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Post-Employment Benefits: Defined Benefit Plans – Recognition
Extract from FRS102: Section 28.10(b) and Section 28.14
28.10 Post-employment benefit plans are classified as either defined contribution plans or defined benefit plans, depending on their principal terms and conditions:
– Defined benefit plans are post-employment benefit plans other than defined contribution plans. Under defined benefit plans, the entity’s obligation is to provide the agreed benefits to current and former employees, and actuarial risk (that benefits will cost more or less than expected) and investment risk (that returns on assets set aside to fund the benefits will differ from expectations) are borne, in substance, by the entity. If actuarial or investment experience is worse than expected, the entity’s obligation may be increased, and vice versa if actuarial or investment experience is better than expected.
Recognition
28.14 In applying the general recognition principle in paragraph 28.3 to defined benefit plans, an entity shall recognise:
(a) a liability for its obligations under defined benefit plans net of plan assets—its ‘net defined benefit liability’ (see paragraphs 28.15 to 28.22); and
(b) the net change in that liability during the period as the cost of its defined benefit plans during the period (see paragraphs 28.23 to 28.27).
OmniPro comment
Defined benefit scheme
The key distinction between the defined benefit scheme and the contribution scheme is that the entity is legally or constructively obliged to contribute to the scheme so as to provide the agreed benefits to the current and former employees which compares to the contribution scheme where the entity is only liable for what it has agreed to contribute. In essence the entity bears both the investment and actuarial risk which is not the case for the defined contribution scheme.
An example of a constructive obligation would be a historical practice of discretionary increases going beyond the formal terms of the plan or statutory minimum increases.
Example 9: Defined benefit plan
Company A has set up a defined benefit scheme for its employees. Under the scheme it has legally agreed to provide employees with a set retirement amount based on a percent of the employees final salary. Based on advice from its actuary the Company contributes towards this scheme. The employees also contribute to the scheme. If the pension assets which the pension fund owns decrease in value, this decrease will have to be made up by the Company. Likewise, if former employees live longer than expected, the entity will have to contribute to the fund. On a yearly basis the Company’s actuary provides it with an a report which values the assets and liabilities of the scheme on the basis of various assumptions. The journals usually required where a defined benefit scheme exists (assuming the employer contributions are posted to the pension liability and not to the profit and loss account) are:
|
|
CU |
|
Cr/Dr Defined Benefit Liability |
XXX |
|
Dr Current/Past Service Costs |
XXX |
|
Dr/Cr Interest Cost |
XXX |
Being journal to reflect the movement on the pension scheme liability at the year-end which would be obtained from the actuary valuation.
|
|
CU |
CU |
|
Dr Defined Benefit Liability |
XXX |
|
|
Cr Bank |
|
XXX |
Being journal to reflect the payments made into the pension scheme during the year
|
|
CU |
|
Cr/Dr Actuarial Gain/Loss/Return on Plan Assets in OCI |
XXX |
|
Dr/Cr Defined Benefit Liability |
XXX |
Being journal to reflect the actuarial gain/loss as per the Actuaries valuation
|
|
CU |
|
Dr/Cr Deferred Tax on Actuarial Gain/Loss Posted to OCI |
XXX |
|
Cr/Dr Deferred Tax in P&L on All Other Postings |
XXX |
|
Dr/Cr Deferred Tax in Balance Sheet |
XXX |
Being journal to recognise the movement on the deferred tax on the net defined benefit liability/asset
|
|
CU |
CU |
|
Dr Defined Benefit Liability |
XXX |
|
|
Cr Bank/Wage Control Account |
|
XXX |
Being journal to reflect the employees contributions withheld from the employees pay and paid over to the pension scheme on the employees behalf
Measurement of the net defined benefit liability
Extract from FRS102: Section 28.15-28.22
28.15 An entity shall measure the net defined benefit liability for its obligations under defined benefit plans at the net total of the following amount
(a) the present value of its obligations under defined benefit plans (its defined benefit obligation) at the reporting date (paragraphs 28.16 to 28.21A provide guidance for measuring this obligation); minus
(b) the fair value at the reporting date of plan assets (if any) out of which the obligations are to be settled. Paragraphs 11.27 to 11.32 establish requirements for determining the fair values of those plan assets, except that, if the asset is an insurance policy that exactly matches the amount and timing of some or all of the benefits payable under the plan, the fair value of the asset is deemed to be the present value of the related obligation.
28.15A Where an entity has measured its defined benefit obligation using the projected unit credit method (including the use of appropriate actuarial assumptions), as set out in paragraph 28.18, it shall not recognise any additional liabilities to reflect differences between these assumptions and those used for the most recent actuarial valuation of the plan for funding purposes. For the avoidance of doubt, no additional liabilities shall be recognised in respect of an agreement with the defined benefit plan to fund a deficit (such as a schedule of contributions).
28.22 If the present value of the defined benefit obligation at the reporting date is less than the fair value of plan assets at that date, the plan has a surplus. An entity shall recognise a plan surplus as a defined benefit plan asset only to the extent that it is able to recover the surplus either through reduced contributions in the future or through refunds from the plan.
OmniPro comment
From the above guidance it is clear that future costs and income should be present valued. The is no maximum on the value of liabilities to be recognised in the balance sheet. However any surplus asset should only be recognised where it can show that it will be able to recover the surplus either through reduced contributions in the future or through refunds from the plan as stated in Section 28.22.
A deferred tax asset/liability should also be recognised on the net pension liability/benefit however, this should not be netted against the net pension liability/asset, it should be included within deferred tax on the balance sheet.
There is no requirement that there is a formal signed agreement with the trustees in relation to the reduction in future contributions or a refund, instead it can be recognised on the balance sheet if it can show that it is able to realise future economic benefits at some point in the future or whether this is when the pension scheme ends.
See example below of the points in the Sections above:
Example 10: Calculating the net defined benefit asset/liability
See below extract from an actuarial report detailing the movement in the plan assets during the year. See below the way in which this will be presented in the financial statements and the journals required to reflect these movements. Assume the prior year discount rate was 3.49% and the 2015 discount rate is 2.6%:
Changes in the present value of the defined benefit obligation are as follows:
|
|
2015 |
2014 |
|
|
CU |
CU |
|
Benefit obligation at start of year |
(26,724) |
(26,236) |
|
Current Service Cost |
(615) |
(689) |
|
Interest Cost |
(1,325) |
(1,270) |
|
Plan participants’ contributions |
(334) |
(334) |
|
Actuarial gain/(loss) |
(10,148) |
1,601 |
|
Benefits paid |
313 |
204 |
|
Curtailment |
122 |
0 |
|
Benefit obligation at end of year |
(38,711) |
(26,724) |
Changes in the fair value of plan assets are as follows:
|
|
2015 |
2014 |
|
|
CU |
CU |
|
Fair Value of Plan Assets at start of year |
18,030 |
17,318 |
|
Expected Return on Plan Assets |
1,093 |
1,161 |
|
Employer contribution |
1,250 |
1,535 |
|
Plan participants’ contributions |
334 |
334 |
|
Benefits paid |
(313) |
(204) |
|
Actuarial gain (Actual less expected) |
2,342 |
(2,114) |
|
Fair Value of Plan Assets at end of year |
22,736 |
18,030 |
The net pension liability as at 31 December 2014 and 2015 is analysed as follows:
|
|
2015 |
2014 |
|
|
CU |
CU |
|
Present value of defined obligations |
(38,711) |
(26,724) |
|
Fair Value of Plan Assets |
22,736 |
18,030 |
|
Net Pension Liability |
(15,975) |
(8,964) |
See below the journals required in the entity’s financial statements assuming a deferred tax rate of 12.5%. How each of the main figures are determined is discussed in the sections that follow.
Example 11: Calculating the net defined benefit asset/liability
If in the above example this was a net defined benefit asset, then this asset could only be recognised where the company can reduce the future contributions or alternatively receive a refund. It must be certain that the refund or reduction of future pension benefits will occur. If the asset was not deemed to be recoverable, that element would be posted through other comprehensive income.
Inclusion of both vested and unvested benefits
Extract from FRS102: Section 28.16
28.16 The present value of an entity’s obligations under defined benefit plans at the reporting date shall reflect the estimated amount of benefit that employees have earned in return for their service in the current and prior periods, including benefits that are not yet vested (see paragraph 28.26) and including the effects of benefit formulas that give employees greater benefits for later years of service. This requires the entity to determine how much benefit is attributable to the current and prior periods on the basis of the plan’s benefit formula and to make estimates (actuarial assumptions) about demographic variables (such as employee turnover and mortality) and financial variables (such as future increases in salaries and medical costs) that influence the cost of the benefit. The actuarial assumptions shall be unbiased (neither imprudent nor excessively conservative), mutually compatible, and selected to lead to the best estimate of the future cash flows that will arise under the plan.
OmniPro comment
Appendix I of FRS 102 defines vested benefits as ‘benefits, the rights to which, under the condition of the retirement benefit plan, are not conditional on continued employment’. An un-vested benefit is the opposite of this i.e. the benefit will be payable only on continued employment. So when valuing the liabilities, the unvested benefits also need to be taken into account. When determining the cost of the un-vested benefits an estimate can be made as to the number of staff that are likely to remain with the entity. Under old GAAP this was not required.
Example 12: Non-vesting conditions
Company A’s defined benefit scheme provides a lump sum benefit of CU100 for every year of service for the first 20 years and will only be applied to the employees’ pension if they stay for 15 years. In this instance, even though the condition is unvested in years 1-15 the standard requires an amount of CU5 to be included in the present value of the pension liabilities for each year the employee is present at each year end. A percentage can then be applied to this CU5 if the entity believes some employees will leave in this period. Also where benefits increase after a certain period of time the costs should be apportioned over the total life.
Discounting
Extract from FRS102: Section 28.17
28.17 An entity shall measure its defined benefit obligation on a discounted present value basis. The entity shall determine the rate used to discount the future payments by reference to market yields at the reporting date on high quality corporate bonds. In countries with no deep market in such bonds, the entity shall use the market yields (at the reporting date) on government bonds. The currency and term of the corporate bonds or government bonds shall be consistent with the currency and estimated period of the future payments.
OmniPro comment
Given the long timescales Section 28 requires the cash flows to be discounted at a rate which incorporates the time value of money but not investment or actuarial risk as these are incorporated in the actuarial assumptions used. The discount to be used is usually bonds which are ‘AA’ rated by credit agencies.
The discount rate used in example 10 was 2.6%
Actuarial valuation method
Extract from FRS102: Section 28.18-28.20
28.18 An entity shall use the projected unit credit method to measure its defined benefit obligation and the related expense. If defined benefits are based on future salaries, the projected unit credit method requires an entity to measure its defined benefit obligations on a basis that reflects estimated future salary increases. Additionally, the projected unit credit method requires an entity to make various actuarial assumptions in measuring the defined benefit obligation, including discount rates, employee turnover, mortality, and (for defined benefit medical plans) medical cost trend rates.
28.20 This FRS does not require an entity to engage an independent actuary to perform the comprehensive actuarial valuation needed to calculate its defined benefit obligation. Nor does it require that a comprehensive actuarial valuation must be done annually. In the periods between comprehensive actuarial valuations, if the principal actuarial assumptions have not changed significantly the defined benefit obligation can be measured by adjusting the prior period measurement for changes in employee demographics such as number of employees and salary levels.
OmniPro comment
Section 28 is very prescriptive on the method to use when determining the actuarial valuation. The standard does not require a valuation to be performed by an independent actuary nor does it dictate how often it should be carried out. However, in reality an actuary will be required, in order to determine the defined benefit accounting journals each year.
See application of the actuarial method below:
Example 13: Projected unit credit method
Company A operates a defined benefit scheme which pays a lump sum on termination of 5% of final salary for each year of service. Assume an employee joins in year 1 on a salary of CU30,000 and salaries are assumed to increase by 6% per year. Assume the discount rate is 5% and the employee will retire after 4 years.
See below the amounts to be built up as a defined benefit obligation:
Expected salary at the end of year 4 = CU30,000*(1.06^3)=CU35,730
Therefore the expected obligation at each year end at a rate of 5% of final salary is CU1,787 (CU35,730*5%)
Therefore, the service charge per year = CU1,787 as this is the amount earned for every year in employment.
|
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
|
Estimated salary |
30,000 |
31,800 |
33,708 |
35,730 |
|
Benefit attributable to current year |
1,787 |
1,787 |
1,787 |
1,787 |
|
Benefit attributable to prior years |
0 |
1,787 |
3,573 |
5,360 |
|
Total benefit payable |
1,787 |
3,573 |
5,360 |
7,146 |
|
|
|
|
|
|
|
Opening pension obligation |
– |
1,543 |
3,241 |
5,105 |
|
Interest @ 5% of opening obligation |
– |
77 |
162 |
254 |
|
Current service cost* |
1,543 |
1,621 |
1,702 |
1,787 |
|
Closing pension obligation |
1,543 |
3,241 |
5,105 |
7,146 |
*Year 1 = 1,787/((1.05)^3), Year 2 = 1,787/((1.05)^2)+ Year 3 = 1,787/((1.05)^1)+ Year 4 = 1,787
We start with year three here as we are present valuing from the end of year 1.
Plan introductions, changes, curtailments and settlements
Extract from FRS102: Section 28.21-28.21A
28.21 If a defined benefit plan has been introduced or the benefits have changed in the current period, the entity shall increase or decrease its net defined benefit liability to reflect the change, and shall recognise the increase (decrease) as an expense (income) in measuring profit or loss in the current reporting period.
28.21A If a defined benefit plan has been curtailed (ie benefits or group of covered employees are reduced) or settled (the relevant part of the employer’s obligation is completely discharged) in the current period, the defined benefit obligation shall be decreased or eliminated, and the entity shall recognise the resulting gain or loss in profit or loss in the current period.
OmniPro comment
A settlement occurs when the relevant part of the employer’s liability under the defined benefit plan is completely discharged. Examples when settlements could occur are when a defined benefit scheme is closed and the assets and liabilities are transferred into a defined contribution scheme.
A curtailment occurs when an entity makes a material reduction in the number of employees covered by a defined benefit plan or amends the plan terms so that a material element of the future service by current employees no longer qualify for benefits, or will qualify only for reduced benefits. It can result in a change to the plan rules due to a termination or suspension of a plan.
The gain or loss as a result of the curtailment should be recognised in the profit and loss account but only when the entity is committed to the curtailment and certain it will be achieved. They do not necessarily have to have formal confirmation from the pension scheme trustees.
Example 14: Curtailment
During the year the company agreed with the pension scheme trustees that going forward the pension payment to retired members would not increase in line with inflation (or no further benefits will accrue for future years of service). This has resulted in the liability decreasing by CU300,000. Given that the entity is irrevocably committed the CU300,000 credit should be recognised in the profit and loss account. If the change was not certain, then it would be recognised in other comprehensive income.
Example 15: Settlement
Prior to the year end a decision was made by the company to cease business 3 months after the year end. As part of negotiations the company agreed with the pension scheme trustees that the pension scheme would be closed and the fair value of the pensions would be determined by an actuary and transferred to a defined contribution scheme for the employees. The valuation showed that the difference between the carrying amount of the pension liability and the actual valuation performed that a gain of CU100,000 existed. As at year end the company had obtained agreement from all parties, this credit should be posted as a credit to the profit and loss account.
Example 16: Plan changes
Company A operates a defined benefit scheme. During the year the company agreed to increase the pension whereby the percentage of final salary per year of service as a pension would increase from 1% to 2% for anyone who has in excess of 5 years of service.
An actuarial valuation indicates that this will result in additional liabilities for past service for members with over 5 years of CU100,000 and CU20,000 for members who have yet to reach the five year mark.
In this instance the full CU120,000 would have be recognised in the profit and loss as vested and non-vested rights must be included.
Cost of a defined benefit plan
Extract from FRS102: Section 28.23
28.23 An entity shall recognise the cost of a defined benefit plan, except to the extent that another section of this FRS requires part or all of the cost to be recognised as part of the cost of an asset, as follows:
(a) the change in the net defined benefit liability arising from employee service rendered during the reporting period in profit or loss;
(b) net interest on the net defined benefit liability during the reporting period in profit or loss;
(c) the cost of plan introductions, benefit changes, curtailments and settlements in profit or loss (see paragraphs 28.21 and 28.21A); and
(d) remeasurement of the net defined benefit liability in other comprehensive income.
Some defined benefit plans require employees or third parties to contribute to the cost of the plan. Contributions by employees reduce the cost of the benefits to the entity.
OmniPro comment
All of the above are recognised in the profit and loss. Any costs in relation to a defined benefit plan would be included in administrative expenses. The net interest cost can be included in interest cost or included in a separate line item in the profit and loss called ‘Pension finance costs/income’). Example 10 shows the journals which go to the profit and loss and those that go to other comprehensive income.
With regard to point c above, the entity must be committed to the change before it is recognised in the profit and loss. Point (b) to (d) have been discussed further below.
In relation to point (a) the current service cost represents the change in the net defined liability arising from employee service rendered during the period. It is in effect the estimated additional cost that the employer is expected to pay as a result of the employees’ current years of service and discounts the costs back to its present value. Example 13 provides an illustration of how this figure is determined.
All contributions paid by the entity are debited to the pension scheme liability/asset on the balance sheet. In example 10 above, this was CU1,250.
Net interest cost –defined benefit plan
Extract from FRS102: Section 28.24-28.24B
28.24 The net interest on the net defined benefit liability shall be determined by multiplying the net defined benefit liability by the discount rate in paragraph 28.17, both as determined at the start of the annual reporting period, taking account of any changes in the net defined benefit liability during the period as a result of contribution and benefit payments.
28.24A The net interest on the net defined benefit liability can be viewed as comprising interest cost on the defined benefit obligation and interest income on plan assets excluding the effect of any surplus that is not recoverable in accordance with paragraph 28.22.
28.24B Interest income on plan assets, excluding the effect of any surplus that is not recoverable in accordance with paragraph 28.22, is a component of the return on plan assets, and is determined by multiplying the fair value of the plan assets by the discount rate specified in paragraph 28.17 both as determined at the start of the annual reporting period, taking account of any changes in the plan assets held during the period as a result of contribution and benefit payments. The difference between the interest income on plan assets and the return on plan assets is included in the remeasurement of the net defined benefit liability.
OmniPro comment
In example 10 above, the actual return on plan assets incorporating the above guidance is as follows:
Actual return on plan assets= (closing FV-opening FV)-(contributions by employer and employee)-benefits paid)). This applied to example 10 above is:
Actual return on plan assets= (CU22,736-CU18,030)-((CU1,250+CU334)-CU313)= CU3,435
The difference of CU2,342 (disclosed as ‘actuarial gain ‘loss expected’) between the actual return on plan assets above of CU3,435 and the interest income on plan assets as per example 10 above of CU1,093 represents the portion to be posted to other comprehensive income. The interest income of CU1,093 is effectively obtained by taking the opening fair value of scheme assets multiplied by the prior year discount rate adjusted for contributions received in the year less benefits paid or similar items.
The interest costs represent the unwinding of the discount on the plan liabilities as benefits are one period closer to settlement. In effect the net interest expense is the fair value of the scheme liabilities in the prior year of CU8,694 in example 10 above less contributions paid into the scheme during the year less benefits paid and transfers out of the scheme which reduces the liability plus transfers into the scheme multiplied by the prior year discount rate of 3.49%. Note this net interest is calculated proportionately as transfers in and out during the year effect the amount on which interest is charged. See below the numbers to support the aforementioned:
CU8,694 – CU1250 – CU313 – CU122 – CU334 = CU6,675 * 3.49%= CU232. The compares to the net interest in the example 10 above of CU232 (CU1,325-CU1,093).
Remeasurement of the net defined benefit liability
Extract from FRS102: Section 28.25-28.27
28.25 Remeasurement of the net defined benefit liability comprises:
(a) actuarial gains and losses;
(b) the return on plan assets, excluding amounts included in net interest on the net defined benefit liability; and
(c) any change in the amount of a defined benefit plan surplus that is not recoverable (see paragraph 28.22), excluding amounts included in net interest on the net defined benefit liability
28.25A Remeasurement of the net defined benefit liability recognised in other comprehensive income shall not be reclassified to profit or loss in a subsequent period.
28.26 Employee service gives rise to an obligation under a defined benefit plan even if the benefits are conditional on future employment (in other words, they are not yet vested). Employee service before the vesting date gives rise to a constructive obligation because, at each successive reporting date, the amount of future service that an employee will have to render before becoming entitled to the benefit is reduced. In measuring its defined benefit obligation, an entity considers the probability that some employees may not satisfy vesting requirements. Similarly, although some post-employment benefits (such as post-employment medical benefits) become payable only if a specified event occurs when an employee is no longer employed (such as an illness), an obligation is created when the employee renders service that will provide entitlement to the benefit if the specified event occurs. The probability that the specified event will occur affects the measurement of the obligation, but does not determine whether the obligation exists.
28.27 If defined benefits are reduced for amounts that will be paid to employees under government-sponsored plans, an entity shall measure its defined benefit obligations on a basis that reflects the benefits payable under the government plans, but only if:
(a) those plans were enacted before the reporting date; or
(b) past history, or other reliable evidence, indicates that those state benefits will change in some predictable manner, for example, in line with future changes in general price levels or general salary levels.
OmniPro comment
Actuarial gains and losses are recognised in other comprehensive income and can arise for a number of reasons including:
- where actual events during the year differ from the actuarial assumptions in the previous valuation e.g. unexpected rates of employee turnover, mortality, changes in salaries not in line with expectation.
- Effects of changes in the discount rate which ultimately alters the liability
- The difference between the actual and expected return on plan assets. In example 10 above this is the difference between the CU3,425 above and the net interest income set against the interest expense shown in the profit and loss of CU1,093.
Examples of the actuary assumptions are:
|
Active Retirement Age |
X years |
|
Rate of wage inflation |
X% |
|
Rate of benefit increase – in payment |
X% |
|
Discount Rate |
X% |
|
Expected rate of return on Plan Assets |
X% |
The application of 28.25A has been discussed in the curtailment section above
Reimbursements
Extract from FRS102: Section 28.28
28.28 If an entity is virtually certain that another party will reimburse some or all of the expenditure required to settle a defined benefit obligation, the entity shall recognise its right to reimbursement as a separate asset. An entity shall treat that asset in the same way as plan assets.
OmniPro comment
See example below illustrating the above point.
Example 17: Reimbursements
Company A has an insurance policy which will cover any liability on a defined benefit scheme. In this example, the amount which is recognised as a separate asset is subject to any maximum stated on the policy.
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