FA3 Lesson 7. Pension costs and obligations 1.Pensions 2.Defined contribution vs. defined benefit 3.Accounting for pensions 4.Pension worksheet.

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Presentation transcript:

FA3 Lesson 7. Pension costs and obligations 1.Pensions 2.Defined contribution vs. defined benefit 3.Accounting for pensions 4.Pension worksheet

1. Pensions A pension plan consists of segregated assets (managed by a trustee) and an actuarially determined, long-term liability to employees for pension entitlements earned. Matching principle: cost of pension benefits should be recorded in the year in which they are earned (when the employees provide the labour services)

Vocabulary Contributory: employees makes contributions to the pension plan (usually, along with employer) Vested: pension benefits become vested at the moment when the employee retains right to receive benefits, even if employee leaves firm Trusteed: independent trustee manages plan assets and pays out benefits – pension assets and liabilities do not appear on company balance sheet

2. Defined contribution vs. defined benefit Defined contribution: employer (and perhaps employee) make defined cash contributions each year to pension fund; employee receives annuity at retirement, based on the market value of pension contributions at retirement Accounting: usually, current employer contributions = pension expense

2. Defined contribution vs. defined benefit Defined benefit plan A certain level of retirement benefits are guaranteed to the employee, usually as function of employee earnings and years of service. To ensure there are sufficient pension benefits to meet this obligation, company must consider: -investment earnings -future salary increases -employee turnover -mortality rates and life expectancy

Defined benefit pension plan: Accrued pension obligation and plan assets -Accrued obligation+ Payment to pensioners Experience/actuarial gains Current service cost Past service cost Interest cost Experience/actuarial losses +Pension plan assets- Employer contributions Employee contributions Investment income Payments to pensioners

Funding a defined benefit plan Basic methods: 1.Accumulated benefit: annual cash contribution is based on years of service to date and current salary 2.Projected benefit: annual cash contribution is based on years of service to date and projected estimate of salary at retirement date 3.Level contribution: projects final salary and years of service, and allocates cost evenly over years of service

Defined benefit: Funding vs. accounting Companies can use any of these three methods (or variants thereof) to fund the pension plan. For accounting purposes (determining annual pension expense), the CICA says that the projected benefit method provides the best matching of pension benefits to periods in which employee provides labour services. Funding method could be different, though, leading to pension asset/liability on balance sheet (which will disappear when all employees retire).

3. Calculating pension expense Pension expense is composed of: 1.Current service cost: present value of pension benefits earned by virtue of labour services provided by employees in current period 2.Interest on (opening) accrued benefit obligation: interest rate is long-term debt rate at balance sheet date. 3.Expected earnings on (opening) plan assets (negative): rate based on long-term market rates of return

3. Calculating pension expense (cont’d) Pension expense is composed of: 4.Past service cost from plan initiation: value of pension benefits granted when plan instituted, usually amortized straight-line over expected period to full eligibility (EPFE) 5.Past service cost from plan amendment: amortized over EPFE or period until next expected amendment 6.Amortization of actuarial or experience gains and losses

Actuarial/experience gains and losses These are gains and losses caused by experience (e. g., actual rates of return) or changes in actuarial assumptions (e. g., discount rate, employee longevity). Gains and losses are netted out and: 1.Amortized using 10% corridor method (amortize excess of G/L over 10% of opening fund assets or accrued obligation, whichever is greater, over average remaining service period (ARSP). This is minimum permitted. 2.Some amount greater than (1) can be included in pension expense.

Examples A20-9 A20-13

4. Pension worksheet A convenient way to put together all of the pension variables. EXAMPLES A20-16 A20-26