Accounting

Accounting for Pensions and Employee Benefits (IAS 19)

Applicable Standard

  • IAS 19: Employee Benefits

SHORT-TERM EMPLOYEE BENEFITS

Requirement

  • Recognise a Liability for employee benefits to be paid in the future for work already done
  • Recognise an Expense when the employees’ services are used

Accounting Treatment

  • Dr Employment Cost (e.g. wages) in Income Statement
  • Cr Liability (e.g. accrued wages) in Balance Sheet

POST-EMPLOYMENT EMPLOYEE BENEFITS

Two types of pension schemes:

  1. Defined contribution plan – Company contributes to a scheme (e.g. IRAs, 401(k))
  2. Defined benefit plan – Company pays out benefits on retirement (e.g. typical private sector retirement pension plans)

Defined Contribution Plan

Accounting Treatment

  • Pension contributions payable are expensed to P&L
  • Balance Sheet will contain prepayments (asset) or accruals (liability) to account for timing mismatch between cash contributions and income statement expenses.

Defined Benefit Plan

Key Terms

  • Current Service Cost
    • Amount of pension entitlement that employees have earned in the current period.
    • Accounting entries
      • Dr Current Service Cost (Income Statement)
      • Cr Pension Liability (Balance Sheet)
    • Example calculation
      • Say you need $100 in 5 years time to meet your employee benefits obligation.
      • For each of the 5 years, you need to put in an amount (i.e. the current service cost), such that when compounded at the discount rate, each individual amount becomes $100/5 = $20. So the total would be $100.
      • Hence at end of Year 1, current service cost = $20/(1+r)^4 (since there are only 4 years from end of Year 5 to end of Year 1).
      • At end of Year 2, current service cost = $20/(1+r)^3
      • At end of Year 5, current service cost = $20.
  • Past Service Cost
    • Change in the pension liability (for employee service in past periods) due to changes in the plan benefits
    • Accounting entries (e.g. if benefits are increased)
      • Dr Increase in Past Service Cost (Income Statement)
      • Cr Pension Liability (Balance Sheet)
    • Note that if the new plan benefits only ‘vest’ after period (e.g. some category of employees need to serve another 2 years), the past service cost associated with those affected group needs to be spread over the vesting period.
  • Interest Cost
    • Increase in PV of defined benefit obligation due to the benefits payout being one period closer.
    • Interest cost = Opening Pension Liability * Discount Rate
    • The Discount Rate used should be the discount rate at the beginning of the period, and should take into account changes in the liability during the period. The change in the liability value due to the change in discount rate from the beginning to the end of the period, is incorporated inside actuarial gain/loss.
    • Accounting entries
      • Dr Pension Interest Cost (Income Statement)
      • Cr Pension Liability (Balance Sheet)
    • The Discount Rate needs to reference market yields of high quality corporate bonds, or in countries where there is no deep market in such bonds, government bonds.
  • Expected Returns on Plan Assets
    • This is the expected return (from dividends, capital gains, interest) less plan administration costs and tax payable by the plan.
    • The expected return used should be the expected return at the beginning of the period, and should take into account changes in the assets during the period. The change in the asset value due to the change in expected return from the beginning to the end of the period, is incorporated inside actuarial gain/loss.
    • Accounting entries
      • Dr Pension Asset (Balance Sheet)
      • Cr Expected Return on Plan Assets (Income Statement)
  • Contributions Paid Into Plan
    • Cr Cash
    • Dr FV of Plan Asset
  • Benefits Paid Out
    • Cr FV of Plan Asset
    • Dr PV of Pension Obligation
  • Actuarial Gain/Loss
    • Changes in value of Pension Asset / Pension Obligation due to changes in actuarial assumptions (e.g. retirement age, life expectancy, expected returns, etc.)
    • Usually calculated as a balancing figure in the reconciliation equations below.
  • Fair Value of Pension Asset
    • Opening Balance
    • + Expected Return on Plan Assets
    • + Contributions Paid into Plan
    • – Benefits Paid Out
    • + Actuarial Gain/(Loss)
    • = Closing Balance
  • Present Value of Pension Obligation
    • Opening Balance
    • + Interest Cost
    • + Past Service Cost
    • + Current Service Cost
    • – Benefits Paid Out
    • + Actuarial Gain/(Loss)
    • = Closing Balance

Accounting Treatment of Actuarial Gain/Loss

Problem with Actuarial Gains/Losses

  • Recognising it in each period in the Income Statement will cause significant fluctuations in the reported profits because the actuarial gain/loss figures can be significant.

Two main approaches

  1. Corridor Approach
    • Calculate (A) = Greater of
      • 10% of the PV of the Pension Obligation at the beginning of the year
      • 10% of the FV of the Pension Asset at the beginning of the year
    • Calculate (B) = Net cumulative unrecognised actuarial gains/losses at the end of the previous reporting period
    • Estimate (C) = Expected average remaining working lives of the employees participating in the plan
    • If (B) <= (A), no recognition of the actuarial gains/losses
    • If (B) > (A), recognise ((B) – (A)) / (C) in the P&L, i.e. recognise the portion that exceeds the corridor, over the expected average remaining working lives of the employees participating in the plan.
    • Note that there is a 1-year lag, i.e. the amount recognised in the current period is based on figures at the end of the previous period.
    • For applying the corridor approach in the next period, add the current period’s net actuarial gain/loss to the cumulative unrecognised actuarial gains/losses.
  2. Recognition in Full
    • Recognise the actuarial gain/loss in full as they occur, in Other Comprehensive Income, which will flow to Retained Earnings, bypassing P&L.
  3. Note that using the Corridor Approach will result in a reported figure in the Balance Sheet that excludes the cumulative unrecognised actuarial gains/losses. If there is a positive unrecognised actuarial loss, the Balance Sheet liability would be understated.

Accounting Treatment of Settlement and Curtailment

Key Terms

  • Settlement is a payment made to plan participants to extinguish their right to future benefits.
  • Curtailment is a reduction in pension liability by the company through plan amendments (e.g. restructuring)
    • There is no clear distinction between curtailment and negative past service cost as yet in the accounting standards (see here).

Accounting Treatment

  • Recognise gains/losses on settlement or curtailment when it occurs.
  • Gain/loss will comprise
    • Any resulting change in the PV of the Pension Obligation
    • Any resulting change in the FV of the Plan Asset
    • Any related unrecognised actuarial gains/losses and unrecognised past service cost (e.g. not yet vested)

Net Pension Liability / (Asset) Reported in Balance Sheet

Net Pension Liability / (Asset)

  • PV of Pension Obligation
  • – FV of Pension Asset
  • + Unrecognised Actuarial Gain / (Loss)  [If there is an unrecognised gain, the liability should be higher, that’s why it is added.]
  • – Past Service Cost Not Yet Recognised (e.g. not yet vested) [the “derecognition” is happening right here! The past service cost not yet recognised is subtracted here because if you don’t recognise it, the liability is lower. This also means that the past service cost that went into the computation of the PV of Pension Obligation is the fully vested past service cost, which must indeed be the case because else the actuarial gains/losses being the balancing figure, would capture the “non-vested past service cost” and would not be correct.]
  • = Pension Liability / (Asset)

Asset Ceiling Test

  • If there is a positive Net Pension Asset (as calculated above), the amount recognised in the Balance Sheet is the LOWER of that amount and the sum of
    • Cumulative unrecognised net actuarial losses and past service cost (a positive number)
    • PV of any refunds from the plan or reductions in future contributions (also a positive number)
  • Note that the asset ceiling test must add the [positive number] cumulative unrecognised net actuarial losses and past service cost in order to push up the ceiling by an amount equal to the unrecognised losses and past service cost embedded in the positive net pension asset value. In this way, that ceiling wouldn’t be violated because of the unrecognised losses and past service cost. Without that term in the sum, the ceiling would be easily violated and value would switch to being the PV of the refunds. That would effectively “throw out” all those rules about not recognising some actuarial losses and past service cost because those rules can’t be implemented already (because if you do follow those rules, you will violate the ceiling and trigger that reset above). You can read BC78F for the official commentary on this. Basically they know its messy, and are looking to revamp this.
  • There is a reasonableness cap placed on the reported value (i.e. you cannot recognise an asset simply because of unrecognised losses)

-END-

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Discussion

9 thoughts on “Accounting for Pensions and Employee Benefits (IAS 19)

  1. Had a query in he corridor approach.

    The actuarial gains/losses need to be kept off balance sheet.

    Following this logic I get why actuarial loss is deducted for the PV of obligation to arrive at the Net pension (Asset)/liability. But why the actuarial gain is added ?

    Would appreciate a revert.

    Posted by Sid | January 10, 2012, 3:35 pm
  2. Hi Sid, the explanation is actually already written in italics beside it, i.e. if there is an unrecognised gain, the liability should be higher, that’s why it is added.

    Take for example a Net Pension Liability of $5. Now within that $5, is embedded an actuarial gain of $3. Of that $3, say $2 is unrecognised. By not recognising the $2 of actuarial gain, the Net Pension Liability goes up to $5 + $2 = $7. Basically your liability amount is higher when some of the actuarial gains are not recognised.

    Posted by whatheheckaboom | January 10, 2012, 4:02 pm
    • Correct me if im wrong.Taking your example a bit forward ,lets the liability reconciliation looks like this

      Op PBO – 7$
      Service Cost – 0.5$
      interest Cost – 0.5$
      Actuarial (gain) – (3$)
      Cl PBO – 5$

      The logic is NOT to recognize the 3$ gain. So , by booking a Net Pension Liability of 8$ , I do not recognize the gain in the books.

      Hope Im right.

      Posted by Sid | January 10, 2012, 4:27 pm
      • Hi Sid, you seem to have answered your own question and understood why you need to add. Just a note though that it is not the case that ALL actuarial gains/losses are not recognised. That’s where the Corridor Approach above comes into play.

        Posted by whatheheckaboom | January 11, 2012, 2:45 pm
      • Yup.. I know that if the gains/losses fall “outside” the corridor then they are amortized over the average future working life..

        Thanks a lot for bearing me.. Now , I can live in peace!!..

        Thanks again

        Posted by Sid | January 11, 2012, 3:36 pm
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    Posted by Antje | January 14, 2013, 8:09 pm
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    Posted by dibakar | March 14, 2014, 5:56 pm

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