Instructor’s Note: Pensions are discussed in great detail at Level II.
One common post-employment benefit offered by companies to their employees is pension. Pensions and other post-employment benefits give rise to non-current liabilities reported by many companies. When companies promise its employees certain benefits after a certain period of time, they are obligated to fulfill that promise.
The accounting treatment of pensions depends on the type of pension plan. There are primarily two types of pension plans:
Disclosures for Defined Benefit Plans
Since the future obligation of defined benefit pension fund cannot be determined with certainty, accounting is more complicated than the defined contribution plan. Listed below are a few rules for you to remember for a defined benefit plan:
Under both IFRS and US GAAP, the net pension asset or liability is reported on the balance sheet. An underfunded defined benefit pension plan is reported as a non-current liability on the balance sheet.
For each period, the change in net pension asset or liability is recognized either in profit or loss or in other comprehensive income.
Under IFRS, the change in net pension asset or liability has three components:
The actual return on plan assets includes interest, dividends and other income derived from the plan assets, including realized and unrealized gains or losses.
Under US GAAP, the change in net pension asset or liability has five components:
The first three are recognized in profit and loss during the period incurred. Past service costs and actuarial gains and losses are recognized in other comprehensive income in the period they occur and later amortized into pension expense. Under US GAAP, companies are also allowed to immediately recognize actuarial gains and losses in profit and loss.
On 31 Dec. 2012, a company has a pension obligation of 100 and pension assets are 90. What will the company report on the balance sheet under IFRS and US GAAP?
Funded status = pension assets – pension obligation = 90 – 100.
The company will report a net pension liability of 10.
Solvency ratios are used to measure a company’s ability to meet its long-term obligations, including both principal and interest payments. There are two categories of solvency ratios: leverage ratios and coverage ratios.
Leverage ratios focus on the balance sheet and measure the extent to which a company uses debt to finance its assets.
The commonly used leverage ratios are as follows:
|Debt-to-assets||Total debt||Total assets|
|Debt-to-capital||Total debt||Total debt + shareholders’ equity|
|Debt-to-equity||Total debt||Total shareholders’ equity|
|Financial leverage||Average total assets||Average total equity|
These ratios provide information on how much debt a company has taken. A low leverage ratio implies the company has low leverage and is well positioned to fulfill its debt obligations. The ratios for a particular company should be interpreted in the context of the industry in which it operates.
Coverage ratios focus on the income statement and cash flow to measure a company’s ability to service debt (make interest and other debt-related payments).
|Interest coverage||EBIT||Interest payments|
|Fixed charge coverage||EBIT + lease payments||Interest payments + lease payments|
Unlike leverage ratios, higher values for coverage ratios are better, all else equal.