Currently,
two approaches are available for private enterprises: the immediate recognition
approach and the deferral and amortization approach.
Instructions
Describe
the advantages and disadvantages of the immediate recognition approach and the
deferral and amortization approach. Explain any differences in the impact on
the earnings and statement of financial position.
The
immediate recognition approach recognizes all changes to the funded status of
the plan immediately into income, and the funded status is reported on the
statement of financial position. The
accrued benefit obligation is determined using the funded valuation approach
prepared by the actuary. Accordingly,
there are no unamortized amounts with respect to past service costs or actuarial
gains and losses that will be recognized in future periods. The advantages are that the accounting is
simplified, since unamortized balances no longer need to be tracked and
estimates of deferral periods need not be determined. Finally, the net liability
(or asset) reported reflects the actual funded status of the plan in most
cases. (Where the plan is in a surplus
position, the amount of the asset reported will be limited to the amount of
expected future funding benefit the company will receive.) The disadvantage of this method is that the
pension expense will be variable year over year due to expensing past services
costs and actuarial gains and losses when they immediately arise. Over time, actuarial gains and losses would
likely reverse and have an overall immaterial impact. In addition, these actuarial gains and losses
are out of management control, and therefore might give a false impression of
the management’s ability to manage the firm’s results and risk.
The
defer-and-amortize approach calculates the accrued benefit obligation using the
projected benefit approach which is strictly a method developed for accounting
purposes. The defer-and-amortize
approach allows for past service costs and actuarial gains and losses to be
deferred and amortized over some reasonable length of time (as defined within
the accounting standards) which results in delaying their recognition. The
rationale for delaying the recognition is that management expects future
benefits to arise from the provision of these past service adjustments to the
plans. Consequently, these past service costs should be recognized over the
future periods in which the benefits are expected to be realized. Actuarial gains and losses arise due to unexpected
changes in the market value of plan assets and changes in actuarial assumptions
impacting the amount of the benefit obligation.
Both of these changes are beyond the control of management and are
likely to reverse over time. By
deferring the recognition of past service costs and actuarial gains and losses
over defined periods ( or in some cases, not recognizing at all), net earnings is less volatile with respect to
these changes which is seen as an advantage by preparers for financial
statements. One alternative allowed
under IFRS is to report all actuarial gains and losses immediately to OCI and
not impact the income statement at all.
The disadvantage
of the defer-and-amortize approach is that the amount reported on the statement
of financial position for the accrued benefit liability or asset, is not equal
to the funded status of the plan. In
some cases, this account may even be reported as an asset, when in reality the
plan is actually in a deficit and is under-funded. To compensate for this, the notes must
describe and reconcile the funded status to the reported amount and indicate
balances of unamortized amounts for past service costs and actuarial gains and
losses. As noted in the above paragraph,
IFRS allows for actuarial gains and losses to be immediately reported to OCI,
resulting in no impact to the earnings, but ensuring that the accrued benefit
liability or asset more closely represents the funded status of the plan.
