Unit 3: Employee Benefits

Introduction

Employee benefits, are provided to employees and may be counted as additional compensation
enjoyed by employees on top of salaries and wages. These employee benefit packages may include
overtime, medical insurance, vacation, profit sharing and retirement benefits, to name just a few.

In this unit, we will focus on one class of employee benefits, that is, post-employment benefits. Post-
employment benefits are more commonly known as retirement benefits or pensions. The accounting
standard that prescribes the accounting for post-employment benefits is IAS 19 Employee Benefits
(amended 2011).

IAS 19 outlines:
• The accounting requirements for employee benefits.
• The standard establishes the principle that the cost of providing employee benefits should be
recognised in the period in which the benefit is earned by the employee, rather than when it is
paid or payable
• How each category of employee benefits are measured, providing detailed guidance in particular
about post-employment benefits.
• Examples of employee benefits:
o short-term benefits (e.g. wages and salaries, annual leave)
o post-employment benefits such as retirement benefits
o other long-term benefits (e.g. long service leave) and termination benefits

Unit Learning Outcomes

After successfully completing this unit, you will be able to:
1. explain post-employment benefits by creating a concept map;
2. prepare journal entries for the recognition of employee benefit expense, accrued
& prepaid benefit costs;
3. prepare working papers computations for defined benefit obligation and plan
assets; and
4. present appropriately, in the financial statements, prepaid/accrued benefit cost
and employee benefit expense.

Timing

Unit 3 is expected to be completed on the second week of the block. Right after you finish Unit 2, you
should still have 3 to 4 days remaining for the week that you can allocate to finishing Unit 3.
UNIT 3 learning plan ideally will be taken up as follows:
• Allocate one to two days to read and digest the content discussions while answering the test
yourself problems you encountered as you progress through the unit.
• The following 2 days for the first week shall be allocated to answering unit 1 activities in
preparation for answering the unit post-test.
• Finally, on the last day of the study week you should devote the 3 hours towards completion
of the exercises in Unit 1 and a few questions in your post-test.

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3.1 Post Employment Benefits

3.1.1. Types of post-employment benefits

Post-employment benefits are arrangements where an entity provides monetary & other forms of
benefits to employees after their retirement, e.g. pensions or lump sum payments, life insurance and
medical care.
A post-employment benefit plan is a retirement plan that requires an employer to make contributions
to a pool of funds set aside for a worker's future benefit. The pool of funds is invested on the
employee's behalf, and the earnings on the investments generate income to the worker upon
retirement.
Note that aside from pension plans from social security systems, the entity may setup a separate
private fund to further improve employee satisfaction or encourage loyalty.

Types of post-employment benefits

DEFINED CONTRIBUTION PLAN DEFINED BENEFIT PLAN

Employer pays fixed contributions to the fund Employer provides agreed benefits to
trustee. employee-retirees.

No legal or constructive obligation to make Places actuarial and investment risk on the
additional payments. entity.

Obligation is therefore effectively limited to Obligation is to deliver the agreed benefits and
the amount agreed to contribute. ensure sufficiency of the funds.

EMPLOYER PROMISES: EMPLOYER PROMISES:

“ I will pay P2,500 per month to SSS to “ I will make sure you receive P10,000 per
finance your retirement pension as long as month as pension after your retirement”
you work for me”

• Employee benefits mostly deals in EXPENSE and LIABILITY recognition.

• Post-employment benefits (pensions) are similar in nature to salaries and allowances. The
only important difference therein is salaries are paid during employment and pensions are
paid after employment.
• Salaries and pension however are similar in the way they are recorded as EXPENSE, wherein
both are expense as incurred and payable when employees render service to the company.
(i.e. day to day office work).

3.1.2. Defined Contribution Plan

In this setup of post-employment benefits, the employer will be obliged to pay a fixed contribution;
while the employees receive undefined benefit. Accounting-wise, the only worry of the accountant
here is determining how much the fixed contribution is. Once that is set, no complex problems will be
encountered since the expense/liability recognition is set as equal to that of the fixed contribution.

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How to compute cost?
• Contribution is expensed when it is payable. (Expense)
• Unpaid contribution is accrued. (Liability)
• Contribution paid in advance or before the services of the employees are rendered. (Asset)

Illustration: Defined Benefit Plan

Friday Company provides benefits to employees through defined contribution plan. The plan
provides that Friday shall contribute annually 9% of gross payroll to a funding agency. In addition,
the entity is also required to contribute 6% annual sales exceeding P15,000,000. During 2019, gross
payroll of the company was P6,500,000 and total sales amounted to P32,000,000.

On December 31, 2019, Friday contributed P1,000,000 to the employees’ pension fund.
Employee benefit
expense:
Gross payroll P 6,500,000
Rate X 9% 585,000

Sales 32,000,000
Floor threshold (15,000,000)
Excess sales 17,000,000
Rate X 6% 1,020,000
1,605,000

To record accrual of employee benefit expense for 2019:

Employee benefit expense 1,605,000
Accrued benefit payable 1,605,000

To record the payment of contribution on December 31, 2019:

Accrued benefit payable 1,000,000
Cash 1,000,000

Independent assumption:
Suppose instead of P1,000,000, Friday made contribution payments of P2,000,000. The only
difference from the above illustration will be:
To record the payment of contribution on December 31, 2019
Accrued benefit payable 1,605,000
Prepaid benefit expense 395,000
Cash 2,000,000

Overfunding or underfunding the pension plan will result to recording either a liability or an
asset as follows:
• LIABILITY. If during the reporting period there is a balance in accrued benefit payable, it
means that the entity is behind in pension contributions (Underfunding).
• ASSET. On the other hand, if prepaid benefit expense is present, it means that an advance
contribution has been made for services yet to be rendered by the employees (Overfunding).

3.1.3. Defined Benefit Plan

Defined benefit plan is more intricate in comparison to defined contribution plans in a sense that the
amount of funding contributions and related expense and liability to be recorded is not immediately
determined in the terms of the post-employment benefit plan.

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3.2 Prepaid benefit expense & Accrued benefit payable

3.2.1. Plan assets and Benefit obligation

To review the idea of post-employment benefits, conceptually the entity contributes to a fund for
future pensions, the fund is invested and held in trust by a trustee (i.e. financial institutions,
investment companies or bank), then later on when employees retire, they receive pension payments
from the earnings of the fund.
The fund and the expected future pensions however may not be equal at all times due to difficulty in
estimating actuarial assumptions. In that event this will result to overfunding (Asset) or
underfunding (Liability)

BENEFIT PREPAID BENEFIT EXPENSE or

PLAN ASSETS
OBLIGATION (ACCRUED BENEFIT PAYABLE)

Important Terminologies:
Plan assets. The fund held by a trustee contributed by the employer to cover benefit
payments to pensioners.
Benefit obligation. Is the amount the employer must pay to the fund to satisfy the estimated
pension entitlements of employees.
Prepaid benefit A result of overfunding a pension plan; is presented as an ASSET in the
expense. financial statements.
Accrued benefit A result of underfunding a pension plan; is presented as a LIABILITY in the
payable. financial statements.
Actuarial Estimates and projections on fund investment & future pension payments
assumptions. that involve various considerations such as the economy, the strength of
the Philippine peso, the mortality of pension recipients their life expectancy
including their health conditions (in most cases they receive pensions in
perpetuity and payments only cease until their eventual death). Fund and
pension projection estimates rest in the able skills of an actuary and an
accountant is not normally expected to be responsible for estimating them.

Components of plan assets and benefit obligation (T-Accounts)

Plan Assets Benefit Obligation

Beginning Balance
Contributions Benefits Paid Benefits paid Current service cost
Settlement price PV of BO settled Past service cost
Remeasurement Remeasurement Remeasurement Remeasurement
Gains Losses Gains Losses
Interest Income Interest expense
Ending balance Ending balance

Plan assets and Benefit obligation are not accounted as asset & liability in the financial statements.
They are setup in a working paper only as a guide in computing the amount of prepaid or accrued
benefit cost.
Plan assets represent the fund or resources (R). Benefit obligation is the expected payments to
retirees, or FUTURE PENSIONS (FP). Future payments to retirees will be taken from resources so:
• when (R > FP) = excess ASSET. (overfunding)
• When (R < FP) = deficit LIABILITY. (underfunding)

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Actual return. Plan assets remeasurement gain or loss and interest income are actually components
of actual return. The actual return or return on plan assets is interest, dividend and other income
derived from the plan assets, together with realized and unrealized gains or losses on the plan assets.
Actual return on Remeasurement Interest income on
= +
plan assets Gain or Loss Plan Assets

A settlement is a transaction that eliminates all further legal or constructive obligations for part or
all of the benefits provided under a defined benefit plan, other than a payment of benefit to, or on
behalf of, employees that is set out in the terms of the plan and included in the actuarial assumptions.
Settlement Present Value of Benefit Settlement loss or
– =
price Obligation settled (Settlement gain)

3.2.2. Defined benefit cost

Defined benefit cost represents the amount of obligation that the entity incurs in an accounting
period. It is split into two recognition components but divided into three (SNR) if classified by nature
of the cost:

Profit & Loss Components (Income statement) Other Comprehensive

income

S ERVICE COST N ET INTEREST REMEASUREMENT

Past Service Cost Int. expense from Plan Asset:
Current Service Cost Benefit Obligation (Remeasurement Gain)
(Settlement Gain) (Interest income from Remeasurement Loss
Settlement Loss Plan Assets)
Benefit Obligation:
Remeasurement Gain
(Remeasurement Loss)

Service cost.
• past service cost, which is the change in the present value of the defined benefit obligation
for employee service in prior periods resulting from a plan amendment (the introduction
or withdrawal of, or changes to, a defined benefit plan) or a curtailment (a significant
reduction by the entity in the number of employees covered by a plan)
• current service cost, which is the increase in the present value of the defined benefit
obligation resulting from employee service in the current period;; and
• any gain or loss on settlement or final payment to retirees.

Net interest
• Interest income on plan assets, or earnings of the plan asset as a result of its investing
activities.
• Interest expense on benefit obligation, the amortization of a future payable such as
pension will accrue interest expense computed at a predetermined discount rate.

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 Remeasurements of the net defined benefit liability (asset) comprise:
• Plan Asset: Remeasurement gain or loss.
or actuarial gains or loss represents fund investment remeasurements a component of
return on plan assets, excluding amounts included in net interest.
• Benefit Obligation: Remeasurement gain or loss.
or actuarial gains and losses are changes in the present value of the defined benefit
obligation resulting from.
o experience adjustments (the effects or differences between the previous actuarial
assumptions and what has actually occurred)
o the effects of changes in actuarial assumptions.

Another component of defined benefit cost (SNR) is effects of asset ceiling which is intentionally
excluded from the discussion material and will be discussed in future special lectures.

Illustration: Plan assets, defined benefit obligation and Employee benefit expense
The following data is available for Ford Company’s defined benefit plan for the year 2019:
Benefit obligation, January 1 P 9,000,000
Fair value of plan assets, January 1 10,000,000
Current service cost 1,700,000
Discount rate 12%
Benefits paid to retirees 2,200,000
Contribution to the plan 2,000,000
Actual return on plan assets 1,500,000
Net actuarial loss due to remeasurement of benefit 400,000
obligation
Past service cost 500,000

Requirements:
1. What is Ford’s plan assets on December 31, 2019?
2. How much is the defined benefit obligation at December 31, 2019?
3. What is the balance of accrued benefit expense (liability) /prepaid benefit cost (Asset)
at December 31, 2019?
4. What amount of employee benefit expense will be presented in the income statement?
5. What amount of remeasurement that will be presented in the income statement?
6. What amount of employee benefit cost of the defined benefit plan?
Requirement 1:
Plan Assets
Beginning balance 10,000,000
2019
Contributions 2,000,000 2,200,000 Benefits paid

Interest income* 1,200,000

Remeasurement gain** 300,000
Ending balance 2019 11,300,000

*Interest income = PA beginning (Discount rate)

= P10,000,000 x 12%
=P1,200,000
**Remeasurement gain =
Remeasurement + Interest income = Actul return on plant assets
Remeasurement + P1,200,000 = P1,500,000
Remeasurement = P1,500,000 – 1,200,000
Remeasurement = P300,000 gain

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Requirement 2:
Benefit Obligation
9,000,000 Beginning balance
2019
Benefits paid 2,200,000 1,700,000 Current service cost
500,000 Past service cost
1,080,000 Interest expense*
400,000 Remeasurement loss
10,480,000 Ending balance 2019

*Interest expense = BO beginning (Discount rate)

= P9,000,000 x 12%
=P1,080,000

Requirement 3:
Accrued / Prepaid Benefit = (Plan Asset 12/31/19) – (Benefit Obligation 12/31/19)
= P 11,300,000 – P 10,480,000
= P 820,000 Prepaid benefit cost (ASSET)

Requirements 4 – 6:
Service Cost: Current service cost 1,700,000
Past service cost 500,000
Settlement losses 0
Settlement gains ( 0 )
Net interest Interest expense – Benefit obligation 1,080,000
Interest income – Plan assets (1,200,000 )
4. Employee Benefit Expense (PL) 2,080,000

Remeasurements Plan Asset – Remeasurement (Gain) Loss ( 300,000 )

Benefit obligation – Rem. (Gain) / Loss 400,000
5. Remeasurements /Actuarial gain or loss (OCI) 100,000
6. Employee Benefit Cost (PL+ OCI) 2,180,000

Supporting journal entries on December 31, 2019 on Ford Company’s defined benefit plan:
Employee benefit expense 2,080,000
Net remeasurement loss - OCI 100,000
Prepaid benefit cost 180,000
Cash 2,000,000

• Prepaid benefit cost is credited for 180,000 because the prepaid asset account declined from
an initial balance of P1,000,000 to an ending balance of P820,000.
• Prepaid benefit cost 1/1/19 balance:
Plan Asset 1/1/19 10,000,000
Benefit obligation 1/1/19 9,000,000
Prepaid benefit cost 1/1/19 1,000,000

Prepaid benefit cost (asset)

1/1/19 1,000,000
180,000 Decrease

12/31/19 820,000

• When the ending balance of the prepaid benefit cost is zeroed out or has excess credit
balance. The excess is carried in another account “Accrued benefit expense” (liability)

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Illustration: Lump-sum Benefit
Alice Co. is in a business industry experiencing high employee turnover due to high demand for the
skilled employees the industry needs. In order to keep employees loyal to the company, Alice Co.
devised a post-employment strategy. Alice pays a lump sum post-employment benefit to employees
when they retire. The lump sum is equivalent to 6% of their last year annual salary multiplied by
the number of years an employee has been in service to Alice Co.
The following actuarial assumptions pertains to Jawhead, one of her employees:
• Jawhead is expected to serve the company for 5 years total.
• The annual salary of Jawhead is expected to increase steadily at 8% annually.
• Jawhead’s Salary in 2020 is P100,000.
• The applicable discount rate is 10%.
Requirements:
1. What is the expected final salary of Jawhead?
2. What is the projected benefit obligation on December 31, 2021?
3. What amount of total employee benefit expense will be recognized in 2020?
4. What amount of total employee benefit expense will be recognized in 2021?

Requirement 1:
Salary in 2020 (first year) P 100,000
Future value of 1 at 8% for 4 years. 1.3605
Final salary (2024) P 136,050
Future value determination is computed by multiplying 1 by 1.08 four times (compounded).
1 x 1.08 x 1.08 x 1.08 x 1.08 = 1.3605
Jawhead is expected to be paid salaries for 5 years. The first year salary of P100,000 is counted
as one year in determining present value (which means 4 more years and the final salary will be
determined.) Since the base of (1 x 100,000) is already one year, the future value period used is
only 4 years (years remaining till final annual salary).

Requirement 2:
Final salary (2024) P 136,050
Lump sum rate x 6%
Expected benefit per year P 8,163
Expected number of years in service x 5 years
Total projected benefit obligation P 40,815

The total projected benefit obligation is the expected amount that Jawhead will receive from the
lump sum benefit and in every year Alice Co. will record current service cost and interest cost that
will eventually total to that amount as projected.
The annual expected benefit is expressed in present value, since the said benefits will be
incurred in a few future periods as follows (rounded to the nearest peso):
Annual PV factor to date PV of
benefit of settlement benefit
2020 8,163 0.683 5,575
2021 8,163 0.751 6,130
2022 8,163 0.826 6,743
2023 8,163 0.909 7,420
2024 8,163 1.000 8,163
40,815 34,031

Jawhead is expected to receive the lump sum (one time) payment on December 31, 2024. December
31, 2020, counts as 4 years till date of settlement, which is why the benefit cost in that year will be
expressed in present value using the PV of 1 at 10% for 4 years. 2021 uses 3 years, 2022 uses 2
years and so on.

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Projected benefit obligation:
Current Interest Projected benefit
Year
service cost expense obligation
1/1/2020 - -
12/31/2020 5,575 - 5,575
12/31/2021 6,130 558 12,263 Answer to Requirement 2
12/31/2022 6,743 1,226 20,234
12/31/2023 7,420 2,023 29,675
12/31/2024 8,163 2,977 40,815

Current service cost is equal to the present value of annual benefits.

Interest expense is equal to beginning balance of PBO multiplied by the discount rate (10%)
The last year’s interest expense is computed as (29,675 + 8,163) – 40,815. This is in order to
bring the balance og PBO to P40,815 the expected amount to be paid to Jawhead.
Due to rounding off, the resulting interest expense computed traditionally will be P2,968,
(difference of P9.00 is nominal)
Projected benefit obligation is equal to beginning balance plus service cost and interest.

Requirement 3 & 4:
Current Interest Total employee
Year
service cost expense benefit expense
2020 5,575 - P 5,575 Answer to Requirement 3
2021 6,130 558 6,688 Answer to Requirement 4
2022 6,743 1,226 7,969
2023 7,420 2,023 9,440
2024 8,163 2,977 11,140

Knowing the uncertainty of employment, it is easy to commit a mistake in actuarial assumptions,

thus it is common that these assumptions may be adjusted when necessary. Any adjustment will be
applied prospectively (current and future years) and will not affect prior years.