Currently, two approaches are available for private enterprises: the immediate recognition approach and the deferral and amortization approach

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.