© 2005 by Robert F. Halsey, all rights reserved Agenda Pensions Deferred Taxes

© 2005 by Robert F. Halsey, all rights reserved

Agenda

Pensions

Deferred Taxes


Defined contribution plans (401k)

Pension expense xxxCash (contribution) xxx

Employees

Company Trustee

Employees

Employees

$$

$

$


Defined Benefit Plans Promise to pay annuity to employee

after retirement, usually based on final salary and years of service

IOU to employees - Pension plan assets/liabilities stay with company until paid/satisfied

Accounting issues: Recognition of assets/liabilities on B/S Recognition of pension expense in I/S

© 2005 by Robert F. Halsey, all rights reserved 7© 2005 by Robert F. Halsey

Fair Market Valueof the Pension Assets

Future Benefits as promised by the

company

Present value of the Projected Benefit Obligation (PBO)

Accrued Pension Asset / Liability (Balance Sheet)

PV

Balance Sheet Presentation

Basic Accounting Entry

Pension expense (I/S) 100

Accrued pension liability (B/S) 25

Cash (B/S) 75

• pension expense is determined first

• accrued (prepaid) pension liability is a function of cash contribution

If contribution > expense dr prepaid pension cost (asset)

If contribution < expense cr accrued pension liability

• amount of cash contribution does not determine expense

© 2005 by Robert F. Halsey

Service cost (determined by actuaries)

+ Interest cost (BOY PBO x discount rate)

- Expected return (BOY investments x L-T ROR)

Pension expense

Overview - Pension Expense

Average rates used by Companies


Basic Pension Example

Pension plan assets, Jan 1 350,000

Projected Benefit Obligation, Jan 1 490,000

Discount rate 8.5%

Service cost for year 40,000

Company contributions 30,000

Expected return on plan assets (9%) 31,500

Actual return on plan assets 49,700

Benefits paid to retirees 34,400

a. Compute pension expense for the year.



Discount rate 8.5%






b. Compute the balance in the PBO at the end of the year.



Discount rate 8.5%






c. Compute the balance in the pension plan assets at the end of the year.



Discount rate 8.5%






d. Prepare the pension journal entry for the year.

JE JE JE Memo Memo Memo

Items Annual Pension Expense

Cash Prepaid/Accrued Pension Cost

PBO Plan Assets Unrecognized (gains) losses

Bal Jan 1

Service cost

Interest cost

Return on plan assets

Contributions

Benefits

Journal entry

Balance Dec 31

Pension Entries Template


3M mini-case1. How much pension expense (revenue) does 3M report in its 2004

income statement? 2. 3M reports a $627 million expected return on plan assets as an offset to

2004 pension expense. Approximately, how is this amount computed? What is the actual gain or loss realized in 2004 on its plan assets? What is the purpose of using this estimated amount instead of the actual gain or loss?

3. What factors affected its 2004 pension liability? What factors affected its 2004 plan assets?

4. What does the term ‘funded status’ mean? What is the funded status of the 2004 3M retirement plans? What amount of asset or liability does 3M report on its 2004 balance sheet relating to its retirement plans? What factors account for the difference between these two amounts?

5. 3M reduced its discount rate from 6.75% to 6% in 2004. What effect(s) does this reduction have on its balance sheet and its income statement?

6. What effect does a change in the expected return have on reported income? Is it unambiguous?

7. What effect does a change in the expected rate of compensation have on the balance sheet and income statement?



Minimum Liability

How computed? (ABO - FMV Pension Investments)

How recorded / reported?Intangible Asset* xxx

Additional Pension Liability xxx (amt to yield ABO)

* Dr OCI for excess of minimum liability > PSC


Deferred Taxes

There are differences between pre-tax income (10-K) and taxable income (tax return) Straight line depreciation for books and

accelerated for tax Restructuring accruals reduce book income,

but are not a tax deductible expense until paid

Therefore, tax expense does not equal taxes payable

Differences result in deferred tax liabilities and deferred tax assets


Accounting entry

Income tax expense xxx (plug) ➂

Def Tax asset/liab xxx / xxx ➁

Tax payable xxx ➀

Note: DTAs/DTLs can be debited or credited. Income tax expense is the plug figure to balance the entry. This is a balance sheet approach

Valuation allowance All assets must be tested for impairment

before issuance of F/S, including DTAs DTAs are only an asset if they provide future

benefits (e.g., company will generate future taxable income to utilize available credits – loss carryforwards are an example)

If DTAs wil not be realized, must provide an allowance Effect is to reduce DTA and increase tax

expense when allowance is created, the opposite when reversed


Amazon mini-case

1. How much pre-tax profit, tax expense, and net income did the company report for 2004? 2. For its tax expense, how much is currently payable and how much is due to changes in

deferred tax assets and liabilities? 3. What deferred tax assets and liabilities does the company report in total? Are the assets and

liabilities reported separately or netted on the balance sheet? 4. What are the major categories of deferred tax assets and liabilities? How might these arise? 5. The company reports net operating loss carry forwards. Generally, these relate to taxable

losses that, under the IRS code, can be carried forward to future years to reduce taxable income in those years. If it is unlikely that the NOL’s will be used before they expire, the company must set up a valuation allowance to reduce the deferred tax asset, just like the allowance for doubtful accounts. What will be the effect on current profitability if a company establishes a deferred tax asset valuation allowance?

6. What changes does Amazon report in its deferred tax valuation allowance account for 2004? Describe what prompted the change and the effect the change had on its reported income?

7. As an analyst, how should you view deferred tax asset valuation accounts? 8. In general, for growing manufacturing companies that typically report a large deferred tax

liability, how should you view the deferred tax asset or liability? That is, does the liability represent a future cash outflow? Under what circumstances?

Documents

© 2005 by Robert F. Halsey, all rights reserved Agenda Pensions Deferred Taxes