A Note on the New International Accounting Standards Board (IASB) Pronouncement IAS No. 19 (R)

Defined-Benefit Plans Overview

This new pronouncement, IAS No. 19 (R), Accounting for Employee Benefits, issued by the International Accounting Standards Board (IASB) based in London, went into effect on January 1, 2013. It applies to the many companies in some 120 countries that are required to use International Financial Reporting Standards (IFRS). This standard covers defined-benefit plans, whereby companies promise retirement benefits to employees based on years of service. The employer is the principal, if not the sole, contributor to these plans.

Today, fewer and fewer companies are funding such plans because they are extremely costly. In light of continued low interest rates and volatility of investment returns, defined-benefit plan obligations have soared in recent years. As a result, new employees are generally not offered these plans.

Instead, most major employers allow new hires to sign up for “defined-contribution” retirement plans, which are employee directed, with the entities matching the level of employees’ contributors to a limited extent. It is the individual enterprise that sets the basic rules governing these plans, illustrated by 401ks for business corporations and 403bs for not-for-profit entities in the United States (e.g., designating the “family” of mutual funds for investment rather than allowing employees to purchase investments in funds from many families).

Rationale for the New Standard

The aim of this standard is to provide information on an employer’s accounting for employee benefits. This standard revises the previous IAS 19 ² on this subject, which was widely criticized for a lack of clarity and understandability. IAS 19 (R) is required to be implemented in current financial reporting, retroactive for all previous comparative periods presented in the financial statements.

Since most U.S. companies use generally accepted accounting principles (GAAP) issued by the U.S. Financial Accounting Standards Board (FASB) as opposed to IFRS, those firms are not applying this pronouncement. It is not known at this time whether GAAP will follow suit with a similar revised standard, but at the very least the FASB will consider reopening its project on revising its standard. Previously the FASB and IASB had worked together to produce the exposure draft of IAS 19 (R). However, the FASB lost interest in this project because it has had so many other projects on its plate, which it considered to be more pressing in nature.

Analysis of the Standard

This standard presents terminology not used before by either IFRS or GAAP, in addition to new financial reporting requirements and disclosures. Although actuaries provide many of the figures used to effectuate this pronouncement, employing an actuarial unit credit method as before to provide the computations for accounting, it is the accountants and auditors of enterprises applying IFRS who have to adhere to this standard in financial reporting.

The standard requires full recognition and disclosure of actuarial gains and losses pertaining to new assumptions made in calculating the plan benefits and obligations of the firm (including changes in assumed mortality rates and inflationary expectations) as well as past service cost amendments adopted to provide greater or lesser benefits to employees. The actuarial gains and losses go immediately into an account called “other comprehensive income (OCI),” which includes income items not contained in net income (profit and loss) as reported in the income statement, often because of their potential volatility. OCI items are included in a broader notion of income outside of the income statement called “comprehensive income” (CI).

Under this standard, the actuarial gains and losses will remain in OCI, not to be recycled into net income. Previously, firms had the option to do that or to recycle a limited amount of such gains and losses into the income statement during each year. Additionally, the entire past service cost amendment, either adding to or subtracting from the actuarial benefit obligation, is now to be reflected in net income within the income statement. Previously, only vested past service costs were expensed immediately into net income. Unvested past service cost was kept in OCI and reported as an offset to the net defined-benefit obligation or an addition to the net defined-benefit asset. Both the net income and CI figures will now undoubtedly reflect greater volatility due to the inclusion of all past service cost and actuarial gains and losses. Nevertheless, the net defined-benefit liability or net asset to the firm will show the total deficit or surplus of assets in the plan. Furthermore, there will now be uniformity in the treatment of the actuarial gains and losses.

A new term in IAS 19 is the net interest on the net defined-benefit liability or asset, which represents the amount that will be reported in the total defined-benefit expense reflected in net income. This figure will reflect the change in the net defined-benefit amount based on the discount rate, which is the interest rate associated with high-quality corporate or government bonds. According to the standard, both the defined-benefit obligation and plan assets will apply the same interest rate, never mind how effectively or ineffectively the firm may be managing its pension fund. The logic for this change to a single interest rate from different rates for the obligation and the asset group in the previous standard is that in the past too many companies had a tendency to overstate the expected return on plan assets and thereby lower their defined-benefit plan expense, thus raising their net income.

This standard requires the reporting in net income of the total period service cost, which encompasses the current service cost (an actuarial present value based on terminal future salaries that increases the defined-benefit obligation), interest on the service cost and past service cost amendments. These amendments include curtailment and settlement plan gains and losses (see Table 1).

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Table 1.

Defined-Benefit Expenses in the Income Statement.

1. Service cost (increase in defined-benefit obligation)

2. Interest cost (on the defined-benefit obligation, plan assets and asset ceiling)

3. Past service cost, curtailment and plan settlement amendments

Note. All three items provided by the actuary.

In addition, net income in the income statement will reflect the net interest cost, comprising interest on the net defined-benefit liability and interest on the plan assets.

The third reported item is remeasurements, which are reflected directly in OCI and are required to remain there. Remeasurements include actuarial gains and losses on the defined-benefit obligation, the actual return on assets (but not including what appears within the net interest on the net defined liability or asset) and the change, if any, in the asset ceiling reflected on the balance sheet (excluding amounts in the net interest on the net defined obligation or asset; see Table 2). Administration costs concerning the management of plan assets are also to be deducted from OCI. All other administration costs fall under operating expenses within net income (see Table 3).

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Table 2.

Remeasurement in Other Comprehensive Income.

1. Actuarial gains and losses

2. Actual return on assets a

3. Changes in the asset ceiling a

a.

Excluding interest on plan assets and obligations.

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Table 3.

Total Defined-Benefit Cost.

1. Service cost (income statement)

2. +Net interest (income statement)

3. +Remeasurements (other comprehensive income)

Summary of the Provisions of the Standard

The new standard provides full recognition of the deficit or surplus on the balance sheet for benefit plans, introducing a new concept of “net interest on the net defined-benefit liabilities or asset,” which appears as a financing cost in the income statement. Past service cost is now expensed immediately as it is incurred to avoid income smoothing or earnings management with this item. There is a change in the presentation of the total defined-benefit cost, which now encompasses the following concepts: service cost + net interest + past service cost + gains and losses on plan curtailments and settlements + remeasurements of the foregoing items. The foregoing first three items now represent the total service cost appearing in the income statement as employment costs. The remeasurements go into OCI in the statement of CI. Most important, the new standard jettisons the alternative acceptable treatments of actuarial gains and losses using a corridor or artificial barrier to amortize those gains and losses or reflecting them all at once on incurrence in either the income statement or the OCI. Now the actuarial gains and losses will have to go in OCI and not be later recycled into the income statement. Disclosures will now include risk sharing by employers and employees in these plans, which was not covered under the previous standard.

The expanded disclosure requirements under IAS 19 are intended to explain the characteristics of the defined-benefit plans, to identify amounts in the financial statements stemming from these plans and to discuss how these plans may affect the timing and amounts of future cash flows and their associated risks. Examples of such enhanced disclosures pertain to sensitivity analysis of actuarial assumptions on pension valuations, the funding policies of the firm, the maturity of pension liabilities and the extent to which the entity is liable for other related entities’ defined-benefit plan obligations.

Concluding Comments

The U.S. counterpart to the new IFRS standard, Statement of Financial Accounting Standards 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (2006, formerly Statement of Financial Accounting Standards 87, 1985) calls for past service cost amendments to be reflected in OCI and recycled subsequently to net income by amortization of these costs over the average remaining service lives of the affected employees. ¹ The same applies to actuarial gains and losses, which can be amortized using an artificial barrier known as the “corridor,” representing 10% of the greater of the defined-benefit obligation versus the fair value of plan assets at the beginning of the reporting period. Should the absolute value of the actuarial gains and losses along with the plan asset gains and losses exceed the corridor, the difference is also amortized over the average remaining service lives of the employees. In this manner, the U.S. standard promotes artificial income smoothing in an effort to avoid volatile earnings fluctuations in net income.

The IASB standard, by contrast, reflects all the changes in plan liabilities and assets within the income statement. IAS 19 (R) promotes greater transparency and disclosure of figures along with the qualitative attributes of these plans. This standard provides greater disclosures of the fundamental actuarial elements of these plans.