INTERMEDIATE ACCOUNTING TENTH CANADIAN EDITION Kieso • Weygandt • Warfield • Young • Wiecek • McConomy CHAPTER 19 Pensions and Other Employee Future Benefits Prepared by: Lisa Harvey, CPA, CA Rotman School of Management, University of Toronto CHAPTER 19 PENSIONS AND OTHER EMPLOYEE FUTURE BENEFITS After studying this chapter, you should be able to: • • • • • • • • • • Understand the importance of pensions from a business perspective. Identify and account for a defined contribution benefit plan. Identify and explain what a defined benefit plan is and the related accounting issues. Explain what the employer’s benefit obligation is, identify alternative measures for this obligation, and prepare a continuity schedule of transactions and events that change its balance. Identify transactions and events that change benefit plan assets, and calculate the balance of the assets. Explain what a benefit plan’s funded status is, calculate it, and identify what transactions and events change its amount. Identify the components of pension expense, and account for a defined benefit pension plan under the immediate recognition approach. Account for defined benefit plans with benefits that vest or accumulate other than pension plans. Identify the types of information required to be presented and disclosed for defined benefit plans, prepare basic schedules, and be able to read and understand such disclosures. Identify differences between the IFRS and ASPE accounting for employee future benefits and what changes are expected in the near future. Copyright © John Wiley & Sons Canada, Ltd. 2 Pensions and Other Employee Future Benefits Introduction and Benefit Plan Basics Defined Benefit Pension Plans •Overview of pensions and their importance from a business perspective •The employer’s obligation Presentation, Disclosure, and Analysis •Plan assets •Presentation •Comparison of IFRS and ASPE •Funded status •Disclosure •Looking ahead •Defined benefit cost components and the immediate recognition approach •Analysis •Defined contribution plans IFRS/ASPE Comparison •Other defined benefit plans •Defined benefit plans Copyright © John Wiley & Sons Canada, Ltd. 3 3 Benefit 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) Copyright © John Wiley & Sons Canada, Ltd. 4 4 Nature of Pension Plans • A pension plan provides benefits (payments) to retirees for services provided during employment • The employer sponsors and contributes to the fund and incurs the cost of the pension plan – Requires accounting for the employer • The pension plan receives the contributions, administers pension assets and makes pension payments to the beneficiaries – Requires accounting for the pension plan Copyright © John Wiley & Sons Canada, Ltd. 5 5 Pension Fund Stream PENSION FUND EMPLOYER Cash paid to pension plan (contributions) $ Fund Assets Pension recipients (benefits) Copyright © John Wiley & Sons Canada, Ltd. 6 6 Pension Terminology • Funded – Employer sets aside money for future pension benefits in a separate legal entity • 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 Copyright © John Wiley & Sons Canada, Ltd. 7 7 Pension Plans • The two most common types of pension plans are: 1. Defined contribution (DC) plans 2. Defined benefit (DB) plans Copyright © John Wiley & Sons Canada, Ltd. 8 8 Defined Contribution Plans • 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 – Plan does not specify the benefits the employees will receive or the method used to determine benefits • Cost of the plan in the current year is known with certainty Copyright © John Wiley & Sons Canada, Ltd. 9 9 Defined Contribution Plans • Accounting is straightforward: – Liability reported if contributions for the period have not been made in full – Asset reported if the amount contributed is more than required for the period – The benefit cost (pension expense) is the amount the company is required to contribute to the plan Copyright © John Wiley & Sons Canada, Ltd. 10 10 Defined Contribution Plans • 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 – Under IFRS, these costs are generally recognized immediately as an expense Copyright © John Wiley & Sons Canada, Ltd. 11 Defined Benefit Pension Plans • Pension benefits received by employee after retiring are specified (i.e. defined) – Pension benefits are based on a formula with key variables such as years of service and expected salary level at retirement – The trust’s main goal is to ensure there will be enough pension assets to pay the employer’s obligation to employees when they retire • The employer assumes the economic risk – Assets are legally owned by the trust but in substance belong to the employer (the beneficiary of the trust) – The employer is responsible for making the defined benefit payments no matter what happens in the trust • Cost of plan not known with certainty, as it depends on uncertain future variables (e.g. employee turnover, mortality, inflation) Copyright © John Wiley & Sons Canada, Ltd. 12 12 Defined Benefit Pension Plans • Can be vesting or non-vesting – Vested amounts plan become the legal property of the employee – Employees are entitled to receive vested benefits even after leaving the employ of the corporation • Accounting for defined benefit plans is not easy to measure: – The pension expense is not same as cash funding contribution – Actuarial assumptions must be used extensively Copyright © John Wiley & Sons Canada, Ltd. 13 13 Pensions and Other Employee Future Benefits Introduction and Benefit Plan Basics Defined Benefit Pension Plans •Overview of pensions and their importance from a business perspective •The employer’s obligation Presentation, Disclosure, and Analysis •Plan assets •Presentation •Comparison of IFRS and ASPE •Funded status •Disclosure •Looking ahead •Defined benefit cost components and the immediate recognition approach •Analysis •Defined contribution plans IFRS/ASPE Comparison •Other defined benefit plans •Defined benefit plans Copyright © John Wiley & Sons Canada, Ltd. 14 14 Defined Benefit Pension Plans • Three methods of measuring the pension obligation valuation 1. Vested benefit method – Based on current salary levels – Includes only vested benefits 2. Accumulated benefit method – Based on current salary levels – Includes both vested and non-vested service 3. Projected benefit method – Based on future salary levels – Includes both vested and non-vested service Copyright © John Wiley & Sons Canada, Ltd. 15 15 Defined Benefit Pension Plans • Projected benefit method is considered the best measure for accounting purposes • Present value of vested and non-vested benefits earned as at the reporting date (using future salary levels) is called defined benefit obligation (DBO) – Under ASPE, the DBO is known as the accrued benefit obligation (ABO) – ASPE also allows the accrued benefit obligation (ABO) for funding purposes which is based on different variables. Copyright © John Wiley & Sons Canada, Ltd. 16 16 Defined Benefit Obligation (DBO) Defined benefit obligation, beginning + Current service cost + Interest cost - Benefits paid to retirees +/- Past service costs of plan amendments during period +/- Actuarial gains (-) or losses (+) . = Defined benefit obligation, end of period Copyright © John Wiley & Sons Canada, Ltd. 17 17 Current Service Cost • The cost of benefits that will be provided in the future in exchange for current services • These costs are prorated on service: – Annual expense is based on the total estimated benefit being allocated evenly over the years of service of the employee Copyright © John Wiley & Sons Canada, Ltd. 18 18 Interest Cost • Interest accrues on the DBO as time passes – Similar to discounted debt • Current market rate – Determined by reference to current yield on high-quality debt instrument (e.g. corporate bonds) – Required by IFRS and ASPE • Settlement rate – Implied rate on insurance contract that would effectively settle pension obligation – Allowed under ASPE Copyright © John Wiley & Sons Canada, Ltd. 19 19 Benefits Paid to Retirees • Pension benefits are paid to retirees (former employees) – Like all liabilities, the amount owing is decreased as these payments are made Copyright © John Wiley & Sons Canada, Ltd. 20 Past Service Costs • Similar to DC plans, when a plan is started or amended, credit is often given for past years of service – This amount is included in the pension benefit cost on the income statement in the year it is incurred • Note that companies can also amend plans to reduce the benefits received – Results in a decreased DBO and a past service benefit Copyright © John Wiley & Sons Canada, Ltd. 21 Actuarial Gains and Losses • These gains and losses can occur because of: – Changes in actuarial assumptions • A change in assumptions about future events – Experience gains or losses • Difference between what actually happened and the actuarial assumption that was made Copyright © John Wiley & Sons Canada, Ltd. 22 Plan 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 + remeasurement gain on assets or – remeasurement actuarial loss on assets Copyright © John Wiley & Sons Canada, Ltd. 23 23 Contributions • Contributions are made each year by: – The employer – The employees (if applicable) • Federal and provincial law dictate the funding requirements • The Canadian Revenue Agency (CRA) also dictates regulations as well as what contributions are tax deductible Copyright © John Wiley & Sons Canada, Ltd. 24 Return on Plan Assets • The income generated on the assets less administration costs – Due to year over year volatility, a long-term rate of return is estimated • This is referred to as the expected return – Under IFRS, rate used must be the same as the discount rate used to calculate interest cost Copyright © John Wiley & Sons Canada, Ltd. 25 Funded Status Defined Benefit Obligation (DBO) - Fair Value of plan assets = Funded status • DBO > Plan assets = underfunded = funded status liability • DBO < Plan assets = overfunded = funded status asset Copyright © John Wiley & Sons Canada, Ltd. 26 26 Accounting for Pensions • 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 • • A form of this approach is required by IFRS Allowed under ASPE – Deferral and amortization approach • Allowed under ASPE Copyright © John Wiley & Sons Canada, Ltd. 27 27 Immediate Recognition Approach Statement of Financial Position Presentation • DBO and fund assets are off-balance sheet or memo accounts – Under IFRS, the net employee benefit or liability is reported – Under ASPE, the net employee benefit or liability is reported based on the funded status of the plan Copyright © John Wiley & Sons Canada, Ltd. 28 Immediate Recognition Approach Income Statement Presentation • Pension expense is made up of: – Current service cost – Interest cost – Actual return on plan assets • Under IFRS, this amount is allocated between net income (interest amounts) and OCI (remeasurements) – Past service cost – Actuarial gains and losses • Under IFRS, these are included in OCI Copyright © John Wiley & Sons Canada, Ltd. 29 The Pension Worksheet • 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 Copyright © John Wiley & Sons Canada, Ltd. 30 30 Immediate Recognition Approach – Example (2013) General Journal Entries Items Annual Pension Expense Cash Bal. Jan 1 2013 a) Service cost b) Interest cost c) Actual return d) Contributions e) Benefits paid Expense entry, 2013 Contribution entry, 2013 Balance Dec. 31, 2013 Net Defined Benefit Liability/ Asset 0 9,000 Dr. 10,000 Dr 10,000 Cr. Memo Record Defined Benefit Obligation 100,000 Cr. Plan Assets 100,000 Dr. 9,000 Cr. 10,000 Cr. 7,000 Dr. 10,000 Dr. 8,000 Dr. 7,000 Cr. 112,000 Cr. 111,000 Dr. 8,000 Cr. 9,000 Dr. 9,000 Cr. 8,000 Cr. 8,000 Cr. 1,000 Cr. Copyright © John Wiley & Sons Canada, Ltd. 31 31 Immediate Recognition Approach – Example (2013) To record expense: Pension Expense 9,000 Net Defined Benefit Liability/Asset 9,000 To record contribution: Net Defined Benefit Liability/Asset 8,000 Cash 8,000 Copyright © John Wiley & Sons Canada, Ltd. 32 32 Immediate Recognition Approach – Example (2014) General Journal Entries Items Annual Pension Expense Cash Bal. Dec. 31 2013 f) Past service cost Memo Record Net Defined Defined Benefit Benefit Obligation Liability/ Asset 1,000 Cr. 112,000 Cr. 80,000 Dr. 80,000 Cr. g) Service cost 9,500 Dr. 9,500 Cr. h) Interest cost 19,200 Dr 19,200 Cr. i) Actual return 11,100 Cr. j) Contributions Contribution entry, 2014 Balance Dec. 31, 2014 111,000 Dr. 11,100 Dr. 20,000 Cr. 20,000 Dr. k) Benefits paid Expense entry, 2014 Plan Assets 97,600 Dr. 8,000 Dr. 8,000 Cr. 212,700 Cr. 134,100 Dr. 97,600 Cr. 20,000 Cr. 20,000 Cr. 78,600 Cr. Copyright © John Wiley & Sons Canada, Ltd. 33 33 Immediate Recognition Approach – Example (2014) To record expense: Pension Expense 97,600 Net Defined Benefit Liability/Asset 97,600 To record contribution: Net Defined Benefit Liability/Asset 20,000 Cash 20,000 Copyright © John Wiley & Sons Canada, Ltd. 34 34 Immediate Recognition Approach – Example (2015: ASPE) General Journal Entries Items Annual Pension Expense Cash Bal. Dec. 31 2014 Memo Record Net Defined Defined Benefit Benefit Obligation Liability/ Asset 78,600 Cr. 212,700 Cr. l) Service cost 13,000 Dr. 13,000 Cr. m) Interest cost 21,270 Dr 21,270 Cr. n) Actual return 12,000 Cr. o) Contributions 24,000 Dr. p) Benefits paid 10,500 Dr. 28,530 Dr. Expense entry, 2015 50,800 Dr. Contribution entry, 2015 Balance Dec. 31, 2015 134,100 Dr. 12,000 Dr. 24,000 Cr. q) Actuarial loss Plan Assets 10,500 Cr. 28,530 Cr. 50,800 Cr. 24,000 Cr. 24,000 Cr. 105,400 Cr. Copyright © John Wiley & Sons Canada, Ltd. 265,000 Cr. 159,600 Dr. 35 Immediate Recognition Approach – Example (2015: ASPE) To record expense: Pension Expense 50,800 Net Defined Benefit Liability/Asset 50,800 To record contribution: Net Defined Benefit Liability/Asset 24,000 Cash 24,000 Copyright © John Wiley & Sons Canada, Ltd. 36 36 Immediate Recognition Approach – Example (2015: IFRS) General Journal Entries Items Remeasurement (Gain) Loss OCI Annual Pension Expense Cash Bal. Dec. 31 2014 Memo Record Net Defined Defined Benefit Benefit Obligation Liability/ Asset 78,600 Cr. 212,700 Cr. l) Service cost 13,000 Dr. 13,000 Cr. m) Interest cost 21,270 Dr 21,270 Cr. n) Expected return 14,610 Cr. o) Remeasurement loss 2,610 Cr. 24,000 Cr. 24,000 Dr. q) Benefits paid 10,500 Dr. r) Liability loss 28,530 Dr. . Expense entry, 2015 31,140 Dr. 19,660 Dr. Balance Dec. 31, 2015 134,100 Dr. 14,610 Dr. 2,610 Dr. p) Contributions Contribution entry, 2015 Plan Assets 10,500 Cr. 28,530 Cr. 50,800 Cr. 24,000 Cr. 24,000 Cr. 105,400 Cr. Copyright © John Wiley & Sons Canada, Ltd. 265,000 Cr. 159,600 Dr. 37 Immediate Recognition Approach – Example (2015: IFRS) To record expense: Pension Expense 19,660 Remeasurement Loss (OCI) 31,140 Net Defined Benefit Liability/Asset 50,800 To record contribution: Net Defined Benefit Liability/Asset 24,000 Cash 24,000 Copyright © John Wiley & Sons Canada, Ltd. 38 38 Valuation of Accrued Benefit Asset • Accrued benefit asset cannot exceed expected future benefits (valuation allowance may be necessary to reduce the value on statement of financial position) – Referred to as the asset ceiling test • Change in valuation allowance is generally recognized through pension expense in net income Copyright © John Wiley & Sons Canada, Ltd. 39 39 Other Defined Benefit Plans with Benefits that Vest or Accumulate • Accrual accounting is appropriate for post-retirement benefits, post-employment benefits and long-term compensated absences – Example: post-retirement health care benefits • Since the right to the benefit is earned by rendering service, the cost and related liability are accrued as employee provides service • IFRS generally follows the same approach as for pension plans, except that actuarial gains/losses and past service costs are reflected in OCI • Under ASPE, defined benefit plans where benefits vest or accumulate based on service are accounted for in same way as defined benefit pension plans Copyright © John Wiley & Sons Canada, Ltd. 40 40 Defined Benefit Plans with Benefits that Do Not Vest or Accumulate • 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 Copyright © John Wiley & Sons Canada, Ltd. 41 41 Pensions and Other Employee Future Benefits Introduction and Benefit Plan Basics Defined Benefit Pension Plans •Overview of pensions and their importance from a business perspective •The employer’s obligation Presentation, Disclosure, and Analysis •Plan assets •Presentation •Comparison of IFRS and ASPE •Funded status •Disclosure •Looking ahead •Defined benefit cost components and the immediate recognition approach •Analysis •Defined contribution plans IFRS/ASPE Comparison •Other defined benefit plans •Defined benefit plans Copyright © John Wiley & Sons Canada, Ltd. 42 42 Presentation • Defined 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 Copyright © John Wiley & Sons Canada, Ltd. 43 43 Disclosure Requirements • Disclosures under ASPE 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 Copyright © John Wiley & Sons Canada, Ltd. 44 44 Disclosure Requirements • Additional disclosure requirements under IFRS include: – Characteristics of defined benefit plans and related risks – Amounts included in statements from the plans – How the plans help with cash flow management – Reconciliations of beginning to ending balances of PV of the net defined benefit liability/asset, plan assets and DBO – Amounts included in periodic net income and OCI – Underlying assumptions and sensitivity information – Many others such as the estimate of following year’s expected funding contributions Copyright © John Wiley & Sons Canada, Ltd. 45 45 Analysis • 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 DBO – Current service cost – Interest cost • Small changes in key variables can have a very significant impact Copyright © John Wiley & Sons Canada, Ltd. 46 46 Pensions and Other Employee Future Benefits Introduction and Benefit Plan Basics Defined Benefit Pension Plans •Overview of pensions and their importance from a business perspective •The employer’s obligation Presentation, Disclosure, and Analysis •Plan assets •Presentation •Comparison of IFRS and ASPE •Funded status •Disclosure •Looking ahead •Defined benefit cost components and the immediate recognition approach •Analysis •Defined contribution plans IFRS/ASPE Comparison •Other defined benefit plans •Defined benefit plans Copyright © John Wiley & Sons Canada, Ltd. 47 47 Looking Ahead • Recent changes to IFRS has created additional differences between IFRS and ASPE – Expected replacement of the ASPE pension section is expected to take these differences into account 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