Graham Holt examines the implications for financial statements of the IASB’s decision to amend IAS 19 in an attempt to improve accounting for post-employment benefits
This article was first published in the August 2011 edition of Accounting and Business magazine.
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The International Accounting Standards Board (IASB) has completed a project to improve the accounting for pensions and other post-employment benefits by issuing an amended version of IAS 19, Employee Benefits. The changes will have a significant effect on financial statements.
The Board has decided to eliminate the option to defer the recognition of gains and losses, known as the 'corridor approach', to streamline the presentation of changes in assets and liabilities arising from defined benefit plans, and to enhance the disclosure requirements for defined benefit plans.
The project forms part of the Memorandum of Understanding between the IASB and the Financial Accounting Standards Board, the US national standard-setter, and by the elimination of the corridor method, it further aligns IFRS and US GAAP.
Defined benefit pension commitments often represent an entity’s largest single financial liability. The amendments to IAS 19 are designed to make users of financial statements aware of the risks associated with those commitments; in particular, by requiring the surplus or deficit of a pension fund to be detailed in the financial statements. Under the revised IAS 19, an entity should recognise all changes, including actuarial gains and losses, unvested past service costs, settlements and curtailments in a net-defined benefit liability (asset) when they occur. The measurement of obligations should reflect the substance of arrangements where the employer's exposure is limited or where the employer can use contributions from employees to meet a deficit. This might reduce the defined benefit obligation, but determining the substance of such arrangements may require significant judgment to be used.
The standard renames actuarial gains and losses as 'remeasurements' and they will be recognised immediately in 'other comprehensive income'. Actuarial gains and losses can no longer be deferred using the corridor approach or recognised in profit or loss. As a result, this may cause volatility in the statement of financial position and other comprehensive income (OCI).
Actuarial gains and losses can vary significantly from period to period, as they include not only changes in estimates regarding employee turnover and life expectancy, but also investment gains and losses, and the impact of changes in discount rates. Now all changes in the value of defined benefit plans will be recognised as they occur. Remeasurements recognised in OCI cannot be recycled through profit or loss in subsequent periods.
In a similar way as actuarial gains and losses, past-service costs are recognised in the period of a plan amendment with unvested benefits no longer spread over the future-service period. A curtailment now occurs only when an entity reduces significantly the number of employees.
The annual expense for a defined benefit plan includes the net interest expense or income, calculated by applying the discount rate to the net defined benefit asset or liability. This value replaces the finance charge and expected return on plan assets, where income is credited with the expected long-term yield on the assets in the fund. This may increase the annual benefit expense. There is no connection now between the assets held by a pension scheme and the return on assets in earnings.
In summary, the revised IAS 19 disaggregates changes in the net defined benefit liability (asset) into service cost, finance cost and remeasurement components, showing service cost and finance cost components in the profit or loss, and the remeasurements component in other comprehensive income.
The revised standard gives less flexibility in the presentation of items in income statements. The benefit cost is split between current-service cost and benefit changes, which include past-service cost, settlements and curtailments and finance expense or income. This information can be disclosed in the income statement or in the notes.
Additional disclosures are required to present the characteristics of benefit plans, the amounts recognised in the financial statements, and the risks arising from defined benefit plans and multi-employer plans. The objectives and principles underlying disclosures are now required and the result may be more extensive disclosure and more subjectivity in determining that disclosure.
The distinction between short-term and other long-term employee benefits is now based on the expected timing of a settlement rather than employee entitlement. The classification is determined in accordance with IAS 1 and reflects whether an entity has the unconditional ability to defer payment for more than a year, regardless of when the obligation is expected to be settled. Changes in the carrying amount of liabilities for other long-term employment benefits will continue to be recognised in profit or loss.
Taxes related to benefit plans should be included either in the return on assets or the calculation of the benefit obligation, depending on their nature. If a benefit has a future-service obligation, then it is not a termination benefit. As a result, the number of arrangements that meet the definition of termination benefits will be reduced. A liability for a termination benefit is only recognised when the entity cannot withdraw the offer of the termination benefit or recognises any related restructuring costs.
Impact and consequences
The IASB's decisions are likely to impact on entities in different ways, depending upon the types of employee benefits that they provide and the manner in which they currently account for such benefits. For example, some entities with significant defined benefit plans will experience 'accounting mismatches' with respect to the accounting for expenses associated with a defined benefit liability, including service cost, any past-service cost and interest expense and returns on plan assets under the new requirements compared to the accounting for defined benefit obligations under the current IAS 19 approach.
Another change is that, in the event of some or all of the scheme’s liabilities being extinguished through a one-off cash payment, the full cost will need to be included in profit or loss expense, even if the transaction occurred outside the pension scheme.
This change is particularly relevant for enhanced transfer value incentive exercises, whereby a cash inducement is offered to members to encourage them to transfer out of the pension scheme. If cash is offered directly to a former employee as part of an enhanced transfer package, it would probably be recorded as a general expense, but now it would be combined with the pension assets transferred to show the true cost.
Under the current standard, expenses associated with running a pension scheme are usually netted off against the return on assets. This has the effect that the expected, rather than actual, expenses in each year are charged to the profit or loss. In future, companies will need to disclose these expenses separately, meaning that actual rather than estimated expenses will flow through to the profit or loss. This could increase attention to the cost of running defined benefit schemes in the future.
The new rules on recognition of gains and losses may mean that companies can change the way in which pension fund assets are invested. Pension companies invest in equities with the knowledge that gains and losses can be smoothed over the working lives of employees if the entity chooses to do so. The removal of the corridor approach may mean that companies will review whether taking risk in equity schemes will affect shareholder value, as moving out of equities into bonds tends to lead to stability in key performance indicators. The amended IAS 19 may lead to greater transparency in financial statements by increasing the disclosure of the costs and risks associated with schemes, and making it easier to compare the impact of pension costs on reported profits between entities.
Previously, entities could record a gain each year based on the expected return on pension scheme investments rather than the actual return. With pension schemes traditionally investing in riskier assets such as equities, this has often meant entities can use this to recognise 'soft' profits.
Observers indicate that the new accounting standard will increase pension costs, as the expected return has traditionally been higher than the net interest. The de-risking in pension plans could lead to lower returns and lower interest on the plan assets for members. This may mean increases in contributions to compensate for this.
Phase two of the IAS 19 revision is set to change the definition of defined benefit plans. The method currently used for defining pension plans is not ideal, but it could be better than a complicated calculation, which includes evaluating options. With commentators estimating that the amendments are likely to reduce the reported earnings of UK companies by around GBP10bn, further changes will come as an unwelcome blow to many entities.
Graham Holt is an examiner for ACCA and executive head of the accounting and finance division at Manchester Metropolitan University Business School