond down to par value and you need to understand
what's happening with the interest expense and you need to understand how
the coupon payments are being categorized. Then we talked about leases,
you need to understand that there is a lessee perspective and a lessor
perspective. The lessee is the entity that is using the machine, you should
learn the advantages of leasing and this is more from the perspective of
operating leases and then the accounting for operating leases and finance leases.
Understand those tables that I presented. Pensions, I don't think is overly
important rules at level 1, but just know the basics. I think the most
important point is the concept of the funded status or whether a company has
net pension liability or net pension assets. These are shown as a single line
item on the balance sheet, and then the details are given in the footnotes. And
then Solvency, you need to know the ratios. You've seen the ratios here and you've
seen the ratios in earlier readings. Go over the curriculum summary, do the
learning objectives. Just see the learning objectives and make sure that
you can say something sensible about each one of them. Examples, in this
particular reading I think, are fairly difficult. If you have time you can go
through the examples, but if you don't have time then definitely do all the
practice problems in the curriculum they are exam type questions, and then do practice
questions from other sources as well.