 Hello and welcome to the session in which we would look at the five components of pension expense. So pension expense is obviously an expense and this is something we need to report on the income statement as part of our pension accounting. What are the five components? First, I'm going to list them. Tell you how they affect pension expense, whether they increase pension expense or they reduce pension expense. Then I will explain each one separately. What does it mean and how does it affect an actuality pension expense? Starting with something called service cost for the year and service cost will increase pension expense. Amortization of prior service cost will increase pension expense and including with the amortization any plan amendment. Plan amendment means plan changes. Interest on liability is the third component. If you remember in the prior session, we discussed something called PBO projected benefit obligation and we said the obligation is a liability. And remember that our liability is based on the present value of the future cash flow because it's a long term liability. Therefore, any long term liability will have an interest component. So we have to compute the interest component. And when we compute the interest component, it's going to increase our interest, our pension expense. Don't worry, we're going to be working with numbers and explaining this little bit further on the next slide. The fourth component actually is a reduction in our pension expense. Actual return on plan asset. If you remember from the prior session, what happened is your employer will contribute money to a pension plan, to a pension fund. Well, what's going to happen, this pension fund will have stocks, will have bonds, will have all sorts of an investment. Now those investments will earn, will have an actual return. They will have interest, dividend, royalties, so on and so forth. So they will earn something. Well, when we have an actual return, when we return as a result of this return, it's going to reduce our expense for that particular period. Because the return is the opposite of an expense. Therefore, it's going to reduce our interest expense. Also, we're going to have what's called gains and losses. In those gain and losses, I will discuss a little bit further. And obviously gains and losses, if we have any gains, we're going to have a positive. If we have any losses, it's going to be negative. Now, why do we have gain and losses? Well, we're going to have gains and losses from changes in the obligation itself or changes, large changes in those plan assets. Either or we'll discuss those later on. But those are the five components. What I'm going to do next, if you don't write them down, write them down. So I'm going to go over each one of them separately. I'm going to explain how they fit all together and how do they affect pension expense. So it's very important, extremely important that you understand the big picture. The reason is because you have five different things all working at the same time. And sometimes you're going to have prior year balances. Sometimes you may not. It's going to affect OCI. So you want to make sure you understand what I'm going to be, how I'm going to be explaining this next. So let's take a look at this company that started in 2010. So we have a company that started in 2010. From 2010 till 2025, let's assume today is 2025. In 2025, the company decided to start a pension plan. So when they started, it was a small company. They did not have the resources. But after 15 years, now they have the resources and they decided to start a pension plan. They wanted to compensate their employees when their employees retired. Okay. That's a great that's what they want to do. That's excellent. Well, now we have 15 years. So all the employees that work for us, let's assume they stayed from 2010 till 2025. We're not going to tell them, look, we're going to start this new pension plan and you don't get anything. Not at all. If they stayed with us, we're going to compensate them. Therefore, what we call this as a prior service cost. And let's assume for the sake of this example, we computed our prior service costs based on the number of employees, their ages, how much they're earning, how much they expect to earn into the future, so on and so forth. The actuarial person told us we should be responsible for $15 million. Hold on a second. We just started this plan today 2025 and immediately, immediately, we have an expense for the past 15 years. And for the sake of simplicity, I chose the expense to be the cost, the expenditure. Now don't say it's an expense. I just hold on the cost or the expenditure is 15 million. Well, what are we going to do? Are we going to expense 15 million today? And the answer is no. What we're going to do for now, we're going to debit OCI, other comprehensive income. So OCI stands for other comprehensive income. And hopefully you know what this is. Other comprehensive income is a balance sheet account. It's an equity account. And remember, if it's an equity, we are reducing our equity. We're going to debit OCI 15 million and we are going to credit pension liability. Now we say we are responsible for 15 million. However, however, we are not going to let this 15 million hit the income statement now. We're going to park this 15 million for now in OCI, which it reduces our balance sheet. Obviously it reduces our equity. Okay, it reduces our equity. Simply put, if you really want to understand it from an asset liability equity perspective. So what happened is our liabilities went up by 15 million. If those are the liabilities, our equity went down by 15. So that's how it equals. That's how the accounting equation would remain in balance. Now, what's going to happen to this 15 million? We will amortize it. Guess what? Over the next 15 years, I just chose this. So I'm going to say we're going to take this 15 million and we're going to amortize it. Now, when we amortize it, it's going to go to interest expense. When it goes to interest expense, it's going to increase interest expense. So over the next 15 years, every year we'll debit pension expense 1 million. We credit OCI. We get it out of OCI for 1 million. And this is for the next 15 years. Now, bear in mind, just like I said, I explained to you prior service cost. What could happen sometime is this. Let's assume in 2028, the company is doing very, very well. And what we decided to do to compensate our employees because the company are doing very well. We can do plan amendment. Same thing. We're going to increase the amount that we want to give to our employees. If that's what we want to do, it's treated the same thing as a prior service cost. We'll determine the amount. First, we would let it sit in OCI. And obviously plan amendment usually. I mean, it could decrease the obligation, but usually it does not. Usually you're not going to penalize your employees for being there, but it could. Could in a problem, for example, telling you plan amendment and the PBO is reduced. What if that's the case? It means the pension liability is debited. Well, that's not the norm. Okay. Usually you want to compensate your employees. If there's any plan amendment, it's the same thing as prior service cost. So this is the first thing. This is one component of interest expense. Remember, this component increases interest expense. Before we proceed any further, I have a public announcement about my company. Forhatlectures.com. Forhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead. Start your free trial today. No obligation. No credit card required. Second component of pension expense is something we called service cost for the year. And this is going to increase the pension expense. What is the service cost for the year? What's going to happen is this. The employees are going to work in year 2026, 2027, 2028, so on and so forth. So every year they work, well, we have to factor that additional cost into the future because if they earn one year, then they earn more into the future. So the actuarial present value of benefit attributed to that particular year, to that particular year. So it's that service cost for the year because they work one additional year. Every year they qualify for more. Simply put, when they do this, we debit pension expense for half a million and credit pension liability for half a million. So notice here, we increase pension expense. As we said, service cost for the year increases pension expense. Now for the sake of illustration, if we are keeping track of our liability, we started with 15 million. Then we increased it here by 500,000, 500K. So simply put our liability for the sake of this example, we have a liability of 15.5 million, 15 million starting. And let's assume that's the liability now. Again, any liability will have to accrue interest. So we're going to have to do, we're going to have to accrue interest on this liability. What does that mean? It means part of this 15.5 is part of this interest. So we have to determine how much of it is interest and we use something called the settlement rate. So we're going to take 15.5 million times the settlement rate to find out what is the interest component of the liability. And the interest component will increase our pension expense. This is the third component. The fourth component, if you remember the fourth component was the actual return on the plan asset. And the reason I put it in a different color because remember the actual return will reduce pension expense because it's what you are earning on your stocks, bonds that are sitting in that plan asset. And it's earning dividend and interest. Well, it's going to reduce it because we are earning. Now, how do we compute actual return on plan asset? Now, remember, we're going to, this is the actual return. Later on, we're going to be using the expected return, but you need to know how to compute the actual return. How do we compute the actual return on plan asset? Well, the formula is the first you want to take the difference between the beginning balance and the ending balance. For the sake of illustration, let's assume the beginning balance of the plan asset. So we had 4,200. The ending balance of the plant asset was 5,000. Well, what do we know? We know that the plan assets increase net of 800 because we started at 4,200. We end up with 5,000. Now, remember, during that period, during that year, the company made contribution. In other words, added to the plant and also deducted from the plant assets. So simply put, from these assets, what we did is we paid to retirees and the company and maybe the employees made contribution. So the payments are a minus, the contribution are a plus. So if we started with 4,200, let's assume for the sake of illustration, we contributed, the company contributed $200. Therefore, it's a contribution. Contribution is a plus. Then we paid out to retirees from these assets, $350 worth. How did we end up with 5,000? Well, simply put, what we have to do is we have to find the net. So what happened is this. If we take 4,200, if we take 4,200 plus 200, that's going to end up with 4,400. So the beginning balance plus the contribution minus 350, what we paid out. So if we take 4,400 minus 350, and that's going to bring us down to 4,050. Well, if we net it out beginning plus contribution minus the benefit paid, we are still at 4,050. Well, it means what? It means the plant asset earned $950. It means the plant asset earned. So this is the actual return. Well, adding the actual return would give us a balance of 5,000. Simply put, the complete formula as you take your beginning balance plus any contribution minus any payment minus any benefit paid. This is contribution. And who makes the contribution? Usually the company or the company and the employees who are currently working minus benefits paid. Okay. Then we're going to have plus or a minus plus or a minus. We could have also the actual return could be negative. Who knows? Gives us ending balance. Now remember down the road, this is the actual return down the road. I told you we're going to be using the expected return rather than the actual return. Just don't be surprised down the road when we use the expected return. And I'll explain why when we get to that point. The fifth component of the pension expense is gain slash losses. What do those gain slash losses arise from? They could arise from two different two different sources. The value of the plan asset. Remember the plan asset, they have an actual return. But sometime what's going to happen is in some years, the stock market could go up a lot. If you have that money in the stocks or the stock market could go down a lot. So there is large and sudden fluctuation. Well, you don't really want to do so. You don't really want to account for those large and sudden changes because they change from year to year. So we're going to learn later how to deal with those gains and losses, but they could result from those changes in the plan asset or changes in the PBO, projected benefit obligation. Remember the actuarial scientist gives us this PBO. So sometime, let's assume suddenly the PBO told us that now people are living longer. Now you have to increase your PBO by five million dollars. And that's a large increase. Well, if that's the case, then we have to do something about this, which is a loss in our situation. We'll have to know how to deal with that loss. This topic to be discussed later because it's worth looking at it. But the point is sometime you could have a gain, sometime you could have losses and we're going to do. We're going to kind of smooth them out. You will see how we do it later. But those are the five components of the pension expense. What should you do now? Go to farhatlectures.com, work MCQs and true, false and exercises to learn more how to deal with those problems, how to compute pension expense because we're going to be adding more and more to this topic. We're going to start with the worksheet and all these components that are going to work together. Study hard. Don't shortchange yourself. Your education is important. Good luck. Study hard. And of course, stay safe.