This article was first published in the January 2009 edition of Accounting and Business magazine.

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IAS 19 uses 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.

The standard identifies several categories of employee benefit including:

  • short-term employee benefits, such as sick pay
  • post-employment benefits such as pensions
  • termination benefits, and
  • other long-term employee benefits including long service leave.

Classification of benefit plans

Defined contribution plans occur when a company pays a fixed contribution into a separate fund and has no legal or constructive obligation to pay further contributions. Actuarial and investment risks of defined contribution plans are assumed either by the employee or the third party. Plans not defined as contribution plans are classed as defined benefit plans.

If an employer is unable to show that all actuarial and investment risk has been transferred to another party and its obligations are limited to contributions made during the period, a plan is defined benefit.

Under a defined benefits plan, the benefits payable to employees are not based solely on the amount of the contributions, but are determined by the terms of the defined benefit plan. The benefits are typically based on such factors as age, length of service and compensation. The employer retains the actuarial and investment risks of the plan.

For example, under the terms of a particular pension plan, a company contributes 6% of an employee’s salary. The employee is guaranteed a return of the contributions plus interest of 4% a year. The plan would be classified as a defined benefit plan as the employer has guaranteed a fixed rate of return and as a result carries the investment risk.

Defined-contribution and defined-benefit plans

The accounting for a defined-contribution scheme is relatively straightforward, as the employer’s obligation for each period is determined by the amount that has to be contributed to the scheme for that period. There are no actuarial assumptions required to measure the obligation or expense and there are no actuarial expenses or losses.

Employers must use the projected unit credit method to determine the present value of a defined benefit obligation, the current service cost and any past service cost. This method looks at each period of service, which gives rise to additional units of benefit and measures each unit separately to build up the final obligation.

All of the post-employment benefit obligation is discounted. Actuarial assumptions are used, which are the best estimate of the variables that determine the ultimate cost of providing post-employment benefits. These will include demographic assumptions such as mortality, turnover and retirement age, and financial assumptions such as discount rates, salary and benefit levels.

The obligation will include both legal obligations and any constructive obligation arising from the employer's usual business practices such as an established pattern of past practice. IAS 19 does not require an annual actuarial valuation of the defined benefit obligation, but the employer is required to determine the present value of the defined benefit obligation and the fair value of the plan assets.

This must be done with sufficient regularity so that the amounts recognised do not differ materially from the amounts that would be determined at the balance sheet date. A volatile economic environment will require frequent valuations at least annually.

Plan assets are measured at fair value, which is normally market value. Fair value can be estimated by discounting expected future cash flows. The rate used to discount estimated cash flows should be determined by reference to market yields at the balance sheet date on high-quality corporate bonds. IAS 19 is not specific on what it considers to be a high-quality bond and therefore this can lead to variation in the discount rates used.

Balance sheet recognition

The amount recognised in the balance sheet could be either an asset or a liability. The amount recognised will be the following:

  • the present value of the defined benefit obligation, plus
  • any actuarial gains less losses not yet recognised, minus
  • any past service cost not yet recognised, and minus
  • the fair value of the plan assets.

If the result of the above is a positive amount then a liability has occurred and it is recorded in full in the balance sheet.

Any negative amount is an asset that is subject to a recoverability test. The asset recognised is the lesser of the negative amount calculated above, or the net total of unrecognised actuarial losses and past service costs, and the present value of any benefits available in the form of refunds or reductions in future employer contributions to the plan.

Plan assets and plan liabilities from the different plans are normally presented separately in the balance sheet.

Actuarial gains and losses

A company should recognise a portion of its actuarial gains and losses as income or expense if the net cumulative unrecognised actuarial gains and losses at the end of the previous reporting period, (ie at the beginning of the current financial year) exceeds the greater of 10% of the present value of the defined benefit obligation at the beginning of the year, and 10% of the fair value of the plan assets at the same date.

These limits should be calculated and applied separately for each defined plan. The excess determined by the above method is then divided by the expected average remaining lives of the employees in the plan. This method is called the corridor approach.

However, an entity can adopt any other method that results in faster recognition of actuarial gains and losses as long as it is applied consistently. Additionally, there is the option of recognising actuarial gains and losses in full in the period in which they occur, outside profit or loss, in a statement of recognised income and expense.

Delays in the recognition of gains and losses can give rise to misleading figures in the statement of financial position. Also, multiple options for recognising gains and losses can lead to poor comparability.

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Example A Plc

  01/01/08 31/12/08
Fair value plan assets 100 110
Present value defined-benefit obligation 90 96
Unrecognised actuarial gain 16 26
Average working life of employees 10 years 10 years

This entity has decided to use the corridor approach in recognising actuarial gains and losses.

It must recognise the portion of the net actuarial gain or loss in excess of 10% of the greater of defined benefit obligation or the fair value of the plan assets at the beginning of the year.

Unrecognised actuarial gain at the beginning of the year was USD16m. The limit of the corridor is 10% of USD100m (value of plan assets) ie USD10m, as this is greater than the present value of the obligation. The difference is USD6m, which divided by 10 years is USD0.6m.

Expense recognition - defined-benefit plans

The amount of the expense or income for a particular period is determined by a number of factors. The pension expense is the net of the following items:

  • current service cost
  • interest cost
  • the expected return of any plan assets
  • actuarial gains and losses to the extent recognised
  • past service cost to the extent that the standard requires the entity to recognise it, and
  • the effect of any curtailments or settlements.

The difference between the expected return and actual return on plan assets is an actuarial gain or loss. The expected return is based on market expectations at the beginning of the period for returns over the entire life of the related obligation. This return is a very subjective assumption and an increase in the return can create income at the expense of actuarial losses, which may not be recognised when entities use the corridor approach.


Accounting for post-employment benefits is an important financial reporting issue. It has been suggested that many users of financial statements do not fully understand the information that entities provide about post-employment benefits.

Both users and preparers of financial statements have criticised the accounting requirements for failing to provide high-quality, transparent information about post-employment benefits.

Graham Holt is principal lecturer in accounting and finance at the Manchester Metropolitan University Business School, and an ACCA examiner