MODULE13.9:SPECIALPURPOSEENTITIES

SpecialPurposeandVariableInterestEntities

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Aspecialpurposeentity(SPE)isalegalstructurecreatedtoisolatecertain

assetsandliabilitiesofthesponsor.AnSPEcantaketheformofa

availableonline.

corporation,partnership,jointventure,ortrust.Thetypicalmotivationistoreduceriskand

therebylowerthecostoffinancing.SPEsareoftenstructuredsuchthatthesponsorcompany

hascontrolovertheSPE’sfinancesoroperatingactivitieswhilethirdpartieshavecontrolling

interestintheSPE’sequity.

Inthepast,SPEswereoftenmaintainedoff-balance-sheet,therebyenhancingthesponsor’s

financialstatementsandratios.

TheFASBusesthetermvariableinterestentity(VIE)todescribeaspecialpurposeentitythat

meetscertainconditions.AccordingtoFASBASCTopic810,Consolidation,aVIEisan

entitythathasoneorbothofthefollowingcharacteristics:

1.At-riskequitythatisinsufficienttofinancetheentity’sactivitieswithoutadditional

financialsupport.

2.Equityinvestorsthatlackanyoneofthefollowing:

Decisionmakingrights.

Theobligationtoabsorbexpectedlosses.

Therighttoreceiveexpectedresidualreturns.

IfanSPEisconsideredaVIE,itmustbeconsolidatedbytheprimarybeneficiary.The

primarybeneficiaryistheentitythatabsorbsthemajorityoftherisksorreceivesthemajority

oftherewards.

PROFESSOR’SNOTE

InaVIE,thecapitalsourcelabeledasstockholders’equityisnottrulyequity,astheamountis

insufficienttohavetherisk/returncharacteristicsofequity.Generally,inthesecompanies,“variable

interest”referstoastakeinthecompany(orguaranteesgiven)bytheprimarybeneficiary.This

stakehasthesameeconomiccharacteristicsas“normal”equity.

TheIASBcontinuestousethetermspecialpurposeentity.AccordingtoIFRS10,

ConsolidatedFinancialStatements,thesponsoringentitymustconsolidateifitcontrolsthe

SPE.

EXAMPLE:Specialpurposeentity

CompanyP,atextilemanufacturer,wantstoborrow$100million.Ithastwooptions:

Option

A:

Borrow$100millionfromBankB.

Option

B:

Sell$100millionworthofaccountsreceivabletoCompanyS,anSPEcreatedforthis

purpose.TheSPEwillfundthepurchasebyborrowingthemoneyfromBankB.

CompanyP’sbalancesheetbeforetheborrowingisprovidedinthefollowing:

Assets

$millions

$50

LiabilitiesandEquity

Currentliabilities

Debt

$millions

$500

Cash

Accountsreceivable

$200

$1,200

Fixedassets

Totalassets

$2,000

$2,250

Equity

Total

$550

$2,250

PreparecompanyP’sbalancesheetunderbothoptionsassumingthattheSPEinoptionBmeetsthe

requirementsforconsolidation.

Answer:

OptionA:CompanyP’scashanddebtwillbothincreasebythenewborrowingof$100million.

CompanyP’sbalancesheetaftertheborrowing:

Assets

$millions

$150

LiabilitiesandEquity

Currentliabilities

Debt

$millions

$500

Cash

Accountsreceivable

Fixedassets

Total

$200

$1,300

$550

$2,000

$2,350

Equity

Total

$2,350

OptionB:CompanyP’s(nonconsolidated)balancesheetwillreflectareductioninaccountsreceivableof

$100millionandanincreaseincashbythesameamount.

CompanyP’sbalancesheetafterthesaleofaccountsreceivabletotheSPE:

Assets

$millions

$150

LiabilitiesandEquity

Currentliabilities

Debt

$millions

$500

Cash

Accountsreceivable

Fixedassets

Total

$100

$1,200

$550

$2,000

$2,250

Equity

Total

$2,250

SPE’sbalancesheetafterpurchaseofaccountsreceivableandbankloan:

Assets

$millions

$100

LiabilitiesandEquity

$millions

$100

Accountsreceivable

Total

Debt

Total

$100

$100

Afterconsolidation,theSPE’sdebtgetsincludedwithcompanyP’sdebt,andaccountsreceivablefor

companyPincreasebythesameamount.

CompanyP’sbalancesheetafterconsolidation:

Assets

$millions

$150

LiabilitiesandEquity

Currentliabilities

Debt

$millions

$500

Cash

Accountsreceivable

Fixedassets

Total

$200

$1,300

$550

$2,000

$2,350

Equity

Total

$2,350

ThebalancesheetofcompanyPundereitheroptionisthesame.CompanyPcannothidetheborrowing

“offthebooks.”

OTHERISSUESINBUSINESSCOMBINATIONSTHAT

WEAKENCOMPARABILITY

ContingentAssetsandLiabilities

UnderIFRS,onlycontingentliabilitieswhosefairvaluecanbemeasuredreliablyare

recognizedatthetimeofacquisition.(Contingentassetsareneverrecognized.)Insubsequent

periods,contingentliabilitiesaremeasuredatthehigherofthevalueinitiallyrecognized,or

thebestestimateoftheamountneededtosettletheliabilities.

U.S.GAAPdividescontingentassetsandliabilitiesintocontractualandnoncontractual.

Contractualcontingentassetsandliabilitiesarerecordedattheirfairvaluesontheacquisition

date.Noncontractualcontingentassetsarealsorecordedif,“morelikelythannot”theymeet

thedefinitionofanassetorliability.Subsequently,measurementofcontingentliabilitiesis

similarunderIFRS,whilecontingentassetsarerecognizedattheloweroftheinitialvalue

andthebestestimateofthefuturesettlementamount.

ContingentConsideration

Ifthetermsoftheacquisitioninvolveacontingentconsideration(e.g.,aspecificextra

amountispayabletotheformershareholdersofthesubsidiaryifcertainearningsorrevenue

targetsaremet),suchconsiderationisrecognizedatfairvalueunderbothIFRSandU.S.

GAAPasanasset,liability,orequity.Subsequentchangesinvaluearerecognizedinthe

incomestatement,unlessthevaluewasoriginallyclassifiedinequity(anychangesthensettle

withinequityandnotviatheincomestatement).

In-ProcessR&D

In-processR&DiscapitalizedasanintangibleassetandincludedasanassetunderbothU.S.

GAAPandIFRS.In-processR&Dissubsequentlyamortized(ifsuccessful)orimpaired(if

unsuccessful).

RestructuringCosts

Restructuringcostsareexpensedwhenincurred—andnotcapitalizedaspartofthe

acquisitioncost—underbothIFRSandU.S.GAAP.

LOS13.c:Analyzehowdifferentmethodsusedtoaccountforintercorporate

investmentsaffectfinancialstatementsandratios.

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Theeffectsofthechoiceofaccountingmethodsonreportedfinancialresultshavebeen

coveredearlierinthistopicreview,sowewon’trepeatthediscussionhere.Instead,we’ll

comparetheeffectsoftheequitymethod,theproportionateconsolidationmethod,andthe

acquisitionmethod.

Therearefourimportanteffectsonthebalancesheetandincomestatementitemsthatresult

fromthechoiceofaccountingmethod(inmostsituations):

1.Allthreemethodsreportthesamenetincome.

2.Equitymethodandproportionateconsolidationreportthesameequity.Acquisition

methodequitywillbehigherbytheamountofminorityinterest.

3.Assetsandliabilitiesarehighestundertheacquisitionmethodandlowestunderthe

equitymethod;proportionateconsolidationisin-between.

4.Revenuesandexpensesarehighestundertheacquisitionmethodandlowestunderthe

equitymethod;proportionateconsolidationisin-between.

Figure13.9:ReportedFinancialResultsfromDifferentAccountingMethods

Proportionate

Consolidation

Acquisition

Method

EquityMethod

Netprofit

margin

Higher—salesarelowerandnetincomeis

thesame

In-between

Lower

ROE

Higher—equityislowerandnetincomeis

thesame

Sameasequitymethod

In-between

Lower

Lower

ROA

Higher—netincomeisthesameandassets

arelower

MODULEQUIZ13.9

Tobestevaluateyourperformance,enteryourquizanswersonline.

1.Acompanyaccountsforitsinvestmentinasubsidiaryusingtheequitymethod.Thereported

netprofitmarginis14%.Ananalystadjuststhefinancialsanddeterminesthatthe

company’sownnetprofitmarginis8%whilethesubsidiary’sprofitmarginis10%.Thenet

profitmarginbasedonconsolidationwouldmostlikelybe:

A.lessthan8%.

B.morethan14%.

C.between8%and14%.

KEYCONCEPTS

LOS13.a

Accountingforinvestments:

Degreeof

Influence

Ownership

AccountingTreatment

Lessthan20%(investmentsin

financialassets)

Nosignificant

influence

Amortizedcost,fairvaluethroughprofitorloss,fair

valuethroughOCI

20%–50%(investmentsin

associates)

Significant

influence

Equitymethod

Morethan50%(business

combinations)

Control

Acquisitionmethod

Investmentsinfinancialassets:Dividendsandinterestincomearerecognizedinthe

investor’sincomestatement.Amortizedcostsecuritiesarereportedonthebalancesheetat

amortizedcost.Subsequentchangesinfairvalueareignored.Fairvaluethroughprofitorloss

securitiesarereportedatfairvalue,andtheunrealizedgainsandlossesarerecognizedinthe

incomestatement.FairvaluethroughOCIsecuritiesarealsoreportedatfairvalue,butthe

unrealizedgainsandlossesarereportedinstockholders’equity.

Investmentsinassociates/jointventures:Withtheequitymethod,theproportionateshareof

theinvestee’searningsincreasetheinvestor’sinvestmentaccountonthebalancesheetand

arerecognizedintheinvestor’sincomestatement.Dividendsreceivedreducetheinvestment

account.Dividendsreceivedarenotrecognizedintheinvestor’sincomestatementunderthe

equitymethod.Inrarecases,proportionateconsolidationmaybeallowed.Proportionate

consolidationissimilartoabusinesscombination,excepttheinvestoronlyincludesthe

proportionateshareoftheassets,liabilities,revenues,andexpensesofthejointventure.No

minorityowners’interestisrequired.

Businesscombinations:Inanacquisition,alloftheassets,liabilities,revenues,andexpenses

ofthesubsidiaryarecombinedwiththeparent.Intercompanytransactionsareexcluded.

Whentheparentownslessthan100%ofthesubsidiary,itisnecessarytocreatea

noncontrollinginterestaccountfortheproportionateshareofthesubsidiary’snetassetsand

netincomethatisnotownedbytheparent.

UnderIFRS,thesponsorofaspecialpurposeentity(SPE)mustconsolidatetheSPEiftheir

economicrelationshipindicatesthatthesponsorcontrolstheSPE.U.S.GAAPrequiresthata

variableinterestentity(VIE)mustbeconsolidatedbyitsprimarybeneficiary.

LOS13.b

DifferencesbetweenIFRSandU.S.GAAPtreatmentofintercorporateinvestmentsinclude:

IFRSandU.S.GAAPdifferbetweencontingentassetandliabilityrecognitionunder

theacquisitionmethod.

IFRSpermitseitherthepartialgoodwillorfullgoodwillmethodtovaluegoodwilland

noncontrollinginterestinbusinesscombinations.U.S.GAAPrequiresthefullgoodwill

method.

LOS13.c

Theeffectsoftheequitymethodversustheacquisitionmethod:

Bothreportthesamenetincome.

Acquisitionmethodequitywillbehigherbytheamountofminorityinterest.

Assetsandliabilitiesarehigherundertheacquisitionmethod.

Salesarehigherundertheacquisitionmethod.

ANSWERKEYFORMODULEQUIZZES

ModuleQuiz13.1

1.A?Usuallyanownershipinterestbetween20%and50%wouldindicatetheabilityto

significantlyinfluence.However,inthiscase,TallisunabletoinfluenceShortas

evidencedbyitsfailuretoobtainboardrepresentation;thus,Tall’sownershipinterest

shouldbeconsideredaninvestmentinfinancialassets.(LOS13.a)

ModuleQuiz13.2

1.B?Initially,thecarryingvalueofallsecurityinvestmentsiscost.

initialcost=$950+250=$1,200(LOS13.a)

2.B?FairvaluethroughOCIandfairvaluethroughprofitorlosssecuritiesarecarriedat

marketvalueonthebalancesheet.Also,bothclassificationscallforrecognitionof

unrealizedlossesandgains.Marketvalueatt=1is$850+$180=$1,030.Unrealized

lossis($850–$950)+($180–$250)=–$170.Notethattherecognitiondiffers.With

fairvaluethroughOCIsecurities,therecognitionisonlyonthebalancesheet.Withfair

valuethroughprofitorlosssecurities,therecognitionimpactstheincomestatement.

(LOS13.a)

3.C?Theincreaseinvaluerequiresthatinvestmentsecuritiesbewrittenupto$900+

$350=$1,250.Becausetheseareequitysecurities,theamortizedcostclassificationis

notavailable.(LOS13.a)

4.A?Classifyingthesharesasfairvaluethroughprofitorlossrequiresbothrealizedand

unrealizedgainsandlossestoberecognizedontheincomestatement.Asaresult,this

wouldhavetheeffectofgreaterreportedearningsvolatility.Thereisactuallya$220

unrealizedgainbetweent=1andt=2;thegainisunrealizedbecausetheshareswere

notactuallysold.Thenetgainof$50betweentheacquisitiondateandt=2is

unrealized;therefore,byclassifyingasfairvaluethroughOCI,thegainisnot

recognizedontheincomestatement(itgoesdirectlytoequity).Classificationaseither

fairvaluethroughprofitorlossorasfairvaluethroughOCIsecuritiesresultsinthe

samefairmarketvalueof$1,250reportedonthebalancesheetatt=2.(LOS13.a)

5.B?Debtsecuritiesatamortizedcostaresecuritiesthatmeetboththecashflowand

businessmodeltest.Theyarecarriedatamortizedcost($1,200),andnounrealizedor

realizedgainsorlossesarerecognizeduntildisposition.Becausethesesecuritieswere

purchasedatpar,thereisnoamortizationofpremium/discount.(LOS13.a)

ModuleQuiz13.3

1.A?Withtheequitymethod,theproportionalshareoftheaffiliate’sincome(%

ownership×affiliateearnings)isreportedontheinvestor’sincomestatement.

(LOS13.a)

2.B?$1,500,000+0.4($500,000?$125,000)=$1,650,000.(LOS13.a)

3.C?$500,000×0.4=$200,000;dividendsarenotincludedinincomeundertheequity

method.(LOS13.a)

4.A?$125,000×0.4=$50,000;thedividendiscashflow=$50,000.(LOS13.a)

ModuleQuiz13.4,13.5,13.6

1.A?$6,000,000+0.2(–$450,000)?0.2($600,000)=$5,790,000.(Module13.5,

LOS13.a)

2.A?0.2(–$450,000)=–$90,000.(Module13.6,LOS13.a)

3.A?Afterremovingtheinvestmentgainsin2016and2017,operatingincomeis$500

eachyear.Basedonagrowthtrendof0%,theappropriateoperatingincomeforecast

for2018isalso$500.

2016

$1,000

500

2017

$1,140

640

Salesandoperatingrevenues

Operatingcosts

Adjustedoperatingincome

500

500

(Module13.6,LOS13.a)

4.B?Totalassets=$1,200,000+$360,000?$120,000=$1,440,000.(Module13.5,

LOS13.a)

5.B?Minorityinterestincome=$60,000(0.2)=$12,000.

Consolidatednetincome(afterminorityinterestincomeissubtracted)=$300,000+

$60,000?$12,000=$348,000.(Module13.4,LOS13.a)

6.B?Thebeginningbalanceoftheminorityinterestis$30,000($150,000Sequity×

20%).TheminorityinterestisincreasedbytheminorityshareofCompanyS’sincome

of$12,000($60,000×20%)andisdecreasedbytheminorityshareofthedividends

paidbyCompanySof$3,000($15,000×20%).Thus,theendingbalanceis$39,000

($30,000+$12,000?$3,000).Notethatthevalueofgoodwillatthetimeof

acquisitioniszero;hence,thereisnoneedtospecifywhetherfullorpartialgoodwill

accountingisused.(Module13.4,LOS13.a)

ModuleQuiz13.7

1.B?Intestinggoodwillforimpairment,thecarryingvalueofthereportingunit

(includinggoodwill)iscomparedtothefairvalueofthereportingunit.Oncean

impairmenthasbeendetected,thelossisequaltothedifferenceinthebookvalueof

thegoodwillandtheimpliedvalueofthegoodwill.(LOS13.a)

2.B?Adamisrequiredtoperformanannualimpairmenttest.Thecarryingvaluecannot

exceedthefairvalue;ifitdoes,thenanimpairmenthastakenplaceandthegoodwill

mustbewrittendown.(LOS13.a)

ModuleQuiz13.8

1.B?CompanyCwouldincludeminorityinterest(50%of$800)alongwithitsown

equityof$5,950intheconsolidatedfinancialstatements.(Module13.5,LOS13.a)

2.C?CompanyCwouldincludealltheassetsofJVCandremoveitsequityinvestment

intheconsolidatedbalancesheet.$13,450?$400+$4,400=$17,450.(Module13.6,

LOS13.a)

3.A?COGS=$7,000CompanyC+50%of$2,000JVC=$8,000.

Netincomeof$930isnotaffectedbyproportionateconsolidation.(Module13.8,

LOS13.a)

4.B?UnderU.S.GAAP(andIFRS),equitymethodisrequiredtobeusedtoaccountfor

jointventures.Onlyinrarecasesisproportionateconsolidationallowed.(Module13.8,

LOS13.b)

ModuleQuiz13.9

1.C?Theequitymethodtypicallyyieldsahighermeasureofnetprofitmargin.

Consolidationismostlikelytoresultinanetprofitmarginsomewherebetweenthe

profitmarginsofthetwoentities.(LOS13.c)

ThefollowingisareviewoftheFinancialReportingandAnalysis(1)principlesdesignedtoaddressthelearning

outcomestatementssetforthbyCFAInstitute.Cross-ReferencetoCFAInstituteAssignedReading#14.

READING14:EMPLOYEE

COMPENSATION:POST-EMPLOYMENT

ANDSHARE-BASED

StudySession5

EXAMFOCUS

Thisisacomplicatedtopic,butdon’tbeintimidated.Accountingforpensionplansmaybe

complex,buttheeconomicreasoningisnottoodifficulttograsp.Despiteconvergence

betweenU.S.GAAPandIFRS,significantdifferencesremain,particularlywithrespectto

recognitionofperiodicpensioncostinincomestatementversusinOCI.Youshouldbeable

toexplainhowreportedresultsareaffectedbymanagement’sassumptions.Youshouldalso

beabletoadjustthereportedfinancialresultsforeconomicrealitybycalculatingtotal

periodicpensioncost.Share-basedcompensationisalsointroduced.Compensationexpense

isbasedonfairvalueonthegrantdate,anditisoftennecessarytouseanoptionpricing

modeltoestimatefairvalue.Makesureyouunderstandtheeffectsofchangingthemodel

inputsonfairvalue.

MODULE14.1:TYPESOFPLANS

LOS14.a:Describethetypesofpost-employmentbenefitplansand

implicationsforfinancialreports.

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Apensionisaformofdeferredcompensationearnedovertimethroughemployeeservice.

Themostcommonpensionarrangementsaredefined-contributionplansanddefinedbenefit

plans.

Adefinedcontributionplanisaretirementplanwherebythefirmcontributesacertainsum

eachperiodtotheemployee’sretirementaccount.Thefirm’scontributioncanbebasedon

anynumberoffactorsincludingyearsofservice,theemployee’sage,compensation,

profitability,orevenapercentageoftheemployee’scontribution.Inanyevent,thefirm

makesnopromisetotheemployeeregardingthefuturevalueoftheplanassets.The

investmentdecisionsarelefttotheemployee,whoassumesalloftheinvestmentrisk.

Thefinancialreportingrequirementsfordefined-contributionplansarestraightforward.

Pensionexpenseissimplyequaltotheemployer’scontribution.Thereisnofutureobligation

toreportonthebalancesheet.Theremainderofthistopicreviewwillfocusonaccountingfor

adefined-benefitplan.

Inadefined-benefitplan,thefirmpromisestomakeperiodicpaymentstotheemployee

afterretirement.Thebenefitisusuallybasedontheemployee’syearsofserviceandthe

employee’scompensationat,ornear,retirement.Forexample,anemployeemightearna

retirementbenefitof2%ofherfinalsalaryforeachyearofservice.Consequently,an

employeewith20yearsofserviceandafinalsalaryof$100,000wouldreceive$40,000

($100,000finalsalary×2%×20yearsofservice)eachyearuponretirementuntildeath.

Sincetheemployee’sfuturebenefitisdefined,theemployerassumestheinvestmentrisk.

Financialreportingforadefined-benefitplanismuchmorecomplicatedthanforadefined-

contributionplanbecausetheemployermustestimatethevalueofthefutureobligationtoits

employees.Thisinvolvesforecastinganumberofvariablessuchasfuturecompensation

levels,employeeturnover,retirementage,mortalityrates,andanappropriatediscountrate.

Acompanythatoffersdefinedpensionbenefitstypicallyfundstheplanbycontributingassets

toaseparatelegalentity,usuallyatrust.Theplanassetsaremanagedtogeneratetheincome

andprincipalgrowthnecessarytopaythepensionbenefitsastheycomedue.

Thedifferenceinthebenefitobligationandtheplanassetsisreferredtoasthefundedstatus

oftheplan.Iftheplanassetsexceedthepensionobligation,theplanissaidtobe

“overfunded.”Conversely,ifthepensionobligationexceedstheplanassets,theplanis

“underfunded.”

Otherpost-employmentbenefits,primarilyhealthcarebenefitsforretiredemployees,are

similartoadefined-benefitpensionplan:thefuturebenefitisdefinedtodaybutisbasedona

numberofunknownvariables.Forexample,inapost-employmenthealthcareplan,the

employermustforecasthealthcarecoststhatareexpectedoncetheemployeeretires.

Fundingisanareawhereotherpost-employmentbenefitplansdifferfromdefined-benefit

pensionplans.Pensionplansaretypicallyfundedatsomelevel,whileotherpost-employment

benefitplansareusuallyunfunded.Inthecaseofanunfundedplan,theemployerrecognizes

expenseintheincomestatementasthebenefitsareearned;however,theemployer’scash

flowisnotaffecteduntilthebenefitsareactuallypaidtotheemployee.

MODULEQUIZ14.1

Tobestevaluateyourperformance,enteryourquizanswersonline.

1.Whichofthefollowingstatementsaboutretirementplansismostaccurate?

A.TotalperiodicpensioncostisequaltothechangeinPBOminusthefirm’s

contributions.

B.Inadefined-contributionplan,periodicpensioncostiscalculatedasthedifferencein

thecontributionamountandtheactualreturnonplanassets.

C.Inadefined-benefitplan,theemployerassumesthemajorityoftheinvestmentrisk.

MODULE14.2:DEFINEDBENEFITPLANS—

BALANCESHEET

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LOS14.b:Explainandcalculatemeasuresofadefinedbenefitpension

obligation(i.e.,presentvalueofthedefinedbenefitobligationand

projectedbenefitobligation)andnetpensionliability(orasset).

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CFAProgramCurriculum,Volume2,page67

Theprojectedbenefitobligation(PBO)[knownaspresentvalueofdefinedbenefit

obligation(PVDBO)underIFRS]istheactuarialpresentvalue(atanassumeddiscountrate)

ofallfuturepensionbenefitsearnedtodate,basedonexpectedfuturesalaryincreases.It

measuresthevalueoftheobligation,assumingthefirmisagoingconcernandthatthe

employeeswillcontinuetoworkforthefirmuntiltheyretire.

Fromoneperiodtothenext,thebenefitobligationchangesasaresultofcurrentservicecost,

interestcost,past(prior)servicecost,changesinactuarialassumptions,andbenefitspaidto

employees.

Currentservicecostisthepresentvalueofbenefitsearnedbytheemployeesduringthe

currentperiod.Servicecostincludesanestimateofcompensationgrowth(futuresalary

increases)ifthepensionbenefitsarebasedonfuturecompensation.Inrarecases,thepension

planmayhaveaprovisionforemployeestoshareintheservicecost.Currentservicecostin

thatcasewouldonlyrepresenttheemployer’sshareofthecost.Employeecontributions

wouldbeaddedtobothbeginningPBOandbeginningplanassetsinPBOandFVplanasset

reconciliationrespectively.

Interestcostistheincreaseintheobligationduetothepassageoftime.Benefitobligations

arediscountedobligations;thus,interestaccruesontheobligationeachperiod.Interestcostis

equaltothepensionobligationatthebeginningoftheperiodmultipliedbythediscountrate.

Past(prior)servicecostsareretroactivebenefitsawardedtoemployeeswhenaplanis

initiatedoramended.UnderIFRS,pastservicecostsareexpensedimmediately.UnderU.S.

GAAP,pastservicecostsareamortizedovertheaverageservicelifeofemployees.

Changesinactuarialassumptionsarethegainsandlossesthatresultfromchangesin

variablessuchasmortality,employeeturnover,retirementage,andthediscountrate.An

actuarialgainwilldecreasethebenefitobligationandanactuariallosswillincreasethe

obligation.

BenefitspaidreducethePBO.

ConsiderthefollowingexampleofcalculatingthePBO.

EXAMPLE:CalculatingPBO

JohnMcElwainwashiredonJanuary1,2016,astheonlyemployeeofTransferTrucking,Inc.,andis

eligibletoparticipateinthecompany’sdefined-benefitpensionplan.Undertheplan,heispromisedan

annualpaymentof2%ofhisfinalannualsalaryforeachyearofservice.Thepensionbenefitwillbepaid

attheendofeachyear,beginningoneyearafterretirement.McElwain’sstartingannualsalaryis$50,000.

InordertocalculatethePBOattheendofthefirstyear,wewillassumethefollowing:

Thediscountrateis8%.

McElwain’ssalarywillincreaseby4%peryear(thisiscalledtherateofcompensationgrowth).

McElwainwillworkfor25years.

McElwainwilllivefor15yearsafterretirementandreceive15annualpensionbenefitpayments.

Answer:

Basedonastartingsalaryof$50,000in2016and4%annualpayincreasesover24years,McElwain’s

salaryatretirementwillbe50,000×(1+0.04)24=$128,165.21.(IfMcElwainworksfor25years,hewill

receive24payincreases.)

IfMcElwainisexpectedtoearn$128,165.21inhislastyearofemployment(2040),hewillbeentitledto

anannualend-of-yearpensionpaymentequalto2%ofhisfinalsalaryforeachyearofservice.Thus,atthe

endofoneyearofservice,McElwain’sbenefitis$2,563.30peryearfromretirementuntildeath

($128,165.21×2%×1year).Assuminghelives15yearspastretirement,thepresentvalueofthe

paymentsontheretirementdate(2040)is$21,940.55(PVof15yearannuityof$2,563.30atPMT=–

2,563.30;N=15;I/Y=8;FV=0;CPTPV→21,940.55).Attheendofhisfirstyearofemployment

(2016),thepresentvalueoftheannuitythatbeginsin24yearsis$3,460.01($21,940.55discountedat8%

for24years).

Therefore,thePBOattheendof2016(McElwain’sfirstyearofemployment)is$3,460.01.Atable

outliningthesecashflowsfollows.

CalculationofthePBOattheEndof2016

Yearsof

Service

Projected

Salary

Yearsin

Retirement

BenefitPayment

(endofyear)

PresentValue

(endofyear)

Year

2016

2017

2018

1

$50,000.00

1

PBO=$3,460.01

2

$52,000.00

3

$54,080.00

23

24

25

2038

2039

2040

2041

2042

2043

$118,495.94

$123,235.78

$128,165.21

$21,940.55

$2,563.30

$2,563.30

$2,563.30

2

3

14

15

2054

2055

$2,563.30

$2,563.30

Aftertwoyearsofemployment,McElwain’sbenefitis$5,126.61($128,165.21×2%×2years).The

presentvalueofthepaymentsontheretirementdate(2040)is$43,881.09(PVof15yearannuityof

$5,126.61at8%).Attheendofhissecond