Canadian subsidiaries of U.S. companies who prepare their local financial statements under Canadian generally accepted accounting principles (GAAP).

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1 Client Advisory AcSB Exposure Draft, Employee Future Benefits March 8, 2012 Summary In late January 2012, the Accounting Standards Board (AcSB) issued an Exposure Draft (ED), Employee Future Benefits, which proposes to replace Section 3461 of Part II (Accounting Standards for Private Enterprises or ASPE ) of the Canadian Institute of Chartered Accountants (CICA) Handbook with new Section The proposal would require immediate recognition of net employee benefit obligations, with no options for amortization, early measurement dates or smoothed asset values. This Advisory provides an overview of the proposals to assist plan sponsors in understanding the potential impact on their accounting and funding strategy. If adopted, the proposed new Section 3462 will apply in 2014 to Canadian entities that did not transition to International Financial Reporting Standards (IFRS) or to public sector accounting standards, including: Privately held Canadian companies; NFPO organizations that are not controlled by government; and Canadian subsidiaries of U.S. companies who prepare their local financial statements under Canadian generally accepted accounting principles (GAAP). Similar to recent changes in IFRS and U.S. GAAP, the key proposed change is to end the delayed recognition of costs by recognizing the plans funded status directly on the balance sheet, with noncash changes in the funded status recognized immediately in profit or loss. As explained in our April 2010 Client Advisory 1, Section 3461 for private enterprises permits firsttime adopters to choose either: 1 After the April 2010 Advisory was issued, the AcSB made amendments to ASPE to allow an entity to carry forward any unrecognized actuarial gains and losses and past service costs that were determined previously in accordance with Section 3461 of Part V.

2 Immediate recognition of gains and losses, with obligations for registered pension plans determined using a valuation prepared for funding purposes (a special-purpose accounting valuation is to be used for supplementary pension plans and post-employment benefit plans as there is no statutory funding valuation required for these plans); or Deferral and amortization of gains and losses and the effect of plan changes over future periods, with obligations for all plans determined using a special-purpose accounting valuation, consistent with the prior requirements of CICA 3461 as found in pre-changeover Canadian GAAP (Part V of the Handbook). Entities electing this method are permitted to use a measurement date up to three months prior to their fiscal year end, and may smooth asset values over a period of up to five years for purposes of determining benefit cost. Section 3462 would retain the option to use a special-purpose accounting valuation in place of a funding valuation, but would eliminate the permissive features unique to this approach. Immediate recognition of gains and losses is intended to provide a meaningful liability or asset and improve consistency with balance sheet reporting under U.S. GAAP and IFRS. However, there are some significant differences and considerations: ASPE does not incorporate a concept of Other Comprehensive Income (defined in the prechangeover Standards as revenue, expenses, gains and losses that are recognized in Comprehensive Income, but excluded from net income). Consequently, there will be more volatility in net income under ASPE than under U.S. GAAP or IFRS. Entities that have significant unrecognized losses at the transition date would be required to recognize those amounts immediately through retained earnings, resulting in an increased balance sheet liability and lower retained earnings. This may be problematic for entities with existing contractual arrangements or debt covenants based on debt/equity or other financial ratios. The inability to amortize the cost of benefit improvements could be an obstacle for plan sponsors interested in improving benefits, such as an ad hoc cost-of-living adjustment. Immediate recognition of employee benefit plan gains and losses and plan changes would affect executive compensation and/or employee profit sharing based on net income, suggesting a need to revisit the formula for those arrangements. Plan sponsors could reduce the short-term volatility of changes in the pension plans funded status through changes to their investment strategy. For example, they could select pension fund investments that are priced according to the same market interest rates used to measure pension obligations. However, those more conservative investments (typically bonds) cannot be expected to produce the same long-term returns as equity investments, and may make defined benefit pension plans less affordable than alternative approaches to providing employees with retirement income. Plan sponsors can also address the balance sheet and income statement volatility from all types of employee benefit plans through a variety of strategies including plan design, cost-sharing approaches, purchase of paid-up insurance, and settlement options. AcSB Exposure Draft, Employee Future Benefits I 2

3 CICA 3462 would permit separation of the more volatile items of benefit cost on the face of the income statement, which could partially address concerns with increased volatility. The finance cost component is consistent with the view that unfunded benefit obligations are debt, with the resulting net interest cost reflective of the cost of servicing that debt. For most entities, the elimination of the expected rate of return on plan assets (EROA), which reflects the pension plan s asset allocation and investment strategy, would result in a higher pension finance cost than the current sum of the interest cost and EROA. In total, profit and loss would reflect the plan s actual asset return. Presentation of benefit cost Current (with special-purpose accounting valuations) Benefit Cost: a) Current service cost b) Interest cost c) Expected return on plan assets d) Amortization of net actuarial gains and losses, past service costs e) Change in any valuation allowance f) Gains or losses on settlements or curtailments determined in a prescribed manner Proposed Benefit Cost: a) Current service cost b) Finance cost Based on discount rate and net defined benefit liability (asset) at the start of period c) Remeasurements and other items: Difference between the actual return on plan assets and the return calculated using the discount rate Actuarial gains and losses Change in any valuation allowance -Past service costs, and Settlements and curtailments. If the effect of remeasurements is not disclosed on the face of the income statement, it must be separately disclosed in the financial statement notes. Use of funding valuation As noted above, the option to use a funding valuation in lieu of a special-purpose accounting valuation would be retained. In fact, this option, which is currently restricted to plans for which the going concern valuation is required by legislation or regulation, would apply to any pension plan that has a funding valuation. Thus, an entity that has elected to use a funding valuation for its registered pension plan but not its funded supplementary pension plan could decide to use the funding valuation for both or neither of these plans. A special-purpose accounting valuation would still be required for post-employment benefit plans. AcSB Exposure Draft, Employee Future Benefits I 3

4 Special-purpose accounting measures of the defined benefit obligation are based on the rate of return on high-rated corporate bonds as at the measurement date. On the other hand, the discount rate used in a funding valuation is typically a long-term expected rate of return on pension fund investments reflecting market conditions at the effective date of that valuation, which may be up to three years prior to the measurement date. Therefore, the use of funding valuations could lead to lower and less volatile estimates of pension obligations. However, if a liability-driven investment strategy had been adopted, use of a funding valuation could produce extra volatility in the funded status due to changes in market conditions between the funding valuation date and the measurement date. CICA 3462 would require the use of the fair value of plan assets as of the measurement date, even though obligations would be extrapolated based on market conditions at the date of the most recent funding valuation. Transitional provisions The AcSB has proposed Section 3462 would be effective for fiscal years beginning on or after January 1, As part of the transitional provisions, retrospective application would be required in accordance with Accounting Changes, Section Restatement of the prior year should be straightforward, since the effect of the change is simply recognition (through retained earnings) of the existing unrecognized amount as of the date of transition. Restatements would not be required for entities (e.g. manufacturers) who capitalized their defined benefit plan costs as part of the cost of inventory. Early measurement dates up to three months prior to the fiscal year-end date are permitted for special-purpose accounting valuations under CICA 3461, but would not be permitted under CICA This change would provide less time for the measurement process but would improve comparability amongst entities. The proposal provides a simplified transition method. Entities would calculate the defined benefit cost for the period from the previous measurement date to the end of the transition year and allocate this cost proportionately between current period benefit cost and retained earnings. This was the most popular option when a similar change was made to U.S. GAAP in The Accounting Standards Board s deadline for comments on the Exposure Draft of CICA 3462 is May 25, For more information This Advisory is not intended to constitute or serve as a substitute for legal, accounting, actuarial or other professional advice. For information on how this issue may affect your organization, please contact your Towers Watson consultant, or: Doug Chandler, doug.chandler@ Catherine Lai, Catherine K.Lai@ AcSB Exposure Draft, Employee Future Benefits I 4

5 About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. For more information on this Client Advisory, visit. AcSB Exposure Draft, Employee Future Benefits I 5