Financial Analysis Using Common-size I ...
Under a defined contribution plan, a company contributes a defined amount, i.e., pension expense into the plan.
Under a defined-benefit plan, a company commits to pay future benefits to employees during their retirement.
Under a defined-benefit plan, a company reports either a net pension asset or a net pension liability.
A company’s balance sheet will reflect a net pension asset if the fair value of the pension fund’s assets is higher than the present value of the estimated pension obligation. Conversely, a company’s balance sheet will reflect a net pension liability if the present value of the estimated pension obligation is higher than the fair value of the pension fund’s assets.
In each period, the change in net pension asset or liability is recognized either in profit or loss. Alternatively, the change in net pension asset or liability is recognized in other comprehensive income.
Under IFRS, the change in net pension asset or liability has three general components: (i) employees’ service costs (which is recognized as pension expense in profit and loss); (ii) net interest expense or income accrued on the beginning net pension asset or liability (which is also recognized as pension expense in profit and loss); and (iii) remeasurements (which is recognized in other comprehensive income).
Under US GAAP, the change in net pension asset or liability in each period has five components: (i) employees’ service costs for the period; (ii) interest expense accrued on the beginning pension obligation; (iii) expected return on plan assets, which reduces the amount of expense recognized; (iv) past services costs; and (v) actuarial gains and losses. The first three components are recognized in profit and loss in the period when they are incurred, while the latter two components are recognized in other comprehensive income and then amortized into profit and loss (as pension expense) over time.
The pension expense related to production employees is added to inventory and expensed through the cost of sales. For those employees who are not directly involved in the production process, the pension expense is included with salaries and other administrative expenses. Pension expense is therefore not directly reported on the income statement. Instead, extensive disclosures are included in the notes to the financial statements.
Question 1
Company XYZ has a defined benefit pension plan. If at the reporting date, the company’s pension obligation is $5 million and pension assets are $7.5 million, the balance sheet reporting would most resemble:
- $2.5 million is shown as a net pension asset.
- $2.5 million is shown as a net pension obligation.
- $7.5 million is shown as an asset, and $5 million is shown as a liability.
Solution
The correct answer is A.
The difference between the pension assets ($7.5 million) and the pension liabilities ($5 million) is reported on the balance sheet as a net pension asset ($2.5 million).
Question 2
A company paying a fixed amount of money to finance its employees’ pension plan is considered to have:
- A defined benefit pension plan.
- A fixed contribution pension plan.
- A defined contribution pension plan.
Solution
The correct answer is C.
A company paying a fixed amount of money to finance its pension plan is considered to have a defined contribution pension plan. A defined benefit pension plan would require the company to pay a variable amount of money depending on the company’s estimates which change from year to year. There is no such thing as a fixed contribution pension plan.