3. Right to receive benefits NOT contingent upon continued employment. CONTRIBUTORY: Employees pay part of funding. NONCONTRIBUTORY: Employees DON’T pay.

4. To record PENSION EXPENSE is simple: Pension expense……….. $XX.XX Cash……………..$XX.XX Liability for underpayments…. $XX.XX Prepaid asset for over payments……………….$XX.XX

5. Pension expense is MUCH MORE COMPLEX And not all that popular in private industry anymore: 18% of private sector workers have Defined Benefit Plan while 80% of government workers have them (USA Today February 21, 2007).

6. Scenario: Lone Pine Corporation is a SOFTWARE development Co. in Central Oregon. We focus on ONE employee; Nicole Whitney. Pension Plan:Noncontributory defined benefit plan. Inception date: January 1, 2008. Co. start date: January 1, 2008. Starting salary: $45,000/year. Age on 1/1/08:40 Expected retirement date: December 31, 2032 (after 25 years of service). Expected salary at retirement:$150,000/yr PENSION BENEFIT FORMULA: Annual retirement payment = 2%(1 year of service)(final salary) Lone Pine vests 10% of benefits after the first year, 15% after the second year, then conforms to present ERISA schedule (20% of total benefits vested after the third year, and so forth. Settlement/Discount rate and expected long-term rate of return on pension plan assets (expected equals actual return) is 10%.

7. Nicole’s expected retirement period is 10 years; payments made at end of each calendar year during retirement. Contributions are made to the pension plan (funding) at the END of the service years. First contribution- 12/31/08 Last contribution- 12/31/32 Retirement benefit payments are made at the END of the retirement years: First payment 12/31/33 Last payment 12/31/42

8. 1.SERVICE COST. 2.INTEREST COST. 3.ACTUAL RETURN ON PLAN ASSETS. 4.AMORTIZATION OF PRIOR SERVICE COST. 5.GAIN OR LOSS RECOGNIZED.

9. SERVICE COST. -Is the actuarial present value of the pension benefits attributed to employee service based on the pension benefit formula. In this example the formula is: Benefit payment = 2%(1 year of service)(Final salary) 2%(1)($150,000)$3,000 = This is the actual amount of money that Nicole will earn in each year of retirement based on this ONE year she just worked. Graphically it looks like this:

10. 1/1/08 Start 12/31/08 Time Zero 12/31/33 First retirement check 12/31/42 Last retirement check Service Cost is the PRESENT VALUE of this $3,000 annuity stream at time zero. 12/31/32 makes it an ORDINARY annuity $3,000(6.14457) T 6-4, 10%, 10 per = $18,433.71 $18,433.71 x.10153 = $1,872 T 6-2, 10%, 24 years

11. All those $3,000 annuity payments shrink down and become $1,872 in total as a charge against 2008 income. If this was all we had to worry about for 2008 the pension expense entry would look like this if $1500 were contributed: Pension expense………. $1,872 Cash………………………$1,500 Pension Asset/ Liability….. $372 Is a LIABILITY which represents the amount the pension fund is under-funded.

12. If instead, the company had decided to pay in $1900 to fund the pension in 08 then the entry would have looked like this: Pension expense………. $1,872 Pension Asset/Liability $ 28 Cash………………………$1,900 Is an ASSET.

13. In 2008 (first year) this is the ONLY piece of PENSION EXPENSE. But a company would also need to be compiling lots of information for the footnotes and for comprehensive income regarding the liability which is building….

14. Is the estimate of pension obligation based on EXPECTED FUTURE values. In our example, the PBO so far would be the PV of the service cost we just calculated or $1,872. Lone would need to currently invest $1872 in order to be able to pay out $3,000 a year when its needed in the retirement years.

15. Is the estimate of pension obligation based on CURRENT salaries. Going back to the formula:.02 (1 yr) ($45,000 current salary) = $900 Then we’d have to find the PV of a $900 annuity stream which would be $900(6.14457)(.10153) = $561

16. Is the estimate of pension obligation based on VESTED salaries. Going back to the formula:.02 (1 yr) ($45,000 current salary)(.10 vested) = $90 Then we’d have to find the PV of a $90 annuity stream which would be $90(6.14457)(.10153) = $56

18. Represent what the firm does with money contributed to the pension plan. It is probably investments like stocks, bonds, etc.. The plan assets ARE NOT recorded on the books of the firm. They are instead recorded on the books of the TRUSTEE FIRM. The employing firm shows this information in their footnotes. We usually need to obtain the FMV of the plan assets at least once a year.

19. Remember Pension Expense is made up of multiple components: 1.Service Cost 2.Interest cost 3.Return on Plan Assets 4.Amortization of Prior Service Cost 5.Gain or loss component. So as we go into year two we’d have to calculate ANOTHER service cost but the way things work we’d first be figuring out the interest cost….

20. Represents the cost of not paying the pension. Even tho its not due yet, you still have to calculate an interest charge. Interest cost = Beginning PBO x Settlement Rate $1,872 x.10$187 = This is the interest charge for the SECOND year of operation. In the first year the only charge was service cost of $1,872.

21. Now for the second year, so far we know the Pension Expense has an interest cost of $187. But in the second year we can also analyze how the Return on the Plan Assets impacts the pension expense. 1.Service Cost 2.Interest cost $187 3.Return on Plan Assets 4.Amortization of Prior Service Cost 5.Gain or loss component.

22. If there is a positive return on plan assets, that REDUCES the pension expense. Makes sense; if the investment for the pension is making money, then that should reduce the cost of the pension expense. Suppose in 2009 the actual return on plan assets = $150.

23. You can find the actual return by using this formula: Beginning fund balance…………………… $XX.XX + Actual return on plan assets during period.. $XX.XX + Employer contributions……………………. $XX.XX - Benefit payments…………………………… $XX.XX ----------------------------------------------------------------------- Ending fund balance……………………….. $XX.XX

24. Now pension expense looks like this: 1.Service Cost 2.Interest cost $187 3.Return on Plan Assets ($150) 4.Amortization of Prior Service Cost 5.Gain or loss component. Now its time to figure out 2009 Service Cost.

25. 1/1/08 Start 12/31/08 Old Time Zero 12/31/33 First retirement check 12/31/42 Last retirement check Service cost for 2009 is the PV of another 10 year annuity stream earned in 09 to be given in retirement. So basically it’s the same as last time only when the PV of the lump sum is calculated its for one year less than before. 12/31/32 makes it an ORDINARY annuity $3,000(6.14457) T 6-4, 10%, 10 per = $18,433.71 $18,433.71 x.11168 = $2,059 T 6-2, 10%, 23 not 24 years New Time Zero 12/31/09

26. Now pension expense looks like this: 1.Service Cost $2,059 2.Interest cost $187 3.Return on Plan Assets ($150) ----------------------------------------------- Pension expense $2, 096 4.Amortization of Prior Service Cost 5.Gain or loss component. If in 2009, $2,000 was funded…. Pension expense…….. $2,096 Pension Asset/Liability…….. $96 Cash…………….…………$2,000

28. Pension Worksheets bring together reports of the ACTUARY and the TRUSTEE. FORMAL RECORDS: Are actually in the ledger and appear on the left-hand side of the work- sheet. INFORMAL RECORDS: Do not appear on the balance sheet and are on the right-hand side of the worksheet.

29. Formal recordsInformal records Items Dr Pension Expense Cr Pension Asset/ Liability Cash Projected Benefit Obligation Plan Assets

30. Items Dr Pension Expense Cr Pension Asset/Liab Cash PBOPlan Assets Beg Bal at 1/1/09 Pension Expense……. $1,872 Pension Asset/Liability…….…. $372 Cash………………………….. $1,500 Closed out $372$1,872$1,500 RECONCILIATION: PBO $1,872 - Plan Assets $1,500 ---------------------- Pension Asset Liab $372

31. Items Dr Pension Expense Cr Ppd/Accd Pension Cost Cr Cash PBOPlan Assets Beg Bal at 1/1/09$372$1,872$1,500 Service Cost $+2,059 Interest Cost $+187 Actual Return ($150)+150 Contributions$+2,000 $2,096$2,000$96$4,118$3,650 Pension expense…. $2,096 Cash……………..…… $2,000 Pension Asset/Liability $96 Journal Entry 12/31/09

32. Items Dr Pension Expense Cr Ppd/Accd Pension Cost Cr Cash PBOPlan Assets Beg Bal at 1/1/09$372$1,872$1,500 Service Cost $+2,059 Interest Cost $+187 Actual Return ($150)+150 Contributions$+2,000 $2,096$2,000$96$4,118$3,650 RECONCILIATION: PBO $4,118 - Plan Assets $3,650 ---------------------- Pension Asset/ Liab $468 Journal Entry 12/31/09 Balance 12/31/09 $468

33. Now we can deal with the 4th component of pensions: 1.Service Cost $2,059 2.Interest cost $187 3.Return on Plan Assets ($150) 4. Amortization of Prior Service Cost 5.Gain or loss component.

34. Amortization of Prior Service Cost Comes from granting pension benefits for service rendered BEFORE the pension plan began or from plan amendments. Its creation results in an INCREASE IN PBO Assume on 1/1/09 Lone Pine Co. AMENDS its plan to award Nicole an additional annual $500 retirement benefit for service rendered in 2008. At this time Nicole has 24 years remaining and is expected to draw 10 retirement payments.

35. 1/1/08 Start 1/1/09 Time Zero 12/31/33 First retirement check 12/31/42 Last retirement check 12/31/32 makes it an ORDINARY annuity $500(6.14457) T 6-4, 10%, 10 per = $3,072 $3,072 x.10153 = $312 T 6-2, 10%, 24 years Putting this into the worksheet would look like as follows:

36. Items Dr Pension Expense Cr Pension Asset/Liab Cr Cash PBO Plan Assets Beg Bal at 1/1/09$372 $1,872$1,500 Service Cost $+2,059 Interest Cost $+187 Actual Return ($150) +150 Contributions$+2,000 $2,096 $2,000$96$4,118$3,650 $+312 Unamortized PSC OCI PSC Journal Entry 12/31/09

37. Items Dr Pension Expense Cr Pension Asset/Liab Cr Cash PBO Plan Assets Beg Bal at 1/1/09$372 $1,872$1,500 Service Cost $+2,059 Interest Cost $+187 Actual Return ($150) +150 Contributions$+2,000 $2,096 $2,000$96$4,118$3,650 $+312 Unamortized PSC OCI PSC Journal Entry 12/31/09 It is a worksheet entry to record its creation.

38. Items Dr Pension Expense Cr Pension Asset/Liab Cr Cash PBO Plan Assets Beg Bal at 1/1/09$372 $1,872$1,500 Service Cost $+2,059 Interest Cost $+187 Actual Return ($150) +150 Contributions$+2,000 $2,096 $2,000$96$4,118$3,650 $+312 Unamortized PSC OCI PSC Journal Entry 12/31/09 $+312 Then during 2009 part of the PSC would need to be amortized. Say 1/10 PSC Amortz +31-31 $2,127 $281

39. Items Dr Pension Expense Cr Pension Asset/Liab Cr Cash PBO Plan Assets Beg Bal at 1/1/09$372 $1,872$1,500 Service Cost $+2,059 Interest Cost $+187 Actual Return ($150) +150 Contributions$+2,000 $2,096 $2,000$96$4,118$3,650 $+312 Unamortized PSC OCI PSC Journal Entry 12/31/09 $+312 PSC Amortz +31-31 $2,127 $281 Pension expense…. $2,127 OCI (PSC)………... 281 Cash……………….…… $2,000 Pension Asset/Liability… $408 AOCI 1/1/09 $0 Bal 12/31/09 $281 $408 $4,430 RECONCILIATION: PBO $4,430 - Plan Assets $3,650 ---------------------- Pension Asset/ Liab $780 $780

40. Is made up of TWO PARTS. Also called ASSET GAINS/LOSSES

41. There are (2) kinds of OCI (G/L) pension gains/losses: 1.LIABILITY GAINS/LOSSES Actual PBO does not equal Actuary PBO 2.UNEXPECTED GAINS/LOSSES Actual Return on Plan Assets does not equal Expected Return on Plan Assets

42. 1.LIABILITY GAINS/LOSSES Actual PBO does not equal Actuary PBO 2.UNEXPECTED GAINS/LOSSES Actual Return on Plan Assets does not equal Expected Return on Plan Assets These two together form ONE CLASSIFICATION of pension expense known as OCI (G/L) + OTHER COMPREHENSIVE INCOME GAINS/LOSSES

43. They are put in comprehensive income because they are not charged to Pension Expense right away. Instead they are stored and amortized over a period of years (if ever). If they ever do get recognized they have to be bigger than something known as the CORRIDOR. That’s because the FASB is trying to cut the volatility of such increases/decreases.

44. Going back to our example, remember that on 12/31/09 our PBO had grown to $4,118 (rounded) (before considering the ‘what if’ PSC change). Suppose that on 1/1/10 the discount rate is changed from 10% to 8% resulting in an INCREASE in the PBO to $6,857. Thus: We thought our obligation was $4,118 But its actually now…………… 6,857 LIABILITY LOSS………….. $2,739 Assume no unexpected gain occurs (ARPA = ERPA) THUS this liability is the total OCI (G/L).

45. THE FIRST RULE IS, THAT THIS OCI (G/L) MUST SIT FOR AN ENTIRE YEAR BEFORE IT CAN EVEN BE CONSIDERED AS A POSSIBLE PART OF PENSION EXPENSE. It would get logged into the pension worksheet as follows: Little OCI loss waiting a year

46. Items Dr Pension Expense Cr Pension Asset/Liab Cr Cash PBO Plan Assets Beg Bal at 1/1/09$372 $1,872$1,500 Service Cost $+2,059 Interest Cost $+187 Actual Return ($150) +150 Contributions$+2,000 $2,096 $2,000$96$4,118$3,650 OCI G(/L) Journal Entry 12/31/09 Liab increase+$2,739 ($2,739)

47. At the end of the 2009, NONE of that liability loss (OCI (G/L) would be eligible to go into pension expense. THE BALANCE MUST EXIST IN OCI (G/L) AT THE START OF THE YEAR IN ORDER TO BE CONSIDERED ELIGIBLE.

48. Is the BARRIER that keeps unexpected gains/losses from being recognized EVEN AFTER they’ve waited for a whole year. THE CORRIDOR EQUALS THE GREATER OF: 10% x Beginning value of PBO OR 10% x Beginning Market Related Value of Plan Assets

49. Thus $2,000 corridor > $1,800 OCI loss and NONE is recognized for current year. Suppose at the BEGINNING of a year there existed an $1,800 OCI (L). Also beginning PBO was $20,000 and beginning MRVPA was $15,000. THE CORRIDOR EQUALS THE GREATER OF: 10% x $20,000 = 2,000 OR 10% x $15,000 = $1,500

50. Suppose instead that beginning OCI loss was $100,000. Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000. THE CORRIDOR EQUALS THE GREATER OF: 10% x $20,000 = 2,000 OR 10% x $15,000 = $1,500 $2000 is still the corridor Thus $2,000 corridor < $100,000 OCI loss so $98,000 is ELIGIBLE for amortization in current year. However, it may be spread out for years based on service yrs (e.g., $98,000/20 = $4,900 is added to pension expense.

51. Suppose instead that beginning OCI loss was $100,000. Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000. THE CORRIDOR EQUALS THE GREATER OF: 10% x $20,000 = 2,000 OR 10% x $15,000 = $1,500 $2000 is still the corridor Thus $2,000 corridor < $100,000 OCI loss so $98,000 is ELIGIBLE for amortization in current year. However, it may be spread out for years based on service yrs (e.g., $98,000/20 = $4,900 is added to pension expense.

52. Suppose instead that beginning OCI loss was $100,000. Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000. THE CORRIDOR EQUALS THE GREATER OF: 10% x $20,000 = 2,000 OR 10% x $15,000 = $1,500 $2000 is still the corridor Thus $2,000 corridor < $100,000 OCI loss so $98,000 is ELIGIBLE for amortization in current year. However, it may be spread out for years based on service yrs (e.g., $98,000/20 = $4,900 is added to pension expense. $4900

53. Suppose instead that beginning unrecognized loss was $100,000. Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000. THE CORRIDOR EQUALS THE GREATER OF: 10% x $20,000 = 2,000 OR 10% x $15,000 = $1,500 $2000 is still the corridor Thus $2,000 corridor < $100,000 unrecognized loss so $98,000 is ELIGIBLE for amortization in current year. However, it may be spread out for years based on service yrs (e.g., $98,000/20 = $4,900 is added to pension expense. sits and waits for another year This much gets through into pension expense! $4900

54. Items Dr Pension Expense Cr Pension Asset/Liab Cr Cash PBO Plan Assets Beg Bal at 1/1/09$372 $1,872$1,500 Service Cost $+2,059 Interest Cost $+187 Actual Return ($150) +150 Contributions$+2,000 $2,096 $2,000$96$4,118$3,650 OCI G/(L) Journal Entry 12/31/09 OCI (L) amtz +4,900 (this would reduce the existing OCI (L) of $100K (just made up) +$4,900 It would look like this in the worksheet.

55. The rest of him forms back together, he’s JUST FINE, and he gets THROWN BACK OVER THE CORRIDOR TO WAIT ANOTHER!

56. Remember tho, pension expense is made up of TWO COMPONENTS:

57. Is the second component of pension expense each year. But unexpected gains/losses IS ALSO one of the two pieces of OCI gains/losses! Doesn’t it seem that if we count it here again, we are double counting???? We aren’t.

58. Adjusting for unexpected gains/losses as a separate component of pension expense is another smoothing technique. When the FASB allows the ACTUAL RETURN on plan assets to be subtracted from pension expense, what it “really” wants to allow to be subtracted is EXPECTED RETURN on plan assets. Thus, adjusting for “unexpected G/L” results in the expected return on plan assets being subtracted from pension expense instead of actual returns.

59. Suppose in a given year a firm had the following components of pension expense: Service Cost……………...…. $20 + Interest expense………….. 10 - Actual Return on P.A……. (10) --------------------------------------------- Pension Expense is…………. $20 But the FASB actually wants us to subtract only the expected return on P.A. (in case there is something volatile that raised/ lowered the actual return in a given year).

60. Thus we have to find out how much EXPECTED RETURN on P.A. is: Plan assets value……………. $100 x expected ROR…………… 8% ---------------------------------------------- Expected return on P.A. $8

61. Now, we can rewrite the pension expense calculation using “expected return on P.A.” instead. Service Cost……………...…. $20 + Interest expense………….. 10 - Expected Return on P.A……. (8) --------------------------------------------- Pension Expense is…………. $22 Remember the pension expense with actual return of $10 subtracted is $20. We need to make it come out to $22.

62. Actual return on plan assets ……………… $10 - Expected return on plan assets………….. $8 Unexpected gain on plan assets…………… $2

63. Pension expense as it would really appear: Service Cost……………...…. $20 + Interest expense………….. 10 - Actual return on P.A. …… (10) + Unexpected Gain………… 2 --------------------------------------------- Pension Expense is…………. $22 The unexpected gain DID NOT reduce the cost of the pension expense. All it did was result in only $8 being subtracted from the cost (expected return) instead of the actual return of $10.

64. Items Dr Pension Expense Cr Pension Asset/Liab Cr Cash PBO Plan Assets Beg Bal at 1/1/09$372 $1,872$1,500 Service Cost $+2,059 Interest Cost $+187 Actual Return ($150) +150 Contributions$+2,000 $2,096 $2,000$96$4,118$3,650 OCI G(/L) Journal Entry 12/31/09 Liab increase+$2,739 ($2,739) Now this +2 unexpected gain and the $2,739 liability loss will go together to become a $2,737 OCI loss that will wait until next year to see if it can clear the corridor. unexpected gain +2 2,737