Hello, and welcome everyone to our lesson today. In our lesson today, we'll introduce one complexity to the simplified pension model that we have built. As of now, we have demonstrated some basic changes in the PBO, the planned assets, and the pension expense. What are those changes, what are those transactions? Let me revise them, review them with you. These are mainly the service cost, the interest cost, the employer's contribution to the pension plan, the return on plan assets. And finally, payment of benefits to retirees, the five main transactions. Today, we will add to the model what we refer to as prior service cost. We'll study, what does it mean, what does it refer to, and how do we account for it in this model? Another reason for the PBO, that change, is if the pension plan itself is amended to revise the way benefits are determined. For example, let's review quickly a simplified formula that we used before, 1.5% times the years of service, times the final year's salary. This is for projected benefit obligation, that is for defined benefit plans. This is the formula that I decide the benefits that will be paid out. Let's assume that the company now decided to increase the formula's 1.5% to 1.7%. Obviously, the annual service cost from this date forward from that change will be higher than it would have been without the amendment. But it also might cause an immediate increase in the PBO as well. This is because most of the companies choose to make amendments retroactive to prior years, what does that mean? In other words, the more beneficial terms of the revised pension formula are not applied to just future service years, but benefits attributable to all prior service years also are recomputed under the more favorable terms. Making the amendment retroactive to prior years adds an extra layer of retirement benefits, increasing the company's obligation. The increase in the PBO attributable to making a plan amendment retroactive is referred to as prior service cost. Prior service cost increase PBO due to recalculating the benefits employees earned in prior years, as a result of the plan amendment. Thus, it is not fair to allocate such a huge cost to the period where the amendment was made. Amending a pension plan, and especially choosing to make the amendment retroactive typically is done with the idea that the future operations will benefit from those choices. For that reason, the cost is not recognized as pension expense in the year the plan is amended. But instead, it is recognized as a pension expense over the time that the employees who benefited from the retroactive amendment will work for the company in the future. So now I have two things. Number one, I made an amendment that added a huge cost, so that you logically visualize what I'm talking about. You had a main huge amendment, that you decided that it will take retroactive effect, so that's a huge cost. And that huge cost will benefit from the services by the employees in the future. So now you have that cost, you want to do something about it. You want it to hang in there, so that you start allocating it on the prior or the future years. Thus the additional cost of such an amendment is reported as a component of AOCI, accumulated other comprehensive income. That's the account that I'm telling you, we'll hang it in there, we'll keep it there, we'll reserve it there. So that we amortize it over the average remaining service life of the active employee group, using the straight-line amortization method. So I'm going to get that cost, calculate this huge cost, and then try to find a way to amortize it over the average remaining service years of my employees. Why don't we take a look at this in the tabular form that is presented in front of you? We have three columns in the table, projected benefit obligation on the left-hand side. Plan assets on the right-hand side, pension expense in the middle. The simplified version of the model has the transactions that we have in front of us. Service cost, interest cost, the benefits And the contribution. Notice that the plan asset has actual return on plan assets, it will increase by the actual, while the pension expense will decrease by the expected. This is the model for a simplified form without yet the prior service cost. Now the prior service cost, you will see, first of all it will increase. That's why it's going to show up in the projected benefit obligation because it's going to increase the obligation. But look at the pension expense, if you notice that the pension expense now, I am not having the prior service cost because I don't want that prior service cost as a whole to hit the pension expense, but it has the amortization of the prior service cost. Then obviously when I record the prior service cost in the obligation, I will record it, the other side will be the AOCI which I am going to reserve it in the AOCI, and then from the AOCI in, the accumulated other comprehensive income, or the OCI, I will actually allocate it and amortize it over the pension expense for the future years. Now let's take a look and update our T accounts journal entries. For whatever reason, it's easier to visualize the account, so I started with the posting process, but actually in the order, we journalize and then we post. So let's take it from the T account, the ledger accounts. In the Ledger accounts, we have the projected benefit obligation, the left-hand side, the planned asset on the right-hand side, the pension expense below them in the middle. If you notice on the left-hand corner I actually added that AOCI and between parenthesis the PSE prior service cost. That is account that I will, that I was telling you that I will reserve that prior service cost in it and then start to amortize. Very good, start with the beginning balances. As you can see, the beginning balance in the projected benefit obligation in the credit, the beginning balance on the planned asset on the debit, and the AOCI the beginning balance is on the debit because most of the time it is a cost that I incurred because of additional obligation that was raised so obviously that OCI, the prior service cost, will have a debit balance. Now I'm starting with the service cost as I did before, increasing the obligation, increasingly the expense, pension expense, increasing cost, increasing the obligation, increasing the expense. Very good. Actual return equals expected return, so that's why you see the actual return is in the debit side of the planned asset, while the expected return is lowering my pension expense, assuming that they are equal, which I am reserving for now that they are equal until we release that assumption later. But for now, the actual return equal expected return and that's why it's showing up in the debit side of the planned asset and the credit side in the pension expense. Finally, the benefits debited through the projected benefit obligation and credited to the planned asset, and then finally the contribution, which are actually going to increase that contribution that are made by the company into the planned asset. So far, those are the components of the simplified pension model. Now, as you can see, we're going to add the prior service cost to the projected benefit obligation, that's why it's showing up in the credit side, while the debit side is going to be in the OCI prior service columns, which is the AOCI and that is doubling it, meaning that I'm increasing that huge loss and I'm not going to hit the expense with it. And then on the other side, you're going to find that the prior service cost will be amortized. That's why I'm crediting the AOCI by the amount that I want to amortize, which is depending on the average remaining years of the service for my employees, and the pension expense will be debited for that amount of the amortization. Thus, the prior service cost as a bulk was actually credited, all of it increased the benefit obligation, but not all of it has increased the pension expense. The pension expense for this particular period has only been affected by the amortization of the pension expense. Now let's take a look at the journal entries. In the journal entries, what I'm adding, the new portion is how to record the prior service cost, and the prior service cost, as I said, we are going to credit as you can see, the PBO, while the AOCI price service cost is being debited while the amortization is debited to pension expense, and then amortizing the AOCI prior service costs and that's why I'm crediting it because you are actually decreasing the loss in the AOCI. In summary, please note that even though we are amortizing it, the prior service cost is not Not an asset but instead part of the accumulated other comprehensive income which is a stockholders equity account. This is the result of the vast breeze intention to not treat the cost as an expense as it is incurred. Because of what we explained before the bulk and it relates to the next future years. The board instead prefers to consider it to be other comprehensive income and not reported among the gains and losses and the traditional income statement. The only portion that will go into the income statement is the amount that is being amortized of this prior service cost during a specific period. Thank you.
