INTRODUCTION
IAS 19 outlines the accounting treatment of various benefits provided to employees by the employer. All benefits provided to employees, whether long-term or short-term in nature, must be accounted for to ensure that the financial statements of the entity reflect a liability where employees have worked in exchange for future benefits.
There are four categories of employee benefits identified by the standard:
- Short-term employee benefits
- These are payments due to be settles within 12 months after the end of the period in which the employees render the related service. They include wages, salaries, holiday pay, sick leave, profit sharing and bonuses (payable within 12 months of the period end) and non monetary benefits such as medical care, company cars and accommodation.
- Post-employment benefits
- These include retirement benefits, pensions and post-retirement medical insurance
- Other long-term benefits
- These are long-term incentive plans, long-service awards and bonuses payable more than 12 months after the reporting period.
- Termination benefits
- For example, lump sum redundancy payments.
IAS 19 seeks to identify the correct expense to be charged in the period by an employer in respect of services provided by employees and to recognise a liability for any of these amounts that remain unpaid.
SHORT-TERM EMPLOYEES BENEFITS
Where an employee has provided service to an entity during the period, the entity must recognise the amount of short-term employee benefits due in exchange as follows:
- As an expense
- As a liability, to the extent that some or all of the amount remains outstanding at the end of the period.
Wages, salaries and related social insurance contributions:
The accounting treatment of these items is relatively straight-forward, i.e. recognise the expense as it incurred together with any outstanding liability at period end.
POST EMPLOYMENT BENEFIT PLANS
The most common type of retirement plan or post-employment benefit is a pension. There are two types of pension plans identified in IAS 19:
- Defined contribution plans
- Defined benefit plans
A pension plan consists of a pool of assets that has been built up, together with a liability for pensions owed to the employees. Pension plan assets are made up of investments, cash, properties and other assets that will generate a return. This return is used to pay the employee pensions.
The accounting treatment of each plan differs greatly from the other, so it is crucial to identify which type of pension plan exists in the question.
Defined Contribution Plans:
An entity’s obligation to its employees is limited to the amount that it contributes to the pension fund, which is usually a fixed percentage of the employee’s salary. The size of the employee’s pension upon retirement is entirely dependent on:
- The level of contributions paid into the fund (by employers and employees); and
- The performance of the pension fund.
Therefore, all the risk falls on the employee or a third party. This risk is made up of:
- Actuarial risk (the risk that the benefits eventually paid out will be less than expected); and
- Investment risk (the risk that the assets invested will be insufficient to meet expected benefits)
As a result of this, the annual cost of the pension plan to the employer is quite predictable and the accounting treatment of such plans is straightforward.
Defined Benefit Plans:
The entity has an obligation to provide an agreed pension to its current and former employees. These obligations include both formal plans and those informal arrangements that create a constructive obligation to the employees. Typically, under a defined benefit plan, a retired employee will receive a pension that is based both on either the average or final salary of the employee during their career and their length of service.
For example, an employee’s pension might be based on the following formula: ½ x average salary x (years of service/40).
It is the job of an actuary to calculate the level of contributions that must be paid into the plan each year in order to meet the employer’s commitment under the terms of the pension agreement. The actuary will use various estimates and assumptions including: • Life expectancy
- Wage inflation
- Investment returns
Since the employer undertakes to finance a pension income of a certain amount, it has an obligation to ensure that sufficient contributions to the plan are being made to fund the eventual pensions that will be payable to the employees. If there is a shortfall in the assets of the plan, the employer must make good this deficit. As a result, the cost of providing pensions is not always predictable and varies from year to year.
Clearly, both the actuarial risk and the investment risk falls on the employer. As a result, the accounting treatment of a defined benefit pension plan is more complex that a defined contribution plan. The actual contributions paid by the employer in the period do not normally represent the true cost to the employer of providing pensions in that period. The financial statements must reflect that true cost.
ACCOUNTING FOR PENSION PLANS
Defined Contribution Plan:
As mentioned earlier, accounting for defined contribution plans is relatively straightforward. The entity’s obligation is limited to the amount that is due to be contributed. The expense of providing the pension is normally the same as the amount of contributions paid (or due to be paid). As a result, where an employee has rendered a service to the entity during the period, the entity should recognise the following:
- In the Income Statement, the agreed pension contribution (as an employment expense)
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- Statement of net assets available for benefits, disclosing;
- assets at the end of the period;
- basis of valuation of assets;
- details of any single investment, exceeding either 5% of the net assets available for benefits, or 5% of any class or type of security;
- details of any investment in the employer; and
- liabilities other than the actuarial present value of promised retirement benefits.Description of the funding policy Description of the plan An asset or liability for pensions only arises to the extent that there is an amount prepaid or accrued at the year end.
Defined Benefit Plan
The accounting treatment of these plans is more complex. Because of the obligation that exists to the employees, the entity must recognise the liability for future pension payments. However, it also recognises the assets of the fund that have been accumulated.
If the liability exceeds the assets, there is a pension deficit. This deficit is then reported in the Statement of Financial Position.
If the fund’s assets exceed the liability, there is a surplus and this is reported in the statement of financial position.
At the risk of being over-simplistic, the pension expense in the period is the difference between the net deficit/surplus at the beginning of the period and the net deficit or surplus at the end of the period.
The pension plans liabilities are measured on an actuarial basis at each reporting period. The actuary uses a method called the Projected Unit Credit Method. The liabilities are discounted to their Present Value. Discounting is essential because the liability will be discharged potentially many years into the future. For example, a newly recruited young employee who joins the company and qualifies for a defined benefit pension might not actually reach pensionable age for another 40 years. Thus, the effect of the time value of money is material. IAS 19 states that the discount rate used should be determined by market yields on high quality corporate bonds at the reporting period.
The plan’s assets are measured at their fair value, which is normally their market value. If no market value is available, then the fair value is estimated, for example by determining the present value of the expected future cash flows from the assets. The standard does not detail the maximum time interval between valuations, other than to say that they should be carried out with sufficient regularity to ensure that the amounts recognised in the financial statements do not differ materially from actual fair values at the reporting date.
If there are unpaid contributions at the year end, these are not included in the plan’s assets. Rather, these are treated as an ordinary liability, due from the entity to the plan.
* Note that there are a number of different methods of dealing with actuarial gains and losses. It is vital that you determine which method is being used in the question.
IAS 19 recognises that in any given year, the extent of actuarial gains or losses can be very large. In recent years, turmoil in the capital markets has given rise to huge falls in asset prices worldwide. This has resulted in huge pension deficits in defined benefit plans for many entities, as a gulf emerged between the fair value of the plans assets and the obligations that the assets were supposed to fund.
IAS 19 attempts to limit the impact of actuarial losses on an entity’s profit or loss for the period. The standard takes the view that in the long term, actuarial gains and losses may offset one another and consequently, the enterprise is not obliged to recognise its actuarial gains and losses immediately. It gives a number of alternative approaches to the treatment of actuarial gains and losses:
- Recognise them immediately in the profit or loss calculation for the period. Given however the potential swing from year to year, many entities avoid this option.
- The entity may recognise them as “Other Comprehensive Income” in the Statement of Comprehensive Income. This option is only available where the gains or losses are recognised in the period in which they occur.
- “The Corridor Rule”, where the gains and losses are excluded from the Statement of Comprehensive Income, provided the gains are losses are within certain limits (i.e. the corridor). Gains or losses outside the corridor must be charged to profit or loss, but again the impact can be alleviated. We will see the corridor rule in action later.
THE 10% CORRIDOR RULE
As mentioned previously, there is an alternative method of dealing with actuarial gains and losses. Under the Corridor approach, actuarial gains and losses may be excluded from the Statement of Comprehensive Income. However, a portion of the actuarial gains or losses should be charged to profit or loss if, at the end of the previous reporting period, cumulative unrecognised actuarial gains and losses exceed the greater of: (i)10% of the present value of the defined benefit obligation; and
(ii) 10% of the fair value of any plan assets at that date
Gains and losses that exceed the 10% corridor must be charged to profit or loss, but they may be spread over the average remaining working lives of employees in the plan. Furthermore, any unrecognised actuarial gains or losses will impact on the final liability (or asset) to be shown in the Statement of Financial Position.
SETTLEMENT AND CURTAILMENTS
A settlement occurs when an entity enters into a transaction to eliminate the obligation for part or all of the benefits under a plan. For example, an employee leaves the entity for a new job elsewhere and is paid a cheque by the pension fund to transfer out of that plan.
A curtailment occurs when an entity:
- Is demonstrably committed to making a material reduction in the number of employees covered by a plan
- Amends the terms of a plan such that a material element of future service by current employees will qualify for no or reduced benefits
For example, an entity closes a factory and makes those employees redundant.
The gain or loss arising on a curtailment or settlement should be recognised when the curtailment or settlement occurs.
The gain or loss comprises the difference between:
- The fair value of the plan assets paid out; and
- The reduction in the present value of the defined benefit obligation (together with the relevant proportion of any unrecognised actuarial gains and losses and past service costs in respect of the transaction)
Before determining the effect of a curtailment, the entity must re-measure the obligation and plan assets using current actuarial assumptions. Curtailments and settlements do not affect profit or loss if they have already been factored into the actuarial assumptions.
PAST SERVICE COSTS
Past service costs arise either where a new retirement plan is introduced, or where the benefits under an existing plan are improved. Where a new plan is introduced, employees are often given benefit rights for their years of service before the introduction of the plan.
If employees have the rights to receive benefits under the plan immediately, the benefits are said to be “vested” and the cost must be recognised immediately. If employees become entitled to benefits only at a later date, the benefits become vested at that later date and the costs may be spread on a straight-line basis over the average period until the vesting date.
Because recognised past service costs increase the plan liability, any that are unrecognised past service costs are deducted in arriving at the plan liability in the Statement of Financial Position.
OTHER LONG-TERM EMPLOYEE BENEFITS
Examples of other long-term employee benefits include;
- long-term compensated absences such as long-service leave
- long term disability benefits
- profit-sharing and bonuses payable twelve months or more after the end of the period in which employees render the related service
The accounting treatment of these benefits is similar to that outlined in respect of defined benefit pension plans. An important difference however is that actuarial gains and losses are recognised immediately. Thus, the corridor option allowed for defined benefit pension plans is not permitted in the case of other long-term employee benefits. In addition, all past service cost is recognised immediately.
Statement of financial position
The net total of the following two amounts should be recognised as a liability:
- PV of the defined benefit obligation at the end of the reporting period
- Less the fair value of plan assets
Statement of comprehensive income
The net total of the following amounts should be recognised as an expense, except when another standard permits or requires their inclusion in the cost of an asset;
- current service cost
- interest cost
- expected return on any plan assets
- actuarial gains and losses, which shall be recognised immediately
- past service cost, which shall be recognised immediately
- TERMINATION BENEFITS
An entity may be committed by legislation, by business practice or by a desire to act equitably to make payments to employees when it terminates their employment.
Since termination benefits do not provide an entity with future economic benefits, they are therefore recognised as an expense immediately. Termination benefits should be recognised as a liability and an expense, however, only when the entity is demonstrably committed to either:
- terminating the employment of an employee or group of employees before the normal retirement date; or
- Providing termination benefits as a result of an offer made in order to encourage voluntary redundancy.
An entity is demonstrably committed to a termination when, and only when, it has a detailed formal plan that has no realistic possibility of withdrawal. If termination benefits are payable after more than 12 months, they should be discounted to present value using the market yield on high quality corporate bonds as the discount rate.
DISCLOSURE
Given the complexity of the subject matter, IAS 19 has extensive disclosure requirements.
The following must be disclosed in respect of defined benefit plans:
- The accounting policy for recognising actuarial gains and losses
- A general description of the type of plan
- A reconciliation of the assets and liabilities recognised in the Statement of Financial Position, showing at least
- The present value at the reporting date of defined benefit obligations that are wholly unfunded
- The present value (before deducting the fair value of the plan assets) at the reporting date of defined benefit obligations that are wholly or partly funded
- The fair value of any plan assets at the reporting date
- The net actuarial gains or losses not recognised in the Statement of Financial Position
- The past service cost not yet recognised in the Statement of Financial Position
- The amounts recognised in the Statement of Financial Position
- A reconciliation showing the movements during the period in the net liability (or asset) recognised in the Statement of Financial Position
- The total expense recognised in profit or loss for each of the following (and the line item in which they are included)
- Current service cost
- Interest cost
- Expected return on plan assets
- Actuarial gains and losses
- Past service cost
- The effect of any curtailment or settlement
- The actual return on plan assets
- The principal actuarial assumptions used at the reporting date
- IAS 26 – ACCOUNTING AND REPORTING BY RETIREMENT BENEFIT PLANS
A retirement benefit plan is an arrangement whereby an entity provides benefits for employees (e.g. annual income or a lump sum) on or after termination of service.
IAS 26 deals with accounting and reporting by the plan to all participants as a group.
Retirement benefit plans may be defined contribution plans or defined benefit plans:
- In a defined contribution plan, amounts to be paid as retirement benefits are determined by the contributions to the fund, together with investment earnings thereon;
- In a defined benefit plan, amounts to be paid as retirement benefits are determined by reference to a formula which is usually based on employees’ earnings and/or years of service.
The financial statements should contain a statement of net assets available for benefits and a description of the funding policy.
The objective of reporting by a defined contribution plan is to provide information about the plan and the performance of its investments. That objective is usually achieved by providing financial statements that include the following:
- a description of significant activities for the period, and the effect of any changes relating to the plan;
- a report on the transactions and investment performance for the period and the financial position of the plan at the end of the period; and
- a description of the investment policies.
The financial statements of a defined benefit plan should contain either:
- a statement that shows:
- the net assets available for benefits;
- the actuarial present value of promised retirement benefits;
- the resulting excess or deficit; OR
- a statement of net assets available for benefits, including either:
- a note disclosing the actuarial present value of promised retirement benefits; or
- a reference to this information in an accompanying actuarial report.
If an actuarial valuation has not been prepared at the date of the financial statements, the most recent valuation should be used and the date of the valuation disclosed.
The financial statements should explain the relationship between the actuarial present value of promised retirement benefits and the net assets available for benefits, together with the policy for the funding of promised benefits.
The objective of the reporting by a defined benefit plan is to provide information about the financial resources and activities of the plan that is useful in assessing the relationship between the accumulation of resources and plan benefits over time. This objective is usually achieved by providing financial statements that include the following:
- a description of significant activities for the period and the effect of any changes relating to the plan;
- statements reporting on the transactions and investment performance for the period and the financial position of the plan at the end of the period;
- actuarial information either as part of the statements or by way of a separate report; and
- a description of the investment policies.
Actuarial present value of promised retirement benefits
The present value of the expected payments by a defined benefit plan may be calculated using current salary levels or projected salary levels up to the time of retirement of participants.
Valuation of plan assets
Retirement benefit plan investments should be carried at fair value.
Disclosure
The financial statements of all retirement benefit plans should disclose:
- a statement of changes in net assets;
- a summary of significant accounting policies; and
- a description of the plan and the effect of any changes in the plan during the period.
Financial statements provided by retirement benefit plans should include the following if applicable:
- Statement of changes in net assets available for benefits, showing the following: employer contributions;
- employee contributions;
- investment income;
- benefits paid;
- administrative expenses;
- other expenses;
- taxes on income;
- profits and losses on disposal of investments;
- changes in value of investments;
- transfers from and to other plans.
- Statement of net assets available for benefits, disclosing;
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- Additional disclosures for defined benefit plans:
- actuarial present value of promised retirement benefits;
- description of significant actuarial assumptions;
- method used to calculate the actuarial present value of promised retirement benefits.
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