In addition to salaries, many
companies offer other benefits to their employees such as pension’s plans,
health insurance, stock option benefits, fitness memberships, or life insurance
plans. There are very specific requirements around pension accounting,
which will be outlined in this article.
For regular benefits, the accounting
is relatively simple – the employer records an expense for the amount
of the benefits employees earn in a year.
However, the accounting treatment
becomes more complicated when employees earn the rights to the benefits NOW but
receive those benefits later in the FUTURE. A clear example of such a benefit
is the pension.
How a pension works:
A pension trust is a legal entity
that holds the pension investments and disburses the funds later, when
necessary.
Trusts are managed by trustees, who
are independent of the company.
Relationship 1: Employees provide services to the employer and in return, they
receive wages.
Relationship 2: Employers make contributions to the pension trust.
Relationship 3: Funds are used from the pension trust to pay the employee in the
future and sometimes, employees can also make contributions to the trust.
Two types of pensions:
There are two kinds of pensions
available today. One is the defined contribution plan and the other is the
defined benefits plan. Below is a tabular comparison between the two:
Defined Contribution Plan
|
Defined Benefits Plan
|
This plan specifies how much money the employer
needs to contribute to the pension plan.
|
This plan specifies how much employees will
receive in payments during their retirement.
|
Investment risk is on the employees.
|
Investment risk is on the employer. Outflows from
the pension trust to employees are pre-specified.
|
Journal Entry:
DR Pension Expense
CR Pension Liability
Funds Transfer:
DR Pension Bank
CR Operational bank
When gratuity is paid to an employee:
DR Pension Liability
CR Employee Liability Account
|
Journal Entry: More complicated. Explained below.
|
Defined benefits plan
Under the defined benefits plan, the
employee is guaranteed a certain amount of benefits/payments in the future.
Because pension payments are usually made much later in the future, there is a
clear time difference between when employees receive the future payments and
when employees actually earn those benefits. Because of this difference,
companies must use the accrual basis of accounting instead of when cash changes
hand.
The pensions accounting treatment for
defined benefit plans require:
- To determine the fair value of the assets and
liabilities of the pension plan at the end of the year
- To determine the amount of pension expense for
the year to be reported on the income statement
- The net asset or liability position of the
pension plan on a fair value basis
Pension expense is an expected value
and when the actual value of the pension differs, those deviations are recorded
through other comprehensive income (OCI) under IFRS. For Canadian private
companies that adhere to ASPE, there is no such OCI account.
Pension accounting example:
XYZ Company has a defined benefit
pension plan. At the end of 2015, the fair value of the assets and liabilities
in the pension amounted to $6 million. In 2016, the pension expense was $10
million and the company contributed $5 million to the pension plan. At the end
of 2016, the fair value of the pension assets and liabilities was at $10
million. Let’s see how the pension accounting works.
To record company contribution to
pension
DR Defined Benefit Pension Liability
5,000,000
CR Cash
5,000,000
To record pension expense
DR pension
expense
10,000,000
CR Defined Benefit Pension
Liability 10,000,000
To adjust pension liability to fair
value
DR Other comprehensive income
(OCI) 1,000,000
CR Net defined benefit liability
1,000,000
