This report provides information about effects on the balance sheet from defined benefit pension plans under the requirements of International Accounting Standard (IAS) 19. The report includes information about major provisions of pension plan, key issues to financial reporting, solutions under IAS19 and evaluation of solutions.
Defined benefit plans are distinguished from other types of pension provision, and which are fairly complicated pension plans. Under IAS 19, difficulties arise for companies in the recognition of the defined pension costs and the liabilities on the balance sheet, therefore the plan always results volatile effect on the balance sheet.
The requirements of IAS19 provide solutions on how to recognize the defined pension costs and liabilities in order to minimize volatility on the balance sheet.
- the projected unit credit method is adopted to determine and calculate the pension liabilities and some components of cost
- higher realized return from investment by using pension funds reduces the pension cost and verse vice
- past service benefits should be funded and recognized for accounting purposes
- gains or losses on curtailments or settlements of such pension benefit plan should be recognized in P&L account when they occur
- 'Corridor approach' has been introduced to allow firms only recognize changes above 10% of the present value of the obligation or 10% of the fair value of any plan assets at that date
Despite the volatility that the requirements cause on the balance sheet, they would enable an entity's financial report to represent a true and fair value of the firm and so that the report can be useful to users in making economic decisions.
There are proposals provided by International Accounting Standards Board (IASB) which are to recognize any changes immediately when they occur. By doing this, it will lead to the balance sheet being even more volatile, and it can also be very costly to change current standards.Introduction
The purpose of this report is to distinguish different types of pension provision, identify the key issues caused by adopting defined benefit plans under the requirements of International Accounting Standard (IAS) 19 and then discuss whether the accounting treatment of these plans under IAS19 help reduce the problems are caused by this pension plan.
Four major topics make up the report:
- Major provisions
- Key issues to financial reporting
- Solutions under IAS19
- Evaluation of solutions
According to Alexander, the pension benefits are regarded as the most essential long-term employee benefits, and the purpose of a pension "is to grant people some money when they are retired". (Ch21, P494) The amount of pension paid per year depends on the earnings of the employee during their working life. Pension schemes can take a variety of different forms, of which I have listed the three major types below:
- State pensions (adopted mainly in the south of Europe)
- Defined contribution plans & Defined benefit plans (adopted in countries like the UK, the US)
This is where employees receive a retirement benefit which is included in their employment contracts. The employees are also entitled to an individual state pension from their pension savings plans. This is because the organisation's obligation is to pay the contributions when they are due, the accounting problems such as recognition of costs and liabilities do not usually occur for firms or organisation. IAS19 therefore pays less attention to the state pension schemes due to its separation from employment contracts.
A defined contribution plan is one where, a fixed amount of money is contributed regularly by the employer to a pension account. This enables the employees to receive the benefits at retirement together with the interest from contribution invested under their names. However in such a situation the employees will have to undertake the risk on their own. The defined contribution plans can be administrated either by the company or by a bank and once the contribution has been paid, the company has no further payment or maintenance obligation. The use of this plan could lead to a much more straightforward view of the finance pattern of the firm and the employer's responsibility and it is therefore preferred by employers.
Defined benefit plans under IAS19 classifies that all plans other than defined contribution plans are defined benefit plans which provide benefits according to pay and years of service. They are benefits promised in advance with a certain amount of return that will be provided to employees when they retire. These plans are based on the plan's benefit formula that is also defined in advance. The three types of formula that are generally used to determine an employee's pension are as follows;
- The final pay plan: a percentage of your final earnings from employment. (E.g. 10% of your final salary)
- The final average pay plan: a percentage of your last 3 or 5 years average earning. (E.g. 10% of your average earnings over last 3 years)
- The career average pay plan: your annual pension benefit is a fixed percentage of your annual earnings. (E.g. 10 % of your average salary)
The above plans 2&3 (Defined contribution plans & Defined benefit plans) can be grouped into Company pension plans. A company pension plan is defined by an agreement between an employer and its employees. The two differ from each other as the defined benefit plan draws most of its structure and directive from IAS19, therefore having a significant impact on a company's financial structure. Moreover, when employers choose either one of Company Pension Plans (2 or 3), they can consider whether to set up the organisation and funding as a single-employer plan or multi-employer plans. As for the benefits plans, the terms of the contract with the third party (insurance company) must specify the type of risks and responsibilities that are to be transferred to it. This is because it is fundamental on deciding if a defined contribution or defined benefit type should be applied.Key Issues to Financial Reporting
Under IAS 19, a number of problems have arisen in the recognition of the defined pension costs and the liabilities on the balance sheet. With regard to the pension costs, they are mainly affected by the current service costs which are amounts to be funded each year relating to the benefit formula mentioned earlier. Other than the current service cost, there are some other factors having an impact on the cost such as interest cost, the expected return on any plan assets compared to actual return, actuarial gains and losses and past service etc. As for the benefit liabilities, they should include the amount to be recognised and reflect any future changes that affect the benefits payable under such scheme. Therefore the plans increase volatility on the balance sheet.
Under IAS19 actuarial difficulties and uncertainties arise with defined benefits schemes, such as, the balance sheet preparation process needs actuarial assumptions which shall be bases on market expectations (i.e. inflation, rate of salary raise and investment return) to measure the legal obligation and the expenses of the organisation. Whereas both decisions concerning assumptions and the valuation method have major effect on the contribution rate calculated at each valuation. The main problem is that there are always differences (actuarial gains or losses) between the expected and realised investment return underlying the complexity of the recognition and measurement process in accounting. These actuarial gains or losses could also be the changes in estimates of future employee's turnover, changes in discount rate and so on. (IAS19, Para 94)Solutions under IAS19
IAS 19 adopts the projected unit credit method to determine and calculate the pension liabilities and some components of cost. Projected unit credit technique takes into account the expected future salary increases, and it provides sufficient reliability to measure and justify an entity's obligation. By adopting this method, it reduces an entity's present value of pension obligation, as the amounts to be funded at the start of a person's career are lower than if one would finance the promised benefit under a projected valuation method. This takes into account from the start the whole expected employment period. With regard to the adoption of this method, Archibald (1980) also encouraged that the pension benefit should be based on the final pay levels. Napier (1983) had a similar conclusion which the amount of benefits depend on future salary amount.
However, if an employee's service in later years will lead to an increase in benefit, an entity should calculate the benefit on a straight line basis rather than depending on the plan formula until the date when employee's further service will lead to no further benefits. In addition, the interest accrual of pension liability (IAS19, Para 82, depending on the discount rate, which reflects the time value of money, but not investment risk) is also included in the total pension cost. Thus both the current service cost and interest cost should be reported as costs on the Profit & Loss Account.
Likewise some other factors also affect the total pension cost in the P&L account, such as when the amounts to be funded are involved in the existing investment. The realised return on plan asset can lead to a lower or higher total pension cost based on the investments performance i.e. higher realised return will reduce the pension cost and verse vice. (Note the actuarial assumptions 'discount factor' and 'expected market return' are different components according to International Accounting Standards Board (IASB) regulation) On the other hand, if another party is contributing such expenditures as included in the obligation, the amount should be recognised immediately and taken out from the total cost.
The final main factor of the total pension cost are the past service costs, where applicable, they are extra liabilities that arises when the council grants additional pension benefit which did not exist for employees before. Any increases that resulted from past service benefits should be funded and recognised for accounting purposes. Additionally if such costs are vested, under IAS19, they should be recognised immediately and added to the pension cost rather than being added to the pension liability. If they are not vested, they are attributed to an expense on a straight line basis over the average period until the benefits become vested. Last but not the least, a firm should also recognise gains or losses on curtailments or settlements of such pension benefit plan in P&L account when they occur. In accordance with IAS19, Para 109, they are any resulting changes in the present value of pension obligation and fair value of plan assent, as well as changes to be recognised in past cost service.
All those variables provided above will raise the volatility of the entity's balance sheet. Consequently, in order to reduce volatility of the pension cost, the IAS19 (Para.92) has opted for the 'Corridor approach' which allows a firm to only recognise the gains and losses above 10% of the present value of the obligation or 10% of the fair value (fair value is "assets held by a long term employee benefit fund and qualifying insurance policies at a market value" [Alexander, P512]) of any plan assets at that date. Although this approach should be applied separately for each different defined benefit plan, it helps avoid short-term fluctuations and in a long-term offset gains and losses against each other. The amounts outside the corridor are normally spread over the expected remaining working life of the employee. On the other hand, those immediately recognised amounts should go to income statement as a pension cost; conversely, unrecognised actuarial gains or losses will be grouped as defined benefit liability.
However pension regulations in the UK suggest that in order to improve the transparency relating to actuarial gains and losses, companies may recognise any gains or losses immediately and report them outside the P&L account on a ' statement of recognised income and expense'. In this case, these amounts should not be taken into account of pension liability either, and instead of including the total amount of pension liabilities and pension assets, only a net pension obligation is required to appear on the balance sheet. In addition the fair value of plan assets, on the balance sheet should be taken out from the net pension obligation.Evaluation of solutions
Although the requirements of IAS19 cause volatility on the balance sheet, they are only telling the truth of defined benefit plans. This issue will be discussed by looking at the discussion from ICAEW Information for better markets conference and the paper of Preliminary Views on Amendments to IAS 19 Employee Benefits published by the International Accounting Standard Board (IASB).Advantages
The type of pension plans determines how these benefits are to be accounted for in the financial statement, and accounting regulations applied will affect asset allocation and management behaviour. IAS19 corresponds to the context of IASB's framework for the preparation and presentation of financial statements, in order to represent faithfully the framework requires financial statements to provide high quality and transparent information of both past and future transactions and obligations.
Requirements of IAS19 for the defined benefits pension plans offer a number of advantages to the employees such as an employee can track the company's obligated contribution towards the plan and make sure it has enough funds to cover both the pensions of retired employees and current employees for the foreseeable future.
Moreover, International GAAP and UK GAAP are principles-based, in order to achieve a picture of true and fair value the standards can be very subjective and require more judgments from expertise. Thus it is very important to disclose a firm's cash flows, as only cash flows can be accurate and otherwise users of financial report would make their own judgments about future cash flows, sometimes users could make worse judgments. Therefore it is essential to apply IAS19 requirements as they highlight the real cost of defined benefit plans which investors are really interested in.Disadvantages
Most of the disadvantages of the requirements of IAS19 are associated with volatility on the balance sheet. Many companies have to close defined benefit pension plans because of this reason, thus defined contribution plans become more preferred. This indicates that firms will have a pension contract with a third party in order to transfer difficulties on recognition of assets and liabilities. By doing this, it leads to more risks for the third party company.
Additionally, the requirements of IAS19 do not meet all objectives of IASB's framework, for instance, as for 'Corridor approach' referred to previously, although it helps reduce the volatile of the pension cost, it does not provide accrual basis information immediately to a wide range of readers in making economic decisions. It is because this approach allows firms to only recognize any amount above 10% of the present value of the obligation or 10% of the fair value of any plan assets at that date, and this may cause cash flows, P&L account and balance sheet to be inaccurate.Alternatives
IASB's project on proposed revision to IAS 19 suggests that in order to improve the usefulness of information provided, a better disclosure for investors and companies themselves is needed, and companies may increase and improve the disclosures by using the corridor approach less. It is because for external users, delays in the recognition of gains and losses leads to a less transparent view and misleading figures for the company's financial performance and/or the current and future impact of the pension plans. Accordingly, IASB amendments require entities to recognize all changes in the value of plan assets and in the pension obligation when they occur.
As it can be seen that Board's been working on the proposals, and it has indicated an interest in eliminating the 'corridor' method. Landsman concludes in the conference that new regulatory requirements for accounting rules can be very costly and therefore result an immediate decrease in retained earnings, for instance, firms could face the prospect of more volatile income by follow immediate recognition for any changes. Therefore he suggests that before making any changes in accounting standards, standard-setters should always list the costs and benefits of proposed standards as sometimes costs can outweigh benefits. Additionally, Kiosse & Peasnell also agree that changes in pension accounting standards could lead to increased volatility in reported earnings and the incorporation of pension surplus and deficits on the balance sheet. Thus the traditional actuarial practice - corridor method allows firms to smooth out the impact of pension costs and returns in a long view.Conclusion
In conclusion, a company should understand the purpose of requirements of IAS19 is to reveal the costs and risks of defined benefit pensions to managers and sometimes to investors as well. "The framework is not an IAS and doesn't override any specific IAS, even though there is conflict between it and IAS, the requirements of latter prevail" (Alexander, P138), however the framework has still been very influential in the development of IASs. Zieke suggests that it is important to improve the communication between firms and their investors, hence an entity should show the real cost and also explain to its investors that paying pensions to employees is a necessary feature in retaining and motivating them as well as in keeping a competitive situation in a difficult environment. Since the requirements of IAS 19 do not disguise the true cost of defined benefit plans, the adoption of these requirements will enable financial reports to reflect the truth and the fact of a company performance.