Types of Post-employment Benefit Plans and Implications for Financial Reports

A company may offer its employees different types of benefits upon retirement. These may include pension plans, medical insurance, health care plans, and life insurance. The company may make assumptions required to estimate and recognize future benefits. These assumptions introduce complexity and significantly impact the company’s reported performance and financial position.

Here are the main types of benefit plans and their implications for financial reports:

1. Defined Contribution (DC) Plan

A company contributes a constant (defined amount) or proportion of an employee’s salary, either monthly or annually, towards the employee’s retirement plan. This constant amount is called a pension expense.

Key Attributes of a DC Plan

• An employer and an employee may each contribute towards the plan.
• The contribution amount varies based on age, experience, salary, and other factors.
• An employee bears the investment risk inherent to the plan assets.

Implications for Financial Reports

Pension expense, if any, is recorded on the income statement as an expense. Since the employer’s obligation is limited to a defined amount, no significant pension-related liability accrues on the balance sheet. However, the employer may recognize the current liability (accrual) at the end of the reporting period only for any unpaid contributions. Since the company has no obligations beyond the required contributions, assessing the impact on its financial statements becomes easy.

2. Defined Benefit (DB) Plan

Here, an employer promises to pay a fixed pension in the future.

Key Attributes of a DB Plan

• An employer offers a defined retirement benefit to the employees until death.
• An employer has to assess the value of future obligations to an employee based on future salary levels, retirement age, mortality levels, and even the pattern of interest rates.
•  An employer bears the investment risk to ensure the availability of sufficient assets in the plan to pay the ultimate benefits promised to participants.

Implications for Financial Reports

Under IFRS and US GAAP, all pension plans and other post-employment benefits – other than those explicitly structured under DC plans – fall under DB plans.

The funded status of a pension plan refers to the value of assets in the pension trust, less the benefit obligations. An overfunded DB plan has a higher value of pension assets than the estimated liability and vice versa. The employer reports the funded status on the balance sheet as a requirement under IFRS and US GAAP.

Under a DB plan, the employer must estimate and allocate the total cost of liabilities to the service life of the employee. The complexity of pension reporting arises since the timing of cash flows can differ significantly from the timing of accrual-basis reporting.

A company bases its pension obligation on many estimates and assumptions. Changes in any of these assumptions increase or decrease the pension obligation. An increase in pension obligation is an actuarial loss, while a decrease is an actuarial gain. A company reports actuarial gains and losses in OCI. It recognizes gains and losses in P&L only when it meets certain conditions under the corridor approach, which we’ll discuss in the objectives that follow.

In addition, the periodic cost, which is the change in the funded status, is recognized in P&L or other comprehensive income (OCI) adjusted for the employer’s contributions.

3. Other Post-employment Benefits (OPB) (e.g., Retiree’s Life Insurance)

These are promises a company makes to pay future benefits such as life insurance and health care insurance to employees. These plans are typically classified as DB plans and have similar accounting treatment to DB plans.

Key Attributes of an OPB Plan

• Future benefits are specified.
• The employer estimates future benefits in the current period.
• The amount of future benefits depends on the type of benefits and plan specification.
• Companies do not pre-fund OPB liabilities.

Implications for Financial Reports

From the discussion on the DB plan, accounting for OPB plans also requires assumptions and estimates. They may have higher complexity in comparison to DB plans due to the need to estimate future costs over a long time horizon, e.g., health care costs. An increase in the assumed inflationary trends in health care costs increases the obligation and associated periodic expense of these plans, impacting a company’s financial position.

Question

A positive funding status is most likely to be:

   A. Reported as an asset in the balance sheet.

   B. Reported as a profit in the income statement.

   C. Reported as interest earned in the income statement.

Solution

The correct answer is A.

A positive funding status results from the pension plan assets being higher than the benefit obligation (overfunding). It is, therefore, recognized as an asset on the balance sheet.

Reading 12: Employment Compensation: Post-Employment and Share-Based

LOS 12 (a) Describe the types of post-employment benefit plans and implications for financial reports.