Basic Labor Cost Accounting for Accountuaries

1. CCA/SOA EB Spring Meeting 1 Basic Labor Cost Accounting for Accountuaries Segment 1, Part 1 The Income Statement, Balance Sheet and Pertinent Sub-Accounts Randy Gullo

2. CCA/SOA EB Spring Meeting 2 Table of Contents History and rationale for accounting Basic principles of accounting for public companies The financial statement: a structural overview The income statement The balance sheet

3. CCA/SOA EB Spring Meeting 3 Table of Contents Statement of cash flow Statement of stockholders� equity Statement of comprehensive income Notes to financial statements Other disclosures in 10-K�s

4. CCA/SOA EB Spring Meeting 4 Table of Contents Basic principles underlying recognition or deferral of benefit costs & liabilities Tie-in with benefits accounting: general comments Q&A

5. CCA/SOA EB Spring Meeting 5 History and rationale for accounting Accurate financial reporting for public so it can rely upon company�s F/S and make informed investment decisions Heightened scrutiny over past few years� post �E� era Sarbanes Oxley - 404

6. CCA/SOA EB Spring Meeting 6 Basic principles of accounting for public companies Accrual basis vs. cash basis of accounting Consolidation Transparent financial reporting Allowing investors to be able to see a company through the eyes of management

7. CCA/SOA EB Spring Meeting 7 The financial statement: a structural overview

8. CCA/SOA EB Spring Meeting 8 The financial statement: a structural overview

9. CCA/SOA EB Spring Meeting 9 The income statement Revenues (industry specific disclosures) Costs (COGS vs. operating expense vs. SG&A) Operating income Other line items: Discontinued operations Extraordinary items Cumulative effect of change in acctg principle Net income (loss) EPS

10. CCA/SOA EB Spring Meeting 10 The income statement Pension expenses: reported net in income statement � �net periodic benefit cost� Compensation cost of pension benefits Interest cost from deferred payment of pension benefits Gains or losses on plan investments Can be recorded in different line items in income statement

11. CCA/SOA EB Spring Meeting 11 The income statement Sample income statement(alt/tab now)

12. CCA/SOA EB Spring Meeting 12 The balance sheet Assets Tangible and intangible Long-term and short-term Liabilities (long-term and short-term) Equity Preferred/Common Stock APIC Retained Earnings Accumulated Other Comprehensive Income

13. CCA/SOA EB Spring Meeting 13 The balance sheet Sample balance sheet(alt/tab now)

14. CCA/SOA EB Spring Meeting 14 Statement of cash flow Two Methods: Direct vs Indirect Reconciliation of beginning and ending cash balances Operating activities Investing activities Financing activities Non-cash disclosures

15. CCA/SOA EB Spring Meeting 15 Statement of cash flow Sample statement of cash flow(alt/tab now)

16. CCA/SOA EB Spring Meeting 16 Statement of stockholders� equity Rollforward of each component of equity including capital accounts and shares Accumulated other comprehensive income (OCI) Equity directly impacted by certain employee benefit plans (ex. LESOP, certain LTIP, share based compensation, and minimum pension liability adjustments)

17. CCA/SOA EB Spring Meeting 17 Statement of stockholders� equity Sample statement of stockholders� equity (alt/tab now)

18. CCA/SOA EB Spring Meeting 18 Statement of comprehensive income Not always present for each company Statement representing the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources Examples of items affecting Comprehensive Income include: Minimum pension liability adjustments Changes in FV of derivatives and certain marketable securities

19. CCA/SOA EB Spring Meeting 19 Statement of comprehensive income Sample statement of comprehensive income (alt/tab now)

20. CCA/SOA EB Spring Meeting 20 Notes to financial statements Integral part of the financial statements Provides more detailed disclosure and �color� to the basic financial statements including: Summary of accounting principles the entity follows Summary of significant line items in basic financial statements Discloses certain assumptions made in the preparation of the financial statements Summarizes certain �off-balance sheet� information including lease obligations, pensions and other post retirement benefits

21. CCA/SOA EB Spring Meeting 21 Notes to financial statements Sample notes to financial statements (alt/tab now)

22. CCA/SOA EB Spring Meeting 22 Other disclosures in 10-K�s Management Discussion and Analysis (MD&A) Critical Accounting Policies Liquidity Results of Operations Risk Factors Principal accountant fees and services

23. CCA/SOA EB Spring Meeting 23 Basic principles underlying recognition or deferral of benefit costs & liabilities Provides comparability and understandability by attributing the cost of pension benefits over the approximate service period in which those benefits are earned and by relating that cost direct to the terms of the pension plan Reduces volatility inherent in accounting for these plans by delaying the recognition of certain differences between actual and expected results through amortization

24. CCA/SOA EB Spring Meeting 24 Tie-in with benefits accounting: general comments Benefits affect many areas of a complete set of financial statements rather than just the �Pensions� footnote Examples include: each statement described previously other notes to financial statements Other disclosures within 10-K�s and 10-Q�s

25. CCA/SOA EB Spring Meeting 25 Q&A

26. CCA/SOA EB Spring Meeting 26 Basic Labor Cost Accounting for Accountuaries Segment 1, Part 2 Accounting for Pensions and Retiree Health Care Josh Bank

27. CCA/SOA EB Spring Meeting 27 Table of Contents What everyone knows about FAS87/ 88/ 106/ 112/ 132 What no one knows about FAS87/ 88/ 106/ 112/ 132 Discount Rates 1: Your own back yard Discount Rates 2: Across the pond

28. CCA/SOA EB Spring Meeting 28 Table of Contents Discount Rates 3: Down Under (the Rio Grande) Discount Rates 4: Godforsaken countries (a.k.a. �emerging markets�) Other assumptions do count, but whaddya gonna do about it? Promenade down ROECD row (the Real OECD):

29. CCA/SOA EB Spring Meeting 29 Table of Contents A peek at non-ROECD benefits GAAP Frequently-asked questions Q&A

30. CCA/SOA EB Spring Meeting 30 What everyone knows about FAS87/88/106/112/132 Everyone knows, so we won�t waste your time repeating it (not right now anyway)

31. CCA/SOA EB Spring Meeting 31 What no one knows aboutFAS87/88/106/112/132 We couldn�t find anyone who knew

32. CCA/SOA EB Spring Meeting 32 Discount Rates 1:your own back yard Actuaries don�t set the rates Auditors don�t set the rates Investment bankers don�t set the rates SEC doesn�t set the rates

33. CCA/SOA EB Spring Meeting 33 Discount Rates 1:your own back yard The Company sets the rate Yeah right This is a fascinating annual spring ritual �So� what are people using?� �I dunno� what were you thinking of using?� �Is that year-end survey out yet?� �Well I heard that PWC is challenging anything above x.25%...� �What DID our December discount rate memo say, anyway?!� �Tell you what� run the numbers at x.00%, x.25% and x.50%...� �I hear that SEC is asking WidgetWorld for �further information� ?�

34. CCA/SOA EB Spring Meeting 34 Discount Rates 2:Across the pond They wonder why we whine so much about two things discount rates the price of gas UK and Eurozone is FinEcon in actual practice Gilts, Libor, iBoxx, RBS, Bund(t?)s, whatever. Fact is, there�s some real pain over there, although they, too, are jacking rates of late

35. CCA/SOA EB Spring Meeting 35 Discount Rates 3:Down Under (the Rio Grande) Mexico: Whatever�s reasonable, or �not unreasonable� (more SCL?). Local SOA puts out arbitrary �guidance� from time to time. Arbitrary maybe, but very calming. Tends to be expressed in terms of real rates. Brazil: Used to be 6%, period (real rate). Recently they�re breaking away from that traditional statutory rate. Venezuela: Switching between Nominal and Real rates creates chaos. Here�s an example.

36. CCA/SOA EB Spring Meeting 36 Discount Rates 4: Godforsaken countries (a.k.a. �emerging markets�) Never figured this one out Usually withhold opinion or write in SCL (Special Consulting Language) What is the rate on long-term high-quality debt instruments in Ivory Coast, anyway? Ecuador? Rarely material, so more of a formality than anything�

37. CCA/SOA EB Spring Meeting 37 Other assumptions do count(but whaddya gonna do about it?) Mortality is probably the hottest topic of debate nowadays� not only in GAAP Effect of turnover can be unpredictable Interplay between salary scale, discount rate and turnover is the key Certain other countries require more detailed disclosures about assumptions Who takes the next step in upgrading mortality?

38. CCA/SOA EB Spring Meeting 38 Promenade down ROECD row(the Real OECD) UK: FRS17 and IAS19 France: IAS19 (pensions) and IFRS2 (shares) Germany: BiRiLiG (or something like that)

39. CCA/SOA EB Spring Meeting 39 Promenade down ROECD row(the Real OECD) Netherlands: IAS19 and RJ271 Belgium: Expense = Cash under Belgian GAAP, but listed cos. Converting to IFRS Korea: IAS19 done by FAS87 actuary for French owners. Fun stuff�

40. CCA/SOA EB Spring Meeting 40 A peek at non-ROECDbenefits GAAP Mexico: D-3. Bad translation of FAS87, although it does try (unsuccessfully) to be creative in the case of severance indemnities and also with hyperinflation. Early on, you could count on local actuaries� calculations to be wrong. Lately, though, there is more uncertainty. Brazil: CVM Delib. 371. Bad translation of D-3. Reads like the instructions for those first �assembly-required� bicycles we started importing from Red China in the �70s, except it�s in Portuguese. Good local actuaries ignore it and follow FAS87.

41. CCA/SOA EB Spring Meeting 41 A peek at non-ROECDbenefits GAAP Chile: IAS19. Chile doesn�t really belong on non-ROECD list, but its pension actuarial profession (maybe half a dozen?) has dwindled and their work is very opaque. Venezuela �then�: VGAAP used to default to D-3, and if D-3 didn�t address specific situation then relied on FAS87 et al. Interesting stories around new D-3 hyperinflation theme Venezuela �now�: (must be careful here�) VGAAP is whatever The People need it to be. In some notable cases lately, The People are needing not to be inhibited by imperialist, oligarchical rules.

42. CCA/SOA EB Spring Meeting 42 Frequently-asked questions Does IAS19/FAS87/FAS112 apply? Will you review this list of assumptions for this company�s plans in 27 countries? Can you look at this IAS19 valuation done by the local Peruvian actuary? You want to charge HOW much to do a real valuation? How much for a ballpark estimate? (and we�d like 5-year projection too!)

43. CCA/SOA EB Spring Meeting 43 Q&A

44. CCA/SOA EB Spring Meeting 44 Basic Labor Cost Accounting for Accountuaries Segment 1, Part 3 Identification and Treatment of Other (non-pension/retiree medical) Labor Costs Iain Jones

45. CCA/SOA EB Spring Meeting 45 Table of Contents Importance of accurate accounting MA&D considerations Confusing terms Typical labor costs considered

46. CCA/SOA EB Spring Meeting 46 Table of Contents Other types of labor costs Relative importance Frequently confused benefits Q&A

47. CCA/SOA EB Spring Meeting 47 Importance of Accurate Accounting Increased focus on accounting for benefit costs Sarbanes-Oxley requirements Increased size of obligations Funding deficits over past few years Movement on to balance sheets (FASB ED) Purchase accounting implications Increased auditor scrutiny

48. CCA/SOA EB Spring Meeting 48 MA&D Considerations Recovery in economy ? more MA&D activity Purchase accounting recognizes actual funded status Impact on deal value Many companies not accounting correctly under US GAAP � need to dig Relative impact on deals varies

49. CCA/SOA EB Spring Meeting 49 Confusing Terms Mandatory vs statutory DB vs DC Reportable assets Vested benefit Local accounting values Appropriate assumptions

50. CCA/SOA EB Spring Meeting 50 Typical Labor Costs Considered � by actuaries in the US Pension plans Typically trust arrangements Additional unfunded executive retirement plans Postretirement benefit plans � medical, life Tip of the iceberg!

51. CCA/SOA EB Spring Meeting 51 Other Types of Labor Costs (1) Pensions mandatory plans unfunded book reserves DC plans with guarantees Underpins/caps/floors Old-age part time programs Bridging/early retirement pensions

52. CCA/SOA EB Spring Meeting 52 Other Types of Labor Costs (2) Medical Insured and self-financed Checkups, dependent benefits Dental, vision Family benefits Death benefits Lump sums Spouse�s and orphans� pensions Disability benefits Short-term; long-term Lump sum and/or pension

53. CCA/SOA EB Spring Meeting 53 Other Types of Labor Costs (3) Workers compensation Unemployment benefits Paid time off Holidays Vacations Maternity/paternity leave Special leave Long service leave/sabbaticals/jubilee

54. CCA/SOA EB Spring Meeting 54 Other Types of Labor Costs (4) Perquisites Cars Loans Subsidized lunches Allowances Memberships (gym, golf, societies) Training Internal; external

55. CCA/SOA EB Spring Meeting 55 Other Types of Labor Costs (5) Don�t forget the basics Base salary Short-term incentives Long-term incentives Stock options Restricted stock Employee stock purchase plans

56. CCA/SOA EB Spring Meeting 56 Relative Importance

57. CCA/SOA EB Spring Meeting 57 Frequently Confused Benefits (1) Australia: long-service leave Belgium/Switzerland: �DC� plans France: Termination indemnities Germany: OAPT, jubilee, reinsurance arrangements, individual plans

58. CCA/SOA EB Spring Meeting 58 Frequently Confused Benefits (2) Italy: TFR Mexico: Termination indemnities and seniority premiums South Korea/Taiwan: book reserves U.K.: realistic pension deficits, life and disability

59. CCA/SOA EB Spring Meeting 59 Treatment Know what to look for Local valuations often not valid US GAAP valuations Purchase accounting Purchase price adjustments

60. CCA/SOA EB Spring Meeting 60 Q&A

61. CCA/SOA EB Spring Meeting 61 Basic Labor Cost Accounting for Accountuaries Segment 1, Part 4 Intangible Assets, Other Comprehensive Income, Deferral/Amortization and other Buzz Terms Randy Gullo

62. CCA/SOA EB Spring Meeting 62 Table of Contents Tie-in with benefits accounting: general comments (revisited) Basic principles underlying recognition or deferral of benefit costs & liabilities (revisited) Book expense vs. cash contributions: Impact on financial statement Accrued or prepaid pension expense

63. CCA/SOA EB Spring Meeting 63 Table of Contents Intangible assets Other comprehensive income Liabilities Deferral and amortization Q&A

64. CCA/SOA EB Spring Meeting 64 Tie-in with benefits accounting: general comments (revisited) Benefits affect many areas of a complete set of financial statements rather than just the �Pensions� footnote Examples include: each statement described previously other notes to financial statements Other disclosures within 10-K�s and 10-Q�s

65. CCA/SOA EB Spring Meeting 65 Basic principles underlying recognition or deferral of benefit costs & liabilities (revisited) Provides comparability and understandability by attributing the cost of pension benefits over the approximate service period in which those benefits are earned and by relating that cost direct to the terms of the pension plan Reduces volatility inherent in accounting for these plans by delaying the recognition of certain differences between actual and expected results through amortization

66. CCA/SOA EB Spring Meeting 66 Book expense vs. cash contributions: impact on financial statements Cash payments will affect the cash flow statement but may not always immediately affect the operations reported by a company Cash contributions to benefit plans (required or not required) may also not necessarily affect the F/S as much as you would expect

67. CCA/SOA EB Spring Meeting 67 Accrued and prepaid pension expense Equal to funded status (PBO � FV of plan Assets = Funded Status) less amounts subject to delayed recognition Formula: Funded Status +/- Unrecognized net (gain) or loss - Unrecognized prior service cost +/- Unrecognized net obligation or (net asset) at date of initial application of FAS 87 = (Accrued)/prepaid pension cost

68. CCA/SOA EB Spring Meeting 68 Intangible assets SFAS No. 142 Defined as: assets (not including financial assets) that lack physical substance Ex. Customer lists, trademarks, patents and licenses Goodwill� well that�s different The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed.

69. CCA/SOA EB Spring Meeting 69 Other comprehensive income SFAS No. 130 Represents the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources Examples discussed previously Pension Plan example: to the extent AML exceeds any unrecognized prior service cost: the residual is recorded in OCI

70. CCA/SOA EB Spring Meeting 70 Liabilities Three essential characteristics of liability: embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice the transaction or other event obligating the entity has already happened. Liabilities commonly have other features that help identify them�for example, most liabilities require the obligated entity to pay cash to one or more identified other entities and such payment is legally enforceable.

71. CCA/SOA EB Spring Meeting 71 Liabilities (Cont�d) Classification � short-term vs. long-term Pension-specific liabilities: Pension plan liabilities are generally off balance sheet Pension liabilities on balance sheet represent the minimum pension liability (MPL) Calculated as ABO � FV of plan assets

72. CCA/SOA EB Spring Meeting 72 Deferral and amortization Certain amounts paid or recorded are �spread� over the period the benefit or detriment is expected to be realized Example: Insurance company receives $1 million for a 3-year insurance policy. $1 million will be initially recorded as a deferred liability and amortized (spread on a reasonable and rational basis) to earnings over 3-year period of the policy $1 million cash received will be recorded in cash flow statement partially offset by change in operating assets and liabilities (change in deferred liability account)

73. CCA/SOA EB Spring Meeting 73 Additional Minimum Liability (AML) Example Assumptions: Accumulated benefit obligation (ABO) = 100 FV of Plan Assets = 70 Accrued Pension Cost (liability on the books) = 20 Unrecognized prior service cost = 5

74. CCA/SOA EB Spring Meeting 74 Additional Minimum Liability (AML) Example (cont�d) Calculations: FV of plan assets � ABO = Unfunded ABO (70 � 100 = (30)) Unfunded ABO � Accrued Pension cost = AML (30 � 20 = 10) AML � Unrecognized prior service cost = Charge to equity through OCI (10 � 5 = 5) Net impact of the F/S based on above calculations and assumptions: Reduction of OCI (equity) 5 Increase in intangible pension asset 5 Increase in accrued pension cost liability 10

75. CCA/SOA EB Spring Meeting 75 Q&A