Week 11 Flashcards
What are the functions of financial systems?
1) Transfering resources across time and space (pension funds, insurance companies, mutual funds)
2) managing risk (insurance companies, hedging instruments)
3) clearing and settling instruments
4) pooling resources and investing
5) providing information
6) dealing with incentive problems (dealing with issues such as moral hazard and adverse selection) Ex: credit rating firms helping the lenders or real estate firms information asymmetry by screening buyers and sellers
What are 2 types of financial markets?
Money market: mostly short-term debt instruments issued by governments and large corporations (highy liquid)
Capital market: equieties and debt instruments usually with a life greater than a year
What are commonly traded assets?
- debts (fixed-income securities/bonds/loans)
- equities: no promise or return, only residual claim on assets (limited liability)
- derivatives (options, forwards, futuresI: for mitigating risk or sometimes even for tasking risk
What are pension funds? Who run pension funds)
- pension funds are investment pools that pay for employee retirement commitments (paid by employees/employers/both)
- mostly run by insurance companies and small section of asset managers
Where are pension funds invested?
- in comparatuveky low risks assets such as money, market instruments, government, and largecap equity
- their asset allocation tends to be lower in higher risk assets such as private equity, hedge funds and real estate.
What is IAS 19-employee benefits?
- it provides guidance on accounting for all forms of employee benefits, except for share based payments (dealt with by IFRS2)
- it demands cost of providing the employees benefits to be matched with the period during which the employees work to earn the benefits
What are the four categories of employee benefits?
1) short term benefits (wages and salaries, annual leave, sick pay)
2) post-employment benefits (pensions, post-employment medical and post-employment insurance)
3) other long-term benefits (profit shares, bonuses payable later than 12 months after the year end)
4) termination benefits (early retirement payments, redundancy payments)
What happens is assets are valued higher? are insufficient?
- higher: employer may be allowed to take a contribution holiday
- insufficient. employer will be required to make additional contribution holiday for someone
What are the risks of defined contrbution? Defined benefit?
defined contribution: obligation for the employer is to pay the defined/agreed amount. After the employer has no further reliability and no exposure to risks if the performanceof the invested assets held in the plan is poor
defined benefit: obligation for the employer is to pay the defined/agreed amount of benefit. The employer is therefore exposed to an uncertain liability which may change multiple times due to a large number of uncomfortable variables. in case the plan assets are insufficient to meet the plan liabilities for future pension pay outs, the employer is obliged to make up the deficit.
Two categories of post-employment benefits
a)defr and current employees in most cases also, pay regular contirbutions into the plan of a given or defined amount each year. Contributions are invested. The size of the post-employment benefits paid to former employees depends on how plan’s investment perform. If the investments perform well, the plan will be able to fund higher benefits that if the investments performed less well.
b) defined benefit plans (final salary scheme) - employer and current employees in most cases also, pay regular contributions into the plan - size is determined in advance - contributions are invested at an amount that is expected to earn enough investment return to meet the obligation to pay the post-employment benefits
How are future pension obligations valued?
-discounting on a present value basis
How can future benefits be estimated?
-under the accruals concept (matching principle) the employer must recognise liability at present. this requires annual actuarial assumptions
What does the contributions depend on?
-acturial assumptions (change in AA will change contriutions)
-excess of liabilities over assets => deficit => surplus
The surplus or deficit on the pension fund is shown on the entire balance sheet.
In the accounting of defined contribution plans what is a liability and what is an asset?
An expense is recognised for the contributions when due, and
any unpaid expense shown as a liability, any overpayment
an asset.
Where is the net surplus and deficit shown?
Under a defined benefit scheme the (net) surplus or deficit on
the pension fund is shown on the entity’s balance sheet. If
there is an excess of liabilities over assets a deficit is
recognised, vice versa a surplus.
What is a carrying value?
The carrying value of the surplus or deficit is the fair value of
the scheme’s assets, less the present value of the
scheme’s liabilities, plus or minus the actuarial
gains/losses and past service costs not yet recognised.
We will NOT look at each of these components separately.
How is the carrying value calculated?
Fair value of the scheme’s Assets
- Present value of the scheme’s liabilities
+/- Actuarial gains/losses
-Previous service costs not yet recognised
So what would an employer choose if
they had the choice?
-An employer would most likely choose a defined
contribution plan. It is for the simple reason that
there is no further liability for the employer in
addition to the agreed amount of the periodic
employer’s contributions. Any market related risks are entirely borne by the
employee and the employer does not need to top
up any assumed shortfalls. Hence no risk is
shared by the employer.
-The DB scheme:
Entire risk for the ultimate liability remains far
more uncertain and with the employer.
The liability may fluctuate in future, owing to a large
number of variables. As the employer remains
exposed to risks related to the performance of the
pension plan assets, therefore it is most likely going
to be a thing of the past for most businesses.
