Effects of Post-Employment Benefits on Financial Statements

Post-employment benefits are provisions offered by employers to their retired employees. These benefits can have various implications on an organization’s financial statements.

Nature of Post-Employment Benefits

Types and Overview

Post-employment benefits can be in the form of cash benefits like pensions or non-monetary benefits. They are commonly offered by companies as a strategy to attract and retain talent. Regulatory and labor market customs influence the offering of these benefits. For example, in the UK, employers are mandated to provide pension plans, while in the US, such offerings are incentivized through tax advantages. The presence of government-sponsored health plans can reduce the prevalence of employer-sponsored retirement health care benefits.

Classification of Post-Employment Benefits

Defined Contribution (DC) Plans

Employers make predetermined contributions. Once this contribution is made, the employer has no further obligation. The investment and actuarial risks fall on the employee. This makes predicting the employer’s future obligations relatively straightforward.

Defined Benefit (DB) Plans

Employers pledge a specific benefit amount upon an employee’s retirement, often calculated based on years of service and pre-retirement salary. Employers must pre-fund these plans, contributing to plan assets to meet future obligations. Unlike DC plans, employers bear the investment and actuarial risks. There is a global shift from DB to DC plans to reduce employer risks. New employees cannot enter closed DB plans and no new benefits accrue in frozen DB plans.

Other Post-Employment Benefits (OPEB)

OPEB includes non-monetary benefits like retiree medical care and life insurance. There is no requirement to pre-fund OPEB and could be “pay-as-you-go” plans. OPEB usually represents a smaller financial obligation than pension plans.

Financial Reporting Implications

DC Plans

For DC plans, the financial reporting aligns closely with the reporting of short-term benefits. Contributions by employers are recognized as an expense on the income statement. The only balance sheet implication is the recognition of a liability for vested but unsettled contributions. The actual DC plan, being a separate legal entity, has its distinct financial statements.

DB Plans

These plans are more complex in terms of financial reporting due to their uncertain nature. A key aspect of DB plans is the “funded status”, which is the difference between the fair value of plan assets and the pension obligation. The financial reporting involves the following:

1. Recognizing the fair value of compensation in the period services are provided by employees.
2. Reporting the funded status on the balance sheet, either as a net pension liability (if underfunded) or a net pension asset (if overfunded).

On the income statement, employers recognize an expense each period for benefits provision. The pension expense has multiple components including service costs, net interest expense/income, and remeasurement. Plan contributions, which are distinct from pension expense, are reported on the statement of cash flows.

OPEB

Financial obligations for OPEB are usually estimated, given that they often lack specific assets earmarked for future payments. This means companies bear both investment and actuarial risks.

Financial Reporting for Defined Benefit (DB) Pension Plans

Under both US GAAP and IFRS, DB plans require recognition of a liability for the present value of expected future pension payments, referred to as the Defined Benefit Obligation (DBO). These are based on actuarial valuations and reflect employee service costs, interest costs, and expected return on plan assets. The employer’s financial statements will reflect the net pension liability or asset, which is the DBO minus the fair value of plan assets.

US GAAP and IFRS Differences in DB Pension Accounting

While US GAAP and IFRS are aligned in their balance sheet and cash flow statement reporting for DB plans, notable differences arise on the income statement and Other Comprehensive Income (OCI).

Components of Pension Expense Under US GAAP

Current Service Costs

These costs are incurred for services rendered by employees during the current year. Both under US GAAP and IFRS, they are calculated using the projected unit credit method and reported as an operating expense.

Interest Cost

This represents the unwinding of the discount or the passage of time. It is computed by multiplying the pension obligation at the start of the year by the discount rate. US GAAP reports this as a “gross” interest expense, segregating it from operating income. Contrarily, IFRS combines it with the return on plan assets for a “net” interest amount.

Expected Return on Plan Assets

This reflects the forecasted return on plan assets at the start of the period. US GAAP bases this on expected returns influenced by historical asset class performance, treated separately in earnings. In contrast, IFRS does not recognize expected returns in the profit and loss (P&L) but includes it in the remeasurements recognized in OCI.

Amortization of Past Service Cost

In US GAAP, past service costs are initially recorded in OCI and then amortized to the income statement over the average service life of employees. IFRS, however, recognizes past service costs immediately in P&L when plan amendments lead to changes in benefits.

Amortization of Net Gains or Losses

US GAAP provides two options: report all actuarial gains and losses (differences between expected and actual returns) directly in the P&L or (a more preferred method) initially in OCI and then moved to the income statement using the corridor approach. The corridor approach is designed to buffer earnings from significant changes in estimates or asset valuations. If unrecognized gains and losses surpass 10% of the pension obligation or asset’s fair value, then the exceeding amount is spread over the anticipated average remaining working lives of plan participants.

Disclosure for Post-Employment Benefit Plans

Transparency in disclosing post-employment benefits is paramount. For Defined Contribution (DC) benefits, the disclosure is straightforward. IAS 19 mandates that companies merely disclose the recognized expense, typically as part of notes named “Employee Compensation” or “Post-Employment Benefits”.

On the other hand, for DB Plans and Other Post-Employment Benefits (OPEB) IAS 19 necessitates comprehensive disclosures, often resulting in one of the longest notes in the financial statements. The objectives include:

1. Explaining the characteristics and risks of DB plans.
2. Identifying and clarifying amounts in the financial statements resulting from DB plans.
3. Describing the potential impact of DB plans on the company’s future cash flows.

Additional considerations

Cash Flow Implications

Cash contributions to DB plans may not directly match the pension expense recognized in the financial statements. This is because pension expenses are calculated based on actuarial assumptions and market conditions that can fluctuate, whereas cash contributions are tangible outflows that occur in real-time. The difference is attributed to the timing and valuation discrepancies between the actual funding of the plan and the expense recognition principles.

Effects on Financial Ratios

Unfunded pension liabilities, which occur when plan assets are insufficient to cover promised benefits, can significantly impact a company’s solvency ratios and operational margins. The accounting for these plans can also introduce volatility into the company’s equity due to potential fluctuations in investment returns and adjustments in actuarial predictions.

Off-Balance Sheet Financing

Companies might use post-employment benefits as a form of off-balance-sheet financing. By not fully funding their pension obligations, companies can potentially invest in other business operations.

However, this can lead to future funding challenges, especially if the pension plan’s investments underperform or if actuarial assumptions change.

Tax Implications

The tax deductibility of pension contributions acts as a tax shield, reducing a company’s current taxable income. However, fluctuations in the value of plan assets and obligations can lead to the creation of deferred tax assets or liabilities, which have implications for the company’s future tax payments and financial flexibility.

Sensitivity Analysis

Given the myriad of assumptions involved in pension accounting, particularly for DB plans, it’s crucial for financial analysts to understand the sensitivity of these assumptions. A slight change in the discount rate or expected return on plan assets can cause significant changes in pension obligations and expenses. Companies often provide sensitivity analyses in their financial statement footnotes, shedding light on the potential variability of pension obligations and costs.

Example: ABC Corporation Defined Benefit Pension Plan for the Year 2024

Consider a theoretical entity, ABC Corporation, which incorporates a defined benefit (DB) pension scheme and stock option awards within its remuneration package for eligible staff members. ABC Corporation compiles its financial reports in accordance with IFRS standards.

Details pertaining to ABC Corporation’s defined benefit plan and the volatility estimates applied in assessing the value of stock option awards were presented as follows:

$$ \begin{array}{l|r}
\textbf{Category} & \textbf{Value} \\ \hline
\text{Employer contributions} & \$800 \\ \hline
\text{Current service costs} & \$150 \\ \hline
\text{Past service costs} & \$100 \\ \hline
\text{Discount rate for plan liabilities} & 6.00\% \\ \hline
\text{Benefit obligation (beginning of year)} & \$35,000 \\ \hline
\text{Benefit obligation (end of year)} & \$34,800 \\ \hline
\text{Actuarial loss due to plan obligation} & \$400 \\ \hline
\text{Plan assets (beginning of year)} & \$33,000 \\ \hline
\text{Plan assets (end of year)} & \$32,800 \\ \hline
\text{Actual return on plan assets} & \$2,200 \\ \hline
\text{Expected return on plan assets} & 7.00\% \\ \hline
{2024 \text{ Valuation Assumptions }(2020–2024)} & 20.00\% \\ \hline
{2023 \text{ Valuation Assumptions }} & 22.00\%
\end{array} $$

Note: All transactions (including plan amendments) are assumed to occur at year-end.

Operating Expense Recognition for the year 2024

The total operating expense related to the DB plan in fiscal year 2024 is calculated by summing the current service cost ($150) and past service costs ($100), leading to a total of $250. This value is recognized as an operating expense on the income statement under IFRS.

Total Amount Recognized under US GAAP for DB Plan in Fiscal Year 2024

Assume that ABC Corporation company opts to defer the immediate recognition of actuarial losses and that it does not carry out any amortization of past service costs or actuarial gains and losses.

Under US GAAP, the total amount recognized on the income statement for ABC Corporation’s DB plan in fiscal year 2024 includes the current service cost, interest expense on the pension obligation, and the expected return on plan assets.

Current Service Cost: $150

Interest Expense on Pension Obligation: 6% of ($35,000 Benefit Obligation at Beginning + $100 Past Service Cost) \(= 6\% \times \$35,100 = \$2,106\)

Expected Return on Plan Assets: 7% of $33,000 (Plan Assets at Beginning) \(= 7\% \times \$33,000 = \$2,310\)

Total Amount Recognized: Current Service Cost + Interest Expense – Expected Return \(= \$150 + \$2,106 – \$2,310 = -\$54\)

This -$54 is the total amount recognized on the income statement under US GAAP.

Estimate of Pension Cost Recognized on Income Statement in FY2025

Assume that the service cost and the discount rate in FY2025 will be the same as the previous year.

Service Cost: $250 (same as previous year)

Net Pension Liability at the Beginning of FY2025: Benefit Obligation at End of FY2024 – Plan Assets at End of FY2024 \(= \$34,800 – \$32,800 = \$2,000\)

Net Interest Expense: 6% of $2,000 \(= 6\% \times \$2,000 = \$120\)

Total Pension Cost: Service Cost + Net Interest Expense \(= \$250 + \$120 = \$370\)

This $370 is the estimated pension cost to be recognized on the income statement in FY2025.

 

Question

If a company shifts from a Defined Benefit (DB) plan to a Defined Contribution (DC) plan, what is the most likely immediate impact on the company’s financial statements?

1. The net pension liability on the balance sheet will increase.
2. The pension expense on the income statement will become more volatile.
3. The pension expense on the income statement will become more predictable.

Solution

The correct answer is C:

When a company moves from a DB plan to a DC plan, the pension expense becomes more predictable because the company is only responsible for the fixed contributions to the DC plan and not for the investment performance or actuarial assumptions required under a DB plan.

A is incorrect: Shifting to a DC plan does not increase the net pension liability; instead, it removes the company’s future liability for pension benefits beyond the contributions made.

B is incorrect: The shift to a DC plan reduces volatility in pension expenses since the company no longer bears the investment and actuarial risks associated with DB plans.

Reading 12: Employee Compensation: Post-Employment and Shared-Based

Los 12 (d) Explain how post-employment benefits affect the financial statements