BUS 321

Chapter 19: Pensions

What is this chapter all about?

Some employers agree to pay salary or other benefits to an employee even after they have stopped working (retired) for the employer. The salary is PENSION. Other benefits include: medical, dental, life insurance, sick and parental leave.

Whats the issue?

CICA Handbook Section 3461 provides guidance when accounting for employee future benefits
The section covers primarily benefits that the employee will receive after retirement from the company; however, if the employer is obligated to provide any ongoing benefits after an earlier resignation (before retirement), then those benefits would also be covered

Pensions
In Canada, pensions are by far the largest part of these post-retirement benefits In the US, health care costs are also a significant part In general, accounting for other postretirement benefits is similar to pensions, so well focus on pensions

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 employment of the corporation Governed by provincial law

Pensions
Two types of pensions
Defined contributions (EASY!!!) Defined benefit (not so easy)

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

Defined contribution
The employer (and employee) make annual contributions which are FIXED The plan earns some rate of return The employee gets all the plan assets upon retirement as an annuity The employees retirement income depends largely on the rate of return the plan earns Therefore, if the plan does not earn as much as expected, it is the employee who loses.

Defined benefit
The employer (and employee) make annual contributions VARIABLE The plan earns some rate of return The employee gets a pre-specified retirement income, independent of plan assets The employer is on the hook to make sure the pension plan has sufficient assets to fund the employees retirement income

Comparison of Plan Types

Types of Plan Periodic contribution Future Benefits Who bears risk? Defined Benefit Defined Contribution

Choosing between the two

How 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?)

Source: Rauh 2006 Journal of Finance

Bombardier example

Accounting for Employee Future Benefits

Note that in accounting for pension plans there are two separate issues:
Funding of the plan Accounting for the pension expense and obligation

Funding vs. Expensing

Canadian employers follow a wide variety of policies with respect to the funding of pension liabilities. At one extreme there are plans in which all of the pension liabilities have been eliminated through payments to a trustee. At the opposite end of the spectrum there are the payas-you-go types of plans. Is the amount of cash paid by the employer into the plan in a period an appropriate measure of the pension expense for the period?

Defined Benefit Pension Plans

Projected benefit obligation is considered the best measure for accounting purposes

Related Account: 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.

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

Financial vs. Off-Financial Statement Effects

The pension benefit obligation and the plan assets are regarded as liabilities and assets of the plan, not of the sponsoring corporation. The pension plan is carried on the balance sheet at a net amount, determined by the difference between 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

Financial vs. Off-Financial Statement Effects

If the cumulative cash payments are greater than the cumulative expense, the balance sheet shows a prepaid pension asset. If the cumulative expense is greater than the cumulative cash payments, the balance sheet shows an accrued pension cost.

Funded Status
Funded status = ABO  Fair Value of plan assets ABO > Plan assets = Underfunded plan The company will have an accrued pension liability on B/S ABO < Plan assets = Overfunded plan The company will have an accrued pension asset on B/S The funded status of the plan is reported in the notes to the financial statements, usually with a reconciliation to the asset or liability reported on the balance sheet.

Defined Contribution - Accounting

In most cases, the pension expense is equal to the pension contribution (there are fewer items to account 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 required in respect of past service at the B/S date is mandatory

Defined Contribution Plans: Employers Journal Entries

Contribution made is less than the pension expense Pension Expense Dr Cash Cr Accrued Pension Liability Cr Pension Expense Dr Accrued Pension Asset Dr Cash Cr Liability

Contribution made is more than pension expense

Asset

Defined Contribution Accounting

Comprehensive Example Adams Corporation has a defined contribution plan covering all salaried employees. The plan was started on July 1, 2008. Under the plan, Adams is to contribute a yearly amount to the benefit pool with respect to current service equal to 5% of net income above the level required to provide an 8% return on the beginning book value of equity, before considering taxes and the effects of the defined contribution plan itself.

Defined Contribution Accounting

At inception, past service benefits were provided to salaried employees with at least 5 years of service. These benefits amounted to $1,200,000 and are required to be contributed to the defined contribution accounts over six years at $200,000 per year. Any unpaid balance carries 6% interest. The vesting period 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 fiscal year (the first payment was made on July 1, 2008). At inception of the plan, the expected period to full eligibility (EPFE = EARSL) of the employees covered by the plan was 12 years.

Defined Contribution Accounting

Contributions are made to each individuals defined contribution account out of this pool based on the ratio of the individuals base salary to the sum of the base salaries of all participants. Contributions are made within 90 days after the fiscal year end. On July 1, 2010, Adams made the required contribution of $456,000 with respect to the PSC installment and the current service for the 2009/10 fiscal year.

Defined Contribution Accounting

Income for fiscal 2010 before taxes and any pension cost was $12,000,000. The book value of equity at July 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. Adams has a June 30 fiscal year end. This JE will involve computation of Pension Expense, Cash, and Accrued Pension Asset / Liability

Components of Pension Expense under Defined Contribution Plan

Pension expense consists of: - Interest cost - Amortization of past service cost - Current service cost Accrued Pension Asset / Liability: Difference between required contributions and amount actually paid

Defined Contribution Accounting

Unfunded Past Service Costs
Balance before July 1, 2008 payment July 1, 2008 payment Balance after July 1, 2008 payment Interest cost for 2008/09 fiscal year (1,000,000 x .06) Balance, June 30, 2009 July 1, 2009 payment (200,000 + 60,000) Balance after July 1, 2009 payment Interest cost for 09/10 fiscal year (800,000 x .06) Balance, June 30, 2010 1,200,000 (200,000) 1,000,000 60,000 1,060,000 (260,000) 800,000 48,000 848,000

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

Defined Contribution Accounting

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

Current Service Cost

Net income before taxes and pension expense 12,000,000 Reduced by: (98,000,000 x .08) (7,840,000) Basis for current service 4,160,000 Percentage x 0.05 Current service cost $ 208,000

Defined Contribution Accounting

Pension expense
Interest cost Amortization of past service cost Current service cost Journal Entry (June 30, 2010) Dr Pension expense Cr Accounts Payable Journal Entry (July 1, 2010) Dr Accrued pension cost (Deferred Asset) Dr Accounts Payable Cr Cash $ 48,000 $ 100,000 $ 208,000

356,000 356,000 100,000 356,000 456,000

Defined Benefit Accounting

Require the employer to guarantee some specified benefit or benefit formula to employees.
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

Defined Benefit Accounting

In defined benefit plans there are many variables 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 currently holds? Will that be enough? What if expectations about the future turn out to be wrong? How do we report the differences between expectations and experience? What if we agree to amend our employer/employee contract with respect to pension entitlements?

Defined Benefit Accounting

Calculation of the Pension Benefit Obligation
Illustration: An employer might state that he will provide a pension benefit when the employee reaches the age of 65 and that this benefit will be equal to 1% of the employees highest annual salary for each year of service.

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 years remaining 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.

Defined Benefit Accounting

Project future benefits to be paid based on expected salary history at retirement and years of service to date. = 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

Defined Benefit Accounting - Actuary

Computes the actuarial present value of these projected future benefits at the retirement date (Projected benefit method) PV, annuity, 20 years, 10% (8.51356) = $17,500 X 8.51356 = $148,987
Today Retirement date Date of Death

60 years

65 years

85 years

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 previous slide, why is that? 2. PV factor, 5 years, 10% (0.62092) = $127,704 x 0.62092 = $79,294
Today Retirement date Date of Death

60 years

65 years

85 years

Projected benefit method

Required by CICA to use this method in determining the current service cost. Each year the pension benefit obligation will increase 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.

Defined Benefit Accounting

Age P.V. of obligation beg of yr. Interest on obligation @ 10% P.V. of current service P.V of obligation end of year

ote
1. (500 X P/A 10 %, 20 yrs) 2. (4,257 x PV 10% 1yr) 5. (4,257 x PV 10% 4yr) 4,257 3,870 2,907 3. (4,257 x PV 10 % 2yr) 4. (4,257 x PV 10 % 3yr) 3,518 3,198

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

Financial vs. Off-Financial Statement Effects

On the income statement:
Pension Expense OCI costs (if 100% of the actuarial gains and losses are recognized)

On the balance sheet:

Cash Accrued Pension Asset / Liability

Financial vs. Off-Financial Statement Effects

Off the balance sheet therefore are the following nominal accounts:
Pension obligation (ABO) Plan assets (Actual returns) Balance of unamortized past service costs Balance of unamortized actuarial gains / losses

Past Service Costs (PSC)

Past service costs may arise when a new plan is begun, and when an existing plan is amended for some reason. In this case, employees who are already with the company may get some pension recognition for services provided in the past.

Past Service Costs (PSC) - Rationale

At inception, the actuary determines the value of any accrued pension benefits using the projected benefit method and estimates of future salaries. This amount is equal to past service costs at inception. At inception there are no plan assets. The only accounting issue which exists at inception is how to handle the past service cost.

Past Service Costs (PSC) - Rationale

CICA HB Recommendation: Past service costs should be amortized in a rational and consistent manner over an appropriate period of time, which normally would be the average expected period to full eligibility of the employee group covered by the plan.

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 service cost was $200,000. What effect did this have on Bakers balance sheet?

Past Service Costs (PSC)

Example:
On Balance Sheet Effects Balance Sheet Asset / Liability $ 0 Off Balance Sheet Effects Pension Benefit Obligation $ 200,000 Cr Plan Assets Past Service Cost $ 200,000 Dr

$ 0

Basic Causes of Changes to the Off-Balance-Sheet Items

Service provided during the current year by employees (i.e., current service cost) Interest that is accruing on the pension benefit obligation due to the passage of time (benefit payments are getting closer). Cash payments to the pension trust. And.

 Earnings on the assets invested by the pension trust.

Actual earnings are determined by the application of market value or market related value principles to the valuation of plan assets. Expected earnings are determined by applying the expected rate of return on plan assets (an actuarial assumption) to the average plan assets actually invested in the period. Differences between actual and expected earnings may need to be amortized, depending on the magnitude of the difference (corridor approach)
. and

Basic Causes of Changes to the Off-Balance-Sheet Items

Amortization of past service costs (arising from plan inception and/or plan amendments). Benefit payments to retired employees.

Example:
ABC Corp. created a defined benefit pension plan on January 1, 2008. At inception the actuary determined that the pension benefit obligation (past) was $120,000 for retroactive service credit. and that the average expected period until full eligibility (vesting) of the employees entitled to benefit from the past service cost was 20 years.

Example:
During 2008, the actuary determined that the actuarial present value of services rendered (Current Service Cost) during 2008 was $10,000 and this amount was earned evenly throughout the period. Plan assets were expected to earn 10% and this was the discount rate used by the actuary in determining the actuarial present value of the benefits.

Example:
On January 1, 2008, ABC contributed $40,000 (Funding contribution) to the pension trust to cover a portion of the past service costs. Earnings on plan assets met expectations and there were no changes in actuarial assumptions ($ 0 actuarial gains and losses) during the year. Benefits (Benefit payments) of $1,000 were paid to employees that retired during the year. These payments were made from trust assets on July 1, 2008.

Defined Benefit Plans: Employers Journal Entries

Contribution made is less than the pension expense Pension Expense Dr Cash Cr Accrued Pension Liability Cr Pension Expense Dr Accrued Pension Asset Dr Cash Cr Liability

Contribution made is more than pension expense

Asset

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 asset or liability.

 There are lots of estimates used THEYRE ALL WRONG! Assumption changes are those in the future Discount rate, Mortality rate, Expected retirement age, 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 in an experience loss, while a decrease in the projected benefit obligation results in an experience gain. A complete actuarial valuation of the plan must occur every three years.

Actuarial gains / losses

Experience estimates are those in the past
Are compared to actual interest rate, actual mortality rate, retirement age, turnover prior to retirement

Actuarial gains / losses

Past (experience) and future (assumption) changes are actuarial gains/losses
We need to bring these into income and also make sure that any funding shortfall is made up (and quickly too)

Because the gains/losses are likely to offset each other, annual recognition is not required
This is similar to how we used to account for FX gains/losses on long term debt

Unamortized Actuarial G/L - Accounting

These gains and losses are amortized to pension expense using a method called the Corridor approach. The general idea behind this approach is that if the accumulated gains or losses are not significant, they can be ignored, on the assumption that over time they might self-correct or reverse. However, once they get sufficiently large, the corporation cannot continue to keep them entirely off balance sheet.

Actuarial gains / losses

IFRS
If the amount of accumulated gains/losses is > 10%, (of greater: beginning-of-period plans assets or ABO), amortize over an appropriate period (Expected average remaining service period - EARSP) Faster amortization, including recording the full gain/loss in the year incurred is allowed

Disclose the method, gains/losses handled the same, be consistent from year to year

Example Continued (Extended)

Continuing the ABC example into 2009, assume that during 2009 the following occurred.
Current Service Cost $13,000 earned evenly throughout 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)

Example
Experience Loss on Assets $1,000 (determined on December 31, 2009) Average period to vesting (or EARSP) of the employee 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 earn 10% and this was the discount rate. Spreadsheet Approach

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

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.

Defined Benefit Plans with Benefits that Do Not Vest or Accumulate (chapter 13)
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

FASB Perspectives
New U.S. accounting standards (2006) require:
previously unrecognized past service cost, actuarial gains/losses and transition costs to be recorded in OCI and the plans funded status (i.e. the difference between accrued benefit obligation and the plan assets) to be recognized on the balance sheet

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

Self-study Problems and Review

Dont worry about Appendix 19A Self-Study: P19-1, P19-3(a), P19-7 In-class: E19-2, E19-14, E19-12(a, b), E19-9, Case RA19-2 HW#6: Posted on the WebCT