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The first two components of pension expense--service and interest cost--are identical to those found in the calculation of PBO. The next component is "expected return on plan assets." Recall that the "fair value of plan assets" includes actual return on plan assets. Expected return on plan assets is similar, except the company gets to substitute an estimate of the future return on plan assets. It is important to keep in mind that this estimate is an assumption the company can tweak to change the pension expense. Finally, the two "amortization" items are again due to the effects of smoothing. Some people have gone so far as to say the pension expense is a bogus number due to the assumptions and smoothing.
Critical Questions
We have just scratched the surface of pension plan accounting, but we have reviewed enough to identify the four or five critical questions you need to ask when evaluating a company's pension fund.
We have two primary concerns in regard to analysis of the pension fund:
• What is the economic status of the liability? A dramatically under-funded plan will require increased cash contributions in the future and foreshadows future increases in income statement expenses.
• How aggressive/conservative is the pension expense? An aggressive accounting policy is a "red flag" because it will usually have to be unraveled by the company in future periods. Conservative policies contribute to earnings that are higher in quality.
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