Hello and welcome everyone to our lesson today. Today, I am going to introduce the basics of a very simplified model for accounting for pensions. We're going to start with the main three elements or accounts that are used in the accounting for pensions. Those are actually, as we understand the pension plan, I have assets, I have funds being invested. I have obligation liabilities, and I have that pension expense that I will record or incur during a certain period. The main three elements is the asset, the liability, and the expense. We'll focus here after on accounting for defined benefit plans and gradually explore the various transactions that will affect those accounts and how to interrelate between the three accounts. The model, as I said, start with the very simplified form and the key elements of a defined benefit pension plans are basically the employer's obligation to pay retirement benefits in the future, which is the obligation. The plan assets that are set aside by the employer from which the retirement benefits are going to be paid and that's the assets. Finally, the periodic pension expense that will be incurred as a result of having that pension plan in place. Now let's take a look at the main transactions affecting these three elements or three accounts. We're going to start with number one, service cost. The service cost represents the increase in the projected benefit obligation attributable to employees service performed during the current year. For each particular year, the service costs represent the first component of that pension expense. Then obviously it's an obligation and it's an expense. Second component, interest costs. What is interest cost? The interest cost is the calculated interest and the interest rate, which is the discount rate, multiplied by the projected benefit obligation at the beginning of the year. I am incurring an interest on the obligation that I have accumulated over the last number of years, whatever that number is, and I'm incurring during this period an interest expense on. The projected benefit obligation balance is not separately reported as a liability in the company's balance sheet, but it is a liability nevertheless. The interest expense that accrues on its balance is not separately also reported in the income statement, but instead becomes the second component of the annual pension expense. It is important to understand that those elements, the interest costs will not be recorded as part of the interest. We will see later how the pension obligations and the pension asset will be netted out, but I don't want to get into the details now. Let's go to the third component of the pension expense. Return on pension plan assets, I invested amount and obviously because I've invested these funds in the pension plan, I have returned. Those represent the earnings on plan assets as a result of the investing activities of the plan assets funds in various securities. Remember, plan assets comprise the funds invested in stocks, bonds, and other securities that presumably will generate dividends, interests, capital gains and that's where the appreciation of those funds from year to year. Each year, these earnings represents the return on plan assets during that particular year. When accounting for the return, as we'll see later, we need to differentiate between two moods of the return. One is referred to as the expected return on those plan assets versus the actual return on plan assets. As as we go into the details, we will explain why those two are different and when do we use each. Fourth component. Employer's contributions. These represent the annual cash contributions that are invested in the plan assets with the objective of accumulating along with the investment returns, sufficient funds to provide the promised retirement benefits. Final element are the benefits paid out to retirees and that's the final stage. I'm doing all this to actually come to the stage where I pay off the benefits. Those represent the reduction in the projected benefit obligation when benefits are actually paid to retired employees. In summary, let's summarize those five transactions or five elements in the following table as you will see. In the left-hand side, I'm generating the pension plan obligation column. In the right hand side, I am generating the pension plan assets. In the middle, I'm generating a column for the pension plan expense. The pension plan obligation is affected by the service cost, the interest cost. Obviously, for now the benefits that are going to be paid off, service costs will increase the pension plan obligation, interest costs will increase it also, while the benefits will decrease. On the other side of the table, I see the pension plan assets, where we'll increase by the contributions, the companies making contributions into the pension funds, the return on plan assets that actually will appreciate. As you can see between parenthesis, it says actual. The pension plan assets will increase by the actual return on those funds. Finally, benefits are paid out and that is going to decrease the pension plan assets because I paid from the funds to those retired employees. In the middle the pension expense has those components, service cost, interest cost, which both will increase the pension expense while the return on plan assets will decrease it. But notice here it is expected return. Pension plan expense will decrease if there is a return, if there is a gain, if there is an appreciation based on the expected return, while the pension plan assets will increase by the actual return on plan assets. Obviously that will cause a problem later on, but I just want to point out, when we get into details we'll know exactly how to account for the discrepancy between the actual versus the expected. Please note, that the pension plan obligation and the pension plan assets are not reported individually in the financial statements. It is critical to understand the composition of both, the pension obligation and the plan assets because number one, they are reported as a net amount on the balance sheet. They are not listed separately. They're balances. The separate balances are reported or disclosed in the notes to the financial statements. Finally, and more importantly, the pension expense reported in the income statement is a direct composite of the periodic changes that occur in both the pension obligation and the pension plan assets. As I said, if we understand the articulation between those three accounts, it will make the progress when we move on to account for the details of the pension will be much easier. Thank you very much.
