Pension accounting rules permit certain expense items to be smoothed into income. However, the required disclosures allow investors to adjust the income statement to reflect the true underlying economic cost related to pension plans. The economic cost should equal any change in the plan liability other than benefits paid or employer contributions.
Consider the following pension disclosures from KLA-Tencor’s (NASDAQ:KLAC) 10K.[click to enlarge]
The pension obligation increases by $4,175, and benefits paid of $1,519 should be added back to that amount to determine the underlying economic change in obligation. $4,175 + $1,519 = $5,694.
The fair value of assets rose by $1,255. The contributions and benefit payments were a net $789 which should be deducted from this. Notice that in this case the benefits paid figure differs between the asset side and the liability side. It is possible some benefits were paid as a lump sum settlement. At any rate, the net change in assets was $1,255 - 789 = $466.
The net change in the economic liability, then, was $5,694 - $466 = $5,228. Contrast that with the reported pension expense.[click to enlarge]
The economic change in the value of the pension was $5,228, but the income statement showed an expense of just $2,280. An investor might want to adjust the income statement by adding $2,948 to pension expense, reducing operating income by the same amount. The effect on net income would be smaller due to the tax effects.
For KLA-Tencor, reported operating income was $589,868 in 2007. After this adjustment it would have been $586,920 - approximately half a percent lower. Earnings per share for the year would have been at least a penny lower. In this case, I wouldn’t consider the difference material.