 Hello and welcome to the session in which we would look at pension accounting. Specifically, we're going to start by defining what is a pension because if we're doing accounting for a pension, we need to know what is a pension plan? Well, simply put, a pension plan is an agreement or a contract where the employer, employer means the company that you work for provides benefit and usually those benefits are in form of payments, cash or sometimes they might provide you with health insurance. Let's just think about receiving payment to retired employees for services they provided under working years. Simply put, it would look something like this. If you work for a company, for an employer, what's going to happen? You're working now. The company now will contribute some money on your behalf to a pension plan, some sort of a financial institution and this financial institution. So they're going to give this financial institution money, which is called a pension, a pension fund, pension fund that could be held by bank financial institution trustee. It doesn't matter. It's a separate entity. That's what we need to know. They're going to take this money and invest this money in stocks and bonds, gold, whatever they want to invest this money in. So they're going to have assets and liabilities in this fund. But this pension fund is accounted for separately from the company. So this money that's sitting here, it's separate than the company's fund. It's because this is basically a trustee. They're holding the money for you. Then 20, 25 years, 30 years down the road, you will retire. They'll start to pay you benefit. And now you're sitting on a beach in Florida and you are receiving benefit because you work for your employer for 20, 30, 40 years. It doesn't matter what the years are. But the point is now you are receiving the benefit. Now, we have two types of pension plan. We have contributory and non-contributory. What's the difference between the two? So in this chapter, since this is an introduction, we're going to be learning some few terms. Contributory pension, it means the employees, you who are working, make payments to contribute to the cost or to increase your benefit. For example, they might have the option if you also contribute, we might be able to give you more money or the company says, well, we're going to you as an employee, if you want to benefit, you have to also contribute. This is called contributory and a contributory pension plan. For example, where I work, I don't contribute any money to my pension plan. I do have a pension plan where my wife works. She does contribute a little bit. Non-contributory plan. So I have a non-contributory. I don't contribute anything. The employer pays for contributing the entire cost. Therefore, you just don't see it. It's basically something in the background you are told you have a pension plan and this usually pension plan are for teachers, firefighters, police officers, so on and so forth, law enforcement. If you have a contributory plan, that contributory plan where you contribute, if it's a qualified pension plans, don't worry about what qualified pension plan is. It means it qualify for deduction. When you contribute, let's assume you contribute a thousand dollar, that money is offered a tax benefit. It's contributed before you pay your taxes. So it will reduce your taxes. So simply put, no difference between contributory versus non-contributory pension plan. I don't have a non-contributory. I don't have to pay for my pension plan. Where my wife works, she does have to pay if she wants to increase her benefit, but she has to also bear some of the cost. But when we say pension plan, just kind of traditionally, you don't pay anything traditionally and those pension plan are going away, less and less companies are not using pension plan anymore and pension plan, the technical word for them is called defined pension plan and we're going to see why they're called defined pension plan. We have defined pension plan and we had the defined contribution plan. We have to know the difference between those two because those are two different things. They sound similar, but they're not similar at all. When you think of a defined contribution plan, think of a 401K or 403B. 403B is, for example, I'm a teacher. Also, I can contribute in a retirement account called 403B, which is, I contributed that account. So in a defined contribution plan, here's what happened. Your employer, the company that you work for, contribute, pay a certain amount, a fixed amount to your account. So what they do, they will have something like this. They would say, this is your 401K account. The company, the employer, will submit, for example, I don't know, 5%, 10% of your salary. It doesn't matter. So they might contribute $15,000 a year. I'm just making this number up. That's it. That's their obligation. They will contribute this money to your 401K account. That's all what they do. And what they do is they debit, I don't know, retirement expense, if they want to call it retirement expense, and they will credit cash 15,000, 15,000. That's it. Now, if they did not pay it yet, they will credit some payable if they did not pay the cash yet, if they did not sign the check. And what I used to work at my CPA firm, we had many small companies where they had a 401K. And that's basically it. And usually, we, the accounting firm will make, will even make the payment for them. So I still remember this entry where we, I will literally, some of them would have to write a check. It was not even automatic withdrawal. So we would write the check and make the journal entry, debit, retirement expense, or contribution expense, or 401K expense, credit cash. So that's it. This is a defined contribution. Once this money is in your account, so let's assume this money in Adam's account. So Adam is an employee. Adam worked for this company. The company contributed 15,000 to the 401K. Now, they don't do it all at once. They spread it out throughout the year from your paycheck. Now, the employee, Adam, what Adam will have to do, Adam will have a menu of investment. And Adam will have to select where do they want to invest this money? Maybe they want to invest 20% in tax stocks, 15% in real estate, 30% in bonds, 10% in government notes. It doesn't matter. So the employees select the investment and bear the risk. Simply put, those 15,000 might go up to be a billion dollar. Who knows, when they, when Adam retire or they might go down to zero. The point is to make the point that the employee bears the risk. The employer actually did their job by giving you the money. Outcome, the outcome of the plan is based on the plan value. As I just told you, it could go up to a billion or it could go down to zero depending on which investment you choose. So they give you a menu of investments and you will choose. Usually a 401K, for example, the company might contribute up to 6% of your salary and they match you, you know, whatever you contribute, they match you up to a certain point. So this is a defined contribution plan. And this is not what we are discussing. What we are discussing in this chapter is defined benefit plan, which is what we know traditionally as pension, which is basically most companies don't have anymore. Under those circumstances, the outcome, the benefit that the employee gets, let's assume Adam is working now for this company. Now Adam, Adam's benefit, Adam knows exactly, not precisely 100% exactly, but close enough, how much they're going to be getting once they retired. So it's based on the plan. You will know, for example, every year, once you retire, every month you will get, you know, $3,000. Let's assume that's the case. So it is in the plan. It's in the pension plan. It's in the contract. You know how much you're going to be getting. The employer contribution varies. Now the employer contribution, sometimes they have to pay more money into the plan, sometimes less money. It's determined by something called the actuary, which is we need to talk about this in a moment. So the employer contribution, what they have to pay into this plan, it depends. And I'm going to show you why it depends. It depends on many factors. Okay. But the point is they have to pay enough money to make sure if they promise Adam $3,000 a month after Adam retires, they have to make that money. The employer select the investment option and bears the risk. Now the employer is rather than you in a 401k, selecting the investment in a pension plan, the company selects the investment because it's their plan. It's your plan, but they're administering the plan. So what happened is they can lose a lot. What does that mean? It means if they made the wrong investment, then the company will have to contribute more because they made the wrong investment. So they bear the risk. You just sit back and wait for your money. Okay. Now, obviously, the outcome, the benefit, and a defined benefit plan is limited because you know exactly how much you're going to be getting. The outcome in a 401k is determined by the plan value. If you selected, if you invested in high-tech industry or for some new drug, then you might do very well. Okay. So now let's go back to how much the employer will have to contribute to the pension plan. And he said it varies. It varies. What does it vary on? It varies on many factors. Actuaries are basically professionals. They try to make a prediction. They try to estimate how much you're going to be responsible for your employee. They make certain assumptions. For example, they make an assumption about the mortality rate. For example, you're working for the company. This year is 2025. You start to work for the company. You're going to work 30 years. So 30 years, 2055. So they would say you're going to retire after 30 years. After 30 years, they're going to have to determine, because they're going to have to make payments to you. How many years you are going to live? This is an estimate after that. What would they use? They would look at averages. If you're a female, this is how long you live. What's the average age? If you're a male, this is on average how long you live. So they would look at the mortality rate. They will take that into account. They will take a look at employee turnover. For example, here we're dealing with one employee. But if they have many employees, some employees might leave. Some employees might join. So they take into account the employee turnover. They take into account interest and earnings rate. Remember, they are investing that money. As you are waiting for the money, they are waiting. The money is being invested. So you're going to earn. The company will earn interest, not the company. The plan will earn interest and they will have additional income. Early retirement frequency. Sometime what happened is after a year 2050, the company might offer you to retire early. Then they have to take that into account. So if they retire you early, they will take you out of the pool. Also, they have to take into account your future salaries, whatever they pay you after you retire, depending on your future salary. And if you are working this day in 2025 and how would they predict your salary in 2040? It's all predictions and estimate. And any other factors necessary to operate a pension plan. The good news is, as accountant, we don't have to worry about any of this. How much the company is responsible for will be given to us? Who give us this information? Some professional that deals with this type of estimate. So they will tell the company you should be responsible for, your obligation should be, I don't know, 10 million dollars based on all of this. And the company would say, okay, our obligation now is 10 million dollars. And this is, remember, the fine benefit plan, it's an obligation because you have to pay your employees into the future. Now, before we proceed any further discussing the pension plan, I would like to remind you whether you are a student or a CPA candidate. And most lately you are one of those. That's why you are watching. If you are watching, I can help you are looking for help. 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We are responsible for two things when it comes to pension. We are responsible how to report the pension obligation, which is the good news it's given to us. We don't have to compute this, but what is the pension obligation? How much should we report on the financial statement? That's the first thing. The second thing that we are responsible for is a pension expense. So we have an obligation, which is a liability, and we have an expense. And this is basically we have to compute. Well, the expense, we have to compute the expense. So what is a pension obligation? Well, the pension obligation is a form of a deferred compensation. It's an obligation to the employees. It's a liability. Simply put, when they tell us our obligation should be 10 million, well, what does that mean? That means in the future, we have a deferred compensation. We have a compensation to be paid into the future. It's a liability. That's what we're looking for. Now, how do we measure the liability? How do we measure what is our future pension obligation? Well, now we have to be familiar with a few terms we need to be familiar with. One is one way to measure it is to look at the benefit of vested employees at the current salaries. For example, if my wife is making, I don't know, it doesn't matter what number, let's assume my wife is making $90,000 a year. So they would look at her salary, $90,000 and they would say if she worked that year, well, she's vested for one year. So they will start with the calculation there. This is called the vested benefit obligation. Vested means she worked for that year and based on her salary, this is how much we will be responsible for in the future. Also, because she worked that year, she might also have non vested. It means she worked this year, but if she stayed another year, then she will get more money. Those are called benefit of non vested employee only at the current salary. So they will take her non vested non vested employee at the current salaries and this is called accumulated benefit obligation or ABO. Now, how do they compute this liability? Yes, look how they compute it. They would look at the benefit that are vested and non vested at future salary. So when they compute this obligation, they don't use vested benefit obligation with that. That's usually a small amount. It's only based on what's vested and based on your current salary. They don't only look at your non vested as well. They look at your vested non vested in your future salary. So the actuary will have to take into account what's your future salary. What is your current vested obligation? What's the expected non vested that's going to be vested into the future? And this one is called PBO projected benefit obligation. And this is how the liability is reported. So the reason I showed you those two, because you might see them in a multiple choice in form of a definition. So you know what they are. We don't use them. We don't use accumulated benefit obligation. We don't use vested benefit obligation. We use the largest amount, the largest amount that we can guess the company is going to be responsible for is PBO projected benefit obligation. Now you might be asking what if my wife left, then they will make the adjustment. That's why the constantly the actuary will make the adjustment. So we are dealing with PBO projected benefit obligation. That's the pension liability. So how do we how do we compute all of those? Well, if we have to compute them, we always have to figure out the present value of the expected cash flow. Simply put, here's what's going to happen. You know, the year let's assume the year is 2025. My wife for retire in 2055. Then starting in 2055, the company will have to determine how much they're going to have to pay her. So they're going to have to find the present value of those obligation to be reported actually today. Okay. So look, there's 30 years and then additional years and they'll have to do the present value computation to find out what's the liability? What's the PBO today? And obviously it's not for my wife only. It's for all the employees. But the point is we use the present value. So it's the present value computation. Once again, the good thing we don't have to worry about this. It's given to us. It's giving to us. So what should we report on the financial statement as far as the obligation? We have to report whether the plan is overfunded or underfunded. Okay. So that's what we have to report on the balance sheet. How to determine whether the plan is overfunded or underfunded? Well, we're going to compare two figures. One is called the PBO, which is we just know, we just figure out how to do this. What is PBO? It's the projected benefit obligation. How much we are responsible? And we're going to compare this to the plan assets. What are the plan assets? You guys remember on the first slide, I told your employer, your company, contribute money to a fund, pension fund, okay, which is outside the company, pension fund. This fund, the money in this fund is invested in stocks, bonds, gold, real estate. It doesn't matter. It's invested. Now we're going to compare this number, how much we have in the plan, pension fund, which are called the plan assets, to the projected benefit obligation. Let's assume for PBO, we have 10 million, 10 million. And the plan assets, and we have plan assets of 12 million. Okay. So we have an obligation based on our actuarial computation. Our obligation is 10 million, but we're doing so good in our pension asset that we have 12 million in our pension asset. Under those circumstances, the liability is less than the asset. The plan is overfunded. Well, the opposite is true. If we have PBO of 10 million, they actually told us you are responsible for 10 million based on all the computation that we made. And in the plan asset, we only have 9 million, then we are underfunded by a million. We don't have enough assets to meet our PBO as of today. Again, the PBO looking into the future, but today, we don't have enough asset to meet this PBO. And most companies, they will not have enough asset. Oftentimes, they are underfunded. They are underfunded. Now, there's also some theory that said, if all government report this type of funding, underfunded or overfunded, the government will, all governments in the United States, cities, state, local, and even federal government, if they report this number, it's going to be a huge underfunded because they don't have enough asset, but the government can always raise taxes. This is what they rely on. So this is what we have to report as far as the PBO, the pension benefit obligation. Now, the next thing we're going to work on, which is important is the pension expense, how to compute the pension expense. Remember, we have the liability which is given to us. Then we have the pension expense and the pension expense, we are going to learn about five important components, extremely important. This is the complicated part in this chapter. So I'm going to keep the pension expense, how to compute the pension expense in a separate recording. What should you do now? Go to farhatlectures.com. If you're not a subscriber, subscribe. Start to work MCQs through falls to learn the material. Invest in yourself, invest in your career. It's worth it, whether you are a student or a CPA candidate, especially CPA candidate, you are investing in yourself. Don't shortchange yourself. Good luck, study hard, and of course, stay safe.