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BUS 321

Chapter 19: Pensions

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Some employers agree to pay salary or other benefits to an employee even after

they have stopped working (retired) for theemployer.

The salary is PENSION.

Other benefits include: medical, dental, lifeinsurance, sick and parental leave.

What is this chapter all about?

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Whats the issue?

CICA Handbook Section 3461 providesguidance when accounting for employee

future benefits The section covers primarily benefits that the

employee will receive after retirement fromthe company; however, if the employer isobligated to provide any ongoing benefitsafter an earlier resignation (before retirement),then those benefits would also be covered

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Pensions

In Canada, pensions are by far the largestpart of these post-retirement benefits

In the US, health care costs are also asignificant part

In general, accounting for other post-retirement benefits is similar to pensions,so well focus on pensions

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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 employment of the corporation

Governed by provincial law

Pension Terminology

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Pensions

Two types of pensions Defined contributions (EASY!!!)

Defined benefit (not so easy)

The main difference is who takes the risk(employee or employer)

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Defined contributionThe employer (and employee) make annualcontributions which are FIXED

The plan earns some rate of return

The employee gets all the plan assets uponretirement as an annuity

The employees retirement income dependslargely on the rate of return the plan earns

Therefore, if the plan does not earn as much asexpected, it is the employee who loses.

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Defined benefitThe employer (and employee) make annualcontributions VARIABLE

The plan earns some rate of returnThe employee gets a pre-specified retirementincome, independent of plan assets

The employer is on the hook to make surethe pension plan has sufficient assets to fundthe employees retirement income

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Comparison of Plan Types

Types of Plan DefinedBenefit

DefinedContribution

Periodic contribution

Future Benefits

Who bears risk?

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Choosing between the twoHow much risk does the employer want?

How much risk do the employees want?

What kind of plan do competitors have?

Implications of starting a pensions plan:

Past service(How many older employees do you have?)

Does a pension plan help with employee

retention? (Vesting?)

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Source: Rauh 2006 Journal of Finance

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Bombardier example

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Note that in accounting for pension plansthere are two separate issues:

Funding of the plan

Accounting for the pension expense andobligation

Accounting for Employee Future

Benefits

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Funding vs. ExpensingCanadian employers follow a wide variety of policies with respect to the funding of pensionliabilities. At one extreme there are plans in

which all of the pension liabilities have beeneliminated through payments to a trustee. At theopposite end of the spectrum there are the pay-as-you-go types of plans.

Is the amount of cash paid by the employer intothe plan in a period an appropriate measure of the pension expense for the period?

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Defined Benefit Pension PlansProjected benefit obligation is considered thebest measure for accounting purposes

Related Account:Present value of vested and non-vested benefitsearned as at reporting date (using future salarylevels) is called accrued benefit obligation (ABO)

for accounting purposes.Accrued benefit obligation (ABO) for fundingpurposes may be based on different variables.

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Capitalization vs. Non-capitalization

Capitalization Full obligation recognized as liability Pension plan assets reported as assets Liability and assets reduced by payment of

benefits

Non-capitalization - Adopted by IFRS Follows substance of the plan as separate legal

and accounting entity Obligation on B/S = amount of expense

recognized less amount funded

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Financial vs. Off-Financial

Statement EffectsThe pension benefit obligation and the planassets are regarded as liabilities and assets of the plan, not of the sponsoring corporation.

The pension plan is carried on the balance sheetat a net amount, determined by the differencebetween the cumulative cash payments to the

plan, and the cumulative pension expense. Rationale is that the management of the

assets is out of the hands of the employer

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If the cumulative cash payments aregreater than the cumulative expense, thebalance sheet shows a prepaid pensionasset.

If the cumulative expense is greater thanthe cumulative cash payments, thebalance sheet shows an accrued pensioncost.

Financial vs. Off-Financial

Statement Effects

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Funded StatusFunded status = ABO Fair Value of plan assets

ABO > Plan assets = Underfunded plan The company will have an accrued pension

liability on B/SABO < Plan assets = Overfunded plan The company will have an accrued pension asset

on B/S

The funded status of the plan is reported in thenotes to the financial statements, usually with areconciliation to the asset or liability reported on the

balance sheet.

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Defined Contribution - Accounting

In most cases, the pension expense is equal tothe pension contribution (there are fewer items toaccount for; Dr Expense, Cr Cash/AP)

Sometimes there are timing differences

There may be amortization of past service costs(arise when a pension plan is initiated or amended)

Disclosure of the PV of any contributions requiredin respect of past service at the B/S date is

mandatory

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Defined Contribution Plans:Employers Journal Entries

Contribution made

is less thanthe pension expense

Pension Expense Dr

Cash Cr Accrued PensionLiability Cr

Liability

Contribution madeis morethan pension expense

Pension Expense Dr Accrued Pension Asset Dr

Cash Cr

Asset

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Defined Contribution AccountingComprehensive Example

Adams Corporation has a defined contribution plancovering all salaried employees. The plan was startedon July 1, 2008.

Under the plan, Adams is to contribute a yearlyamount to the benefit pool with respect to current

service equal to 5% of net income above the levelrequired to provide an 8% return on the beginningbook value of equity, before considering taxes and theeffects of the defined contribution plan itself.

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Defined Contribution Accounting At inception, past service benefits were provided tosalaried employees with at least 5 years of service.These benefits amounted to $1,200,000 and arerequired to be contributed to the defined contributionaccounts over six years at $200,000 per year. Anyunpaid balance carries 6% interest. The vestingperiod for Adams is 20 years. No one has worked for

Adams for more than 10 years.

Each installment is made on the first day of the fiscalyear (the first payment was made on July 1, 2008).

At inception of the plan, the expected period to fulleligibility (EPFE = EARSL) of the employees coveredby the plan was 12 years.

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Defined Contribution Accounting

Contributions are made to each individuals definedcontribution account out of this pool based on theratio of the individuals base salary to the sum of the

base salaries of all participants.Contributions are made within 90 days after the fiscalyear end.

On July 1, 2010, Adams made the requiredcontribution of $456,000 with respect to the PSCinstallment and the current service for the 2009/10fiscal year.

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Defined Contribution AccountingIncome for fiscal 2010 before taxes and any pensioncost was $12,000,000. The book value of equity atJuly 1, 2009 was $98,000,000.

Required:Prepare the journal entry to account for all aspects of this pension plan for the 2009/10 fiscal year. Adamshas a June 30 fiscal year end.

This JE will involve computation of Pension Expense,Cash, and Accrued Pension Asset / Liability

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Components of Pension Expenseunder Defined Contribution Plan

Pension expense consists of:

- Interest cost

- Amortization of past service cost

- Current service cost

Accrued Pension Asset / Liability:

Difference between required contributionsand amount actually paid

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Defined Contribution AccountingUnfunded Past Service CostsBalance before July 1, 2008 payment 1,200,000July 1, 2008 payment (200,000)Balance after July 1, 2008 payment 1,000,000Interest cost for 2008/09 fiscal year (1,000,000 x .06) 60,000Balance, June 30, 2009 1,060,000July 1, 2009 payment (200,000 + 60,000) (260,000)

Balance after July 1, 2009 payment 800,000Interest cost for 09/10 fiscal year (800,000 x .06) 48,000Balance, June 30, 2010 848,000

Note that there is an accrued balance of $200,000 on June 30, 2010for the installment.

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Defined Contribution Accounting

Amortization of Past Service Costs(1,200,000 12 years) = $100,000 per year

Current Service CostNet income before taxes and pension expense 12,000,000Reduced by: (98,000,000 x .08) (7,840,000)

Basis for current service 4,160,000Percentage x 0.05Current service cost $ 208,000

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Defined Contribution AccountingPension expense

Interest cost $ 48,000 Amortization of past service cost $ 100,000Current service cost $ 208,000

Journal Entry (June 30, 2010)Dr Pension expense 356,000

Cr Accounts Payable 356,000

Journal Entry (July 1, 2010)Dr Accrued pension cost (Deferred Asset) 100,000Dr Accounts Payable 356,000

Cr Cash 456,000

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Defined Benefit AccountingRequire the employer to guarantee somespecified benefit or benefit formula to employees.

Pension cost should be accrued and recognized in

accounting periods that benefit from employeesservice

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

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Defined Benefit AccountingIn defined benefit plans there are manyvariables to be accounted for: How much pension did the employees earn this

year?

What is the PV of that obligation?

What is the value of the assets the plan currentlyholds? Will that be enough?

What if expectations about the future turn out to bewrong? How do we report the differences betweenexpectations and experience?

What if we agree to amend our employer/employee

contract with respect to pension entitlements?

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Defined Benefit Accounting

Calculation of the Pension Benefit Obligation

Illustration:

An employer might state that he will provide a pensionbenefit when the employee reaches the age of 65 andthat this benefit will be equal to 1% of the employeeshighest annual salary for each year of service .

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Defined Benefit Accounting Assumptions:

Employee works for 35 years until his 65th birthday.

Estimated highest salary is $50,000 in the last year of employment (Projected Benefit Obligation method).

Employee earns a pension benefit of 1% of highest salary for each year of service.

Employee has just turned 60, therefore has five yearsremaining until retirement.

Employee is expected to live to age 85 or for 20 years after retirement.

The discount rate is 10%.

Current service is earned at the end of each year.

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Defined Benefit AccountingProject future benefits to be paid based on expectedsalary history at retirement and years of service todate.

= 1% of highest salary for each year of service.= 1% X 50,000 X 35 years= $17,500

Notice that as of today he has only earned:= 1% X 50,000 X 30 years= $15,000

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Defined Benefit Accounting - ActuaryComputes the actuarial present value of these projected future benefits at theretirement date (Projected benefit method)

PV, annuity, 20 years, 10% (8.51356)= $17,500 X 8.51356= $148,987

Retirement dateToday Date of Death

60 years 65 years 8 5 years

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Calculate the pension benefit obligation now:1. PV, annuity, 20 years, 10% (8.51356)

= $15,000 X 8.51356= $127,704

Notice, this is not the same amount as on the previousslide, why is that?2. PV factor, 5 years, 10% (0.62092)

= $127,704 x 0.62092= $79,294

Retirement dateToday Date of Death

60years

65years 8

5years

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Projected benefit methodRequired by CICA to use this method indetermining the current service cost.

Each year the pension benefit obligation willincrease by:

1) The discounted present value of benefits

earned in that year (current service)i.e. PV of 1% X 50,000 X 1 year, and

2) The interest on the pension benefit

obligation .

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Defined Benefit Accounting

Age

P.V. of obligationbeg of yr.

Interest onobligation@ 10%

P.V. of currentservice

P.V of obligationend of year

ot e1. (500 X P/A 10%, 20 yrs) 4,257 3. (4,257 x PV 10% 2yr) 3,5182. (4,257 x PV 10% 1yr) 3,870 4. (4,257 x PV 10% 3yr) 3,198

5. (4,257 x PV 10% 4yr) 2,907

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Deferral and Amortization Approach

Pension Expense

Current serviceCost

+

Current interestcost

+

Expected return onPlan Assets

A mortization of Past Service Costs

A mortization of Net Actuarial Gain

or Loss

+ or + or

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On the income statement: Pension Expense

OCI costs (if 100% of the actuarial gains andlosses are recognized)

On the balance sheet: Cash Accrued Pension Asset / Liability

Financial vs. Off-FinancialStatement Effects

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Off the balance sheet therefore are thefollowing nominal accounts:

Pension obligation (ABO)

Plan assets (Actual returns)

Balance of unamortized past service costs Balance of unamortized actuarial gains /

losses

Financial vs. Off-FinancialStatement Effects

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Past service costs may arise when a newplan is begun, and when an existing planis amended for some reason. In this case,employees who are already with thecompany may get some pensionrecognition for services provided in thepast.

Past Service Costs (PSC)

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Past Service Costs (PSC) - Rationale

At inception, the actuary determines thevalue of any accrued pension benefitsusing the projected benefit method andestimates of future salaries. This amountis equal to past service costs at inception.

At inception there are no plan assets.

The only accounting issue which exists atinception is how to handle the past servicecost.

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Past Service Costs (PSC) - Rationale

CICA HB Recommendation:

Past service costs should be amortized in a

rational and consistent manner over anappropriate period of time, which normallywould be the average expected period to fulleligibility of the employee group covered bythe plan.

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Past Service Costs (PSC)

Example:

On January 1, 2007, Baker Corp. adopted a

defined benefit pension plan. On that date,the actuarial estimate of the past servicecost was $200,000. What effect did thishave on Bakers balance sheet?

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Past Service Costs (PSC)

Example:

On BalanceSheet Effects Off Balance Sheet Effects

BalanceSheet Asset /

Liability

PensionBenefit

ObligationPlan Assets Past Service

Cost

$ 0 $ 200,000 Cr $ 0 $ 200,000 Dr

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Basic Causes of Changes to

the Off-Balance-Sheet ItemsService provided during the current year by employees (i.e., current service cost)

Interest that is accruing on the pensionbenefit obligation due to the passage of time (benefit payments are getting closer).

Cash payments to the pension trust.

And.

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Earnings on the assets invested by thepension trust.

Actual earnings are determined by the applicationof market value or market related value principlesto the valuation of plan assets.

Expected earnings are determined by applying theexpected rate of return on plan assets (an actuarialassumption) to the average plan assets actuallyinvested in the period.

Differences between actual and expected earningsmay need to be amortized, depending on themagnitude of the difference (corridor approach)

. and

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Amortization of past service costs(arising from plan inception and/or planamendments).

Benefit payments to retired employees.

Basic Causes of Changes to

the Off-Balance-Sheet Items

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Example: ABC Corp. created a defined benefit pensionplan on January 1, 2008.

At inception the actuary determined that thepension benefit obligation (past) was$120,000 for retroactive service credit.

and that the average expected period untilfull eligibility (vesting) of the employeesentitled to benefit from the past service costwas 20 years.

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Example:

During 2008, the actuary determined thatthe actuarial present value of servicesrendered (Current Service Cost) during 2008was $10,000 and this amount was earnedevenly throughout the period.

Plan assets were expected to earn 10% andthis was the discount rate used by theactuary in determining the actuarial presentvalue of the benefits.

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Example:On January 1, 2008, ABC contributed $40,000(Funding contribution) to the pension trust tocover a portion of the past service costs.

Earnings on plan assets met expectations andthere were no changes in actuarial assumptions($ 0 actuarial gains and losses) during the year.

Benefits (Benefit payments) of $1,000 were paidto employees that retired during the year. Thesepayments were made from trust assets on July1, 2008.

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Defined Benefit Plans:

Employers Journal EntriesContribution madeContribution made

is less thanis less thanthe pension expensethe pension expense

Pension Expense Dr Pension Expense Dr Cash Cr Cash Cr

Accrued Pension Accrued PensionLiability Cr Liability Cr

LiabilityLiability

Contribution madeContribution madeis moreis morethan pension expensethan pension expense

Pension Expense Dr Pension Expense Dr Accrued Pension Accrued Pension Asset Dr Asset Dr

Cash Cr Cash Cr

Asset Asset

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Actuarial gains / losses

Actuarial gains or losses arise from:

periodic re-valuations of the pension

obligation and its underlying assumptions(actuarial gains/losses) and from

comparison of expected plan earnings to

actual earnings (experience gains/losses).The result is another off-balance sheet assetor liability.

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There are lots of estimates used THEYRE ALL WRONG!

Assumption changes are those in the future Discount rate, Mortality rate, Expected retirementage, Turnover prior to retirement

The projected benefit obligation rises with:

Decreases in the discount rate Decreases in mortality Increases in expected retirement age Decreased in turnover

An increase in the projected benefit obligation results inan experience loss, while a decrease in the projectedbenefit obligation results in an experience gain.

A complete actuarial valuation of the plan must occur every three years.

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Actuarial gains / losses

Experience estimates are those in thepast

Are compared to actual interest rate, actualmortality rate, retirement age, turnover prior to retirement

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Actuarial gains / lossesPast (experience) and future (assumption)changes are actuarial gains/losses We need to bring these into income

and also make sure that any funding shortfallis made up (and quickly too)

Because the gains/losses are likely tooffset each other, annual recognition is notrequired This is similar to how we used to account for

FX gains/losses on long term debt

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Unamortized Actuarial G/L - Accounting

These gains and losses are amortized to pensionexpense using a method called the Corridor approach.

The general idea behind this approach is that if the accumulated gains or losses are notsignificant, they can be ignored, on theassumption that over time they might self-corrector reverse.

However, once they get sufficiently large, thecorporation cannot continue to keep them entirely

off balance sheet.

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Actuarial gains / lossesIFRS

If the amount of accumulated gains/losses is >10%, (of greater: beginning-of-period plansassets or ABO), amortize over an appropriateperiod (Expected average remaining serviceperiod - EARSP)

Faster amortization, including recording the fullgain/loss in the year incurred is allowed

Disclose the method, gains/losses handled

the same, be consistent from year to year

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Example Continued (Extended)

Continuing the ABC example into 2009,assume that during 2009 the followingoccurred.

Current Service Cost $13,000 earned evenlythroughout the period

Benefit Payments $2,000 (paid uniformly over the year)

Contributions $25,000 (paid on July 1, 2009)

Actuarial gain on plan obligation $18,000(arose from revaluation on January 1, 2009)

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Example Experience Loss on Assets $1,000 (determinedon December 31, 2009)

Average period to vesting (or EARSP) of theemployee group at January 1, 2009 = 18 years.

Amortization of the actuarial gain or loss (if any)will not commence until the following year (2010).

Recall that plan assets were expected to earn10% and this was the discount rate.

Spreadsheet Approach

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Immediate Recognition Approach

Pension Expense

Current servicecost

+

Current interestcost

+

A ctual return onPlan Assets

Past Service Costsrecognized

immediately

ActuarialGains / Lossesrecognized

Immediately

+ or + or

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Immediate Recognition ApproachABO and fund assets are not recognized as separatebalance sheet accounts (they are off-balance sheet or memo accounts).

Accrued pension asset/liability recorded on thebalance sheet represents the net position or fundedstatus.

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), pensionexpense is highly variable from year to year.

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Defined Benefit Plans with Benefits that DoNot Vest or Accumulate (chapter 13)

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

Use event accrual method to accrue full costWhen event occurs that obligates entity:

Benefit Expense XXBenefit Liability XX

When the compensated absence is taken:Benefit Liability XX

Cash XX

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FASB PerspectivesNew U.S. accounting standards (2006) require:

previously unrecognized past service cost, actuarialgains/losses and transition costs to be recorded in OCIand

the plans funded status (i.e. the difference betweenaccrued benefit obligation and the plan assets) to berecognized on the balance sheet

IFRS requirements continue to evolve with a newexposure draft expected in 2010, and a new standardin 2011 aim: Immediate Recognition Approach

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