Defined Benefit (DB) pension accounting can be tricky and non-intuitive for investors to understand, primarily I would say, because of all the assumptions that are required as part of the calculations. The purpose of this article is to point out a few adjustments that investors should consider making to the reported pension expense items included in financial statements.
The pension expense that shows up on income statements (I/S) typically gets included in the calculation of net operating income. The key contributing factors to the total I/S pension expense include:
- Current service costs
- Pension interest expense
- The expected return on pension assets as a reduction of this expense
(Note: There are other DB pension related components that are included as part of comprehensive income, including past service costs and actuarial gains/losses due to changes in actuarial assumptions. I am not referring to those components in this article.)
Current service costs represent the increase in the pension obligation for services rendered by employees during the current reporting period. Another item is pension interest expense, which is the current period interest accrual on the existing pension obligation. The expected return on plan assets reduces the pension expense. It should be noted that it is an expected return based on assumptions of rate of return on plan assets that is used in this calculation, not the actual return on plan assets! Management is permitted (under U.S. GAAP and IFRS) to use the expected return on pension assets in order to reduce volatility of reported income from one period to the next.
One problem with pension expense being included as part of operating expenses, is that it is comprised of elements that are not typically considered operating in nature. It makes sense to keep current service costs as an operating expense since it arises due to work performed by employees during the current reporting period. However, pension interest expense is really a financing expense so why leave this under operating expenses? Calculations such as EBIT are supposed to be before interest expense, so it makes sense to back this out of operating expenses.
Likewise, expected return on plan assets seem more related to an investing activity rather than an operating activity and therefore it also makes sense to back this out of the operating earnings calculation. These adjustments should improve both the accuracy and comparability between different companies' operating income, related ratios and other calculations that depend on operating income.
If a company has a defined benefit pension plan, check the notes to financial statements to read the details on what was done and assumptions made for the pension accounting. As discussed here, there is a lot of important info you can find in the notes!