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Intermediate Accounting

Thomas H. Beechy Joan E. D. Conrod


Schulich School of Faculty of Management
Business, Dalhousie University
York University

Powerpoint slides by:


Michael L. Hockenstein Commerce Department Vanier College

Copyright 2003 McGraw-Hill Ryerson Limited, Canada


Pensions and Other Post-Retirement Benefits

Chapter 20
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Types of Pension Plans

There are two general types of pension plans:


defined contribution plans
defined benefit plans
Defined contribution plan: the employer (and
often the employee) make agreed upon cash
contributions to the plan each period, which are
invested by a trustee on behalf of the employee
The task of figuring out how much the employer should
contribute to a pension plan is the task of the actuary

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Types of Pension Plans (cont.)

Defined benefit plan: the eventual benefits to the


employee are stated in the pension plan
The essential difference between the two types of
plans can be summarized as follows:

Type of plan Contributions Benefits


Defined contribution Fixed Variable
Defined benefit Variable Fixed

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Pension Variables

Contributory vs. Non-Contributory


Vested vs. Unvested
Trusteed
Registered

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Pension Variables (cont.)
Probability Factors
investment earnings
future salary increases
future inflation rates
employee turnover
mortality rates
life expectancy after retirement
Funding vs. Accounting

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Contributory vs. Non-Contributory
Pension plans are contributory when the employee
pays into the plan; contributory plans are usually
defined contribution plans
Any amounts paid into a defined contribution plan will
increase the eventual pension; voluntary contributions
(by the employee) are usually permitted
Defined benefit plans are usually non-contributory; the
cost of the pension is borne entirely by the employer,
since it is a risk of the employer that the contributed
amounts may not earn a high enough rate of return
Employee contributions would not increase the
eventual pension, which is fixed
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Vested vs. Unvested

An employee does not have a guaranteed pension


until the pension rights have vested
Employee contributions are always vested
In most provinces, vesting of employer contributions
is legally required when an employee has reached
the age of 45 and has worked for the company for
10 years
Some provinces require faster vesting of
employers contributions (e.g., after only two years
in Ontario)
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Trusteed
Pension plans normally are trusteed, wherein the
employer pays required amounts into the pension
plan and the trustee administers the plan, invests
the contributions, and pays out the benefits
Trustees of pension funds are financial institutions
such as trust companies and banks; a pension
trustee is not an individual person
When a plan is administered by a trustee, the plan
assets are beyond control of the companys
managers; neither the plan assets nor the pension
liability are reported on the employers balance
sheet
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Trusteed (cont.)

Trusteeship does not absolve the employer of


responsibility to make sure that the pension plan
is solvent
A plan must be trusteed in order for the employer
to be able to deduct pension plan contributions
from taxable income
Trusteeship is also essential for a plan to be
registered

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Registered
Pension plans are usually registered with the
pension commissioner in the province of
jurisdiction
Employers can deduct their contributions to a
pension plan from taxable income when a formal
plan is registered (and trusteed)
The commissioners office is responsible for seeing
that the pension plan abides by the pension
legislation, including requirements for funding,
reporting, trusteeship, actuarial valuation, and
control over surpluses

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Probability Factors
In a defined benefit plan, the future benefit is known,
but the annual contributions that are necessary to
provide that defined future benefit must be estimated
Many factors must be taken into account in order to
estimate the current cost of the distant benefit
investment earnings
future salary increases
future inflation rates
employee turnover
mortality rates
life expectancy after retirement

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Probability Factors (cont.)

Actuaries often are very conservative, and they


may estimate the return on plan assets on the
low side and the projected rate of salary
increases on the high side
The company need not use the same estimates
for accounting purposes that is used by their
actuaries for funding purposes
The auditor needs to ascertain that the estimates
used by management are best estimates and that
they are internally consistent

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Funding vs. Accounting
In approaching the issue of pension accounting
for defined benefit plans, it is extremely important
to keep the accounting measurements separate
from the plan funding
Funding: the manner in which the employer (or
the trustee, on behalf of the employer) calculates
the necessary contributions to the plan
Keeping accounting separate from funding is
difficult because identical factors and the same
family of methods are used for both

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Defined Contribution Plans
Defined contribution pension plans are relatively
easy to deal with, both for the company and for the
accountant
Because the contribution is agreed upon, there is
little uncertainty about either the cash flow or the
accounting measurement
The one uncertainty that arises is that if the plan is
not fully vesting from the start of an individuals
employment with the company, it will be necessary
to estimate the probable portion of individuals who
will stay with the company long enough for the
pension to become vested

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Defined Contribution Plans (cont.)

For a defined contribution plan, there can be


three components of pension expense:
current service cost
past service cost
interest on accrued contributions

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Defined Benefit Plans: Actuarial Methods
There are three basic methods used to
calculate the cash contributions that a company
must make in order to provide for defined
pension benefits
Accumulated benefit method:
calculates the contributions that an employer
must make in order to fund the pension to
which the employee currently is entitled, based
on the years of service to date and on the
current salary

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Defined Benefit Plans: Actuarial Methods
(cont.)

Projected benefit method: calculates the


required funding based on the years of service to
date but on a projected estimate of the employees
salary at the retirement date
Level contribution method: projects both
the final salary and the total years of service, and
then allocates the cost evenly over the years of
service

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Pension Expense--List of Ingredients
Under current pension recommendations, there
are 10 components of pension expense, including
continuing components and special components:
continuing components:
1. current service costs
2. plus: interest on the accumulated accrued
benefit obligation
3. minus: expected earnings on plan assets
4. plus: amortization of past service cost from
plan initiation or amendment
5. plus (or minus): amortization of excess
actuarial loss (or gain)
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Pension Expense List of Ingredients
(cont.)
special components:
6. amortization of the transitional obligation (or
asset)
7. any changes to the valuation allowance for
pension plan assets
8. gain or loss on the plans settlement or
curtailment
9. any expense recognized for termination
benefits
10. any amount recognized as a result of a
temporary deviation from the plan
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Current Service Cost
The current service cost is an estimate of the cost
of providing the pension entitlement that the
employee earned in the current year of
employment
The AcSB recommends that the current service
cost be measured by using
the projected benefit method when future salary
levels affect the amount of the employees future
benefits
the accumulated benefit method when the future
salary levels do not affect future benefits

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Interest on Accrued Obligation
The accrued benefit obligation: the
present value of the post-retirement benefits that
the employees have earned to date
The accrued accrued benefit obligation is sensitive
to the assumed interest rate because it is a present
value of a future stream of payments
The AcSB recommends that the rate used to
discount the obligation should be based on market
rates at the measurement date

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Expected Earnings on Plan Assets
Expected earnings on the plan assets reduces the
amount of pension expense
The expected earnings is based on the expected
long-term rate of return on plan assets, multiplied
by the weighted average of the value of the plan
assets over the year
The rate of return may be equal to the rate used by
the actuary for funding calculations but if the
actuarys rate is conservative, then a more realistic
rate should be used by the company to calculate
the expected earnings

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Expected Earnings on Plan Assets (cont.)

The value of the plan assets that is used in


this calculation may be either
the fair value of the plan assets
or
a market-related value
A market-related value: one that is based on
fair values but that is not actually the current fair
value

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Past Service Cost from Plan Initiation
The past service cost: an estimate of the
present value of the retroactive pension
entitlements relating to previous years service
when a new pension plan is instituted
Past service costs (PaSC) are deferred and
amortized over the expected period to full
eligibility, which for pensions is normally the
estimated average remaining service life of the
employee group
Funding of past service costs generally is limited
to no more than 15 years
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Past Service Cost from Plan Amendment

From time to time a company will amend its


pension plan, usually to increase benefits either
as the result of collective bargaining or to remedy
purchasing power erosion that has occurred due
to inflation
When a plan is amended to increase benefits, an
additional unfunded obligation is established that
relates to prior service
The liability that arises from a plan amendment is
known as prior service cost (PrSC)

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Actuarial Gains and Losses

Actuarial gains and losses arise either


because:
actual experience is different from
expectations
assumptions about the future are changed,
or both

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Actuarial Gains and Losses

Actuarial gains and losses must be amortized only if


the accumulated amount exceeds
10% of the higher of the accrued pension
obligation
or
the value of the plan assets at the beginning of the
year
Only the excess over the 10% corridor need be
amortized

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Actuarial Gains and Losses (cont.)

The amortization period is the average remaining


service period (ARSP) of the employee group
A company may choose to amortize actuarial gains
and losses on a different basis, as long as the
amortization is at least equal to the corridor
amortization
A company may also elect to recognize actuarial
gains and losses in income in the period in which
they arise
Any amortization policy must be used consistently
for all plans
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Actuarial Gains and Losses (cont.)
Pension gains and losses arise from periodic
actuarial revaluations
Pension legislation usually requires an employer to
have an actuarial revaluation at least once every
three years
Surpluses that arise as the result of an actuarial
revaluation (such as an unexpectedly high return on
plan assets) are not withdrawn from the pension
plan, but usually entitle the employer to take a
pension holiday by using the surplus to reduce or
eliminate payments for the current service costs

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Special Components of Pension Expense

Special Components of Pension Expense:


transitional amortization
valuation allowance for pension plan assets
gains and losses on plan settlements and
curtailments
termination benefits
temporary deviations from the plan

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Disclosure Recommendations
The disclosure recommendations for post-retirement
benefits are unusually extensive
The financial statements themselves include only two
amounts relating to pensions and other post-
retirement benefits:
1. on the income statement, the amount of the
expense relating to providing post-retirement
benefits
2. on the balance sheet, the net deferred pension
cost or liability that reflects the difference between
the accumulated accounting expense and the
accumulated funding
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Disclosure Recommendations (cont.)

There are two levels of disclosure:


1. disclosure for all companies
2. additional disclosure for public companies

The AcSB recommends that all disclosures be


provided separately for:
pension plans
other post-retirement benefits

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Basic Disclosures

All companies should disclose:


1. important accounting policies
2. important measurements being used for
pension accounting
The policy disclosures belong in the
accounting policy note or description, along
with other policy choices that the company
has made

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Disclosure Recommendations (cont.)

The AcSB suggests several relevant policy


disclosures, including:
the amortization period for past service costs
the method chosen for recognizing actuarial
gains and losses and the period of
amortization (if amortization is being used)
the valuation method for plan assets

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Disclosure Recommendations (cont.)
The measurement disclosures include:
1. the amount of the deferred pension cost or
accrued pension liability that has been included in
the balance sheet
2. the amount of expense recognized for the period
3. the actuarial present value of accrued pension
benefits at the end of the period
4. the fair value of the pension plan assets
5. the resulting plan surplus or deficit
6. the amount of funding contributions made by the
company during the period

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Disclosure Recommendations (cont.)

7. the amount of contributions by employees,


if any
8. the amount of benefits paid
9. important measurement variables
discount rate, expected long-term rate on plan
assets, the projected rate of compensation
increase, and the assumed health care cost
trend rate

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Additional Disclosures for Public
Companies

The AcSb recommends that public companies


disclose the following additional information:
1. a reconciliation of beginning and ending balances
of the accrued benefit obligation for the period,
showing separately:
a. the current service costs
b. the amount of benefits paid
c. the interest costs
d. actuarial gains and losses arising during the
period

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Additional Disclosure for Public
Companies (cont.)

2. a reconciliation of beginning and ending


balances of the fair value of the plan assets
for the period, showing separately:
a. the amount of funding contributions by the
employer and by the employees
b. the amount of benefits paid
c. the actual return on plan assets

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Additional Disclosure for Public
Companies (cont.)
3. the balance of unamortized amounts not
recognized in the financial statements, showing
separately:
a. unamortized past service costs
b. unamortized actuarial gains and losses
c. unamortized transitional obligation or asset
4. the expected return on plan assets
5. the current periods amortization of
a. past service costs
b. actuarial gains or losses
c. the transitional obligation or asset

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Additional Disclosure for Public
Companies (cont.)

The AcSB also suggests that:


entities are encouraged to provide additional
disclosures about the actuarial assumptions
underlying the reported amount of an entitys
accrued benefit obligation when the disclosure
will enhance financial statements users
understanding of that amount

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