CFA CFA Level 2 Why do we need to re-classify periodic pensions in P&L (Income Statement)

Why do we need to re-classify periodic pensions in P&L (Income Statement)

  • This topic has 5 replies, 3 voices, and was last updated Oct-18 by googs1484.
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      A bit puzzled by this part of the study. Can someone explain further on this? Investopedia seems to be pretty silent about Defined Benefits.

      Also, I thought under IFRS, Net Interest expense’s formula is NIE = Net Pension Liability (Asset) x discount rate or NIE = (Pension Obligation x r) – (Fair value of Plan Asset x r)?

      Thank you in advance!

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      Thanks @googs1484

      What I wanted to know is why do we need to re-classify the periodic pensions? I understood the mechanism of the re-classification but couldn’t catch the reason why the need to re-classify them. For example, why do we need to re-add the entire amount of pension costs to operating income? 

      Understood about the points you made about NIE under IFRS. I got the same understanding but was confused by this sentence in the note, “Under IFRS, net interest expense/income on the P&L incorporates a return on plan assets based on the discount rate”. But I think i understood it now – they are referring to the second term of the following formula: NIE = (PO x r) – (Fair value of plan asset x r). 

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      The information in the image you presented is correct. Can you be more specific regarding your question? I could go on and on all day over defined benefit pension plans. Under IFRS the NIE is the discount rate times net pension liability or asset. Or, PBO times discount rate minus the plan assets times the discount rate. Basically the plan assets and PBO use the same rate and are offset against each other but US GAAP allows different rates for plan assets and the PBO. The purpose is simply smooth out reported net income. The actual returns bring things back to where they should be through OCI.

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      Ohhh I gotcha now buddy. So the entire pension expense is dragged through operating income,  EBIT, on the income statement.  You need to start thinking of things from an Analysts perspective and adjusting the statements to reflect performance. Having said that some may add pension expense back to EBIT then remove only the operating parts of it; current service costs. Another adjustment made is to cash flow.  If the firm pays more in contributions than the pension expense we could view that aa being comparable to paying down principal on a bond.  We would reduce CFF and increase CFO. 

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      In this case, it seems like the “change in estimates/policies”  are just being disregarded. When I say estimates I am referring to the gain/losses due to actuarial assumptions. And when I say change in policies, I am referring to the adjustment for prior service costs(eg. decision to pay out 85%, rather than 80% at retirement for future and past employees.)

      Are we able to disregard these amortization reclasses (from OCI to IS) because they are referencing a prior period and do not really impact “normal”/pro forma Income Statements, and already are hitting the balance sheet? Is the assumption that the required return on PBO(increased due those items) covers any prior adjustments, by increasing interest expense?

      I agree smoothing out earnings benefits analysts, but should they not either recognize those types of adjustments(PSC and Actuarial G/L) either up front, or “smoothly” amortized over the service years? It seems to just be not considered above. UNLESS of course, we use OCI as part of the analysis from the get-go, right?

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      This image should help clear up what you are asking. For the test, you do not need to make prior period adjustments, just current period. You also do not need to go screwing around with changes in actuarial assumptions through OCI. I think in the real world you probably would go back and restate financials if firms are always changing salary growth, mortality and retirement dates.

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