CFA Level 1
Liabilities - Accounting For Long-Term Liabilities
A mortgage is a long-term debt secured by a real estate property such as a building or land. The mortgage is usually paid back in equal installments. These installments include a portion that is attributable to interest expense and the other to capital repayment.
Companies generally acquire the right to use an asset by purchasing it outright. But in some cases companies can lease an asset as opposed to an outright purchase. Leases can be classified as operating leases or capital leases. Operating leases are defined as short-term leases by which the company enters into an agreement with the lessor to use the asset for a portion of the asset's economic life. The lessee (the company leasing the equipment) will have no obligation to purchase the asset in the future. Capital leases, on the other hand, are long-term leases that create a long-term obligation for the lessee. If the asset qualifies as a capital lease, the asset is recorded on the balance sheet and the present value of the lease obligations are also recorded on the balance sheet. The asset is amortized over the life of the lease by using a straight-line depreciation method. Each rental payment includes a portion that is allocated to interest expenses and repayment of principal.
A pension plan is a qualified retirement plan set up by a corporation, labor union, government or other organization for its employees. A pension plan is an agreement under which the employer agrees to pay monetary benefits to employees once their period of active service has come to an end. A third party frequently manages the pension plan.
The CFA institute concentrates on two types of pension plans: defined-benefit plans and defined-contribution plans.
A defined-benefit pension plan promises a specific benefit at retirement to its employees. Since the benefits are defined, the employer is responsible for accumulating sufficient funds. Such plans insulate employees from investments that perform poorly, but it also prevents them from enjoying the entire upside potential of the pension if it does well.
That said, pension funds are governed by the Employee Retirement Income Security Act of 1974 (ERISA), a more conservative investment approach, and large gains are unlikely to occur. Corporations refrain from setting up these types of plans because they can create enormous pension liabilities for a company if the pension's portfolio does not perform well.
Defined pension plans need to be revalued periodically by an actuary. Under SFAS 87, companies are required to use the same actuarial cost method and are required to disclose assumptions about the pension obligation and pension cost. The major issue with SFAS 87 is that a company may make pension contributions using different assumptions when valuing the present value of the underlying assets using capital market assumptions.
- A defined-contribution pension plan, by contrast, specifies how much the employer will contribute annually. The actual amount the employee will receive at retirement will depend on the overall performance of the pension fund. With such a plan, investments that perform poorly mean lower income in retirement, and vice versa. Under this plan the company does not carry any risk and does not create any pension liabilities if it pays its annual contribution amount. Contributions made are simply expenses on an annual basis and are usually discretionary.
- Accounting for pension funds. To be able to pay their pension obligations, companies must accumulate funds known as the "plan assets". Plan assets are not formally recognized on the balance sheet, but are actively monitored in the employer's informal records. The plan assets can change due to returns on plan assets - such as dividends, interest, market-price appreciation and cash contributions - employer contributions and retiree benefits paid, which are benefits actually paid to retired employees. The composition of pension expenses is beyond this problem set.
Candidates should know that pension expenses are deducted from the income statement.
Though the pension plan assets and liabilities are not included in the financial statement, companies are required to include the following information in the footnotes:
- The components of the annual pension expense
- The projected benefit obligation (as well as the accumulated benefit obligation and vested benefit obligation)
- Other information that makes it possible for interested analysts to reconstruct the financial statements with pension assets and liabilities included.