PRACTICAL ACCOUNTING 1

LIABILITIES – DEBT RESTRUCTURING – Lecture

Debt restructuring – is a situation in which “the creditor for economic or legal reasons related to the debtor’s financial
difficulties grants a concession to the debtor that it would not otherwise consider. That the concession either from an
agreement between the creditor and the debtor or imposed by law or a court”.

Types of Restructuring:

Asset Swap – transfer of non-cash asset, such as real estate , inventories, receivables or investments , to fully settle a
payable. This type of restructuring usually recognizes gains or losses on the release of financial liability and disposal of
non-cash assets.

Equity Swap – PAS 32 does not specifically deal with debt to equity conversions and so the question arises as to how
such transactions should be accounted for. One argument is that the accounting treatment should be the same as when
convertible debt is converted into shares, the carrying value of the existing debt instrument is simply transferred to
equity and no gain or loss on the conversion is recognized. This accounting treatment is consistent with the usual
accounting for the issue of shares that are recorded at the proceeds received rather than the fair value of shares and
does not result in gain or loss. Alternatively, one could argue that the replacement or exchange of an issuer’s existing
debt instrument with new equity instrument of the issuer is an extinguishment of existing financial obligation as the
entity is legally released from its obligation to pay cash. Therefore in accordance with PAS 39 par. 40, the debt
instrument should be derecognized and the difference between the carrying amount of the existing debt instrument
extinguished and the consideration paid (including non-cash assets or liabilities assumed) should be recognized in profit
or loss.

Modification of Terms – this type of restructuring may or may not derecognize the carrying value of the original liability.
If the modification is considered substantial, the carrying value of the original financial liability is derecognized; the
restructured; any gain or loss on debt restructuring is recognized in the profit and loss. Any transaction costs incurred is
included in the measurement of gain or loss. If the modification is not considered substantial, the carrying value of the
original financial liability is not derecognized; the gain or loss is not given accounting recognition and any transaction
costs incurred is being deferred and amortized based on the restructured term of the contract using the effective
interest method.

The modification may involve the interest, the maturity value, or both. Interest concession may involve a reduction of
the interest rate, forgiveness of unpaid interest; of a moratorium on interest payments for a period of time. Maturity
value concession may involve an extension of the maturity date or a reduction in the amount to be repaid at maturity.

The amount of gain or loss on modification of terms is measured as the difference between the carrying value of the
original financial liability and the remaining cash outflows required to settle the restructured debt discounted at the
original effective interest rate. If the amount of gain or loss is at least 10% of the carrying value of original financial
liability, the restructuring is considered substantial; however, if the amount of gain or loss is below 10% of the carrying
value of the original financial liability, the restructuring is considered not substantial modification.

LIABILITIES – POST EMPLOYMENT BENEFITS

Post-employment benefits – are defined as employee benefits (other than termination benefits) that are payable after
the completion of employment or upon retirement. These benefits may include pension plans, post-employment life
insurance and post-employment medical care.

Types of pension plans:

Pension plan maybe a state or government plan or an employer plan. A state plan is one that is administered by the
state or government, such as the plan administered by the Social Security System. An employer plan is one that is
sponsored by the employer.

Pension plan may be contributory or noncontributory. A contributory pension plan is one both the employer and
employee contribute. A noncontributory pension plan is one which the cost of the plan is paid solely by the employer;
the employee does not contribute to the plan.

Pension plan may be unfunded, partly unfunded or fully funded. When funded, the contributions are paid to a separate
entity (fund). This entity is tasked to manage the plan’s assets, with the goal of maximizing their earnings potential.

Pension plan may be a defined contribution plan or a defined benefit plan. A defined contribution plan defines the
amount to be contributed to the plan based on a formula that uses employee compensation as its basis of calculation.
The benefits to be received by the employees will depend on the total amount contributed plus the earnings on it. A
defined benefit plan defines the benefits to be received by employees upon retirement. The contributions to the plan
depend on the defined benefits.

Definitions related to pension plans:

Actuarial gains and losses
a. Experience adjustments (the effects of difference between the previous actuarial assumptions and what has
actually occurred)
b. The effect of changes in actuarial assumptions
PRACTICAL ACCOUNTING 1

Actuarial gains and losses arise from increase or decrease in:

1. Present value of a defined benefit obligation;
2. Fair value of plan asset

Causes of actuarial gains and losses are the following

1. Unexpected high or low rates of employee turnover, early retirement or mortality or of increase in salaries,
benefits or medical costs.
2. The effect of changes in estimates of future employee turnover, early retirement or mortality or of increases in
salaries, benefits or medical costs.
3. The effect of changes in discount rates; and
4. Differences between the actual return on plan assets and the expected return on plan assets.

Current service cost – is the increase in the present value of the defined benefit obligation resulting from employee
service during the current period.
Fair value – is the amount for which an asset could be exchanged on a liability settled between knowledgeable, willing
parties in an arm’s length transaction.
Interest cost – is the increase during a period in the present value of defined benefit obligation that arises because the
benefits are one period closer to settlement.
Past service cost – is the increase in the present value of the defined benefit obligation for employee service in prior
periods, resulting in the current period from the introduction of , or changes to, post-employment benefits or other
long-term employee benefits. Past service cost may be either positive (where benefits are introduced or improved) or
negative (where existing benefits are reduced).

Plan assets comprise:

a. Assets held by a long-term benefit fund
b. Qualifying insurance policies

Present value of defined benefit obligation – is the present value, without deducting any plan assets, of expected future
payments required to settle the obligation resulting from employee service in the current and prior periods.

Return on plan assets – is interest, dividends and other revenue derived from the plan assets together with the realized
and unrealized gains or losses on the plan assets, less any costs of administering the plan and any tax payable by the
plan itself.

Vested employee benefits – are benefits that are not conditional on future employment.

DEFINED CONTRIBUTION PLAN:

- Is a post employment benefit plan under which an entity pays fixed contributions into a separate entity and will
have no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets
to pay all employee benefits relating to employee service in the current and prior periods.

Defined Contribution Plan recognition and measurement:

An entity should recognized the contribution payable to defined contribution plan in exchange for service rendered by
an employee during a period:
a. As a liability (accrued expense) after deducting any contribution already paid. If the contribution already paid
exceeds the contribution due for service before the balance sheet date, an entity shall recognize that excess as
an asset (prepaid expense) to the extent that the prepayment will lead to, for example a reduction in future
payments or a cash refund.
b. As an expense, unless another standards requires or permits the inclusion of the contribution in the cost of an
asset (PAS 2 for inventories and PAS 16 for PPE).

DEFINED BENEFIT PLANS:

Accounting for defined benefit plans is complex because actuarial assumptions are required to measure the obligation
and the expense and there is a possibility of actuarial gains and losses. Moreover, the obligations are measured on a
discounted basis because they may be settled many years after the employees render service.

Recognition and measurement:

Defined benefit plan may be unfunded, or they may be wholly or partly funded by contributions by an entity, and
sometimes its employees, into an entity, or fund, that is legally separate from the reporting entity and from which the
employee benefits are paid. The payment of benefits when they fall due depends not only on the financial position and
the investment performance of the fund but also on an entity’s ability (and willingness) to make good any shortfall in the
fund’s assets. Therefore, the entity is in substance, underwriting the actuarial and investment risks associated with the
plan. Consequently, the expense recognized for a defined benefit plan is not necessarily the amount of the contribution
due for the period.

Accounting steps for defined benefits are as follows:

1. Using actuarial techniques to make a reliable estimate of the amount of benefit that employees have earned in
return for their service in the current and prior periods. This requires an entity to determine how much benefit
is attributable to the current and prior periods and to make estimates (actuarial assumptions) about
demographic variables and financial variables.

Demographic variables or assumptions deal with matters such as:

a. Mortality, both during and after retirement
b. Rates of employee turnover, disability and early retirement
PRACTICAL ACCOUNTING 1

c. The proportion of plan members with dependants who will be eligible for benefits, and
d. Claim rates under medical plans

Financial variables or assumptions deal with items such as:

a. The discount rate
b. Future salary and benefit levels
c. Future medical costs, including where material, the cost administering claims and benefit payments, and
d. The expected rate of return on plan assets

2. Discount the benefit using the Project Unit Credit Method in order to determine the present value of the
defined benefit obligation and the current service cost.

An entity discounts the whole of a post-employment benefit obligation, even if part of the obligation falls due
within twelve months of the balance sheet date.

3. Determine the fair value of any plan assets

4. Determine the total amount of actuarial gains and losses and the amount of those actuarial gains and losses to
be recognized.
5. Where a plan has been introduced or charged, determine the resulting past service cost.
6. Where a plan has been curtailed or settled, determine the resulting gain or loss.

Where an entity has more than one defined plan, the entity applies these procedures for each material plan
separately.

Project Unit Credit Method (Sometimes known as the accrued benefit method pro-rated on service or as the
benefit/years of service method) sees each period of service as giving rise to an additional unit of benefit entitlement
and measures each unit separately to build up the final obligation.

In determining the present value of its defined benefit obligation and the related current service cost and, where
applicable, past service cost, and entity shall attribute benefit to periods of service under the plan’s benefit formula.
However, if an employee’s service in later years will lead to a materially higher level of benefit than in earlier years,
entity shall attribute benefit on a straight line basis from:
a) The date when service by the employee first leads to benefit under the plan (whether or not the benefit are
conditional or further service); until
b) The date when further service by the employee will lead to no material amount of further benefits under the
plan, other than from further salary increases.

Balance sheet account for a defined benefit plans:

Pension liability is the net total of the following
1. The present value of the defined benefit obligation at the balance sheet date
2. Plus any actuarial gains (less any actuarial losses) not recognized
3. Minus any past service cost not yet recognized
4. Minus the fair value at the balance sheet date of plan assets (if any) out of which the obligation are to be
settled directly.

However, if the result of the above computation is negative (an asset), an entity shall measure the resulting
asset (Pension Asset) at the lower of
a) The negative amount, and
b) The total of (1) any cumulative unrecognized net actuarial losses and past service cost (2) the present value
of any economic benefits available in the form of refunds from the plan or reduction in the future
contributions to the plan.

Income statement account for a defined benefit plans:

An entity shall recognize the net total of the following amounts in profit or loss, except to the extent that another
standard requires or permits their inclusion in the cost of the asset:
1. Current service cost
2. Interest cost
3. The expected return on any plan assets and on any reimbursement rights
4. Actuarial gains and losses, as required in accordance with the entity’s accounting policy
5. Past service cost
6. The effect of any curtailments or settlements, and
7. The effect of the limit for the recognition of Pension Asset above.

Recognition of the following components of pension expense:

Actuarial gain or loss – PAS 19 specifies two approaches of actuarial gains and losses:
1) Immediate recognition – under this approach, the actuarial gains and losses should be recognized in full during
the period not as a component of pension expense but directly inside the shareholders’ equity.
2) The corridor approach – an entity is permitted to recognize as an expense or revenue a portion of the actuarial
gains and losses if the net cumulative unrecognized gains and losses at the beginning of the period (or end of
the previous period) exceeded the greater of:
a) 10% of the present value of the defined benefit obligation, beginning of the period, or
b) 10% of the fair value of plan assets, beginning of the period.
PRACTICAL ACCOUNTING 1

The amount of gains or losses to be recognized during the current periods is the excess of the beginning balance
over the corridor divided by the average working lives of the employees participating in the plan.

Past service cost

1) Past service cost relating employees whose benefits have already vested should be recognized immediately.
2) Past service cost relating to employees whose benefits have not yet vested should be amortized over the
remaining vesting periods.

Reimbursements – when and only when, it is virtually certain that another party will reimburse some or all of the
expenditure required to settle a defined benefit obligation, an entity shall recognize its right to reimbursement as a
separate asset. The entity shall measure the asset at fair value. In all other respects, an entity treats that asset in the
same ways as plan assets. In the income statement, the expense relating to a defined benefit paln may be presented net
of the amount recognized for a reimbursement.

Return on plan assets – the expected return on plan assets is one component of the expense recognized in the income
statement.

Curtailments and settlements – PAS 19 provides that gains and losses arising from curtailment or settlement should be
recognized in the pension expense immediately

A curtailment occurs when an entity either; is demonstrably committed to make a material reduction in the number of
employees covered by a plan; or amends the terms of a defined benefit plan such that a material element of future
service by current employees will no longer qualify for benefits, or will qualify only for reduced benefits.

A settlement occurs when an entity eliminates its entire legal of constructive obligation for part or all of the defined
benefits under a plan. An example of this is when a lump-sum payment is made to, or on behalf, of plan participants in
exchange for their rights to receive specified post-employment benefits.

Memorandum accounts that are used extensively in determining the retirement benefit costs:
Present value of defined benefit obligation:
Beginning of the year balance P xx
Interest cost (beginning of year balance x settlement rate or discount rate) xx
Current service cost xx
Benefits paid (xx)
Actuarial gain or loss (balancing item) (xx) xx
End of year balance P xx

Fair value of plan asset:

Beginning of year balance P xx
Current year contribution xx
Actual return on plan asset during the current year:
Positive (income) return xx
Or
Negative (loss) return (xx)
Benefits paid during (xx)
End of year balance P xx

Actuarial gain or loss:

Beginning of year balance (under a corridor approach) Pxx(Pxx)
Actuarial gain or loss during:
From plan asset (actual return – expected return) xx (xx)
From benefit plan obligation (balancing figure or a direct computation) xx (xx)
Amount recognized during the current year xx (xx)
End of year balance Pxx(Pxx)