Thursday, January 21, 2010

Pension Accounting

Bonjour! Dear Friend

Prior to initiating the discussion on the subject matter for the day, I want to make some confessions. Pension Accounting was a thorny topic for me and it took me some time to imbibe it. Whilst I am going to write about it, makes me feel perturbed, yet I want to share my learning with you. At work, a project director taught me a mantra once “keep things simple, keep things stupid” and they are easy to manage. I tried applying the same mantra here and it least I was able to answer the multiple choice questions expected on the exam. Knowing that this was not a very heavily tested area, I took some risk and kept my fingers crossed of not running over a simulation on the D-day! I was glad, I could sail through a few multiple choices slickly on the test.

Lets begin with looking at the applicable authoritative pronouncements. The new Codification Topic 715 covers all of the following FASB statements under its various subtopics:-

1)FAS 87 and FAS 88, Employer's Accounting for Pensions,

2)FAS 132R, Employers Disclosures about Pensions and Other Post  Retirement Benefits,

3)FAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans amending  FAS 87 and FAS 88 and

4)FAS 106, Employers' Accounting for Post Retirement Benefits other than Pension.

Defined Benefit Pension Plan (FAS 87) is crucial from the exam perspective. It is a plan that defines an amount an employer commits to pay to its employee, called pension benefit, for life beginning at retirement. It is a function of age, number of years of service and compensation. The objective is:-
a) to provide a measure of pension expense reflecting the terms of underlying plan and
b) recognize the pension expense of an employee over his/her approximate service period.

Knowing the Pension Expense components or Net Periodic Pension Cost 
Net Periodic Pension Cost is the amount recognized in employer's financial statement as the cost of pension plan for the period. Please ensure to take a look at the key terms laid out in FAS 87 for a better understanding.

1)Service Cost (cost - addition to pension expense) - It is the discounted PV of benefits earned by an employee during the current period.

2)Interest Cost (cost - an addition to pension expense) - Causes an increase in Projected Benefit Obligation (PBO) due to passage of time. It is calculated as interest rate * beginning PBO, where interest rate is the assumed discount rate at which the pension benefit could be effectively settled.

3)Actual Return on Plan Assets (return - decreases the pension expense) - It is calculated as FV of plan assets at the end less FV of plan assets in the beginning plus Benefits paid during the year less contributions made during the year.

4)Prior Service Cost amortization - It is the cost of retroactive benefits granted in a plan amendment. Retroactively increasing benefits increases the PBO and prior service cost at the date of amendment and vice-versa. The increased or decreased cost is amortized as a component of net periodic pension cost. Amortization can be done on Straight Line basis that amortizes cost over the average remaining service life of the active employee.

5)Actuarial gains/losses - It occurs due to changes in actuarial assumptions. Gains decrease and losses increase the penion cost. There are 2 components of gains/losses - a) Current period difference being the difference between actual and expected return (expected rate of return on plan assets * market related value of plan assets) and b) Amortization of the unrecognized gain/loss for previous periods.

6)Amortization of Transition Asset (decrease) or Liability (increase) to penion expense, a FAS 87 adjustment. This indicates the funded status of the plan when FAS 87 was adopted. The employer records the amortization over average remaining service of plan employees or over 15 year year period, if the service period is below 15 years.
Note - Under FAS 106, the amortization period is 20 years instead of 15 years.

I have tried to exemplify the expense elements in the file linked below.

Post Retirement Benefits other than pension (FAS 106) is very much similar to FAS 87 except that it talks about plan for fringe benefits to retired employees. They both allocate benefit costs based on years-of-service. Since the expense elements are same as explained above, I would now like to talk about FAS 158.

Recognition of Liability or asset - FAS 158 amended FAS 87 and FAS 106 requiring companies to report their plans’ funded status as either an asset or a liability on their balance sheets. This has been well explained in an article below by Kenneth W. Shaw.

There is another article on FAS 158 explaining how FAS 87 and 106 have been amended and gives a bird's eye view in a tabular form on the pension expense elements and the related journal entries. I highly suggest you to go through Figure 1 and 2 in it.

With this, I conclude the topic on Pension Accounting. Speaking candidly, this topic was hard for me to write on and is still giving me butterflies.  I sincerely hope that I was able to justify the topic. Would love to see your comments on this one for sure!


Monday, January 11, 2010

Accounting for Investments - Equity and Cost Method

Hello and Welcome Dear Reader

Before I begin with my topic of the day, I wanted to share an interesting article on Investing in Gold. With sudden rise in price of Gold, it seems, everyone's getting more passionate about buying yellow metal. Then I landed on this article in Money magazine " Coming down with Gold fever" and I had to ask myself...Is it another bull run? The truth is Gold prices may rise further but this is not the right time to invest in it. The article stated that it is a myth to consider precious metal offering better protection than stock or bonds against inflation. So, what is an investor's best bet? Invest prudently at different points in time for better returns as timing to buy can never be perfect and definitely investing in Gold is a good way to diversify one's portfolio.

Now coming back to today’s subject for dialogue “Accounting for Investments-Equity Method” laid out in Codification Topic 323 (APB Opinion No 18). This method is applicable if an investment enables the investor/parent to influence the operating or financial decisions of the investee/subsidiary. In other words, the parent company exercises significant influence over the subsidiary and holds 20% or more of the voting stock in it. Furthermore, the equity method of accounting meets the objectives of accrual accounting than does the cost method. The cost method is generally followed for investments in noncontrolled corporations and unconsolidated subsidiaries.

It is important to understand the meaning of "significant influence".  It is indicated by many factors, some of them being:-
- Level of Parent Co's representation in the Board of Directors;
- Parent's ability to make policy decisions for the subsidiary; or
- Parent being the single largest shareholder of the subsidiary.

Upon acquisition, the initial investment is recorded at cost and subsequent to acquisition, the Investment and Investment Income account are adjusted periodically by recognizing the share of investee's earnings. I have explained this in more detail by charting a T account of  "Investment Account". Refer to the link below to view the file.

Accounting for Investments - Cost Method ( Codification 325 formerly referred as APB 18) - This method is applicable when the investor is not able to exercise significant influence over the investee and generally is evidenced by lack of ability to take policy decisions, temporary investment, holds non-voting preferred stock or ownership in voting stock is less than 20%.

Upon acquisition, the investment is recorded at Cost. Unlike Equity Method, the investment account under this method is not adjusted for investor's share of investee's income. Dividend is recorded as income and an adjustment is made for liquidating dividends (i.e dividends distributed by the investee exceed the investor's share of earnings since acquisition are treated as return of capital and recorded as reduction of the investment account).

Example: P Co acquired 20% stock of S Co on Jan 1, Year 1 and S Co's net income for year 1 was $10,000. During the year P Co received dividend of $2,300.
Liquidating dividends = $2,300 - (20% of 10,000) = $300
Journal entry: Dr Cash $2,300
                     Cr Dividend Income $2,000
                     Cr Investment in S Co $300

Now, keeping the facts of the case same, try out the entries under the equity method and compare the end result. You will notice that under both the methods Investment in S Co is reduced by the amount of liquidating dividend.

To summarize Investments are accounted for by one of three methods — the cost method (Codification Topic 325/APB 18), the fair value method (Codification Topic 320/FAS 115) of which I talked in my last blog post , and the equity method (addressed in Topic 323/APB 18).

Focus on how investment account and investment income account get affected by various transactions under Equity method. Remember, investment and investment Income accounts are always reciprocal to each other except for when the dividend is received by the Investor.

With this, I wind up the topic related to Investments. I have tried to wrap the significant areas related thereto and and earnestly wish that you find it useful.

Warm Regards.......


Monday, January 4, 2010


"Every year gives us another chance, chance to change, to hope and wish for the better. That betterment will surely come. Wishing You all a Very Energetic, Healthy n Fulfilling New Year!

Since, I have fairly talked about Bonds, I would like to shift to "Investments" which is a closely related topic. It is a pretty interesting area, frequently used and easy to absorb.

The Authoritative Pronouncement on Investments, Codification 320 (formerly known as FASB Statement 115) discusses accounting treatment for following Investment types:-

a. Held-to-Maturity Securities (HTM) comprising only Debt securities with the management's ability and intent to hold until maturity. These are carried at amortized cost i.e acquisition cost is adjusted for amortization of premium or discount. Unrealized holding loss is not reported unless the decline in FV  is permanent.

b. Trading Securities comprising of both debt and equity securities held with the purpose of selling in the short run. These are carried at Fair Value and unrealized holding gain/loss is reported on the income statement.

c. Available-for-Sale Securities (AFS) also includes both debt and equity securities which are not actively traded but not necessarily held to maturity. These are also carried at fair value and unless the decline in FV is permanent the unrealized holding gain/loss is reported under other comprehensive income (OCI).

Note:-In case of equity securities this codification is applicable only if significant influence does not exist (i.e. investment in equity securties is less than 20%).

On the Statement of Cash Flows both HTM and AFS securities are classified as cash flow from investing activity. Trading securities are, however, classified as cash flow from operating actitvity.

In the Balance SheetHTM and AFS securities may be classified as current or non-current where as Trading securities are short-term investments.

Decline in FV
If there is a permanent decline in Fair Value of HTM and AFS securities, investment is written down to fair value, thus, becoming a new cost basis and unrealized loss is taken to earnings.

Sale of securities
Premature sale of HTM securities is considered as a sale at maturity in either of two cases:-
1. The sale occurs so close to maturity that interest rate risk is virtually eliminated; or
2. Sale occurs after 85% of principal is recovered.

Realized gain/loss on sale of HTM securities is recognized in accordance with its amortized cost method (either staright line or effective interest).

When AFS securities are sold, the proportionate amount of unrealized gain/loss in OCI is reclassified and becomes part of realized gain/loss. The realized gain/loss on sale is then the difference between original cost and the selling price.

Since unrealized gain/loss on Trading securities is included in earnings in the period they occur, the realized gain/loss on sale of such securities is the amount not already recognized as unrealized.

Transfer of Securities between Categories
When the securities are transferred between the categories i.e from HTM to AFS or Trading or vice versa, such transfers are recorded at FV with adjustment to unrealized gain/loss and recognized gain/loss. This is summarized in the chart which can be viewed by following the link below.

In the next post I will continue with this topic and talk about investment in equity securities when siginificant influence does exist.

Thank you and Good bye