ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 14: Employee benefits and share based payments

1.2 Short-term employee benefits

Short-term employee benefits are employee benefits that are paid within twelve

months after the end of the period in which the employee provides the service. This

includes:

 wages, salaries and social security contributions

 paid annual holiday and paid absences due to sickness

 profit-sharing payments and bonuses

 other benefits not in a monetary form, such as medical insurance, free

accommodation in a house or flat owned by the entity and company cars.

The expense must be accounted for on an accruals basis and any unpaid entitlement

should be recognised as a short-term liability. Discounting the liability to a present

value is not required, because it is payable within 12 months.



Example

A company allows each employee five weeks of paid holiday in each calendar year

(1 January to 31 December). Any holiday not taken by the end of one year can be

carried forward to the next calendar year.

If some employees have not taken their full holiday entitlement by the end of the

year, a liability should be recognised for the monetary value of the holiday

entitlement that is carried forward to the next year. In this way the cost of the full

five-week holiday entitlement is charged as an expense in the current year, even if

some of the entitlement has been carried forward as a liability in the statement of

financial position.

1.3 Post-employment benefits

Post-employment benefits are benefits that are given, or will be given, to employees

after they have retired from the company. The most significant post-employment

benefit is a retirement pension, but there may also be post-employment life

insurance and medical care.

Accounting for post-employment benefit plans is the most complex aspect of IAS 19.

Pension schemes (or pension ‘plans’) are either:

 defined contribution plans or

 defined benefit plans.

The accounting treatment differs for each type of pension plan.

1.4 Defined contribution pension schemes

In a defined contribution pension scheme, the employer pays an agreed amount of

money (‘defined contributions’) at regular intervals into a pension fund for the

employee. The contributions are usually paid in cash. The amount of money that the

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employer contributes is usually a fixed percentage of the employee’s wages or

salary – say 5% of the employee’s basic salary.

The contributions of cash into the pension fund are invested by the fund in a range

of investments, to earn a return and increase the value of the fund. When an

employee retires, he or she is paid a pension out of the fund. The amount of pension

received by the employee is not pre-determined, but will depend on the size of the

fund when the employee retires.

The size of the fund depends on:

 the amount of contributions that have been paid into the fund for the employee,

and

 the returns earned by the investments in the fund.

The size of the employee’s pension therefore depends on the performance of the

investments in the fund, and the employee bears the risk of poor performance by

the fund investments. If the investments perform worse than expected, the fund will

be smaller than expected and the employee’s pension will be lower than the

employee would want it to be. However, the employer is under no obligation to pay

any further amounts of money to the employee.

As the name ‘defined contribution’ implies, the company’s obligation to pay a

pension to the employee is limited to the agreed amounts of contribution. The

company is not required to make good any shortfalls if the pension fund does not

have enough assets to pay the pension benefits that the employee would like to

have. In effect, the employee bears the risk of a poor-performing fund, not the

employer.

Accounting treatment: contributions to defined contribution schemes

Since the risk of low investment returns and a lower-than-expected pension is a risk

for the employee, not the employer, accounting for the employer’s contributions to a

defined contribution scheme is very simple.

Using the accruals concept:

 the contributions payable for the reporting period are charged to profit or loss as

an expense (an employee cost) in the income statement.

 any unpaid contributions at the end of the year will be shown in the statement of

financial position as an accrual/liability and any prepaid contributions will be

shown as an asset (a prepayment). The accrual or prepayment will usually be

current, not long-term.

1.5 Defined benefit pension schemes

A defined benefit pension scheme (or pension plan) has some similarities to a

defined contributions scheme. An employer makes regular contributions into a

pension fund for its employees, and the money paid into the fund is invested. The

fund is used to provide pension benefits to employees when they retire.

Chapter 14: Employee benefits and share based payments

The fund grows over time with the returns from the investments made by the fund

and also from the payments of additional contributions that the employer regularly

makes. The fund is also reduced by payments of pensions to employees who are

now past their retirement age.

The major difference between defined benefit and defined contribution schemes is

that in a defined benefits scheme, the employer guarantees the amount of pension

benefits that its employees will receive after they retire. The risk remains with the

employer.

The amount that an employee will receive is usually linked to the number of years

that he or she has worked for the company, and the size of his/her annual salary at

retirement date (or on leaving the company). For example, a scheme may promise

an annual pension of:

2/3 × Final annual salary × [Number of years of service/40]

So if the entitlement to a pension is calculated by this formula, an employee earning

$60,000 on retirement, and who has worked for the company for 20 years will collect

a pension of $20,000 each year until death (2/3 × $60,000 × 20/40). This may be

increased each year to allow for inflation, depending on the terms of the pension

plan.

An actuary will advise the company how much to pay in contributions into the

pension plan each year, in order to ensure there are sufficient funds to cover the

company’s obligation to make the pension payments. The actuary will have to make

a large number of estimates to calculate these payments. For example, the actuary

has to estimate the average life expectancy of retired employees, the expected

number of years of service that retired employees will have given when they retire,

their final salary and the expected returns on investments in the pension fund.

It is highly likely that the actuary’s estimates will not be 100% accurate, so when the

value of the pension fund and the size of the employer’s future pension obligations

are re-valued at the end of each year, the actuary may find that there is a shortfall or

a surplus.

 When the value of the investments in the pension fund is higher than the value

of the employer’s obligations to make future pension payments, the fund is in

surplus.

 When the amount of the employer’s future pension obligations is more than the

value of the investments in the pension fund, the fund is in deficit.

The company will be required to eliminate a deficit, but not necessarily

immediately. A deficit may be eliminated over a period of several years. A deficit is

eliminated by the employer making additional contributions into the fund.

When the fund is in surplus, perhaps because of a large rise in the value of the

investments in the fund, the actuary may recommend that the employer should not

make any more contributions into the fund for a period of time (and ‘take a pension

holiday’). Alternatively the company may withdraw the surplus from the fund, for

its own benefit.

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

Example

An actuary values the investments in a pension fund at $470 million and estimates

the present value of the employer’s future pension obligations to be $500 million.

The scheme is $30 million in deficit.

The employer may decide to eliminate the deficit by making extra contributions into

the fund for the next five years.

1.6 Definitions: defined benefit pension schemes

The cost to the company of funding a defined benefit scheme will vary from one

year to the next, due to the variability in fund asset values and the expected future

pension obligations. This variability complicates the accounting treatment of an

employer’s defined benefit pension scheme costs and the liability to its pension

scheme fund.

It will be useful to understand some of the terminology used in accounting for

defined benefit schemes.

Fair value of the plan assets. A pension fund owns investments, many of them in

the form of shares, bonds and other financial instruments. ‘Fair value’ is the market

value of these financial investments and other investment assets held by the fund.

Present value of the plan obligations. A defined benefit scheme has future pension

obligations. These are the obligations to pay pension benefits in the future that have

already been incurred for current employees (who have not yet retired) and former

(retired) employees. These are the future obligations that have already accrued as a

future liability.

The obligations are estimated by an actuary, and are based on actuarial estimates

and assumptions.

Since the obligations are payable in the future, and most are payable many years in

the future, the value of the obligations should be discounted to a present value for

accounting purposes.

Current service cost. Each year, the future obligations of a defined benefits pension

fund change. They often increase, because existing employees have worked an extra

year for the company, and their salaries will have gone up. This increases their

future pension entitlements. For example, if an employee serves one more year with

a company, his number of years of service increases and so his future pension

entitlement increases.

Changes in the obligations of a pension scheme due to changes in the ‘service

history’ of current employees are called the ‘current service cost’. This increases the

pension liability and the increase is treated as an expense in the income statement.

Contributions paid. Each year the employer pays additional contributions into the

fund, adding to the assets of the fund. This increases the pension assets and

decreases cash in the employees accounts.

Chapter 14: Employee benefits and share based payments

Benefits paid. Each year, retired employees are paid pension benefits from the

fund. When benefits are paid, assets of the fund are reduced, and the liabilities

(pension obligations) are also reduced.

Discount rate (interest cost). This is the rate used to discount the future payment

obligations in order to calculate their present value as at the end of each reporting

period. Currently, the discount rate should be based on the market yield of a high-

quality corporate bond at the end of the reporting period.

Each year, since pension liabilities are one year closer to settlement, they should be

adjusted for the time value of money. The pension liability is already shown as a net

present so this adjustment unwinds the discount on the liability.

The interest cost is calculated on the opening pension liability and increases the

liability and is charged as a cost in the income statement.

Expected return on plan assets. The actuary has to make a forecast of the income

(dividends, interest and capital gains) that will be generated by the investments in

the pension fund. This should be based on market expectations at the beginning of

the financial year, for returns on investment over the entire life of the plan (which

may be many years).

Returns on investments increase the value of the pension fund, and an actuary

needs to estimate what these returns are likely to be, in order to assess whether a

scheme will be in surplus or deficit. The return is calculated on the opening assets of

the pension scheme and is added to pension assets and shown as income in the

income statement.

Measuring the pension obligation

The pension obligation is measured using the projected unit credit method, as is the

current service cost and past service cost. It is discounted to present value. This

method makes actuarial assumptions based on how the pension liability will be

used, such as mortality rates; changes in retirement age, and discount levels

amongst others.

Measuring the plan assets

The pension assets are measured at fair value, which is usually market value.

1.7 Basic principles of a defined benefit scheme

In order to understand the accounting treatment of defined benefit (DB) schemes in

the accounts of the employer, it is important to understand how the employer is

affected by a DB scheme.

When a DB pension scheme operates, the scheme itself exists independently of the

employer, with its own assets and liabilities to its scheme members. The assets and

obligations of the DB scheme are therefore excluded from the employer’s statement

of financial position.

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However the employer has a liability to fund any financial shortfall in the DB

scheme (and it has a ‘right’ to any surplus). The net deficit (or surplus) of the

scheme is the difference between:

 the (fair) value of the assets of the scheme, which are its financial investments

and other investments, and

 the future obligations of the scheme to provide benefits to the scheme members,

mainly in the form of pensions after retirement: these future obligations are

long-term and so are discounted to a present value.

The difference between these two amounts is shown as a long-term liability or long-

term asset in the statement of financial position of the employer.

Changes in the fair value of scheme assets

The fair value of the assets of a DB scheme change each year.

 They increase with the returns obtained on the assets owned by the scheme,

such as the returns on its financial investments. They also increase as more

contributions are paid each year into the scheme.

 They are reduced by actual payments of benefits from the scheme, as pensions to

members who are now retired.

Changes in the PV of scheme obligations

The PV of a scheme’s obligations also changes each year.

 The obligations are stated as a present value, so each year some of the discount

unwinds and the PV of the obligations increases.

 Obligations also increase as employees who are currently members of the

scheme earn more pension entitlements by providing more service to the

employee. Current service costs (and past service costs, which are explained

later) therefore add to the obligations.

 The scheme’s obligations are reduced by actual payments of benefits from the

scheme, as pensions to members who are now retired. This is because payments

of benefits are the settlement of some of the obligations of the scheme.

Actuarial differences

There is one extra complication. The expected value of the scheme’s assets at the

year end depend partly on assumptions made by actuaries about the return that will

be obtained on the scheme’s assets during the year. These actuarial expectations or

assumptions are usually wrong, to a smaller or larger extent.

Similarly the present value of the scheme’s obligations depends on assumptions

made by actuaries about factors such as the life expectancy of retired scheme

members. These assumptions might also change. When actuarial assumptions are

changed, there will be an actuarial gain or loss, and this affects the obligations of the

employer to the DB scheme.

Chapter 14: Employee benefits and share based payments

1.8 Accounting treatment of defined benefit pension schemes

Stages in the accounting treatment

Each year, the expected surplus or deficit in the employer’s obligations to a DB

pension fund has to be re-assessed. The following steps must be taken to make this

assessment:

 Start with the pension scheme’s assets and the present value of its future

obligations, as at the beginning of the financial year.

 Calculate what would be the scheme’s assets and PV of future obligations at the

end of the financial year, if the actuary’s estimates were correct. In particular,

assume that the discount rate is correct and that the expected rate of return on

the fund’s investments is also correct.

 To calculate what the scheme’s assets would be, on these assumptions, the

following calculation is necessary:

Pension scheme assets at the beginning of the year A

Add: Expected return from the fund’s investments during the year B

Add: Contributions paid into the fund C

Minus: Benefits paid from the fund (D)

Expected pension scheme assets at the end of the year A + B + C – D

 To calculate what the expected present value of the scheme’s existing future

obligations should be, the following calculation is necessary:

PV of pension scheme obligations at the beginning of the year A

Add: The discounted value of these obligations for one year

= PV of obligations × Discount rate %.

(This is because the obligations are one year nearer, so the PV is higher.)

Add: Current service cost (increase in obligations in the year) C

Minus: Benefits paid from the fund (= liabilities paid) (D)

Expected PV of pension scheme obligations at the end of the year A + B + C – D

 These calculations provide the expected position of the pension scheme at the

end of the year, and the expected surplus or deficit.

 The actuary must provide a current estimate, as at the year end, of what the

actual value of the plan assets, the most recent estimate of the PV of existing

future obligations and the current estimate of the scheme’s surplus or deficit.

 In profit or loss for the year in the accounts of the employer, the following items

are costs or benefits:

Recognised in profit or loss

Current and past service costs: an expense (X)

Interest cost (unwinding of the discount, see above): an expense (X)

Expected return on plan assets (see above): a benefit X

Actuarial gain or loss (or some of it): this is explained later X or (X)

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This accounting treatment can best be explained using an example:



Example

The following information relates to the defined benefit plan of Company X for the

year to 31 December 20X6.

At1January20X6:

$000

Fairvalueoftheplanassets 900

Presentvalueoftheplanobligations 1,850

Therearenounrecognisedactuarialdifferences

During20X6:

$000

Currentservicecost 90

Contributionspaidintotheplan 150

Benefitspaidoutbytheplan 60



Actuarialassumptions:



Discountrate 11%

Expectedreturnonplanassets 3%



Newactuarialvaluationat31December20X6: $000

Fairvalueoftheplanassets 850

Presentvalueoftheplanobligations 1,960

Step 1: The opening position

At the beginning of the year, there is a deficit on the scheme of $950,000, because the

assets of the scheme ($900,000) are less than the PV of expected future liabilities

($1,850,000).

The $950,000 must be shown as a liability in the company’s statement of financial

position. This is an obligation that the company has to the pension scheme. (The

fund assets and liabilities are held within a separate pensions entity, and so do not

appear in the statement of financial position of the company. Only the deficit is

shown as a liability in the company’s accounts.)

Step 2: Rolling forward the position

The actuary’s assumptions about discount rate and return on investments, the

actual cash payments into and out of the pension fund and the current service cost

are used to ‘roll forward’ the opening position at the beginning of the year,

assuming that the actuary’s assumptions are correct. This will give an amount for

the expected surplus or deficit at the end of the year.

Chapter 14: Employee benefits and share based payments

 Fundposition Companyposition

Accountingsteps Workings Liabilities Assets Net

$000 $000 $000

Atstartofyear (1,850) 900 (950)

1.Interestexpense 11%×1,850,000 (204)(204)

2.Interestearned 3%×900,00027 27

3.Currentservicecost Given (90)(90)

4.Contributionspaid Given150 150

5.Benefitspaidout Given 60 (60) 0



–

––––––––––––

–

–––––––––––– –––––––––––––

Expectedyearendposition (2,084) 1,017 (1,067)



–

––––––––––––

–

–––––––––––– –––––––––––––

Notes

(1) At the year end, the future pension payments are one year closer and so the

discounting starts to unwind. As the liability was discounted at 11%, the

$1,850,000 at the beginning of the year unwinds at 11%. The PV of the liability

increases by $1,850,000 × 11% = $204,000, and this causes the company’s

deficit to increase.

(2) The assets in the scheme were expected to generate a return of 3% during the

year, and this will reduce the company’s deficit by $27,000.

(3) As the employees have served an extra year’s service, their future pension

benefits will increase. The current service cost reflects the increase in the

deficit due to these higher pension payments.

(4) The company paid cash into the fund during the year, which reduces the

deficit.

(5) The scheme pays out contributions to members who have retired. It does so by

selling some of the investments to settle part of the liability. This transaction

has no effect on the company.

After rolling forward the position at the beginning of the year, the scheme deficit

has increased from $950,000 to $1,067,000, which is an increase of $117,000. This

increase is taken to the income statement as an expense for the year. The double

entry to record this transaction in the company’s accounts is as follows:

$000 $000

Incomestatement(204–27+90) 267 

CR Pensionliability(increase=1,067–950)

117

Cash(contributions)

150

Step 3: The actuarial difference

By rolling forward the pension position using the actuary’s estimates, the expected

year end deficit was $1,067,000. However the new actuarial valuation at the end of

the year shows that the actual deficit is now estimated at $1,110,000 ($1,960,000 PV

of obligations - $850,000 value of plan assets).

Paper P2: Corporate Reporting (International)

There is an ‘unexplained’ difference of $43,000 ($1,110,000 - $1,067,000). This is the

called the ‘actuarial difference’.

Fund

position

Company

position

Accountingsteps

Workings Liabilities Assets Net

$000 $000 $000

Atstartofyear

(1,850) 900 (950)

1.Interestexpense

11%×1,850,000 (204)

(204)

2.Interestearned

3%×900,000

27 27

3.Currentservicecost

(90)

(90)

4.Contributionspaid

150 150

5.Benefitspaidout

60 (60) 0 



–––––––––––––– –––––––––––––– ––––––––––––––

Expectedyearendposition

(2,084) 1,017 (1,067)

Actuarialdifference

124 (167)

(43)



–––––––––––––– –––––––––––––– ––––––––––––––

Actualposition31December20X6 (1,960) 850 (1,110)



–––––––––––––– –––––––––––––– ––––––––––––––

When an actuarial valuation is updated at the end of each year, errors in the original

estimates are discovered. The actuarial valuation is based on a number of

assumptions, and over time, the actual results may not match the assumptions

made.

In this example, the actuary had assumed the assets would generate a return of 3%.

At the end of 20X6 it appears they have generated a return of less than 3%, because

the actual asset valuation at the year end is considerably lower than the ‘roll-

forward’ suggested that it should be.

The actuarial difference has to be accounted for. IAS 19 allows a number of possible

accounting treatments of the actuarial difference.



Example

The previous example provides a lengthy explanation of the calculations. In your

exam, you might be required to produce the necessary figures quickly. The

following example shows how the calculations should be made.

XYZ Company has a defined benefit scheme for its employees, to which the

following information relates:

Year 8

1 January Present value of scheme obligations 850

Fair value of scheme assets 780

Year to 31 December

Expected return on scheme assets: 5%

Discount rate at start of year: 6%

Service costs 40

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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