ch19 - keiso

Prepared by:

Dragan Stojanovic, CARotman School of Management, University of Toronto

Chapter Chapter 1919

Pensions and Other Employee Future Pensions and Other Employee Future BenefitsBenefits

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Pensions and Other Pensions and Other Employee Future BenefitsEmployee Future Benefits

Introduction Introduction and Benefit and Benefit Plan BasicsPlan Basics•Introduction

•Defined contribution plans

•Defined benefit plans

•Nature of pension plans

Presentation, Presentation, Disclosure, and Disclosure, and AnalysisAnalysis•Presentation

•Disclosures

•Illustration

•Analysis

Defined Benefit Defined Benefit Pension PlansPension Plans•The employer’s obligation

•Plan assets

•Funded status

•Benefit cost components

•Immediate recognition approach

•Deferral and amortization approach

•Other considerations

•Comparison of results

•Other defined benefit plans

IFRS / Private IFRS / Private Enterprise Enterprise GAAP GAAP ComparisonComparison•Comparison of IFRS and private enterprise GAAP

•Looking ahead

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•Disclosures

•Illustration

•Analysis


•Plan assets

•Funded status








•Looking ahead

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Benefit PlansBenefit Plans

• Three examples of benefit plans:1. Pension and other post-retirement plans

(e.g. health care and life insurance)2. Post-employment benefit plans (e.g.

severance benefits and long-term disability benefits)

3. Compensated absences (e.g. parental leaves, unrestricted sabbatical leaves)

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Benefit PlansBenefit Plans• Employee future-benefit plans can be:

1. Defined contribution (DC) plans• Specifies the contributions or payments into the

plan• Does not specify the benefits the employees will

receive or method used to determine benefits2. Defined benefit (DB) plans

• These are any benefit plans that are not a defined contribution plan

• Further subdivided as:a. Benefits that vest or accumulateb. Benefits that do not vest or accumulate

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• Employer contributes a defined sum (either a fixed sum or related to salary) to a third party– Ownership of plan assets assumed by

plan trustee– Trustee is responsible for investment and

distribution of plan assets• Employee assumes the economic risk

– No guarantee made by employer as to benefits paid

• Cost of the plan in the current year is known with certainty

Defined Contribution PlansDefined Contribution Plans

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Defined Contribution PlansDefined Contribution Plans• Liability reported if contribution (funding) is less than

required• Asset reported if the amount contributed is more

than required for the period• When plan is first established or when there is an

amendment to the plan, the employer may be obligated to make contributions for previous employee services (called prior or past service cost)

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Defined Contribution Plans:Defined Contribution Plans:Employers’ Journal EntriesEmployers’ Journal Entries

Contribution madeContribution madeis less thanis less than

the pension expensethe pension expense

Pension Expense DrPension Expense Dr Cash CrCash Cr Accrued PensionAccrued Pension Liability CrLiability Cr

LiabilityLiability

Contribution madeContribution madeis moreis more

than pension expensethan pension expense

Pension Expense DrPension Expense DrAccrued PensionAccrued PensionAsset DrAsset Dr Cash CrCash Cr

AssetAsset

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Pension PlansPension Plans

• A pension plan provides benefits (payments) to retirees for services provided during employment

• Employer sponsors and contributes to fund, and incurs the cost of the pension plan– Accounting for the employer

• Pension plan receives the contributions, administers pension assets, and makes pension payments to the beneficiaries– Accounting for the pension plan

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COMPANYCOMPANY TRUSTTRUST

Pension Fund Stream Pension Fund Stream

Pension ExpensePension Expense

Cash paid to pension Cash paid to pension plan (funding)plan (funding)

Accrued pension Accrued pension asset/liabilityasset/liability

$$PlanPlan

AssetsAssets

Retirees (pension benefits)Retirees (pension benefits)

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• Contributory– Employee and employer make contributions to the

plan • Non-contributory

– Employers bear the full cost of the pension plan– No contributions made by employee

• Vested– Amounts in the plan become the legal property of

the employee• Employee is entitled to receive benefits even

after leaving the employ of the corporation

Pension TerminologyPension Terminology

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Defined Benefit Pension Defined Benefit Pension PlansPlans

• It is a benefit plan that pension benefits to be received by employee after retiring

• The trust’s main goal is to ensure there will be enough pension assets to pay employer’s obligation to employees when they retire

• Example: employee will receive an annual pension benefit on retirement equal to 2% of average best three years of salary multiplied by years of service

• Pension benefits are based on a formula:– Employee’s years of service and expected salary

level at retirement are usually key variables

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Defined Benefit Pension PlansDefined Benefit Pension Plans

• Employer is the beneficiary of a defined benefit trust • Pension obligations belong to the employer• The employer remains liable to ensure benefit

payments, no matter what happens in the trust• Employer assumes economic risks• Cost of plan not known with certainty, as it depends

on uncertain future variables (e.g. employee turnover, mortality, inflation)

• The pension expense is not same as cash funding contribution

• Actuarial assumptions used extensively in accounting for defined benefit plans

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•Disclosures

•Illustration

•Analysis


•Plan assets

•Funded status








•Looking ahead

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• Three methods of measuring the pension obligation valuation

1. Vested benefit obligation– Based on current salary levels– Includes only vested benefits

2. Accumulated benefit obligation– Based on current salary levels– Includes both vested and non-vested service

3. Projected benefit obligation– Based on future salary levels– Includes both vested and non-vested service

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• Projected benefit obligation is considered the best measure for accounting purposes

• Present value of vested and non-vested benefits earned as at reporting date (using future salary levels) is called accrued benefit obligation (ABO) for accounting purposes.

• Accrued benefit obligation (ABO) for funding purposes may be based on different variables.

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Pension Liability Pension Liability MeasurementMeasurement

Vested benefit obligation

Accumulated benefitobligation

Projected benefit obligation

Pro-rated on servicePro-rated on salaries

Pension obligation

Present value of the estimated future benefits to be paid to employees

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Projected Benefit ObligationProjected Benefit Obligation

• Pro-rated on salaries–Annual expense based on percentage of

total estimated compensation earned by the employees over their career

• Pro-rated on services–Annual expense based on the total

estimated benefit being allocated evenly over the years of service of the employee

–Recommended method

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Accrued Benefit Obligation Accrued Benefit Obligation (ABO)(ABO)

Accrued benefit obligation, beginning+ Current service cost+ Interest cost- Benefits paid to retirees+/- Past service costs of plan amendments

during period+/- Actuarial gains (-) or losses (+) = Accrued benefit obligation, end of period

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Interest CostsInterest Costs

What rate should be used?• Current market rate

– Determined by reference to current yield on high-quality debt instrument (e.g. corporate bonds)

– IFRS and PE GAAP• Settlement rate

– Implied rate on insurance contract that would effectively settle pension obligation

– Allowed under PE GAAP

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Plan AssetsPlan Assets Plan assets, fair value at beginning

+ Contributions +/- Actual return *- Benefits paid to retirees

= Plan assets, fair value at end of period

* Actual return = Expected return + actuarial gain on assets

or – actuarial loss on assets

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Funded StatusFunded Status

Accrued Benefit Obligation (ABO)- Fair Value of plan assets= Funded status

• ABO > Plan assets = underfunded = funded status liability

• ABO < Plan assets = overfunded = funded status asset

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• Components that change ABO and fund assets (therefore, funded status) include:

1. Current service cost2. Interest cost3. Past service cost4. Return on plan assets5. Actuarial gains and losses

Components ofComponents of Pension Benefit Cost Pension Benefit Cost

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• Pension cost should be accrued and recognized in accounting periods that benefit from employees’ service

• Two approaches to accounting for pension expense

– Immediate recognition approach• Allowed under PE GAAP

– Deferral and amortization approach• Required under IFRS• Allowed under PE GAAP

Accounting for PensionsAccounting for Pensions

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Immediate Recognition ApproachImmediate Recognition Approach

Pension Expense

Current servicecost

+

Current interestcost

+

Actual return onPlan Assets

Past Service Costsrecognizedimmediately

Actuarialgains/lossesrecognizedImmediately

+ or + or

Immediate Recognition Immediate Recognition ApproachApproach

• ABO and fund assets are not recognized as separate balance sheet accounts (they are off-balance sheet or memo accounts)

• Accrued pension asset/liability recorded on the balance sheet represents the net position or funded status

• ABO is based on valuation used for funding purposes, not based on projected benefits obligation

• Because all changes are recognized immediately (i.e. actuarial gains/losses and post service costs), pension expense is highly variable from year to year

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• Used to accumulate information needed for the formal journal entries and to keep track of the relevant pension plan items and components reported off-balance sheet

The Pension WorksheetThe Pension Worksheet

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Immediate Recognition - ExampleImmediate Recognition - ExampleGeneral Journal Entries Memo Record

Items Annual Pension Expense

Cash Accrued Pension

A/L

Accrued Benefit

Obligation

Plan Assets

Bal. Jan 1 2010 0 100,000 Cr. 100,000 Dr.

a) Service cost 9,000 Dr. 9,000 Cr.

b) Interest cost 10,000 Dr 10,000 Cr.

c) Actual return 10,000 Cr. 10,000 Dr.

d) Contributions 8,000 Cr. 8,000 Dr.

e) Benefits paid 7,000 Dr. 7,000 Cr.

Expense entry, 2010 9,000 Dr. 9,000 Cr.Contribution Entry, 2010 8,000 Cr. 8,000 Cr.

Balance Dec. 31, 2010 1,000 Cr. 112,000 Cr. 111,000 Dr.

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Immediate Recognition - Immediate Recognition - ExampleExample

To record Expense:Pension Expense 9,000 Accrued Pension Asset/Liab 9,000

To record contribution:Accrued Pension Asset/Liab 8,000

Cash 8,000

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Immediate Recognition - ExampleImmediate Recognition - ExampleGeneral Journal Entries Memo Record

Items Annual Pension Expense

Cash Accrued Pension

A/L

Accrued Benefit

Obligation

Plan Assets

Bal. Dec. 31 2010 1,000 Cr. 112,000 Cr. 111,000 Dr.

f) Past service cost 80,000 Dr. 80,000 Cr.

a) Service cost 9,500 Dr. 9,500 Cr.

b) Interest cost 19,200 Dr 19,200 Cr.

c) Actual return 11,100 Cr. 11,100 Dr.

d) Contributions 20,000 Cr. 20,000 Dr.

e) Benefits paid 8,000 Dr. 8,000 Cr.

Expense entry, 2011 97,600 Dr. 97,600 Cr.Contribution Entry, 2011 20,000 Cr. 20,000 Cr.

Balance Dec. 31, 2011 78,600 Cr. 212,700 Cr. 134,100 Dr.

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Immediate Recognition - Immediate Recognition - ExampleExample

To record Expense:Pension Expense 97,600 Accrued Pension Asset/Liab 97,600

To record contribution:Accrued Pension Asset/Liab 20,000 Cash 20,000

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Deferral and Amortization Deferral and Amortization Approach Approach

Pension Expense

Current serviceCost

+

Current interestcost

+

Expected return onPlan Assets

Amortization of Past Service Costs

Amortization of Net Actuarial Gain

or Loss

+ or + or

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Amortization of Past Service Amortization of Past Service Costs (PSC)Costs (PSC)

• Past service costs arise from either the initial adoption of a pension plan or an amendment to the existing plan

• Under PE GAAP, past service costs are not recognized initially– They are amortized (straight-line) to pension expense

over the expected period of benefit from change in plan

• Under IFRS– Vested benefits are expensed immediately

– Benefits not vested are amortized (straight-line) over average period until benefits become vested

• Unamortized balances remain off-balance sheet and are known as unamortized PSC or unrecognized PSC.

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• Assets gains and losses– The assets in the pension plan earn income and

this income reduces the cost of the pension to the company

– Since actual returns can vary significantly year to year, the expected rate is used under the defer-and-amortize approach

– Long-term rate of return is applied to fair value of plan assets at the beginning of the year

– Gains and losses occur when actual returns are different from expected returns

Actuarial Gains and LossesActuarial Gains and Losses

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• Liability gains and losses– Also known as actuarial (experience) gains and

losses– Caused by

• Changes in actuarial assumptions • Actual experience in ABO differing from actuarial

(expected) experience


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• These gains/losses are not initially recognized• Over time, accumulated effect of the changes

(net gains/losses) may even out• Corridor approach adopted to allow for

circumstances where no accumulating offset occurs

• Amortization used only when the opening unrecognized gains/losses are greater than 10% of the larger of the beginning-of-period balances of the ABO and the fair value of Plan Assets

• If so, amortize excess over expected average remaining service life (EARSL), determined by actuary

• Other amortization approaches are also allowed

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Corridor Approach - ExampleCorridor Approach - Example

2010 2011 2012

ABO, January 1 $2,100,000 $2,600,000 $2,900,000

FV Plan Assets, Jan. 1 2,600,000 2,800,000 2,700,000

Net Actuarial Loss (gain) 400,000 300,000 (170,000)

Corridor – 10% of the larger of the ABO or PA

260,000 280,000 290,000

Cumulative Net Actuarial Loss (Beginning of Year)

0 400,000 678,182

Excess 0 120,000 388,182

Current Year Amortization 0 21,818 70,579

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Corridor Approach - Corridor Approach - ExampleExample

• Opening Net Actuarial Loss in 2011 $400,000

Less: Corridor 280,000

Excess over corridor $120,000

– Amortized over 5.5 years – Amount amortized in 2012 = $21,818 (120,000 / 5.5)

• The minimum amortization is the accumulated gain or loss in excess of the corridor amount divided by the expected average remaining service life of employee group (EARSL)

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Options within Defer-and-Options within Defer-and-Amortize ApproachAmortize Approach

• Both PE GAAP and IFRS allow for option to immediately recognize actuarial gains and losses into income

• IFRS also allows for immediate recognition in other comprehensive income (OCI) rather than net income

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Valuation of Accrued Valuation of Accrued Benefit AssetBenefit Asset

• Accrued benefit asset cannot exceed expected future benefits (valuation allowance may be necessary to reduce the value on statement of financial position)

• Change in valuation allowance is generally recognized through benefit expense

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Other Defined Benefit Plans Other Defined Benefit Plans withwith

Benefits that Vest or Benefits that Vest or AccumulateAccumulate• E.g. post-retirement health care benefits

• Accrual accounting is appropriate for post-retirement benefits, post-employment benefits and compensated absences

• Since the right to the benefit is earned by rendering service, the cost and related liability are accrued as employee provides service

• Under PE GAAP, defined benefit plans where benefits vest or accumulate based on service are accounted for in same way as defined benefit pension plans

• IFRS also follows same approach as for pension plans, except that actuarial gains/losses and past service costs are expensed as they occur

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Defined Benefit Plans with Defined Benefit Plans with Benefits that Do Not Vest or Benefits that Do Not Vest or

AccumulateAccumulate

• E.g. parental leave plans (in excess of what government provides), long-term disability plans

• Use “event accrual” method to accrue full cost• When event occurs that obligates entity:Benefit Expense xx Benefit Liability xx• When the compensated absence is taken:Benefit Liability xx Cash xx

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•Disclosures

•Illustration

•Analysis


•Plan assets

•Funded status








•Looking ahead

44

PresentationPresentation

• Accrued benefit assets/liabilities– Generally reported separately for each

benefit plan (unless all plans result in asset or liability)

– Generally classified as long-term• Benefit costs

– Components of benefit costs may be reported together or separately on the income statement

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Disclosure RequirementsDisclosure Requirements

• Disclosures under PE GAAP include:– Description of each plan and any major

changes in terms during the year– Information on most recent actuarial

valuation for funding purposes– Funded status at year end, (including FV of

plan assets and ABO)– Explanation of differences between funded

status and amounts recorded on balance sheet

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Disclosure RequirementsDisclosure Requirements

• Additional disclosure requirements under IFRS include:– Reconciliations:

• Beginning to ending balances of PV of ABO and FV of fund assets

• Funded status to balance sheet benefit liability or asset

– Amount included in periodic net income (and OCI)– Underlying assumptions and sensitivity information– Estimate of following year’s expected funding

contributions

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AnalysisAnalysis

• Analysis generally focuses on predicting future cash flow obligations

• It is very important to validate the major assumptions underlying the fund status and future cash requirements, especially– Discount rate used to measure ABO– Expected rate of return on fund assets

• Small changes in key variables can have a very significant impact

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•Disclosures

•Illustration

•Analysis


•Plan assets

•Funded status








•Looking ahead

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Looking AheadLooking Ahead

• IFRS requirements continue to evolve with a new exposure draft expected in 2010, and a new standard in 2011

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