Chapter 19
Pensions and Other Employee Future Benefits
Prepared by:
Dragan Stojanovic, CA
Rotman School of Management, University of Toronto
Pensions and Other Employee
Future Benefits
Introduction
and Benefit
Plan Basics
Defined Benefit
Pension Plans
•The employer’s obligation
Presentation,
Disclosure, and
Analysis
•Introduction
•Plan assets
•Presentation
•Defined
contribution
plans
•Funded status
•Disclosures
•Benefit cost components
•Illustration
•Immediate recognition
approach
•Analysis
•Defined
benefit plans
•Nature of
pension plans
IFRS / Private
Enterprise
GAAP
Comparison
•Comparison of
IFRS and private
enterprise GAAP
•Looking ahead
•Deferral and amortization
approach
•Other considerations
•Comparison of results
•Other defined benefit
plans
2
Pensions and Other Employee
Future Benefits
Introduction
and Benefit
Plan Basics
Defined Benefit
Pension Plans
•The employer’s obligation
Presentation,
Disclosure, and
Analysis
•Introduction
•Plan assets
•Presentation
•Defined
contribution
plans
•Funded status
•Disclosures
•Benefit cost components
•Illustration
•Immediate recognition
approach
•Analysis
•Defined
benefit plans
•Nature of
pension plans
IFRS / Private
Enterprise
GAAP
Comparison
•Comparison of
IFRS and private
enterprise GAAP
•Looking ahead
•Deferral and amortization
approach
•Other considerations
•Comparison of results
•Other defined benefit
plans
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)
4
Benefit 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
benefits
2. Defined benefit (DB) plans
• These are any benefit plans that are not a
defined contribution plan
• Further subdivided as:
a. Benefits that vest or accumulate
b. Benefits that do not vest or accumulate
5
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
• Cost of the plan in the current year is known
with certainty
6
Defined 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)
7
Defined Contribution Plans:
Employers’ Journal Entries
Contribution made
is less than
the pension expense
Contribution made
is more
than pension expense
Pension Expense Dr
Cash
Cr
Accrued Pension
Liability
Cr
Pension Expense Dr
Accrued Pension
Asset
Dr
Cash
Cr
Liability
Asset
8
Pension 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
9
Pension Fund Stream
TRUST
COMPANY
Pension Expense
Cash paid to pension
plan (funding)
$
Plan
Assets
Accrued pension
asset/liability
Retirees (pension benefits)
10
Pension Terminology
• 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
11
Defined Benefit Pension Plans
• 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
12
Defined 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
13
Pensions and Other Employee
Future Benefits
Introduction
and Benefit
Plan Basics
Defined Benefit
Pension Plans
•The employer’s obligation
Presentation,
Disclosure, and
Analysis
•Introduction
•Plan assets
•Presentation
•Defined
contribution
plans
•Funded status
•Disclosures
•Benefit cost components
•Illustration
•Immediate recognition
approach
•Analysis
•Defined
benefit plans
•Nature of
pension plans
IFRS / Private
Enterprise
GAAP
Comparison
•Comparison of
IFRS and private
enterprise GAAP
•Looking ahead
•Deferral and amortization
approach
•Other considerations
•Comparison of results
•Other defined benefit
plans
14
Defined Benefit Pension Plans
•
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
15
Defined Benefit Pension Plans
•
•
•
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.
16
Pension Liability Measurement
Pension obligation
Present value of
the estimated
future benefits to
be paid to
employees
Vested benefit obligation
Accumulated benefit
obligation
Projected benefit obligation
Pro-rated on salaries Pro-rated on service
17
Projected 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
18
Accrued Benefit Obligation (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
19
Interest 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
20
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
+ actuarial gain on assets
or – actuarial loss on assets
21
Funded 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
22
Components of
Pension Benefit Cost
•
Components that change ABO and fund assets
(therefore, funded status) include:
1.
2.
3.
4.
5.
Current service cost
Interest cost
Past service cost
Return on plan assets
Actuarial gains and losses
23
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
•
Allowed under PE GAAP
– Deferral and amortization approach
•
•
Required under IFRS
Allowed under PE GAAP
24
Immediate Recognition Approach
Current service
cost
+
Current interest
cost
+
Actual return on
Plan Assets

Pension Expense
+ or 
Past Service Costs
recognized
immediately
+ or 
Actuarial
gains/losses
recognized
Immediately
25
Immediate Recognition
Approach
• 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
26
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
27
Immediate Recognition - Example
General Journal Entries
Items
Annual
Pension
Expense
Cash
Bal. Jan 1 2010
Accrued
Pension
A/L
0
Memo Record
Accrued
Benefit
Obligation
100,000 Cr.
a) Service cost
9,000 Dr.
9,000 Cr.
b) Interest cost
10,000 Dr
10,000 Cr.
c) Actual return
10,000 Cr.
d) Contributions
Balance Dec. 31, 2010
100,000 Dr.
10,000 Dr.
8,000 Cr.
8,000 Dr.
e) Benefits paid
Expense entry, 2010
Contribution Entry,
2010
Plan Assets
7,000 Dr.
9,000 Dr.
7,000 Cr.
9,000 Cr.
8,000 Cr.
8,000 Cr.
1,000 Cr.
112,000 Cr. 111,000 Dr.
28
Immediate Recognition Example
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
29
Immediate Recognition - Example
General Journal Entries
Items
Annual
Pension
Expense
Cash
Bal. Dec. 31 2010
f) Past service cost
Accrued
Pension
A/L
1,000 Cr.
Memo Record
Accrued
Benefit
Obligation
112,000 Cr.
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.
d) Contributions
Balance Dec. 31, 2011
111,000 Dr.
11,100 Dr.
20,000 Cr.
20,000 Dr.
e) Benefits paid
Expense entry, 2011
Contribution Entry,
2011
Plan Assets
8,000 Dr.
97,600 Dr.
8,000 Cr.
97,600 Cr.
20,000 Cr.
20,000 Cr.
78,600 Cr.
212,700 Cr. 134,100 Dr.
30
Immediate Recognition Example
To record Expense:
Pension Expense
97,600
Accrued Pension Asset/Liab
To record contribution:
Accrued Pension Asset/Liab
Cash
97,600
20,000
20,000
31
Deferral and Amortization Approach
Current service
Cost
+
Current interest
cost
+
Expected return on
Plan Assets

Pension Expense
+ or 
Amortization of
Past Service Costs
+ or 
Amortization of
Net Actuarial Gain
or Loss
32
Amortization of Past Service
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.
33
Actuarial Gains and Losses
• 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 deferand-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
34
Actuarial Gains and Losses
• 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
35
Actuarial Gains and Losses
• 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
36
Corridor Approach - Example
2010
ABO, January 1
FV Plan Assets, Jan. 1
Net Actuarial Loss (gain)
Corridor – 10% of the
larger of the ABO or PA
Cumulative Net Actuarial
Loss (Beginning of Year)
Excess
Current Year Amortization
2011
$2,100,000 $2,600,000
2012
2,600,000
400,000
2,800,000
300,000
$2,900,00
0
2,700,000
(170,000)
260,000
280,000
290,000
0
400,000
678,182
0
0
120,000
21,818
388,182
70,579
37
Corridor Approach - Example
• 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)
38
Options within Defer-andAmortize 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
39
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)
• Change in valuation allowance is generally
recognized through benefit expense
40
Other Defined Benefit Plans with
Benefits that Vest or Accumulate
• 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
41
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
42
Pensions and Other Employee
Future Benefits
Introduction
and Benefit
Plan Basics
Defined Benefit
Pension Plans
•The employer’s obligation
Presentation,
Disclosure, and
Analysis
•Introduction
•Plan assets
•Presentation
•Defined
contribution
plans
•Funded status
•Disclosures
•Benefit cost components
•Illustration
•Immediate recognition
approach
•Analysis
•Defined
benefit plans
•Nature of
pension plans
IFRS / Private
Enterprise
GAAP
Comparison
•Comparison of
IFRS and private
enterprise GAAP
•Looking ahead
•Deferral and amortization
approach
•Other considerations
•Comparison of results
•Other defined benefit
plans
43
Presentation
• 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
44
Disclosure 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
45
Disclosure 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
46
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 ABO
– Expected rate of return on fund assets
• Small changes in key variables can have a very
significant impact
47
Pensions and Other Employee
Future Benefits
Introduction
and Benefit
Plan Basics
Defined Benefit
Pension Plans
•The employer’s obligation
Presentation,
Disclosure, and
Analysis
•Introduction
•Plan assets
•Presentation
•Defined
contribution
plans
•Funded status
•Disclosures
•Benefit cost components
•Illustration
•Immediate recognition
approach
•Analysis
•Defined
benefit plans
•Nature of
pension plans
IFRS / Private
Enterprise
GAAP
Comparison
•Comparison of
IFRS and private
enterprise GAAP
•Looking ahead
•Deferral and amortization
approach
•Other considerations
•Comparison of results
•Other defined benefit
plans
48
Looking Ahead
• IFRS requirements continue to evolve with a new
exposure draft expected in 2010, and a new
standard in 2011
49
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50