Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

C H A P T E R 20 Pensions and Other Employee Future Benefits

1. Distinguish between accounting for the employer’s pension costs and accounting for the pension fund. 2. Identify types of pension plans and their characteristics. 3. Identify the accounting and disclosure requirements for defined contribution plans. 4. Explain alternative measures for valuing the pension obligation. 5. Identify the components of pension expense. 6. Identify transactions and events that affect the projected benefit obligation. Learning Objectives

7. Identify transactions and events that affect the balance of the plan assets. 8. Explain the usefulness of—and be able to complete— a work sheet to support the employer’s pension expense entries. 9. Explain the pension accounting treatment of past service costs. 10. Explain the pension accounting treatment of actuarial gains and losses, including corridor amortization. Learning Objectives

11. Identify the differences between pensions and post- retirement health care benefits. 12. Identify the financial reporting and disclosure requirements for defined benefit plans. 13. Identify the financial accounting and reporting requirements for defined benefit plans whose benefits do not vest or accumulate. 14. Explain the basics of what current service cost, the projected benefit obligation and past service cost represent. (Appendix 14A)

Pensions and Other Employee Future Benefits Introduction and Terminology Nature of pension plans Defined contribution plans Defined benefit plans The role of actuaries Defined Benefits that do not Vest or Accumulate Post- employment benefits and compen- sated absences Defined Benefits that Vest or Accumulate - Basics Alternative measures of the liability Capitalization vs. non-capitalization Major components of pension expense Projected benefit obligation and plan assets Basic Illustration Defined Benefits that Vest or Accumulate - Complexities Past service costs Actuarial gains and losses Corridor amortization Other benefits that vest or accumulate Comprehensive illustration Reporting defined benefit plans Perspectives Plan complexities Appendix A- Example of a One Person Plan Current service cost Projected benefit obligation Past Service Cost

Pension Plans A pension plan provides benefits to retirees for services provided during employmentA pension plan provides benefits to retirees for services provided during employment Employer sponsors and contributes to fund, and incurs the cost of the pension planEmployer 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 beneficiariesPension plan receives the contributions, administers pension assets, and makes pension payments to the beneficiaries –Accounting for the pension plan

COMPANY TRUST Pension Fund Stream Pension Expense Cash paid to pension plan (funding) Accrued pension asset/liability $ Plan Assets Assets Projected Benefit Obligation Employees (pension benefits)

ContributoryContributory –Employee and employer make contributions to the plan Non-contributoryNon-contributory –Employers bear the full cost of the pension plan –No contributions made by employee VestedVested –Amounts in the plan become the legal property of the employee Employee is entitled to receive benefits even after leaving the employ of the corporationEmployee is entitled to receive benefits even after leaving the employ of the corporation –Governed by provincial law Pension Terminology

Employer contributes a defined sum to a third party – plan trusteeEmployer contributes a defined sum to a third party – plan trustee –Ownership of plan assets assumed by trustee Employee assumes the economic riskEmployee assumes the economic risk –No guarantee made by employer as to benefits paid Cost of the plan in the current year is known with certaintyCost of the plan in the current year is known with certainty Defined Contribution Plans

Liability reported if contribution (funding) is less than requiredLiability reported if contribution (funding) is less than required Asset reported if the amount contributed is more than required for the periodAsset reported if the amount contributed is more than required for the period Disclosure requirements:Disclosure requirements: –Annual pension expense amount –Nature and effect of matters affecting comparability

Defined Contribution Plans: Employers’ Journal Entries Contribution made is less than the pension expense Pension Expense Dr Cash Cr Cash Cr Accrued Pension Accrued Pension Liability Cr Liability Cr Liability Contribution made is more than pension expense Pension Expense Dr Accrued Pension Asset Dr Cash Cr Cash Cr Asset

Exercise 20-1: LinDu Limited Given: Defined Contribution Plan Employee Contribution:5% of gross pay Employer Contribution:Equal amount November 30, 2005:$25,500 combined employee and employer contribution owing December 2005: $274,300 gross pay

Exercise 20-1: LinDu Limited Requirement a) December 10, 2005 Journal Entry: Pension Liability25,500 Cash25,500 To record payment to pension trustee

Exercise 20-1: LinDu Limited Requirement b) 5% of December gross pay=$274,300 x.05 x.05 Employer Contribution Expense 13,715

Exercise 20-1: LinDu Limited Requirement c) Current liability: Pension Contributions Payable $ 27,430 ($13,715 + $13,715) This assumes amounts for previous months were remitted as required each month. At December 31 st all that remains as payable is the amount withheld from employees in December and the required employer matching amount.

Defined Benefit Pension Plans End benefit received by employees is predefinedEnd benefit received by employees is predefined –Contributions based on formula: Employee’s years of service and expected salary level at retirementEmployee’s years of service and expected salary level at retirement –Actuarial assumptions used extensively in accounting for defined benefit plans –Cost of plan in current year not known with certainty The employer remains liable to ensure benefit paymentsThe employer remains liable to ensure benefit payments Employer is the trust-beneficiaryEmployer is the trust-beneficiary

Defined Benefit Pension Plans Pension obligation valuationPension 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 nonvested service 3.Projected benefit obligation –Based on future salary levels –Includes both vested and nonvested service

Pension Liability Measurement Vested benefit obligation Accumulated benefit obligation (ABO) Projected benefit obligation (PBO) Pro-rated on service Pro-rated on salaries Pension obligation Present value of the estimated future benefits to be paid to employees Recommended method - CICA Handbook, Section 3461

Projected Benefit Obligation (PBO) Pro-rated on salariesPro-rated on salaries Annual funding based on percentage of total estimated compensation earned by the employees over their careerAnnual funding based on percentage of total estimated compensation earned by the employees over their career Pro-rated on servicesPro-rated on services Annual funding based on the total estimated benefit being allocated evenly over the years of service of the employeeAnnual funding based on the total estimated benefit being allocated evenly over the years of service of the employee

Projected Benefit Obligation (PBO) Defined as the portion of the defined obligation attributed to services provided to dateDefined as the portion of the defined obligation attributed to services provided to date –Based on the present value of vested and nonvested benefits Also referred to as accrued benefit obligationAlso referred to as accrued benefit obligation

Capitalization vs. Noncapitalization CapitalizationCapitalization –Full obligation recognized as liability –Pension plan assets reported as assets –Liability and assets reduced by payment of benefits NoncapitalizationNoncapitalization –Follows substance of the plan as separate legal and accounting entity –Obligation on B/S = amount of expense recognized less amount funded –Adopted by Accounting Standards Board

Components of Pension Expense Pension Expense Service Cost for Current Year + Interest on the Liability + Expected return on Plan Assets  Amortized Net Actuarial Gain or Loss + or  Amortized Past Service Costs + AmortizedTransitional Asset or Obligation + or 

Service CostService Cost –The amount of pension benefit earned in the current period InterestInterest –Consider PBO as a long-term liability (albeit off- balance sheet) that accrues interest –Interest rate used is the current yield on high- quality debt, or current settlement rate Components of Pension Expense

Expected Return on Plan AssetsExpected Return on Plan Assets –The assets in the pension plan earn income and this income including any capital appreciation reduces the eventual cost of the pension –Long-term rate of return applied to fair value of plan assets Components of Pension Expense

Amortization of Past Service Costs (PSC)Amortization of Past Service Costs (PSC) –PSC are from either the initial adoption of a pension plan or an amendment to improve the existing plan –PSC are the present value of those additional future benefits –Amortized over the expected period to full eligibility of the employee group

Amortization of Net Actuarial Gains/LossesAmortization of Net Actuarial Gains/Losses –Two sources for these gains and losses 1.Change in plan’s actuarial assumptions 2.Plan experiences gains and losses –Amortized using “corridor approach” Components of Pension Expense

Amortization of Transitional Asset or ObligationAmortization of Transitional Asset or Obligation –Stem from CICA Handbook, Section 3461 (introduced in 2000) –When Section 3461 is applied prospectively, any difference between plan assets and PBO is amortized –Amortization period is the Expected Average Remaining Service Life (EARSL)

EARSL is the expected average remaining service life of the employee groupEARSL is the expected average remaining service life of the employee group It is another number determined by the actuaryIt is another number determined by the actuary Consider the following exampleConsider the following example Notes on EARSL

Picture a bus full of employees heading for retirement. Given an EARSL of 10 years in 2005, what is a reasonable EARSL in 2006? Are the same employees on the bus at retirement as were on at the beginning? Retirement Some got on the bus, others got off the bus… A reasonable estimate for 2006 might be 10 years. EARSL

Summary of Pension Expense Components and Methods Pension expenseMethod used toEffect on pension componentdetermine cost expense Service CostPresent Value+ 1 Interest ExpenseCurrent Rate + 2 Expected ReturnLong-Term Expected Rate - on Plan Assets of Return 3 Prior Service CostAmortize + 4 Actuarial Gains Corridor method +/- and Losses and Losses (amortize excess) 5 Transition GainsAmortize over EARSL +/- and Losses 6

PBO Transactions PBO, beginning of period + Current Service Cost + Interest Cost + PSC during period  Benefits paid to retirees  Actuarial Gains + Actuarial Losses = PBO, end of period The PV of pension benefits earned to date by employeesThe PV of pension benefits earned to date by employees Most information relating to PBO provided by actuariesMost information relating to PBO provided by actuaries

Plan Assets Transactions Plan assets (FV) beginning of period + Employer/employee funding  Actual return  Benefits paid out = Plan assets (FV) end of period Actual return = expected return + experience gain or  Experience loss on assets

Funded Status Funded status = PBO  FV of plan assetsFunded status = PBO  FV of plan assets PBO > Plan assets = underfundedPBO > Plan assets = underfunded PBO < Plan assets = overfundedPBO < Plan assets = overfunded

CICA Handbook, Section 3461 recommends the noncapitalization approachCICA Handbook, Section 3461 recommends the noncapitalization approach –Pension amounts recorded by the company (most are disclosed in notes) PBOPBO Plan AssetsPlan Assets Unrecognized Past Service Costs (PSC)Unrecognized Past Service Costs (PSC) Unrecognized Net Actuarial Gains/LossesUnrecognized Net Actuarial Gains/Losses Unrecognized Net Transitional Asset/LiabilityUnrecognized Net Transitional Asset/Liability Notes on Pension

Used to accumulate information needed to record both the formal journal entries and the memo entries to keep track of the relevant pension plan items and componentsUsed to accumulate information needed to record both the formal journal entries and the memo entries to keep track of the relevant pension plan items and components The Pension Worksheet

General Journal Entries Memo Record Items Annual Pension Expense Cash Projected Benefit Obligation Plan Assets Accrued Pension A/L Beginning Balances recorded here Pension transactions are recorded through the worksheet, using debits and credits (all entries must therefore balance) An ending credit balance here is reported with Long-term Liabilities An ending debit balance is reported with other Deferred Charges The Pension Worksheet

The Pension Worksheet - Example Bal. 100,000 Cr. 100,000 Dr. 9,000 Dr. 9,000 Cr. a) 9,000 Dr. 9,000 Cr. b) 10,000 Dr. 10,000 Cr. c) 10,000 Cr. 10,000 Dr. d) 8,000 Cr. 8,000 Dr. e) 7,000 Dr. 7,000 Cr. General Journal Entries Memo Record Items Annual Pension Expense Cash Projected Benefit Obligation Plan Assets Accrued Pension A/L 9,000 Dr. 9,000 Cr. 8,000 Cr. 8,000 Cr. 8,000 Cr. 8,000 Cr. 1,000 Cr. 112,000 Cr. 111,000 Dr.

Pension Entries To record: Pension Expense 9,000 Accrued Pension/Liability 9,000 Accrued Pension/Liability 9,000 To record contribution: Accrued Pension Liability 8,000 Cash 8,000 Cash 8,000

Actuarial Gains and Losses Caused by:Caused by: 1.Actual return on plan assets differing from expected return 2.Changes in actuarial assumptions affecting the PBO 3.Actual experience in PBO differing from expected experience If changes large enough, including full amount of the gains or losses in expense results in substantial fluctuations in reported pension expenseIf changes large enough, including full amount of the gains or losses in expense results in substantial fluctuations in reported pension expense Amortization allows for “smoothing” the impact of these changesAmortization allows for “smoothing” the impact of these changes

Actuarial Gains and Losses Over time, accumulated effect of the changes (net gains/losses) may even outOver time, accumulated effect of the changes (net gains/losses) may even out Corridor approach adopted to allow for circumstances where no accumulating offset occursCorridor 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 opening balance of the PBO and the FV of Plan AssetsAmortization used only when the opening unrecognized gains/losses are greater than 10% of the larger of the opening balance of the PBO and the FV of Plan Assets Amount calculated under the Corridor Approach uses Beginning Balances onlyAmount calculated under the Corridor Approach uses Beginning Balances only

Corridor Approach - Example PBO, January 1 $2,100,000$2,600,000$2,900,000 FV Plan Assets, Jan. 1 2,600,0002,800,0002,700,000 Net Actuarial Loss (gain) 400,000300,000(170,000) Corridor – 10% of the larger of the PBO or PA 260,000280,000290,000 Cumulative Net Actuarial Loss (Beginning of Year) 0400,000678,182 Amount to be Amortized 0120,000388,182 Current Year Amortization 021,81870,579 Opening Balance$400,000 Less: Corridor 280,000 $120,000 Amortized over 5.5 years – average remaining service life Opening Balance$678,182 (400,000 – 21, ,000) Less: Corridor 290,000 $388,182

All enterprises must disclose:All enterprises must disclose: –Amounts recorded in the financial statements –Off-balance sheet accounts –Underlying assumptions Financial institutions and public enterprises have additional disclosure requirementsFinancial institutions and public enterprises have additional disclosure requirements –Reconciliation of PBO and Plan Assets beginning and ending balance –Unamortized balances of PSC, Net actuarial Gains/Losses, Net Transitional amounts; and amortization amount for each Disclosure Requirements – Defined Benefit Plans

Defined Benefit Plans E.g. parental leave plans (in excess of what government provides), some long-term disability plansE.g. parental leave plans (in excess of what government provides), some long-term disability plans No basis on which to accrue expense – benefits not related to service provided. Entitlement comes with being an employeesNo basis on which to accrue expense – benefits not related to service provided. Entitlement comes with being an employees

Defined Benefit Plans Therefore use “event accrual” method to accrue full costTherefore use “event accrual” method to accrue full cost When event occurs that obligates entity:When event occurs that obligates entity: Benefit Expense xx Benefit Liability xx Benefit Liability xx

Defined Benefit Plans When the compensated absence is taken event occurs that obligates entity:When the compensated absence is taken event occurs that obligates entity: Benefit Liability xx Cash xx Cash xx

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