DIGESTING FINANCIAL STATEMENTS: PENSION PLANS
Deducing on the topic we previously discussed, this tutorial now puts the spotlight on the pension fund. It is a distinct long-term obligation for majority of companies, but it is not given much emphasis in the financial statement. But when included, accounting this item is intricate and the footnotes are lengthy.
There are various types of pension plans. But, for discussion purposes, we will only focus on the defined benefit plan. This retirement plan is sponsored by a company where benefits are determined using a formula which considers different factors including tenure and salary. The employer needs to carry the associated risk in order to recompense their employees.
In essence, a pension plan has two components: assets (used for compensating benefits) and obligations (coming from employee service). A pension plan’s structure is simple. An entity contributes to the pension fund. The contributions are then invested into several derivatives or securities. Returns from these instruments are paid to beneficiaries.
The plan assets refer to the investment fund, while the projected benefit obligation is an estimation of future obligations discounted to the current value. Subtract the obligation from the asset’s value and you will obtain the plan’s current status. Take note of this one since it is normally overlooked in the annotation.
But outlining the plan in the balance sheet is complicated for three reasons. First, actuaries estimate salary increments, number of retirees, and other factors. Second, employing accrual accounting discounts actual cash flows. Third, smoothing yearly fluctuations makes it more difficult for everyone to gauge the fund’s economic standing at a particular time period.
You also need to remember this before wrapping up this session: pension cost is not the total amount of contribution. Rather, it is the expenditure a firm incurs annually for offering pension plan for its workers. Therefore, this element is of little importance.
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