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Appendix 10A: Pensions and Postretirement Benefits Appendix 10B: Deferred Income Taxes

Appendix 10A: Pensions and Postretirement Benefits Appendix 10B: Deferred Income Taxes. In these appendices, special issues that may affect current liabilities and current assets, as well as long-term liabilities and assets.

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Appendix 10A: Pensions and Postretirement Benefits Appendix 10B: Deferred Income Taxes

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  1. Appendix 10A:Pensions and Postretirement BenefitsAppendix 10B:Deferred Income Taxes

  2. In these appendices, special issues that may affect current liabilities and current assets, as well as long-term liabilities and assets. Appendix 10A discusses some of the issues relating to pensions and other postretirement benefits. Appendix 10B discusses some of the issues relating to deferred income taxes. Appendix 10A and Appendix 10B

  3. Types of pension plans defined contribution plans defined benefit plans Defined contribution plan simple to report journal entry at time of funding: Pension expense xx Cash xx no recognition of asset or liability promising only accumulated amount in pension investment. Appendix A: Pensions

  4. Defined benefit plan promising an eventual benefit to employees make payments to achieve the benefit recognize assets/liabilities relating to the plan if insufficient investment to meet promise: liability if investment in excess of promise: asset basic journal entry, as cash is paid: Pension expense xx Prepaid/Accrued Pension Cost xx / xx Cash xx note that pension expense is calculated by a set of rules developed by SFAS 87, and it will seldom be equal to the amount paid. note that P/A PC is one account; it may be a debit one period and a credit next period. Pensions - continued

  5. SFAS 87 measures 3 different levels of pension obligation: Vested benefit obligation: for vested employees at current salaries. Accumulated benefit obligation (ABO): for all employees at current salaries. Projected benefit obligation (PBO): for all employees at future salaries. PBO is most conservative, and used for most calculations (including our exercises). SFAS 87 also measures the fair value of plan assets (FVPA) to indicate the amount of assets accumulated to meet the PBO. Defined Benefit Plan and SFAS 87

  6. Prior to SFAS 87, most companies were recognizing expense, only as they funded the plan (and no future asset or liability) FASB initially wanted companies to recognize the difference between PBO and FVPA as the net asset or liability of the plan. If PBO greater, then company has a net liability (underfunded). IF FVPA greater, then the company has a net asset (overfunded). Compromises in SFAS 87

  7. At the time of the proposal, most companies were significantly underfunded. Corporations and CPA firms lobbied the FASB, saying that, if they had to recognize the full liability, the effect would be disastrous: they would violate existing debt covenants. they would be unable to get additional funding. the extra expense would make the income statement look terrible. they would be driven out of business. Compromises in SFAS 87

  8. The FASB backed down, and created several techniques to smooth the recognition of liability and expense over time. Amortization of “transition amount”: allowed companies to recognize a portion of their initial liability over 15-20 years (now fully amortized for most companies). Amortization of “prior service costs”: allowed companies to recognize, over future service years of employees (using technique similar to sum-of-the-years’-digits), the effect of plan adoptions or amendments. Amortization of net gains/losses on change in estimates relating to PBO and FVPA. Most of these gains and losses are never recognized. Compromises in SFAS 87

  9. Pension expense is calculated with the following components: 1. Service cost (SC) - present value of new benefits, as calculated by actuary.(+) 2. Interest cost - current period’s estimated interest on the PBO.(+) 3. Return on plan assets - expected income from plan assets this year.(-) 4. Amortization of unrecognized PSC - usually an additional cost, which leads to additional expense. (+) 5. Amortization of unrecognized net G/L - more expense if amortizing loss; opposite for gain.(+/-) 6. Amortization of transition amount (no longer included in most disclosures). More expense if liability. (+/-) Calculations in SFAS 87

  10. The reconciliation schedule is found in the notes to the financial statements, and it contains all of the summary information regarding the “true” asset or liability, the unrecognized amounts, and the “recognized asset or liability. The schedule usually contains a number of related calculations (like the change in PBO from the beginning to the end of year), but you should focus on the following components: Pension Reconciliation Schedule

  11. Example 1 Example 2 Underfunded: Overfunded: PBO (110) (120) FVPA 90 150 (1) Excess(PBO)FVPA ( 20) 30 (2) Unamortized PSC 22 5 (2) Unrecognized Loss (Gain) 12 ( 50) (3) Prepaid (Accrued) PC 14 ( 15) (1) The excess PBO or FVPA is the “real” asset or liability. This is the amount that would have been recognized if FASB had not initiated the smoothing techniques. This is also called the “funded status.” (3)The amount shown in the Prepaid or Accrued Pension Cost account is the amount that is actuallyrecognized in the financial statements (although it may not be shown separately in the balance sheet). (2) The UPSC and UNL/Gare the amounts that are not yet recognized in the calculation of pension expense, and therefore are not yet recognized in the financial statements. To get from (1) to (3), we have to reverseout the effects of the items in (2). Pension Reconciliation Schedule

  12. Note that underfunded plans do not always recognize an accrued pension cost, and overfunded plans do not always recognize a prepaid pension cost. In Example 1, the present value of the PBO is $20 higher than the assets available to settle the liability. However, because of non-recognition of prior service costs and losses, the net reported amount in the financials is an asset (Prepaid Pension Cost) of $14. There are limitations to the asset that can be recognized, based on minimum liability calculations that are discussed in intermediate accounting. Pension Reconciliation Schedule

  13. In Example 2, the present value of the PBO is $30 less than the assets available to settle the liability. This plan is overfunded. However, because of non-recognition of prior gains, the net reported amount in the financials is a liability (Accrued Pension Cost) of $15. Pension Reconciliation Schedule

  14. Also note that companies usually separate reporting into U. S. and international plans, as well as overfunded and underfunded plans. Companies may also report information for other postretirement benefits (OPBs) in this reconciliation. Sometimes, companies report OPBs separately. Pension Reconciliation Schedule

  15. There are several activities regarding pension accounting that are not covered in this text: Minimum Liability Intangible Asset Excess of Additional Liability over Unamortized Prior Service Cost These accounts relate to more complex issues of pension reporting and are discussed in intermediate accounting courses. Other Pension Accounts

  16. Financial versus tax accounting Financial income based on GAAP. Taxable income based on tax laws. The difference between financial income and taxable income is generally leads to something called “deferred income taxes. Historical treatment of income taxes Recognize income tax expense based on financial income. Recognize income tax payable based on taxable income. The difference is a “plug,” and represents the timing difference between taxable and financial income. Appendix B: Deferred Income Taxes

  17. Journal entry for historical treatment: I. T. Expense xx net income x % DIT (debit or credit) xx / xx plug I. T. Payable xx tax income x % Problems: after many years, the difference, primarily due to things like depreciation, had become one of the larger liabilities on the balance sheet. in some cases, the liability was greater than anything else in the balance sheet. Solution (in SFAS 109): prepare a detailed schedule to calculate the amount for IT Payable and DIT, and let IT Expense be the plug. Problems with Historical Treatment

  18. Journal entry for SFAS 109: I. T. Expense xx plug DIT xx / xx schedule I. T. Payable xx schedule Before developing the schedule, we first need to discuss what items need to go into the schedule. Permanent differences (like income on municipal bonds) are excluded from the DIT schedule. Only temporary differences are included in the schedule. Temporary differences fall into two categories: those differences that lead to lower taxable income at the time of origination (future taxable). those differences that lead to higher taxable income at the time of origination (future deductible). SFAS 109

  19. Future taxable (FT) items are amounts that are taxable in the future, because they are not taxable now. They represent the difference between financial and taxable income in the year of origination. They include: Revenues or gains that are recognized in taxable income after they are recognized in financial income (such as income from equity investments in excess of dividends received). Expenses or losses that are recognized in taxable income before they are recognized in financial income (such as MACRS depreciation used for taxable income, while straight-line depreciation used for financial income.) SFAS 109 - Future Taxable Items

  20. Future deductible (FD) items are amounts that lead to more tax now, but less tax in the future They represent the difference between financial and taxable income in the year of origination. They include: Revenues or gains that are recognized in taxable income before they are recognized in financial income (such as cash received in advance for future services). Expenses or losses that are recognized in taxable income after they are recognized in financial income (this includes most estimates, such as bad debt expense, warranty expense loss contingencies, and pension expense in excess of cash paid). SFAS 109 - Future Deductible Items

  21. We will have only 2 columns for our schedule: Current IT Payable Deferred Income Taxes However, most companies report the net current deferred tax asset or liability, and the net noncurrent deferred tax asset or liability. In the year of origination (or the first year of the difference), the amounts should total across any line to-0- . In the year of origination, the adjustment in the IT Payable column is to convert financial income to taxable income. SFAS 109 - Scheduling DIT

  22. Current year Future years I. T. PayableDeferred I.T. Pretax financial income $ xx Future deductible: Rev: customer advances + - Exp: estimated expenses + - Future taxable: Rev: excess equity income - + Exp: excess MACRS depr. - + Taxable income $ xx Note: if you schedule -1,000 for excess MACRS for the IT Payable column, then you would schedule +1,000 in the DIT column. Any originating amounts must reverse out in future periods in order to be considered for DIT. Effect in schedule is shown on the next slide. Illustration of Schedule in First Year

  23. Assume a 30% tax rate for current and future years. Current year Future years I. T. PayableDeferred I.T. Pretax financial income $100,000 Future taxable: Exp: excess MACRS depr. (1,000) 1,000 Taxable income Deferred amount Tax rate .30 .30 Income tax payable Deferred tax liability Journal entry (income tax expense is the plug): Illustration of Schedule in First Year $ 99,000 1,000 $29,700 $300 Income tax expense 30,000 Income tax payable 29,700 Deferred tax liability 300

  24. Question 1: Is the DTL from depreciation difference really a liability? First: refer to the definition of a liability in Chapter 10, particularly the part that says "probable future sacrifices of economic benefits . . ." For deferred income taxes, the implied benefit that we are going to sacrifice is cash. Now: refer to the illustration. What happens to deferred tax liability if a company chooses to use MACRS for both financial and tax reporting? Did the company pay any cash to make the deferred tax liability disappear? SFAS 109 - Conceptual Issues It disappears. No

  25. Question 1 (continued): Is the DTL from depreciation difference really a liability? If the company can make a "liability" disappear with an accounting choice, and not a cash payment, is it really a liability? This finding can be applied to many deferred tax items, but is particularly obvious with DIT relating to depreciation. SFAS 109 - Conceptual Issues NO.

  26. Question 2: How do analysts perceive DIT? Research findings are mixed. Some analysts completely ignore DIT when evaluating a company’s financial position. Some reclassify the DIT effect to equity (where the difference would be absorbed if we used the same accounting rules for financial and tax). Others have found that the current portion of the DIT has value when predicting cash flows for a company. Those items that will reverse out next year are indicative of a portion of next year’s tax payment. Financial statement users are cautioned to view DIT differently than other assets and liabilities. SFAS 109 - Conceptual Issues

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