Chapter 16: Pensions - Comprehensive Study Guide

Overview of Employee Benefit Plans

Benefit plans are categorized based on their nature and the timing of the benefits' consumption relative to when they are earned. Employers participate in these plans primarily to share risk with employees and to take advantage of tax incentives.

• Categories of Benefit Plans:

  • Pension Benefits and Other Post-Retirement Plans: These include pension payments, post-retirement health care, and life insurance.

  • Post-Employment Benefit Plans: These include severance benefits and long-term disability benefits.

  • Compensated Absences: These include parental leaves and unrestricted sabbatical leaves.

• Accounting Logic:

  • Same-Period Benefits: For benefits consumed in the same period they are earned, the employer simply records an expense for the amount of benefits earned during that period.

  • Future-Consumption Benefits: For benefits earned now but consumed far in the future (e.g., pensions), accounting becomes complex. This requires determining how to measure the employer’s obligation and identifying the correct point in time to recognize the cost of the benefits.

Nature and Structure of Pension Plans

A pension plan is a formal arrangement where an employer (the sponsor) provide payments (benefits) to employees after retirement for services rendered while they were employed.

• Three Parties Involved:

  1. Employer (Sponsor): The entity providing the plan.

  2. Employees: The beneficiaries of the plan.

  3. Pension Trust: The entity that holds the plan assets.

• Funding Types:

  • Contributory: The employee pays into the plan alongside the employer.

  • Non-contributory: Only the employer contributes to the plan.

Defined Contribution (DC) vs. Defined Benefit (DB) Plans

Accounting for Defined Contribution Plans

Accounting for DC plans is governed by IAS 19 and ASPE 3462.

• Recognition: The employer recognizes a contribution payable when the employee has rendered the service.

• Measurement: The value is based on calculations/formulas agreed upon in the employment contract.

• Standard Journal Entry:

  • Debit Pension Expense (the total amount owed based on the agreed formula).

  • Credit Cash (the portion actually contributed).

  • Credit Pension Contribution Payable (the portion owed but not yet paid).

• Capitalization Exception: In specific scenarios, pension costs are capitalized rather than expensed. For example, for employees involved in manufacturing, pension costs are capitalized into inventories. However, general accounting assumes these costs are expensed.

Example: Templeton Company

Templeton sponsors a DC plan where it contributes $2.00$ for every $1.00$ an employee contributes. Employees can contribute up to $5\%$ of their salary.

• Data: Total salaries = $40\,million$; Employee contributions = $1.8\,million$; Templeton paid cash of $3\,million$.

• Calculation: Because the employer matches 2:1, the total employer obligation is $1.8\,million \times 2 = 3.6\,million$.

• Entry:

  • Dr. Pension Expense $3.6\,million$

  • Cr. Cash $3.0\,million$

  • Cr. Pension Contribution Payable $0.6\,million$

Professional Actuarial Roles in Defined Benefit Plans

Actuaries are specialized professionals who estimate risk and uncertainty to ensure employers set aside sufficient funds to meet future obligations. They make various assumptions:

• Employee Turnover: Timing of retirement and eligibility.

• Mortality: How long employees will live and receive payments.

• Salary Growth: The final amounts of periodic pension payments.

• Service Allocation: Determining what portion of expected benefits relates to services in the current year.

• Retirement Obligation: The value of the pension at the point of retirement.

• Investment Returns: Expected income from plan assets required now to satisfy future obligations.

Core Accounts in Defined Benefit Accounting

Defined Benefit accounting involves several key interconnected accounts:

• Income Statement Accounts:

  • Pension Expense

  • Other Comprehensive Income (OCI)

• Balance Sheet Account:

  • Net Defined Benefit Asset/Liability (DBA/DBL). This is the only pension-related balance reported on the face of the balance sheet.

• Note Disclosure Accounts (Off-Balance Sheet):

  • Plan Assets (PA): Assets held in the trust, measured at Fair Value (FV).

  • Defined Benefit Obligation (DBO): The actuarial present value of the cost of benefits accumulated for services to date.

• Relationship Formula:

  • $DBO - PA = Net\,DBL\,(if\,positive)\text{ or }DBA\,(if\,negative)$

  • Net Asset (Surplus): $PA > DBO$ (the plan is overfunded).

  • Net Liability (Deficit): $PA < DBO$ (the plan is underfunded).

Periodic Reconciliation of DBO and Plan Assets

Defined Benefit Obligation (DBO) Reconciliation

$DBO_{Beginning\,PV}$ $+ \text{Current service cost}$ $\pm \text{Past service costs}$ $+ \text{Interest cost on plan obligations}$ $- \text{Benefits paid to retirees}$ $- \text{Actuarial gains during period}$ $+ \text{Actuarial losses during period}$ $= DBO_{Ending\,PV}$

Plan Assets (PA) Reconciliation

$PA_{Beginning\,FV}$ $+ \text{Contributions from employers and employees}$ $- \text{Benefits paid to retirees}$ $+ \text{Expected income on plan assets}$ $+ \text{Unexpected gain on plan assets}$ $- \text{Unexpected loss on plan assets}$ $= PA_{Ending\,FV}$

Note: Benefit payments reduce both the DBO and PA by the same amount, resulting in a zero net impact on the Net DBL/DBA.

Components of Pension Expense (PE)

Pension Expense reflects the expected performance of the pension plan and consists of four components:

1. Current Service Cost (CSC): Increase in PV of obligations due to employee service in the current year. Recording this matches the expense with the service received in that period.

2. Past Service Cost (PSC): Change in PV of obligation due to:

   • Initiation: Introducing a new plan (always increases PE).

   • Amendment: Changing the current plan. Improving benefits increases PE; reducing benefits decreases PE.

   • Curtailment: Reducing the number of employees, which decreases benefits and PE.

3. Interest Cost on DBO: Increase in the obligation due to the passage of time. This is treated as interest on deferred compensation.

   • Rate Selection: IFRS requires using yields on high-quality corporate bonds with a maturity matching the term of the pension obligation.

4. Expected Income on Plan Assets: Calculated by actuaries to ignore short-term volatility.

   • Rate Selection: The same rate used for the interest cost on the DBO must be used for expected income.

Components of Other Comprehensive Income (OCI)

OCI reflects deviations from expected performance. Under IFRS, these amounts are never recycled to the income statement. It consists of two components:

1. Actuarial Gains and Losses (on DBO): Differences between actual and expected obligation values. This can stem from actual experience differing from assumptions or a change in future assumptions. Pension legislation requires actuarial revaluations at least every three years.

   • Actuarial Gain: Favorable (actual < expected); decreases liability (Credit OCI).

   • Actuarial Loss: Unfavorable (actual > expected); increases liability (Debit OCI).

2. Unexpected Gains and Losses (on Plan Assets): Deviations of actual fair value from expected values.

   • Unexpected Gain: Favorable (actual > expected); increases assets (Credit OCI).

   • Unexpected Loss: Unfavorable (actual < expected); decreases assets (Debit OCI).

Timing and Weighting of Transactions

The timing of transactions affects the calculation of interest cost and expected income:

• End of Period: Not included in interest/income calculations.

• Beginning of Period: Fully included (100%) in calculations.

• Specific Point Partway Through Year: Included proportionally based on the time elapsed from the activity to the end of the year.

• Evenly Throughout Period: Included at a 50% weighting.

Case Study: Calculating Current Service Cost (CSC)

Scenario (Mabel Lam):

• Age: 55 at end of 2021.

• Retirement age: 65 (10 years away).

• Benefit: $2,000/year for each year of service.

• Life expectancy: 85 (20 years of payments).

• Discount rate: 8%.

Three-Step Calculation:

1. Identify Benefit: Mabel is entitled to an annuity of $2,000/year$ for 20 years.

2. PV of Annuity at Retirement (Age 65):

   • $PV = 2,000 \times 9.81818\,(n=20, i=8\%)$

   • $PV = 19,636$.

3. PV of Step 2 Amount at Current Date (Age 55):

   • $PV = 19,636 \times 0.4632\,(n=10, i=8\%)$

   • $CSC = 9,095$.

Summary Illustration: GB Corp

Data for 2020:

• Beginning Net DBL: $5\,million$.

• Expected Income on PA (8%): $4\,million$.

• Interest Cost (8%): $4.4\,million$.

• Current Service Cost: $15.9\,million$.

• Contributions at Year End (EOY): $13\,million$.

• Benefits Paid at EOY: $11\,million$.

• Actual Value of PA at YE: $60\,million$ (Expected was $56\,million$).

• Actual Value of DBO at YE: $62.5\,million$ (Expected was $64.3\,million$).

Calculations:

• Pension Expense: $15.9\,million (CSC) + 4.4\,million (Interest) - 4.0\,million (Expected\,Income) = 16.3\,million$.

• OCI:

  • Unexpected gain on PA: $60\,million\,actual - 56\,million\,expected = 4.0\,million\,gain$.

  • Actuarial gain on DBO: $64.3\,million\,expected - 62.5\,million\,actual = 1.8\,million\,gain$.

  • Total OCI: $4.0\,million + 1.8\,million = 5.8\,million$.

Journal Entries:

1. To record contribution:

   • Dr. Net DBL $13,000,000$

   • Cr. Cash $13,000,000$

2. To record OCI adjustments:

   • Dr. Net DBL $5,800,000$

   • Cr. OCI - Actuarial G/L $1,800,000$

   • Cr. OCI - Unexpected G/L $4,000,000$

3. To record Pension Expense:

   • Dr. Pension Expense - CSC $15,900,000$

   • Dr. Pension Expense - Interest on DBO $4,400,000$

   • Cr. Pension Expense - Expected Income on PA $4,000,000$

   • Cr. Net DBL $16,300,000$

Presentation and Disclosure Requirements

• Affected Accounts: Cash, Pension Expense, OCI, and Net DBA/DBL.

• Note Disclosures Must Include:

  • Breakdown of Pension Expense components.

  • Separate information for total plan assets and total liabilities.

  • Reconciliation schedules showing movements in assets and liabilities from start to end of the year.

• Netting Rule: If an employer has multiple plans, they cannot net a DBA from one plan against a DBL from another. However, if both plans are in the same position (both assets or both liabilities), they may be combined.

Comparison of Standards: IFRS vs. ASPE

• Actuarial and Unexpected Gains/Losses:

  • IFRS: Flow through Other Comprehensive Income (OCI).

  • ASPE: Flow through Net Income.