ACCA Technical article IAS 19
The accounting for contribution-based promises in employee benefits is only one of the issues with IAS 19, says Graham Holt
This article was first published in the May 2015 international edition of Accounting and Business magazine.
In 2011, the International Accounting Standards Board (IASB) issued amendments to IAS 19, Employee Benefits, and indicated that there were further matters that required a more fundamental review of pensions and related benefits. These matters included the issues relating to contribution-based promises (CBPs).
Examples of CBPs are where the employee receives a pension based on the performance of the assets in the pension plan and the employer provides a guarantee of the minimum performance of those assets. The employee accordingly receives a benefit that is the higher of the contributions plus the actual return on the assets in the plan and the guaranteed amount.
Alternatively, the employee may receive a guaranteed benefit based on a specified return on ‘notional’ plan contributions by the employer. The IFRS Interpretations Committee (IFRIC), which issues guidelines for International Financial Reporting Standards (IFRS), tried to develop a solution for the accounting for such plans but removed it from its project agenda in May 2014.
Although some schemes may have a few features that bring them into the defined benefit category of IAS 19, they may be so much closer to a standard defined contribution plan that full defined benefit accounting does not seem appropriate. Meanwhile other schemes may be close to defined benefit arrangements, but have risk-sharing provisions that reduce the sponsor’s exposure.
The IASB considered contribution-based promises in the discussion paper that preceded its latest revisions to IAS 19. In that paper, the IASB looked at a fair value measurement basis for such schemes. However, neither the Interpretations Committee nor the IASB decided that change was needed.
IAS 19 requires an entity to classify post-employment benefits as either defined contribution plans or defined benefit schemes. A defined contribution scheme is one where the entity pays specified contributions into a separate entity (a fund) and has no obligation to pay more contributions if the fund does not have enough assets to pay all the accrued benefits.
By definition, if a scheme is not defined contribution, then it has to be defined benefit, and the entity must use ‘the projected unit credit method’ to account for it.
Using an actuarial technique with this method, the entity calculates the present value of defined benefit obligation (DBO), which has been discounted by bond rates. The discount rate used is determined by reference to market yields at the end of the reporting period on high-quality corporate bonds, or, if there is no deep market in such bonds, by reference to market yields on government bonds.
The entity determines the deficit or surplus as the difference between the present value of DBO and the fair value of its related plan assets. This deficit or surplus is recognised as a net defined benefit liability (asset) in the statement of financial position, subject to an asset ceiling test.
IAS 19’s measurement process does not properly reflect risk differences among plans because the present value of the DBO does not fully reflect the value of risk relating to future cashflows from the DBO. However, the fair value of the plan assets reflects the value of risk relating to future cashflows from them by the use of market prices.
Defined benefit plans are distinguished from defined contribution plans by the fact that the entity suffers the actuarial and investment risks. The accounting for defined benefit plans is covered by IAS 19 but the accounting for hybrid plans such as CBPs under IAS 19 often results in counterintuitive measurement.
Many hybrid plans are classified as defined benefit schemes but their risks are quite different. For example, in some CBP schemes, the obligation is calculated by the entity projecting the benefit on the basis of an assumption of future performance of the plan’s assets, which is potentially higher than bond rates. In CBPs, investment risk does not always fall entirely on the entity, but is often shared by employees. This sharing of risk is not dealt with by IAS 19 and thus the entity could show an excessive plan deficit because the present value of the DBO is much higher than the fair value of the plan assets. This is because the discount rate is lower than the projected higher return on plan assets.
The number of hybrid plans is rising as more employers reduce their risk exposure. Entities are also buying annuities, and using longevity swaps to manage pension risk.
IAS 19 has been questioned from various other conceptual viewpoints as IAS 19’s measurement basis is quite different from other IFRSs. For example, it is difficult to reconcile a pension liability with the definition of a liability in the conceptual framework, and similarly, the requirement to reflect unvested benefits and future salary increases in the entity’s obligations.
The netting off of the plan assets and defined benefit obligations is also inconsistent with other IASB pronouncements. IAS 19 has current acceptance because of its relative ease of use and because issuers and users have found some merit in its information content. A new model would increase costs and have significant effects on the business. The general opinion is that frequent changes of pension accounting are unnecessary and costly.
The IASB feels that the issues relating to CBPs and eliminating diversity in practice are important, and that costs and benefits should be carefully assessed when recommending any change to the accounting treatment of pensions.
The main scope of IASB’s current research project is accounting for new pension plans that incorporate features that were not envisaged when IAS 19 was issued. It is proposing to fundamentally review the principles of measurement, and classification in IAS 19. The research will probably revisit such issues as CBPs, the discount rate for employee benefits, and exemptions for entities participating in multi-employer defined benefit plans.
Another topic under discussion concerns whether a pension surplus could be recorded as an asset on the statement of financial position in certain circumstances. IAS 19 limits the measurement of a net defined benefit asset to the lower of the surplus in the defined benefit plan and the asset ceiling.
IAS 19 defines the asset ceiling as ‘the present value of any economic benefits available in the form of refunds from the plan or reductions in future contributions to the plan’.
IFRIC’s IFRIC 14 interpretation of the requirements in IAS 19 addresses when refunds or reductions in future contributions should be regarded as available.
IFRIC 14 states that a refund is available if the entity has ‘an unconditional right’ to a refund. The IASB has undertaken a project to clarify whether a trustee’s power to augment benefits or wind up a plan affects the employer’s unconditional right to a refund and thus, in accordance with IFRIC 14, restricts recognition of an asset.
Essentially the project is assessing whether an entity could get economic benefit from a surplus in a scheme and whether there is an unconditional right to a refund. At present, entities can recognise a surplus as an asset, even though the trustees could change the benefits and wipe out the surplus. The implications of these changes appear less severe than previously thought – IFRIC is not seeking to prohibit recognition of surplus in schemes where there is no future accrual of benefits. The changes are expected to be made separately from the annual IFRS improvements process and, once they are confirmed, entities should review the rules of their scheme and revisit any legal opinion previously obtained about the ability to recognise a surplus.
Because pension schemes can have infinite variations with differing degrees and forms of risk-sharing, the IASB may consider the general principle of measurement of pension schemes with the aim of determining a measurement basis that works for all types of schemes. The IASB’s work relating to the measurement of insurance liabilities and discount rates may help here.
Finally, compounding the above potential changes, the economic situation has had an impact on pension schemes. In 2014, long-term inflation assumptions derived from the gilt market were about 0.2% a year lower than at the start of the year. Taking the changes in inflation, discount rates and interest costs into account, a typical pension obligation could be significantly higher than at the end of 2013.
The degree of change in the net defined benefit liability will depend on whether the asset performance has kept pace with the change in the size of the obligation. However, as bond yields are down significantly since the start of the 2014, the value of liabilities will probably have increased much quicker than scheme assets.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School