Post Employment Benefits

A pension is a form of deferred compensation earned over time through employee service. The most common pension arrangements are defined contribution plans and defined benefit plans.

A defined contribution plan is a retirement plan whereby the firm contributes a certain sum each period to the employee’s retirement account. The firm’s contribution can be based on any number of factors including years of service, the employee’s age, compensation, profitability, or even a percentage of the employee’s contribution. In any event, the firm makes no promise to the employee regarding the future value of the plan assets.

The investment decisions are left to the employee, who assumes all of the investment risk.

Financial reporting for defined contribution plans is straightforward: the pension expense is simply equal to the employer’s contribution, and nothing is reported on the balance sheet. The remainder of this topic review will focus on accounting for the other major category of retirement scheme: defined benefit plans.

In a defined benefit plan, the firm promises to make a lump sum or periodic payment to the employee after retirement. This periodic payment is usually based on the employee’s years of service and the employee’s compensation at retirement. For example, an employee might earn a retirement benefit of 2% of her final salary for each year of service.

Under this scheme, an employee with 20 years of service and a final salary of $100,000 upon retirement would receive $40,000 ($100,000 final salary × 2% × 20 years of service) each year until death.

Because the employee’s future benefit is predetermined, it is the employer that assumes the investment risk.

Financial reporting for a defined benefit plan is much more complicated than for a defined contribution plan because the employer must estimate the value of its future obligation. This involves forecasting a number of variables such as future compensation levels, employee turnover, retirement age, mortality rates, as well as choosing an appropriate discount rate.

A company that offers defined pension benefits typically funds the plan by contributing assets to a separate legal entity, usually a trust. The plan assets are managed to generate the income and principal growth necessary to pay the pension benefits as they come due.

The difference between the benefit obligation and the plan assets is referred to as the funded status of the plan. If the plan assets exceed the pension obligation, the plan is said to be “overfunded.” Conversely, if the pension obligation exceeds the plan assets, the plan is “underfunded.”

Other post employment benefits, primarily health care benefits for retired employees, are similar to a defined benefit pension plan. The future benefit is defined today but is based on a number of unknown variables. For example, in a postemployment health care plan, the employer must forecast the health care costs that are expected when the employee retires.

Funding is an area where defined benefit pension plans differ from other postemployment benefit plans. Pension plans are typically funded at some level, while other post employment benefit plans are usually unfunded. In the case of an unfunded plan, the employer recognizes an expense in the income statement as the benefits are earned; however, the employer’s cash flow is not affected until the benefits are actually paid to the employee.

Balance Sheet

The projected benefit obligation (PBO) is the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases. It measures the value of the obligation, assuming the firm is a going concern and that the employees will continue to work for the firm until they retire. The discount rate used for PV computation is typically the yield on investment grade corporate bonds.

The funded status reflects the economic standing of a pension plan:

The balance sheet presentation under both U.S. GAAP and IFRS is as follows:

If the funded status is negative, it is reported as a liability. If the funded status is positive, it is reported as an asset.

Income Statement

Pension expense is comprised of several elements, and the accounting treatment differs between U.S. GAAP and IFRS. Let’s look at the different components of pension expense:

Current service cost. Current service cost is the present value of benefits earned by the employees during the current period; it represents the increase in PBO that results from the employees working one more period. Current service cost is recognized in the income statement “above the line” (i.e., before EBIT).

Past (prior) service costs. When a firm amends its pension plan retroactively (i.e., grants increased benefits for prior years’ of service), the PBO is immediately increased by the PV of increased benefits already earned. The beginning PBO is effectively understated by the amount of past service cost.

Under U.S. GAAP, instead of expensing the cost immediately, it is reported as a part of other comprehensive income and amortized over the remaining service life of the affected employees. Under IFRS, the past service costs are recognized in P&L immediately and not amortized.

Interest cost.

Under U.S. GAAP:

Under U.S. GAAP:

Under IFRS:

If the resulting amount is negative (i.e., the plan is underfunded), an expense is reported. (If positive, it is reported as net interest income.)

Expected return on plan assets. The employer contributes assets to a separate entity (trust) to be used to satisfy the pension obligation in the future. The “expected” return on the plan assets has no effect on the PBO or fair value of plan assets. Expected return (versus actual return) on plan assets is used as an offset for the computation of reported pension expense.

Expected rate of return should be consistent with historical data and the plan’s asset allocation. The difference between expected return and the actual return is combined with other items related to changes in actuarial assumptions into the “actuarial gains and losses” account (discussed next).

Actuarial gains and losses (‘Remeasurements’ in IFRS): There are two components within actuarial gains and losses. The first component is the gain (loss) due to a decrease (increase) in PBO caused by changes in actuarial assumptions; the second component is the difference between actual and expected return on plan assets. Actuarial gains and losses are recognized in other comprehensive income (OCI).

Under IFRS, actuarial gains and losses are never amortized.

Under U.S. GAAP, actuarial gains and losses are amortized using the corridor approach.

Corridor Approach (U.S. GAAP Only)

For any period, once the beginning balance of actuarial gains and losses exceeds 10% of the greater of the beginning PBO or plan assets, amortization is required under U.S. GAAP. An excess amount outside the “corridor” is amortized as a component of pension cost in P&L over the remaining service life of the employees. The amortization of an actuarial gain reduces pension cost, while the amortization of a loss increases pension cost.

Figure 8.1: Difference Between Recognition of Components of Pension Costs Under

U.S. GAAP and IFRS

From one period to the next, the benefit obligation changes as a result of current service cost, interest cost, past (prior) service cost, changes in actuarial assumptions, and benefits paid to employees.

Cash Flow Statement Impact

Actual cash flow is the employer contributions during the year as is reported in operating activities.

Disclosures

Under IFRS, plans are required to disclose the main characteristic of the plan and the risks involved, identify and explain the figures in the financial statements arising from them, and

describe the amount, timing, and uncertainty of future cash flows.

Estimates of pension cost and funded status rely on a number of assumptions, some of which are disclosed in the footnotes. Analysts must compare the pension and other post employment benefit assumptions over time and across firms to assess the quality of earnings. Aggressive accounting choices (those that reduce the pension expense and PBO) include low life expectancy of plan beneficiaries, low future inflation, low salary growth rate, and a high discount rate.

Assumed higher expected rate of return on plan assets (U.S. GAAP only) reduces reported pension expense but does not affect the PBO or the FV of plan assets.

Pension costs are generally embedded within a relevant expense category (e.g., SG&A, COGS), and those expenses are typically modeled as a percentage of revenues. This is an acceptable practice because pension expenses typically vary systematically with wages/salaries. However, if there are changes in the plan or if the plan is closed (or frozen), separate forecasts need to be made.

Detailed forecasts are not needed for smaller plans that are well funded or closed/frozen.

For valuation purposes, an underfunded liability should be deducted from enterprise value.

1. The total service cost and interest cost for Carlingson Bakery’s pension plan for 20X3 was $38 million. The fair market value of plan assets on January 1, 20X3, was $159 million. The projected benefit obligation (PBO) on January 1, 20X3, was $193 million, and the PBO on December 31, 20X3, was $220 million.

There are no effects of foreign currency exchange rate changes, changes in assumptions affecting the PBO, business combinations, divestitures, curtailments, settlements, special terminations, or contributions by the employer or plan participants. Actual return on assets in 20X3 was $32 million. The expected return on plan assets for 20X3 was 10%.

The fair value of plan assets on December 31, 20X3, is closest to:

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