Impact of proposed accounting standards on defined-benefit pension plans

Charmaine Johnson, Guest Writer

Accounting standard IAS 19 governs the financial reporting of a company's employee benefits obligations. The principle of is that costs associated with the provision of employees' benefits - pensions being one category - should be recognised in the period the benefits are earned, rather than when they are paid or payable.

IAS-19 is only applicable to defined-benefit pension plans, under which the employer guarantees a future pension, thereby bearing the risk of having to finance the guaranteed benefits in the event that the pension plan's investments underperform.

Under IAS 19, an employer is required to determine the present value of the defined-benefit obligation and the fair value, or market value, of the plan assets.

Defined-benefit obligation is the actuarial estimate of the amount of money required to satisfy all pension entitlements earned by employees up to reporting date.

The defined-benefit pension plan has three main elements of measurement.

First - projections made today about a series of future payments requires actuaries to make assumptions about economic conditions leading up to employees' retirement, such as salary escalation and inflation.

Second - determining the annual pension expense is not the actual cash outflow for the period but rather, incorporates the level of entitlements earned and changes in assumptions of economic conditions.

And third - recording investment returns and changes in actuarial assumptions, IAS 19 permits entities to defer the effects that market fluctuations in the pension plan's assets and obligations have on the sponsor's (employer) financial statements. It is reasoned that this protects against short-term market movements, which could produce significantly over or understated accounts when the investments' performance for a single period is above or below average. This process is termed smoothing.

In April 2010, the International Accounting Standard Board (IASB) issued an exposure draft of the proposed amendments to IAS 19. The proposed amendments are intended to address several acknowledged deficiencies in the current reporting requirements for DB plans, such as:

1. The fact that companies do not have to account for changes in their defined-benefit plans immediately (smoothing);

2. Companies may choose different options for recognising gains and losses; and

3. The disclosures in the financial statements do not emphasise the risks associated with DB plans.

It is anticipated that addressing the deficiencies cited above will make it easier for the various users of financial statements to better understand the possible effects that a defined-benefit plan will have on the sponsoring company's financial statements. The IASB invited comments on the draft up to September 6, 2010, and aims to finalise these short-term improvements by mid-2011.

The exposure draft proposes improvements in the following areas:

1. Immediate recognition/ recording of defined benefit cost

Current position:

The existing standard permits the deferred recognition of changes in the defined-benefit obligations and the fair value of plan assets as outlined above. Some concerns in relation to this treatment are:

Delays in recognition of gains and losses may result in misleading figures in the statement of financial position and the pension plan reported as better funded than it actually is,

Gains or losses which resulted from prior periods' events are recognised in current period accounts;

Delays in recognition of gains and losses;

Companies having similar defined-benefit obligations might report different amounts.

The IASB proposal:

All changes in defined-benefit obligations and fair value of plan assets should be recognised in the period they occur. This would eliminate the deferral option.

Potential impact on DB sponsors: initial significant adjustment in the financial statements of companies which had utilised the deferral option; and volatility in the companies' financial statements, reflecting short-term market fluctuations.

2. Presentation-separation of defined benefit costs

Current position:

IAS 19 permits companies to report the recognised amounts in different ways as:

Service cost - Operating expense or finance costs

Interest cost - Operating expense or finance costs

Expected Return on plan assets - Operating expense or finance costs

Actuarial gains and loss - Operating expense or finance costs, or other comprehensive income and deferrals

Additionally, actuarial gains and losses from previous periods may also be recognised in any of the expense line item above. It is apparent that costs may be recognised in different categories; and inconsistency in reporting of actuarial gains and losses.

The IASB proposal:

A new presentation approach that will improve the visibility of the different types of gains and losses arising from defined-benefit plans.

Specifically, the draft proposes that companies should present:

Service cost - profit or loss

Interest cost - profit or loss

Remeasurement - other comprehensive income.

3. Disclosure

Current position:

Common criticisms of the disclosure requirements are that they are voluminous yet not easily understood, and therefore, pertinent information might not be overlooked; do not explain clearly how defined-benefit plans affect the sponsor's financial statements; and the risks associated with participation in this type of pension plan are not sufficiently highlighted.

The IASB proposal:

Disclosure requirements about matters such as the characteristics of the company's defined-benefit plans; effect on the company's cash flow; and risks arising from defined-benefit plans.

Conclusion

The IASB believes the proposals in the exposure draft would significantly improve the reporting for defined-benefit plans for the following reasons:

Changes in the carrying amounts for defined-benefit obligations and changes in the fair value of plan assets will be reported in a more understandable way;

Some presentation options currently allowed by IAS 19 will be eliminated, thus improving comparability among companies;

Requirements that have resulted in diverse practices will be clarified;

Companies will provide improved information about the risks arising from a company's involvement in defined-benefit plans.

Trustees and sponsors of defined-benefit plans should closely follow these pending developments and engage their service providers - actuary and auditors - to assess the implication of the changes on their reported financial statements.

Charmaine Johnson is the chief financial officer of Prime Asset Management Limited.

charmaine.johnson@primepensions.com

Plan Assets Benefit Obligations

Fair Value at start of the yearEstimated Defined Benefit Obligation

at the start of the year

Add Return on Plan AssetsAdd Service CostAdd ContributionsAdd Interest credited to membersDeduct Benefits PaidAdd/Deduct Actuarial Gain / Loss

Add/Deduct Plan Amendment/Adjustment

Deduct Benefits Paid

= Fair Value of Plan Assets = Estimated Defined Benefit Obligationat the end of the year at the end of the year

When plan assets are greater than plan obligations, the plan is overfunded.

When plan assets are less than plan obligations, the plan is underfunded.