Accounting Treatment for Pension Plans: IAS 19 - Term Paper Example

Financial Reporting Accounting Treatment for Pension Plans - IAS 19 The objective of IAS 19 (Revised 1998) is to establish the accounting standardsfor the treatment of employee benefits including pension plans and the disclosure thereof. The basic principle underlying the principle of IAS 19 with all its requirements is that it should be made mandatory for the entities to recognize the cost of providing the benefits to the employees in the same period during which the benefits were earned by the employees rather than the time at which the benefits are paid or payable. Employee Pension Plans The accounting treatment for the employee pension plan differs depending on the nature of the plans. The treatments are different for a 'defined contribution plan' or 'defined benefit plan'. Defined Contribution Plan Under a defined contribution plan, fixed amounts of contributions are paid in to a pension fund by the employers. The employers' liability is limited to the extent of contributions payable by them and they are not obligated to make any further payments to the funds if the funds does not have sufficient assets to meet the liabilities in respect of the pension benefits payable to all the employees as post-employment benefits (Accountancy). The defined contribution plans which includes multi-employer plans, state plans, and other insurance schemes. Under these plans, since the liability of the employer is similar to the liabilities arising under defined contribution plans, the cost of the contribution plan should be accounted for in the income statement of the same period in which the contribution becomes payable by the employer in consideration for the services rendered by the employee during that period. (IAS 19.44) "If contributions to a defined contribution plan do not fall due within 12 months after the end of the period in which the employee renders the service, they should be discounted to their present value". [IAS 19.45] Defined Benefit Plans Any plan meant to provide post employment benefits to the employees other than defined contribution plan shall be construed as a defined benefit plan. Such plans include both formal and informal plans which create a constructive obligation to the employees of a firm with respect to the post employment benefits. In order to account for the defined benefit plan the cost that would be recognized for the balance sheet purposes would be the present value of the defined benefit obligation. The present value in this case represents the present value of the anticipated future payments that may be needed to settle the obligations of the employees, post-employment benefits. The benefits might have accrued to the employees by reason of his/her service during the current or prior periods. "This value is to be adjusted for unrecognised actuarial gains and losses and unrecognised past service cost, and reduced by the fair value of plan assets at the balance sheet date". [IAS 19.54] Accounting Treatment The accounting treatment of defined contribution plan poses no problem as the employer/employee contributions to the fund have to be written off immediately to the income statement, as there if no further obligation for the employer to contribute to the fund in case there is any shortfall in the employer's provision. However in the case of defined benefit plans two approaches are being followed: Corridor approach and Immediate write off to reserve approach Corridor Approach As such the standard IAS 19 does not insist on recognizing the actuarial gains and losses immediately unless the variations in them are abnormal to make the deferral inappropriate. This is based on the view that the actuarial gains and losses will tend to offset each other while they operate on a long term basis. Based on this principle IAS 19 has prescribed a corridor of 10 percent as the range of normal fluctuations in the gains and losses. The firm is allowed to continue to defer the accumulated net actuarial gain or loss, in case the unrecognized actuarial gain or loss is not more than 10 percent of the present value of the defined benefit obligation or the fair value of fixed assets whichever is larger. In those cases where the accumulated net actuarial gain or loss exceeds the prescribed corridor of 10 percent value then the firm has to amortize the excess over the expected remaining working lives of the employees who are active participants of such benefit plan. IAS 19 also permits other methods of amortization, however subject to the fulfillment of certain other conditions (Ahmad Hamidi-Ravari) Immediate Write off Approach Under this approach if there is a change from the corridor approach in the last year to this approach it is necessary that a prior year adjustment due to change in the accounting policy. The firm is allowed to adjust the unrecognized gain or losses on account of the employee benefit funds in the same year of accounting. In this approach there is no need for any calculation of corridor and the profit of the firm will get impacted directly by the extent of gains or losses. The overall net actuarial loss for the year should be written off to the income statement charging against the revenue reserves for the year. This treatment will ensure that the balance sheet is correctly shown by bringing the liability up to the actual levels. Advantages By calculating the actuarial values and writing off in the same year the gains or losses are immediately recognized and charged off to keep the plan value of assets and liabilities more exact to the actual values. This approach is also flexible since it tolerates any method of amortizing the excess of gains or losses, provided the same method is applied in case of both gains and losses and also consistently over the period. The adoption of IAS 19 universally acts as one of the major impact areas of IFRS convergence process. Disadvantage These approaches involve complicated actuarial calculations and the estimation of the remaining working lives of employees. This makes the application difficult. Since the approach of IAS 19 has many requirements that are excessively in detail to the defined benefit plans like the use of actuarial techniques, discounting and fair values, it entails a responsibility on the firm to act on a timely and proactive manner, failing which the firms may not be able to meet the reporting requirements. In addition to complicating the accounting for defined benefit plans, the corridor approach has not lessened the volatility in respect of the reported profits that arise from the immediately recognizing the actuarial gains and losses in the net profit or loss (Accounting Alert). Similarly under the immediate write off approach there will be increased volatility in reported profits compared to applying the corridor approach. References Accountancy 'IAS - 19 Employee Benefits' Accounting Alert 'Second Tranche of Convergence Exposure' Ahmad Hamidi-Ravari 'IA 19: Employee Benefits - A summary Read More