Postemployment benefits [such as pensions, postemployment medical benefits, and postemployment life insurance] are categorized as either defined contribution plans or defined benefit plans. How are both benefit-plans accounted? I pull accounting standard for defined benefit and contribution plans as it is described on IAS 19. This [though any other post I ever adapted from IAS or IFRS] does not proposed to replace or replicate the standard. But, it is rather to provide easier descriptions for easier understanding. Case examples always help; you will find them through this post. If you have difficulties to understand IAS 19, you may find this post useful; otherwise you may interest to read hundred of my other posts rather.
Defined Benefit Plans – IAS 19
- In accounting for defined benefit plans, an entity should determine the present value of any defined benefit obligation and the fair value of any plan assets with such regularity that the amount shown in the financial statements does not differ materially from the amounts that would be determined at the balance sheet date.
- IAS 19 requires an entity to account not only for its legal obligation to defined benefit plans but also for any constructive obligation that arises.
- Defined benefit plans should use the projected unit credit method to measure their obligations and costs.
Accounting For Defined Benefit Plans
The obligation of an employer under a defined benefit plan is to provide an agreed amount of benefits to current and former employees in the future. Benefits may be in the form of cash payments or could be in-kind in terms of medical or other benefits.
Normally benefits will be based on age, length of service, and wage and salary levels. Pensions and other long-term benefits plans are basically measured in the same way. Actuarial gains and losses of long-term benefits plans other than pensions are reported immediately in net income.
The defined benefit plan can be unfunded, partially funded, or wholly funded by the employer. The employer contributes to a separate entity or fund that is legally separate from the reporting entity. This fund then pays the benefits. The payment of benefits depends on the fund’s financial position and the performance of its investments. However, the payment of benefits will also depend on the employer’s ability to pay and to make good any shortfall in the fund. The employer is essentially guaranteeing the fund’s investment and actuarial risk.
Accounting for defined benefit plans is more complex because actuarial assumptions are needed to determine the obligation and the expenses. Often the actual results differ from those determined under the actuarial valuation method. The difference between these results creates actuarial gains and losses.
Discounting is used because the obligations often will be settled several years after the employee gives the service. Usually actuaries are employed to calculate the defined benefit obligation and also the current and past service costs.
Key Information To Be Determined On Defined Benefit Plans
The entity must determine certain key information for each material employee benefit plan. This information is required:
- A reliable estimate is required of the amount of the benefit that the employees have earned in the current and prior period for service rendered.
- That benefit must be discounted using the projected unit credit method in order to determine the present value of the defined benefit obligation and the current service cost.
- The fair value of any plan assets should be determined.
- The total amount of actuarial gains and losses and the amount of those actuarial gains and losses that are to be recognized must be calculated.
- The past service costs should be determined in cases in which there has been a change or an introduction of a plan.
- The resulting gain or loss should be calculated in cases in which a plan has been curtailed, changed, or settled.
The entity must account not only for its legal obligation but also for any constructive obligation that arises from any informal practices. For example, the situation could arise wherein the entity has no realistic alternative but to pay employee benefits even though the formal terms of a defined benefit plan may permit an entity to terminate its obligation under the plan.
What Amount Recognized On The Balance Sheet?
The amount recognized in the balance sheet could be either an asset or a liability calculated at the balance sheet date. The amount recognized will be:
- The present value of the defined benefit obligation; plus
- Any actuarial gains less losses not yet recognized because the gains and losses fall outside the limits of the corridor; minus
- Any past service cost not yet recognized; and minus
- The fair value of the plan assets at the balance sheet date.
If the result of the preceding calculation is a positive amount, then a liability is incurred, and it is recorded in full in the balance sheet. Any negative amount is an asset that is subject to a recoverability test.
The asset recognized is the lesser of the negative amount calculated above or the net total of:
- Any unrecognized net actuarial losses and past service costs; and
- The present value of any benefits available in the form of refunds or reductions in future employer contributions to the plan.
An entity has these balances relating to its defined benefit plan:
- Present value of the obligation: $33 million
- Fair value of plan assets: $37 million
- Actuarial losses: $3 million unrecognized
- Past service cost: $2 million unrecognized
- Present value of available future refunds and reduction in future contributions: $1 million
The question is: How to calculate the value that will be given to the net plan asset under IAS 19?
Here is how:
- The negative amount [asset] determined under the IAS 19 will be: Present value of the obligation $33 million [minus] Fair value of plan assets $37 million [minus] Actuarial losses $3 million [minus] Past service cost $2 million which equals $9 million.
- The limit under IAS 19 is computed in this way: unrecognized actuarial losses of $3 million [plus] unrecognized past service cost of $2 million [plus] the present value of available future refunds and reductions in future contributions of $1 million, which equals $6 million.
- The entity recognizes an asset of $6 million and discloses the fact that the limit has reduced the carrying amount of the asset by $3 million.
Any element of the asset that is not recognized in the balance sheet must be disclosed. It is often difficult to determine the benefits available in the form of refunds or reductions in future employer contributions.
FYI: The control of pension and benefit plans is often dependent on national laws and regulations, which are unlikely to allow refunds to employers of overfunded amounts. The trustees of the pension plan are also unlikely to allow the management of an entity to reduce the contributions to a plan up to the limit of any overfunded amount.
A Little bit about Defined Benefit Obligation
IAS 19 states that entity should use the projected unit credit method to determine the present value of its defined benefit obligation, the related current service cost, and past service cost. This method looks at each period of service, which creates an additional increment of benefit entitlement. The method then measures each unit of benefit entitlement separately to build up the final obligation. The whole of the postemployment benefit obligation is discounted.
The use of this method involves a number of actuarial assumptions. These assumptions are the entity’s best estimate of the variables that will determine the final cost of the postemployment benefits provided. These variables include assumptions about mortality rates, change in retirement age, and financial assumptions, such as discount rates and benefit levels. Any assumptions should be compatible, unbiased, and neither imprudent nor excessively conservative. The Standard provides guidance on certain key assumptions.
Actuarial Gains And Losses—Defined Benefit Plans
An entity can recognize actuarial gains and losses in the following ways:
An entity should recognize a portion of its actuarial gains and losses as income or expense if the net cumulative unrecognized actuarial gains and losses at the end of the previous reporting period (i.e., at the beginning of the current financial year) exceeds the greater of:
- 10% of the present value of the defined benefit obligation at the beginning of the year; and
- 10% of the fair value of the plan assets at the same date.
These limits should be calculated and applied separately for each defined plan. The excess determined by this method is then divided by the expected average remaining lives of the employees in the plan.
An entity can adopt any other systematic method that results in a faster recognition of actuarial gains and losses, provided that the same basis is applied to both gains and losses and that the basis is applied consistently from period to period.
Entities have the option of recognizing actuarial gains and losses in full in the period in which they occur but outside profit or loss in the statement of recognized income and expense. This must be done for all defined benefit plans and for all of its actuarial gains and losses.
An entity has a defined benefit pension plan. As of January 1, 20X9, these values relate to the pension scheme:
• Fair value of plan assets: $50 million
• Present value of defined benefit obligation: $45 million
• Cumulative unrecognized actuarial gains: $8 million
• Average remaining working lives of employees: 20 years
At the end of the period at December 31, 20X9, the fair value of the plan assets has risen by $5 million. The present value of the defined benefit obligation has risen by $3 million. The actuarial gain is $10 million, and the average remaining working lives of the employees is 20 years. The entity wishes to know the difference between the corridor approach and the full recognition of actuarial gains and losses.
The question is: How the actuarial gain or loss for the period ending December 31, 20X9, could be recognized in the financial statements?
You can use the following two approcahes:
- Corridor Approach: The entity must recognize the portion of the net actuarial gain or loss in excess of 10% of the greater of defined benefit obligation or the fair value of the plan assets at the beginning of the year. Unrecognized actuarial gain at the beginning of the year was $8 million. The limit of the corridor is 10% of $50 million, or $5 million. The difference is $3 million, which divided by 20 years is $0.15 million.
- Full Recognition Approach: Under this approach, the full amount of the actuarial gains ($10 million) will be recognized in the statement of recognized income and expense.
Defined Contribution Plans
Under a defined contribution plan, payments or benefits provided to employees may be simply a distribution of total fund assets or a third party—for example, an insurance entity—may assume the obligation to provide the agreed level of payments or benefits to the employees. The employer is not required to make up any shortfall in the fund’s assets.
Accounting For Defined Contribution Plans
The accounting for a defined contribution scheme is fairly simple because the employer’s obligation for each period is determined by the amount that had to be contributed to the scheme for that period. Contributions can be based on a formula that uses employee compensation as the basis for its calculation.
There are no actuarial assumptions required to measure the obligation or expense, and there are no actuarial gains or losses. The employer recognizes the contribution payable at the end of each period based on employee service during that period. This amount is reduced by any payments made to employees in the period.
If the employer has made payments in excess of the required amount, this excess is treated as a prepayment to the extent that the excess will lead to reduction in future contributions or refund of cash.
Defined Contribution and Defined Benefit Plans Classification
In defined contribution plans, an entity pays a fixed contribution into a separate entity [fund] and will have no legal or constructive obligation to pay further contributions if the fund does not have sufficient assets to pay employee benefits relating to employee service in the current and prior periods. An entity should recognize contributions to a defined contribution plan where an employee has rendered service in exchange for those contributions. All other postemployment benefit plans are classified as defined benefit plans. Defined benefit plans can be unfunded, partly funded, or wholly funded.
Under the defined benefits scheme, the benefits payable to the employees are not based solely on the amount of the contributions, as in a defined contribution scheme; rather, they are determined by the terms of the defined benefit plan. This means that the risks remain with the employer, and the employer’s obligation is to provide the agreed amount of benefits to current and former employees. The benefits normally are based on such factors as age, length of service, and compensation. The employer retains the investment and actual risks of the plan. The accounting for defined benefit plans is more complex than defined contributions plans.
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