Cash Contributed to the Pension Is Not Pension Cost
Now we have enough understanding to take a look at why cash contributed to the pension plan bears little–if any–resemblance to the pension expense (also known as “pension cost”) that is reported on the income statement and reduces reported earnings.
The first two components of pension expense–service and interest cost–are identical to those found in the calculation of PBO. The next component is “expected return on plan assets.” Recall that the “fair value of plan assets” includes actual return on plan assets. Expected return on plan assets is similar, except the company gets to substitute an estimate of the future return on plan assets. It is important to keep in mind that this estimate is an assumption the company can tweak to change the pension expense. Finally, the two “amortization” items are again due to the effects of smoothing. Some people have gone so far as to say the pension expense is a bogus number due to the assumptions and smoothing.
Critical Questions We have just scratched the surface of pension plan accounting, but we have reviewed enough to identify the four or five critical questions you need to ask when evaluating a company’s pension fund. We have two primary concerns in regard to analysis of the pension fund:
- What is the economic status of the liability? A dramatically under-funded plan will require increased cash contributions in the future and foreshadows future increases in income statement expenses.
- How aggressive/conservative is the pension expense? An aggressive accounting policy is a “red flag” because it will usually have to be unraveled by the company in future periods. Conservative policies contribute to earnings that are higher in quality.
In regard to our first concern–the economic status of the liability–we want to look at the funded status that equals the fair value of plan assets minus the PBO. The two key assumptions that impact the PBO are the discount rate and projected rate of salary increases. A company can decrease its PBO (and therefore, increase its funded status) by either increasing the discount rate or lowering the projected rate of salary increases. You can see that PepsiCo’s rate of salary increase is fairly stable at 4.4% but the discount rate dropped to 6.1%. This steady drop in the discount rate contributes significantly to the increased PBO and the resultant under-funded status.
The discount rate is a little bit mixed because it has opposite effects on the service and interest cost, but in most cases, it behaves as before: a lower discount rate implies a decrease in pension expense. Regarding expected return on plan assets, notice that PepsiCo’s assumption here has steadily decreased over the two years to finish at 8.2%. Soft equity markets are a double-whammy for pension funds: they not only lower the discount rate (which increases the PBO) but they lower the expected return on the plan assets!
Taken From : Advanced Financial Statements Analysis