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Pension Accounting Article

Pension Accounting Article

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Published by Atiq Rehman

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Published by: Atiq Rehman on Dec 02, 2010
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05/07/2011

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 t     e  c h  ni      c  a l     
58
student accountant
 January 2007
pension accounting
This article outlines the principles ofaccounting for employee benefits, as definedby IAS 19,
Employee Benefits
. Unlike theUK standard, FRS 17, which sets out theaccounting treatment for retirement benefits– such as pensions and medical careduring retirement – IAS 19 deals with otheremployee benefits including:short-term employee benefits, such aswages and salariespost-employment benefits, such aspensionstermination benefits, such as severancepayother long-term employee benefits,including long service leave.
This article also deals with post-employmentbenefits and, in particular, defined contributionand defined benefit plans. An understandingof the definitions of certain terms is critical. Amajor problem for students is often confusionover what the various terms actually mean.The accounting entries are relatively simple butstudents find it difficult to relate to the natureof the transaction being carried out. First, it isimportant to understand the nature of the twotypes of pension scheme.
DEFINED CONTRIBUTION PLAN
In a defined contribution pension plan, acompany pays a fixed pension contributioninto a separate entity (fund) and has nolegal or constructive obligation to pay furthercontributions if the fund does not havesufficient assets to pay employee benefitsrelating to employee service in the current andprior periods. A company should recognisecontributions to a defined contribution planwhere an employee has rendered service inexchange for those contributions. All otherpost-employment benefit plans are classifiedas defined benefit plans.The accounting for a defined contributionscheme is fairly simple because the employer’s
IAS 19, employee benefits
relevant to Professional Scheme Paper 3.6 (INT)and new ACCA Qualification Paper P2 (INT)
obligation for each period is determined bythe amount that has to be contributed to thescheme for that period.
DEFINED BENEFIT PLAN
Under a defined benefit pension plan, thebenefits payable to the employee are not basedsolely on the amount of the contributions (asin the defined contribution scheme), but aredetermined by the terms of the defined benefitplan. This means that the risk remains withthe employer and the employer’s obligationis to provide the agreed amount of benefit tocurrent and former employees.In accounting for a defined benefit plan,a company should regularly determine thepresent value of any defined benefit obligationand the fair value of any plan assets. Thismakes sense as a company will need to knowits net liability for employee benefits.
KEY FEATURES
It is important to understand certain key terms:
Current service cost
is the increase inthe present value of the defined benefitobligation which occurs as a result ofemployee service in the current period.In simple terms, this is the amount ofpension entitlement that employees haveearned in the accounting period. Therefore,it will increase the pension liability in thebalance sheet and be expensed in theincome statement.
Past service cost
is the increased presentvalue of a defined benefit obligationfor an employee’s service in previousperiods, which has arisen because of theintroduction of changes to the benefitspayable to employees. In other words, thisrepresents an increase or decrease in theemployer’s liability because of a changein the terms of the pension scheme. Thepension liability in the balance sheet willincrease or decrease, and the incomestatement will be affected accordingly.
Interest cost
is the increase in the periodin the present value of the defined benefitobligation which arises because thebenefits payable are one year closer to thesettlement of the scheme. It represents theunwinding of the discount on the plan’sliabilities. It is calculated by multiplyingthe discount rate at the beginning ofthe period by the present value of thedefined benefit obligation throughoutthe period. This, in theory, means thata form of averaging should take place tocalculate the ‘average’ present value ofthe obligation in the period. For exampurposes, the approach taken by theexample in IAS 19 will be adopted. Thatis, the interest cost will be calculated onthe basis of the opening obligation. Theinterest cost will increase the obligationand will be charged to the incomestatement.
Expected return on plan assets
is basedon the market’s expectations of the returnexpected from the pension scheme’sassets. It is calculated using the expectedlong-term rate of return on the planassets at the beginning of the period. Theamount so calculated will be added to thescheme’s assets and will be credited to theincome statement.
DEALING WITH DEFINED BENEFIT PLANSIN THE FINANCIAL STATEMENTS
The present value of a defined benefitobligation, and the fair value of the planassets are determined at the end of eachaccounting period. Additionally, the schemewill receive contributions that will increasethe plan assets, and will pay out pensionbenefits which will, in turn, reduce theobligation and the plan assets. Havingdefined key terms and events, it is nowpossible to show how these elements aredealt with in financial statements, as shownin
Table 1
on page 61. Random amounts
 
have been used for this example, and at thisstage we are not dealing with the recognitionof actuarial gains and losses arising out ofthe scheme. There are no actuarial gains andlosses arising at 01/01/X1.The total amount charged in the incomestatement will be $90m. The gain on the planassets and the loss on the obligation are justthe balancing figures and amount to a net lossof $30m ($140m - $170m) and this has notbeen recognised anywhere in the financialstatements.As a result, the liability in the balancesheet will be $1,070m ($2,300m - $1,200m -$30m). Another way of showing this amount is:Opening net liability (1,000 - 2,000) 1,000Net amount charged in income statement 90Contributions (20)1,070As can be seen, the liability is either calculatedby taking the opening balances and adjustingfor the charge in the income statement andcontributions to the scheme, or by takingthe closing balances and deducting theunrecognised loss. Either way will obviouslyproduce the same result.
SUMMARY
The amount recognised in the balance sheetwill be as follows:the present value of the defined benefitobligation
minus
the fair value of the plan assets at the balancesheet date
 plus
any actuarial gains
less
losses not yet recognised
minus
any past service cost not yet recognised.If the result of the above is a positive amountthen a liability occurs and it is recorded in full
 January 2007
student accountant
59
 
 t     e  c h  ni      c  a l     
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student accountant
 January 2007
in the balance sheet. Any negative amount isan asset, which is subject to a recoverabilitytest. The pension expense is the net of thefollowing items:
 
current service cost
 
interest cost
 
the expected return of any plan assetspast service cost (to the extent thatthe standard requires the company torecognise it)
 
the effect of any curtailments or settlementsand actuarial gains and losses to the extentrecognised (more on this later).
MEASURING THE DEFINED BENEFITOBLIGATION
IAS 19 states that the projected unit creditmethod should be used to determine thepresent value of the defined benefit obligation,the related current service cost, and pastservice cost.This method looks at each period ofservice, and so creates an additional incrementof benefit entitlement. The method thenmeasures each unit of benefit entitlementseparately to build up the final obligation.The whole of the post-employment benefitobligation is discounted.The use of this method involves anumber of actuarial assumptions, based onthe company’s best estimate of the variablesthat will determine the final cost of thepost-employment benefits. These variablesinclude wider issues such as mortalityrates or changes in the retirement age, andfinancial assumptions such as discount ratesand benefit levels. Note that plan assets aremeasured at fair value. Fair value is normallymarket value, where available, or estimatedvalue where it is not.
GAINS AND LOSSES
A company should recognise its actuarial gainsand losses under one of three methods:1 The ‘corridor’ approach: actuarial netgains and losses are recognised as incomeor expenditure if cumulative, unrecognised,actuarial gains and losses at the end ofthe previous reporting period (ie at thebeginning of the current financial year)exceed the greater of:10% of the present value of thedefined benefit obligation at thebeginning of the year, and10% of the fair value of the planassets at the same date.These limits should be calculated and appliedseparately for each defined plan. The excessdetermined by the above method is thendivided by the expected average remainingworking lives of the employees in the planin order to give the income or expense to berecorded in the income statement.2 Recognised in full as they occur in thestatement of recognised income andexpense.3 Any other systematic method that resultsin a faster recognition of actuarial gainsand losses in the income statement,provided that the same basis is applied toboth gains and losses and that the basisis applied consistently from period toperiod.
EXAMPLE 1
A company has a defined benefit pension plan.At 1 January 20X1 the following values relateto the plan:The fair value of the plan assets is $30m.
 
The present value of the defined benefitobligation is $25m.There are cumulative unrecognisedactuarial gains of $4m.The average remaining working lives ofemployees is 10 years.At the end of the period, at 31 December20X1, the following values relate to thepension scheme:
 
The fair value of the plan assets has risento $35m.The present value of the defined benefitobligation has risen to $28m.The actuarial gain is $5m.The average remaining working lives ofemployees is 10 years.
Required
Show the ways in which actuarial gain could betreated for the period ending 31 December 20X1(the asset ceiling test is ignored in this example).
Answer
There are three possible treatments:1 The company could recognise the portionof the net actuarial gain or loss in excessof 10% of the greater of the definedbenefit obligation or the fair value of theplan assets at the beginning of the year.Unrecognised actuarial gain at thebeginning of the year was $4m. The limitof the corridor is 10% of $30m (ie $3m)as the fair value of the assets is greaterthan the value of the obligation. Thedifference is $1m which, divided by 10years, is $0.1m to be recognised in profitor loss. The accounting for the corridorapproach takes no account of actuarialgains and losses arising in the year– instead it considers the state of the planat the previous year end.2 The actuarial gains and losses canbe recognised in full in the statementof recognised income and expense.Accordingly, the $5m gain will berecognised in the statement. This gaincannot be recycled through the incomestatement and should be added to retainedearnings.3 Any other systematic method that resultsin a faster recognition of actuarial gainsand losses in the income statement can beused. So, all the actuarial gain of $5m canbe recognised in the income statement,but this is extremely rare in practice.
RESTRICTIONS ON THE AMOUNTRECOGNISED AS A DEFINED BENEFITASSET
IAS 19 restricts the amount that can be shownas a defined benefit asset.The asset may not exceed the aggregate of:
 
any cumulative, unrecognised net actuariallosses and past service cost, and
 
the present value of any refunds from theplan or reductions in future contributions.
EXAMPLE 2 
The fair value of the plan assets is $130mThe present value of the defined benefitobligation is $105mThere are cumulative unrecognisedactuarial losses of $4m

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