16.10 Chapter Summary

LO 1: Describe the nature of a pension plan and identify the key issues in accounting for a pension plan.

A pension plan is an arrangement by which employers offer benefits to employees after the completion of their employment. Employees earn pension benefits over the course of their employment with the company. These benefits can take many forms, but pension plans usually involve post-employment payments made to the retired employee on a periodic basis. The key accounting issues are: Who pays for the plan? How will the plan’s activities be measured? How will the plan be reported?

LO 2: Define and contrast defined contribution pension plans and defined benefit pension plans.

A defined contribution pension plan is one in which the employer has agreed to contribute a specified amount on behalf of an employee, but has not guaranteed the amount of retirement income the employee will receive. In contrast, a defined benefit pension plan does specify the amount of income the employee will receive upon retirement. Under both types of plans, it is the employers’ responsibility to make sufficient contributions to the plans as per the agreements made with their employees. The key accounting difference between the two plans is that a defined benefit pension plan creates a liability for the employer to cover any shortfall of funding, based on the present value of future expected payments, to ensure the agreed upon amount of retirement income is available to the employee. A defined contribution pension plan, on the other hand, only creates a liability to the extent that the company is required to make the agreed upon contributions to the plan. The employer is not responsible for the performance of a defined contribution pension plan, but is indirectly responsible for the performance of a defined benefit pension plan.

LO 3: Prepare the accounting entries for a defined contribution pension plan.

The employer records an expense every year for the amount of contributions they are required to make. They will also record a liability if the contributions are unpaid at the end of the year. However, as there is no guarantee of future retirement income, the company does not record any liability beyond the amount of contributions required.

LO 4: Describe the various estimations required and elements included in the accounting for defined benefit pension plans, and evaluate the effects of these estimations on the accounting for these plans.

The determination of the DBO requires estimation of several amounts. The expected date of the employee’s retirement and the expected duration of pension payments (i.e., the amount of time between the employee’s retirement and death) need to be estimated. As well, the amount of the expected pension payment will need to be predicted, as this amount may be based on future salary levels. The interest rate used to discount the obligation should be based on the yields on high-quality debt instruments, but there may be subjectivity in determining which instruments to choose. Most accountants don’t have the required training to make these kinds of estimations, so they will likely have to rely on the work of an expert called an actuary. Because the estimates can change every year based on new information and assumptions, it is possible that the accounting for the pension plan may create some volatility in reported earnings, including comprehensive income.

LO 4.1: Calculate pension expense for a defined benefit pension plan and prepare the accounting entries for the plan.

The pension expense includes the cost of current service provided by employees, the net interest on the scheme, and changes due to past service adjustments and other amendments. The net interest represents the difference between interest calculated on the DBO and the interest expected to be earned on the plan assets. Both calculations use the same interest rate—the yield available on high-quality debt instruments. The pension expense should be allocated to the various components of net income in the same fashion as the underlying compensation costs.

The DBO is increased by the current service cost, the cost of any past service benefits granted during the year, and interest calculated on the balance. The DBO will be decreased by any pension payments made during the year and may be increased or decreased by any re-measurements caused by changes in actuarial assumptions. The pension plan assets will be increased by actual returns earned on the assets and contributions made by the employer. The pension plan assets will be decreased by any pension payments made during the year.

Several issues are involved in the determination of the net asset or liability to be reported on the balance sheet. First, the amount of the DBO is based on future events for which complex actuarial calculations are required. Second, the fair value of the pension plan assets must be determined. For many assets, this is quite straightforward, but if the pension plan holds real estate or other assets not actively traded, expert consultations may be required. Once the amounts are determined, the net pension liability (asset) can be determined and reported on the balance sheet, usually as a non-current item. Other changes in value, such as changes in actuarial assumptions used to determine the DBO or differences between the expected and actual return on plan assets, are recorded as part of other comprehensive income.

LO 4.2: Describe the accounting treatment of net defined benefit assets.

A net defined benefit asset represents a situation in which the plan assets exceed the DBO. This means that the plan is overfunded. The amount of overfunding should be reported as an asset, but only to the extent that it doesn’t exceed the asset ceiling, that is, the present value of the future benefits available to the plan sponsor, either through reduced contributions or cash refunds.

LO 5: Discuss the challenges in accounting for other post-employment benefits.

Other post-employment benefits, such as supplementary health coverage, are treated in a similar fashion as pension plans for accounting purposes. However, challenges can arise in estimating the future payable amounts and the amount of the obligation. Future payments for health care coverage can be very unpredictable in both the timing and the amount. A greater degree of estimation risk may exist for these kinds of benefits as compared to pension plans.

LO 6: Describe the accounting treatment for other employment benefits.

Other kinds of employment benefits may include paid vacations, sabbaticals, or sick leave. For these kinds of benefits, it is important to understand whether they vest or not. Benefits that vest, such as paid vacations, must be accrued and recorded by the company. However, these benefits are not normally discounted, and any remeasurement gains or losses that occur are recorded directly in net income instead of other comprehensive income. For benefits that do not vest, an expense is recorded when the benefit is used, but no amounts are accrued.

LO 7: Identify the presentation and disclosure requirements for defined benefit pension plans.

Accrued net defined benefit amounts are normally recorded as non-current liabilities or assets. When the company sponsors multiple pension plans, they are generally not netted on the balance sheet. Pension expense can be shown as a single item on the income statement or it can be split into component parts. Remeasurement amounts recorded in other comprehensive income should be disclosed separately. There are extensive note disclosure requirements for pension plans to help the readers understand the risks of these plans and potential effects on future cash flow.

LO 8: Identify differences in the accounting treatment of post-employment benefits between ASPE and IFRS.

The treatment under ASPE is similar to the treatment under IFRS, but there are some differences. Under APSE, remeasurement amounts are reported directly in net income, rather than in other comprehensive income. Also, companies have a choice in the method used to measure the DBO and in the interest rate chosen to discount the obligation. If a net defined benefit asset is reported, ASPE requires the use of a valuation allowance. ASPE provides more detailed guidance on how to calculate some of the amounts required to determine the DBO, but less detailed guidance on disclosure requirements. They also require actuarial valuations every three years, whereas IFRS only requirements them with sufficient frequency.