Pablo Ltd. (PL) reproduces fine works of art as posters. The company was started 10 years ago with used equipment. Demand for the posters increased recently when PL began to glue the posters onto a wood backing and laminate them. The old equipment has become very expensive to maintain and keeps breaking down, disrupting production. Pietro Pablo, the owner, has decided to go to the bank for a loan to buy new equipment. In preliminary talks with the bank, the manager indicated that financial statements are needed from PL for the year ended December 31, 2011.
While the statements have now been drafted, Pietro is not happy with the net income figure, which is lower than he had expected. Pietro calls you, his accounting manager, and asks if the net income has been correctly calculated. He points to the large payroll expense, which has increased over the last year. You note that the main cause of the increase is that pension expense increased for the following two reasons:
1. The employee pension plan was renegotiated at the beginning of the year and a key change was to increase the amount of pension benefits for each employee for each hour worked. The plan is a defined benefit plan and the amendment provided for retroactive application, so that most of the employees, who were older, would benefit from the plan. The increase in the pension obligation arising from this amendment is being amortized to net income over 14 years, beginning with 2011.
2. The actuary has recently prepared a new actuarial valuation of the pension obligation. In doing so, she suggested that the interest rate used for discounting be changed to reflect recent reductions in interest rates. Short-term interest rates have declined but many economists predict that the mid- to long-term rates will remain more stable at the higher rate. The reduction in the interest rate for discounting has resulted in an increase in the pension obligation. The increase is also being amortized to net income over 14 years, beginning in 2011.
Pietro asks you to determine whether there is any flexibility in applying PE GAAP. The company is a private company.
Instructions
Discuss the financial reporting issues.
Overview
- It would appear that the financial statements are being prepared for the bank for purposes of obtaining a loan or financing. The bank will want conservatively prepared statements with full disclosures so that they can make their decision.
- Pietro, on the other hand, is biased in that he wants the financial statements to look as good as possible to induce the bank to give him the financing.
- GAAP would appear to be a constraint since the bank will want reliable information. Pietro is interested in whether there is flexibility in applying ASPE. Note that the company could also follow IFRS.
- Care should be taken since it appears as though Pietro is trying to bias the numbers. Accounting should be neutral. In your role – ensure that the accounting used results in the most transparent financial statements.
Analysis and Recommendations
The main issues are how to account for the amendment to the plan and whether the increase in the obligation due to the change in assumptions is valid and has been accounted for properly.
Issue: Amendment to the plan:
| ASPE | IFRS |
| - ASPE allows the entity to use the immediate recognition method or the deferral and amortization method. - Under the deferral and amortization method, there are additional choices. - May choose to recognize all of the change in current income or defer. - If deferred – amortize over the period deemed to benefit from the amendment (generally expected eligibility period although may be shorter). - Note that full recognition will worsen net income this year but net income will be higher next year. - If deferred, should recalculate the 14 year period to eligibility to ensure appropriate. - Under the immediate recognition method - the company may choose to fully recognize any changes in the surplus/deficit of the plan (immediate recognition method). Must use a funding valuation measure (actuary may be more conservative in the assumptions). | - Generally - defer and amortization approach although the option exists to recognize most changes directly in income or comprehensive income. - If the past service costs are vested, then must recognize immediately in net income. Otherwise amortize over the average period until vesting occurs. - In all likelihood, the benefits are vested and so the company would have to recognize the costs in net income in the current year. |
Recommendation: There are many choices as to how to present the information. The company also has the choice to follow IFRS as well. Note that no matter what the accounting is, the economic reality is the same (i.e. same pension plan). Care should be taken to ensure that the bank understands this and that the cash flows will be the same no matter which accounting policies are followed.
Issue: Changes in the assumptions - the change in the assumption regarding the discount rate has caused the pension obligation to increase.
| ASPE | IFRS |
| - May use either a current yield on high-quality debt instruments or a current settlement rate. The cash flows should match that of the benefit obligation. - The choice of interest rate in this case appears to reflect short-term interest rates. This is not necessarily appropriate since the pension plan obligation is of a long-term nature. Market interest rates should be used that reflect/match timing and amounts of benefit payments. This means that the long-term nature of the plan should be considered. - Under the deferral and amortization method, the entity must recognize a minimum amount of amortization if the opening unrecognized balance exceeds the greater of 10% of the ABO and FV of assets. The minimum amount equals the excess noted above divided by the expected average remaining working lives of employees. - Under the deferral and amortization method, the company may also choose to fully recognize any changes in net income immediately. - Under the immediate recognition method - the company may choose to fully recognize any changes in the surplus/deficit of the plan. Must use a funding valuation measure (actuary may be more conservative in the assumptions). | - Under IFRS must use the current yield on high-quality debt instruments. The currency and term of the instruments should be the same as the benefit obligation. - The current choice of interest rate in this case appears to reflect short-term interest rates. This is not necessarily appropriate since the pension plan obligation is of a long-term nature. Market interest rates should be used that reflect/match timing and amounts of benefit payments. This means that the long-term nature of the plan should be considered. - Any changes may be recognized immediately income or other comprehensive income. Alternatively, the entity must recognize a minimum amount of amortization if the opening unrecognized balance exceeds the greater of 10% of the DBO and FV of assets. The minimum amount equals the excess noted above divided by the expected average remaining working lives of employees. |
Recommendation: There are many choices as to how to present the information. The company also has the choice to follow IFRS as well. Note that no matter what the accounting is, the economic reality is the same (i.e. same pension plan). Care should be taken to ensure that the bank understands this and that the cash flows will be the same no matter which accounting policies are followed.
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