International financial reporting and analysis

Executive summary

As an accountant working in a team which provides research and support on accounting issues to clients and employees, I have prepared this report to answer your query. To summarise, you have read an article which discussed the accounting treatment of defined benefit pension plans under IAS19. One writer argued that the requirements of IAS19 had caused some companies to close such pension plans because of their volatile effect on the balance sheet. Another writer argued that IAS 19 simply highlighted the real cost of defined benefit plans, causing management to question whether such schemes are sustainable. As such, you require me to explain the financial reporting issues in this debate. In my report, I will focus on defined benefit plans, distinguishing them from the other types of pension provision available. I will then discuss the main problems that arise in determining the amount to be expensed in a company's financial statements in any one year for the cost of a defined benefit plan, and any associated liabilities. Following this, I will critically assess the rationale behind IAS 19 Employment Benefits, and its current requirements in relation to defined benefit plans, in the context of the IASB's Framework for the preparation and presentation of Financial Statements as a theory of financial accounting. I will then discuss some of your concerns around the impact of IAS 19 of the balance sheet and financial statements, and how this has affected some real life organisations.

Introduction and background

The employee benefits are a way giving an earning to the people who are no longer in a working circumstance. Under International Accounting Standard 19(IAS 19), short-term employee benefits, post-employment benefits, other long-term employee benefits and termination benefits are the four parts of the employee benefits (IAS 19, 2008, pp.5). There are two main forms of long-term pension schemes: defined benefit schemes and defined contribution schemes. A defined contribution scheme is where an employee makes a regular defined contribution to a pension pot. This pension pot them grows over time, and when the employee retires they use it to fund their retirement, usually through purchase of an annuity (Alexander, Britton and Jorissen, 2009, pp. 495). The other type is a defined benefit scheme, which is where an employer promises their employee that the employee will receive a regular defined benefit when they retire. This means that, for a defined benefit scheme, the employer is responsible for making enough contributions to pot so that is large enough to fund the defined benefits their employees receive when they retire (Alexander, Britton and Jorissen, 2009, pp. 495). In contrast, for the defined contribution scheme, the employee receives a benefit based on their contributions to date, and there is no requirement on the employer that this benefit be of a certain amount. The primary consequence of this is that when an employer has hot made enough contributions to a defined benefit scheme for the scheme to meet the obligations that have been promised to all employees, the employer is required to make up these obligations as some point in the future. This thus creates a liability for the employer. IAS 19 was passed with the intention of defining this liability, and forcing employers to account for it. This report will examine some of the thinking that led to the development of this standard, what the standard requires of employers, and the impact this has on employers and defined benefit pension schemes.

Main body


The problem of how to account for the potential liabilities accruing to employers as a result of their defined benefit pension schemes is not a new one, and the accounting standard setters have been considering it for several decades. In particular, Camfferman and Zeff (2006, pp. 119) reported that the International Accounting Standards Committee, the fore runner of the International Accounting Standards Board, was debating the issue as early as 1977. Following this debate, the issue has arguably not been solved at any point over the following thirty years, although some progress has been made and there is now an accounting standard in place. The fundamental problem that standard setters face is how to understand and monetise the changing nature of the pension arrangements, and the liabilities that may arise as a result of them. Eventually, pensions and retirement benefits are complicated and financially difficult to pin down, making it difficult of fit them into a standard financial reporting framework. In particular, given that pension benefits were likely to accrue to the employees relatively far in the future, it was difficult for standard setters to decide how to translate this into a present day cost, taking into account factors such as the time value of money (Ryan and Fabozzi, 2002, pp. 7).

Ultimately, in 1981, the Financial Accounting Standards Board switched the focus away from fairly nebulous cost ideas, and began considering what liabilities employers would face in terms of the full life cost of realising their pension benefits. This then lead to the question of how this liability should be measured and recognise in the financial statements. This led to the conclusion that it would be best to attribute the cost of providing a defined benefit pension scheme over the employee's period of service, using a systematic and rational method to determine if a liability existed, and using actuarial funding methods to measure the size of said liability, and hence determine the costs to the company of servicing it over the employee's working life (FASB, 1981, pp. 52). This led to the creation of the original International Accounting Standard on pensions: "IAS 19 Accounting for Retirement Benefits in the Financial Statements of Enterprises" (IASC, 1983, pp. 1). This standard aimed at using the actuarial methods to measure the costs associated with providing define benefit pensions. The standard was revised in 1993 to require companies to use salary projections to measure the cost of providing their pensions, again recording these costs on their profit and loss account (IASC, 1993, pp. 1).

However, in 1998, the IASC revised the standard again, and this time required employers to recognise any gaps their defined benefit pension schemes as liabilities on the balance sheet (IASC, 1998, pp. 1). In particular, the standard required companies to recognise a liability equal to the pension benefits the employer owed in the future due to the services the employee had provided to date, and a cost then this economic benefit was actually consumed by the employee. This is the fundamental basis of the contemporary version of IAS 19, and its treatment of defined benefit pension plans.

Main treatments

This treatment is based on providing a subjectively accurate measurement of the defined benefit obligation facing the company at the date of producing the financial accounts, and any gaps in this defined benefit obligation which need to be filled. As a result, the projected unit credit method must be used in order to value the liability associated with the defined benefit obligation, with the present value of any payments being attributed across the period of service. Ultimately, this requires companies to use actuarial concepts to calculate the present value of the future pension payments which have been earned by the employee during their service period, based on expectations of future salary and pensions (Welsch and Zlatkovich, 1989, p.p. 974). Future salary is also important for the special case of the final salary scheme, where the company has to calculate the pension based on the employee's final salary before their retirement.

Another important consideration of the treatment under IAS 19 is that it makes the data useful for decision making purposes. This is because all obligations must be calculated based on the current market yield, which is used as the discount rate for future purposes. Unfortunately, this has the consequence of causing fairly significant fluctuations in the liability that a company faces due to changes in the bond market yield, which is used as the basis for calculating future benefit obligations. Similar variations can occur due to differences between the previous year's assumptions and the actual values, as well as changes in assumptions around the survival probability and actual survival of employees (Winklevoss, 1993, p.p. 96). For instance, companies generally make assumptions around the longevity of their workers, and these are based on averages. However, it is very rare for all people in a defined benefit pension plan to all die at the same average age. Instead, some people will live much longer and some much less. This is one of the key reasons for volatility driven by IAS 19: as the company must recognise all future obligations based on past experience, the longer its employees live, the higher its projected obligations become, and the higher its liability. In contrast, should a large number of employees in the defined benefit scheme all die in the same year, the actuarial forecast would fall sharply, causing the liability to shrink rapidly, and causing significant balance sheet volatility (Winklevoss, 1993, p.p. 56).

Whilst this might seem to be beneficial to companies, Accountancy (2007a, p.p. 73) argues that the changes to the pension accounting rules introduced to IAS 19 in response to the International Financial Reporting Interpretations Committee's interpretation IFRIC 14 can actually make them harmful to a company. This is because companies whose pension id overfunded are subject to tougher funding terms, to avoid them become complacent. As a result, the surplus that has accumulated in the pension fund is values at less than it would be under pure actuarial rules, and effectively resulting in a negative impact on the bottom line profit figure. In contrast, companies, who maintain a reasonable sized pension liability, can simply leave it on their balance sheet with no penalties and no impact on profitability. Accountancy (2007a, p.p. 73) argues that this represents a significant accounting complexity, making it difficult for companies to effectively manage defined benefit pension schemes even if they contain no liabilities, and hence discouraging companies from keeping them open.

In an attempt to avoid such large impacts on companies, it should be noted that IAS 19 does allow for some flexibility in the method used to account for the costs of the defined benefit schemes (Amen, 2007, p.p. 253). These two methods are termed the 'corridor approach' and 'equity approach '. the corridor approach is based on the fact that IAS 19 required the cumulated actuarial gains and losses of the defined benefit scheme to be recognised in profit or loss if they around outside a predetermined corridor. The corridor is defined as being limited to 10% of either the present value of the scheme obligations or the value of the scheme's assets. This allows companies to gradually recognise major changes in the value of their pension schemes and liabilities over time. In the other approach, the company is allowed to recognise the total actuarial gains and losses immediately by placing them in a separate statement of recognised income and expense, and hence balancing them off against the company's equity (Amen, 2007, p.p. 253).

As a result of this, potentially damaging fluctuations and volatility can arguably be avoided by most companies. Indeed, Kiosse and Peasnell (2009, p.p. 1) argue that whilst changes in accounting regulations have played a role in some companies closing their defined benefit schemes, the main driver is a desire to limit the burden that these schemes place on companies, given the current trend towards increased longevity. As such, the main impact of the introduction of the actuarial accounting requirements in IAS 19 has been that they require companies to declare their defined benefit liabilities, thus making it clearer to firms how much these schemes cost. In addition, as stock markets have become ever more wary of firms carrying large defined benefit liabilities on their balance sheets, so firms have increasingly been forced to pay large sums of cash and other assets into these schemes. This has had the effect of diverting capital away from more productive uses, and reducing the potential growth and efficiency of many companies. This implies that the trend of employers closing their defined benefit pension schemes is more due to the increased costs of providing defined benefit pensions, although the greater volatility of contributions required due to accounting rules have also played a part (Kiosse and Peasnell, 2009, p.p. 1).

Indeed, the available evidence around costs and contributions indicates that defined contribution plans are much cheaper for employers than defined benefit plans, and are becoming ever more so. This can be seen in UK government actuarial figures, which showed that in 2005 the employer's contribution to defined benefit schemes was as an average of 16 percent of the employee's salary, but just 6.3 percent for defined contribution schemes (Government Actuary's Department, 2006, p.p. 94). Of course the argument can be made that defined benefit pensions are much more desirable than their defined contribution cousins, and hence the additional costs might be offset by greater hiring power. However, employers are increasingly coming to recognise the trend towards greater longevity, and are unsure of how long this trend may continue. As such, they often prefer to go for the certainty of a less attractive defined contribution plan over the volatile demands for cash placed on them by a defined benefit plan, particularly if the demands will become more volatile and large over time (Pensions Regulator, 2007, p.p. 70). As a result, increasingly in developed nations such as the UK, the only employers to offer defined benefit pension schemes are those in the public sector, who do not have to report on liabilities, and can rely on future taxation to pay for the benefit obligations to their retiring employees.

Another important requirement from IAS 19 is that any material actuarial assumptions must be disclosed, in order to promote transparency in financial reporting and regulation (Accountancy, 2007b, p.p. 84). Indeed, Accountancy (2007b, p.p. 84) reported that WPP, a major UK advertising company, has now taken steps to disclose its actuarial mortality assumptions and a voluntary sensitivity analysis as part of enhanced pension disclosures. The company has reported that its male employees on retirement are expected to live a further 19.4 years with females expected to live a further 22.1 years for a female. The company has also published a voluntary sensitivity analysis, demonstrating how changes in the discount rate used by the company affect the value of its pension expense. This disclosure showed that a 0.25% change in the discount rate would affect the deficit in the defined benefit scheme by around £20m (Accountancy, 2007b, p.p. 84). Whilst this company is willing to publish such details, many staff and their employers would tend to feel somewhat uneasy and uncomfortable about making such public disclosures on such a sensitive topic. Given that IAS 19 may begun to make such disclosures mandatory in the future, this may increase the tendency for employers to shy away from defined benefit schemes, on the basis that they are more difficult to administer, fund and monitor than they are worth in additional staff loyalty.


IAS 19 represented the culmination of a significant change in international accounting regulations governing the treatment of pensions and pension liabilities in final reporting. Specifically, the standard was the first to formalise an accounting treatment of pension costs, and the first to specifically refer to the need to report pension liabilities in financial statements. This has had a significant impact on many companies: the disclosure of the costs associated with their financial statements has often had a significant and volatile impact on balance sheets due to varying discount rates and life expectancies, and the changes that there have caused in the value of the pensions. In addition, as the value of pensions and their liabilities and deficits has been exposed to shareholders, so companies have come under pressure to fill these liabilities, and have done so with capital which could otherwise be used for valuable investment purposes. However, the evidence from the literature does not imply that this is the main reason why so many companies are closing their defined benefit schemes. Instead, the literature implies that the main cause is steadily rising life expectancies amongst employees, raising the cost of defined benefit schemes dramatically. Ultimately, this has made defined benefit schemes too expensive for many employers to support, in relation to cheaper defined contribution schemes. The main role of IAS 19 in this trend is that it has exposed the rising and fluctuating costs of defined benefit schemes, and hence highlighted to companies the need to address the cost of these schemes as soon as possible.


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