Summary of Weeks 1 & 2

My plan is to post a Friday summary of what we talked about during the week.

Due next week:  Wiley plus chapter 20 on Wednesday

Chapter 20: Pensions
We began our discussion on Pensions with a review of the type of pension plans. In defined contribution plans, employers are only obligated to provide a specified contribution towards the nest egg of employees, and therefore employees bear all of the risk. This type of plan is becoming increasingly common through the rise of 401(k) plans, and the accounting for them is really straightforward because the amount contributed for employees becomes a form of compensation expense.

Defined benefit plans are a whole other beast, and are the basis for most of the chapter. Our goal for the chapter will be to answer two big questions regarding these defined benefit plans. First, what is the pension obligation to be reported on the balance sheet, and what is the current period pension expense to be put on the income statement?

A pension plan is going to have some assets (money that the firm has transferred to it to cover pension expenses), and some liabilities (obligations to pay benefits to employees). Since the pension plan is a separate entity, we don’t actually list these on the balance sheet of the firm (except to the extent they are different, which is a comment on the funded status that is discussed below).

There are a few ways to think about the obligation facing the pension plan. One option is to only consider vested benefits, which are those that have already been “unlocked” by employees. This idea comes up when pension benefits are based on an employee’s entire career with the firm, but employees must work for the company for a specific amount of time before they formally become eligible. A second option is to consider both vested and unvested benefits, but with estimates made assuming current salary conditions. The FASB, however, recognizes that since pension benefits are usually based on employee salaries at the end of their career (which tend to be higher), it makes sense to think of the obligation on a projected basis. This gives rise to the projected benefit obligation (PBO) that requires the use of actuaries to help calculate the present value of pension benefits earned by employees to date.

On the income statement side, there are five components of pension expense. The first is service cost, which measures the increase in the PBO because employees worked in the current year. Note that employees can’t receive negative benefits, so it is always positive. The second is interest on the liability, which is basically the amount of interest on the outstanding PBO. This is also always going to be positive, and is calculated by taking the PBO and multiplying it by the settlement rate. The third the actual return on plan assets, which considers the fact that the more assets the pension plan has, the more resources are available to cover the pension obligation. Note that pension expense is reduced for positive asset returns, and increased for negative asset returns. The fourth involves amortization of prior service cost, which comes up when a firm amends or creates a pension plan and provides benefits retroactively for employees’ prior service. These costs are amortized over the remaining service life of the employees that are receiving these particular benefits (i.e. not everyone). Note that prior service costs are stored up in a stockholder’s equity account called “accumulated other comprehensive income”. The fifth is called gains and losses, and deserves its own paragraph because it is so much fun.

The gains and losses piece can come up the asset or liability front, and they are both stored up in the accumulated OCI account. In terms of the asset side, the FASB has argued that since returns on plan assets can be pretty volatile (see crisis, financial) in the short term but fairly smooth in the long run, then it makes more sense to calculate return on plan assets using an expected rate of return provided by actuaries. An asset gain or loss comes up when there is a difference between the actual and expected returns. On the liability side, this comes up when the actuaries make some change in their assumptions that alters the amount of the PBO. This can come up because of things like changes in the assumed rate of salary growth, or the overall discount rate used to put the PBO in terms of present value. Most of the time asset and liability gains/losses balance each other out, but if they don’t we use the corridor approach to amortize some of the excess to pension expense. If the amount in accumulated OCI at the beginning of the year exceeds 10% of the greater of the beginning PBO or plan assets, then the excess is amortized over the remaining service life of all employees.

Even though we don’t formally put the plan assets and liabilities on the underlying firm’s balance sheet, we do include the funded status. For example, if the plan’s assets are less than the PBO, then the firm is going to have to pony up some cash in the future to make up the difference. This doesn’t have any impact on the income statement (we used accrual accounting to deal with that through pension expense), but we do include a pension liability based on the obligation. Alternatively, if the plan assets exceed the PBO, then the firm will have a pension asset. Given that the accumulated OCI amount is a stockholder’s equity account, it is on the balance sheet as well.

Chapter 23: Cash Flows
We started talking about the cash flow statement on Wednesday, which is designed to provide investors with information regarding how the company spent its cash during the period. In a nutshell, it explains the difference between beginning and ending cash. Firms are required to list cash flow from operating, investing, and financing activities. Operating cash flow relates to the day-to-day activities of the firm; investing cash flow relates to the purchase and sale of long-lived assets or investments; and financing cash flow relates to the borrowing of money and paying it back.

Whether a company has positive or negative cash flow in these categories can tell a lot about where the firm is in it’s life cycle, as well as it’s overall health. Firms typically have positive cash flow from financing activities early in their life because they have secured some outside financing, and negative cash flow from investing activities because they are spending that cash on things like machinery and equipment. Pay special attention to how these different categories relate as well – we discussed four different combinations and what that might mean for the firm. For example, positive operating and financing cash flow mixed with negative investing cash flow suggests a profitable firm with remaining growth opportunities, while positive operating cash flow mixed with negative financing cash flow suggests a cash cow whose best investment opportunity is to pay back debt or buy back some equity shares. Also be wary of positive investing cash flow – this suggests that the firm is selling off assets, which can be a big problem if it is offsetting negative operating cash flow. Being able to come up with companies in each category is useful.

There are two methods to calculate operating cash flow. Under the indirect method, firms start with net income and make tweaks to it to transition to cash flow from operations. The first adjustment is to add back non-cash transactions such as depreciation and amortization expense. This comes up because depreciation serves to reduce net income, but there is no cash consequence from it. The second set of adjustments relate to changes in current account balances. Net income only relates to revenue earned in the current period and the matching expenses, but there are often differences from a cash flow perspective. For example, an increase in accounts receivable suggests that customers didn’t pay for everything sale included in revenue, so we need to adjust net income downward. The third adjustment is to take out gains or losses from the sale of long-lived assets. If an asset is sold for something other than book value, then there will be a gain or loss included in net income. Since the proceeds from the sale get included in cash from investing activities (where they belong), leaving the gain or loss in net income would cause the gain or loss to be included twice. Therefore we subtract out gains and add back losses when calculating operating cash flow.