Accounting by Employers for Employees' Retirement Benefits - Assignment Example

 Accounting by Employers for Employees’ Retirement Benefits a) Employees’ retirement benefits include pensions, healthcare benefits, life insurance, legal services, day care, housing subsidies, and like others. In UK accounting for post retirement benefits by the employers was earlier governed by SORP 1and SSAP 24 till the introduction FRS 17. Listed entities are also required to follow the regulations of IAS 19 since 2005.Earlier SORP (Statement of Recommended Practices) 1 detail of pension schemes in the financial statements produced. Also SORP 1 required different reports like trustee reports, actuary report, and investment report in respect pension plans. SSAP 24 was based on the assumption that employer recognizes the cost of providing pension as that accrued. Pension expenses were actuary estimated long term funding cost of the stated scheme and expressed as percentage of payroll bill. The surplus of the scheme used to be spread out over the entire period of scheme to reduce the cost of funding the scheme. The scheme was to spread out net cost over the period of scheme and charge to profit and loss account on yearly basis. Whereas the approach of charging yearly pension or retirement benefit cost under FRS 17 is different as it charges to income statement the cost of arranging only that year’s benefits for the members of the scheme. Pension cost consists of regular cost, variation cost, interest cost, actual return on plan assets, prior service costs, and gain or losses on actuarial valuation of plan assets and employee benefit liabilities. Regular cost is the service cost resulting from services being performed by the company’s employees. Service cost is the increase in pension plan’s projected benefit obligation (PBO). Variation costs are surpluses or deficit resulting from plan’s actual happenings and the assumptions made earlier. There is no direct reference of interest on balance sheet items under SSAP 24 but it states that ‘when a scheme is unfunded the provision of pension cost is assessed and reviewed on discounted basis and adjusted each year by an amount comprising a charge for the year (equivalent to contribution in a funded scheme) and interest on unfunded liability.’(Miss Maria Monica Gil Barba, page 21)1 Prior Service costs results from allowing employees to retroactively participate in a plan. As per SSAP 24 prior service cost is spread over or amortized over the average remaining service lives of the employees. Each period, the actual return on plan assets is compared to the expected return (fair value) on plan assets. Gain results when actual return on plan assets exceeds expected returns, and vice versa. Under SSAP 24 such gains or losses are recognized immediately and there is no deferment of recognition. This approach of SSAP 24 is purely income statement based approach. Companies may not make contributions to the pension plans. When they do make contributions, they may be equal to the annual pension expense, or greater or lower than the expense. When the cumulative net pension cost exceeds the contributions, the difference should be recognized as accrued pension cost. When the cumulative net pension cost is lower than the contributions, the difference will be recognized as prepaid pension cost. This approach of SSAP 24 suggests that ‘the cost should be recognized on a systematic and rational basis over the period during which the employer is expected to reap benefit from the employee’s services.’(Steve Lawrence, page 181)2 Similarly when plan assets and liabilities are valued at the year end shortfall or surpluses are bound to occur when actual returns are compared with expected returns. Under SSAP 24 accountant is supposed to spread the effects of such surpluses or shortfall over the average remaining service lives of the employees. Naturally such treatment would result in provisions and prepayments in balance sheets. During initial applications such approach appeared perfect but a serious study would indicate that ‘provisions and prepayments that arose on the balance sheets were not real assets and liabilities but rather meaningless figures left over from smooth process.’ (Peter Holgate, page 140)3 When there is short fall or losses between fair value and book value of plan net assets, it becomes the obligation of the company to invest more into the plan assets, and therefore it is a liability simple and straightforward. What is the purpose of spreading such a loss over a future period? It should be written off immediately as a loss and a liability be created to cope up by the company. Similarly when there is surplus between fair value and book value of plan assets that should be taken as gain. This exactly is the balance sheet approach adopted by the amended FRS 17. FRS 17 has now sorted out this issue because of its balance sheet approach towards such adjustments. ‘Under the Statement of principles, now applied in FRS 17, this spreading or accrual based approach is abandoned and instead the proper recording of balance sheet assets and liabilities has become the focus of the revised accounting standard.’(Robert Kirk, page 237)4 There are other difference between SSAP 24 and FRS 17 that have further illustrate the shift from income statement approach of SSAP 24 to the balance sheet approach of accounting for pensions and other retirement and employee benefits. First assets under FRS 17 are allowed to be valued at market price. On the other hands company can adopt actuarial valuation and that may or may not be the fair value confining to balance sheet approach envisaged under FRS 17. Under SSAP 24 liabilities are discounted using a discounting rate that reflects expected returns on plan assets. Whereas FRS 17 takes current rate of return AA rated corporate bonds of equivalent term to discount liabilities. Apparently this is more practical and is a fair value approach. But there is an inherit limitation attached to this approach. How would FRS 17 handle the volatility of the market attached with current rate of return? Sometimes this may result into an altogether different balance sheet scenario than the factual status of assets and liabilities on reporting date, and this may have far reaching consequences. In fluctuating markets ‘it is unreasonable to expect a company to make a massive reduction one year and significant increase the next year a liability that will not arise for another 38 years. FRS 17 can generate huge changes in company profits from one year to the next which can reflect the stock market rather than company’s fortunes, defeating the point of having accounts at first place.’(Robert Leach, page 116)5 FRS 17 has proved to be a revolutionary in its approach. In the past there have been number of accounting standards that have caused a fair amount of controversies, but few have reached outside the finance pages of the media to the extent that FRS 17 has.(Michelle Perry, 2002)6 b) Various amendments of IAS 19 in 1998 and after that have in a way overhauled the standard in its treatment with employee benefits. Its title has been changed from ‘retirement benefits costs’ to ‘employee benefits’. That indicates that asset is concerned with both pre and post employment benefits. The important issue is the recognition of cost of providing post employment benefits to employees. Amended IAS 19 in 1998 direct such cost to be recognized in the year in which such benefits were earned by the employees. Earlier such costs could also be recognized at the time when benefits become payable or actually paid to employees. The employee benefits that are identified by IAS 19 also include short term employee benefits that become due within 12 months after the employee has rendered the benefit related services; post employment benefits like pensions and other retirement benefits; other long term employment benefits if they are not wholly payable with 12 months after the end of period; termination benefits; and equity benefit compensations. Accordingly IAS 19 ‘deals with a broader range of issues, including profit sharing and termination benefits.’(Paul Gee, page 115)7 Pension schemes are either defined contribution plans or defined benefit plans, and the standard IAS 19 provides an elaboration about both ‘defined contribution plan’ and ‘defined benefit plan’. Under ‘defined contribution plan’ the company pays a fixed pension contribution to a separate entity and the company is under no obligations, whatsoever, to contribute further. On the other hand ‘defined benefit plan’ is not dependent upon contributions of employer and employees. The terms of the plans define various deliberations of the plan, though the risk remains with employer. ‘The company should regularly determine the present value of any defined benefit obligation and the fair value of plan assets. This makes sense as a company will need to know its net liability for employee benefits.’(Graham Holt, page 1)8. Whatever pension plan is in operation ‘IAS 19 postulates that pension costs should be recognized as expense at the time that the service is being rendered to the business and not when they are ultimately paid.’(Peter Walton and Others, page 52)9 The amended IAS 19 seeks recognition of actuarial gains or losses under a ‘corridor approach’ limited to 10% of the larger of present value of defined obligation or fair value of plan assets. Actuarial gains and losses are ‘gains and losses arising from the difference between the previous actuarial assumptions and what actually occurs, and changes in actuarial assumptions.’(Roger Hussey and others, page 192)10 When actuarial gains or losses are within the corridor then such gains or losses are not recognized but continually deferred. However when those gains or losses fell beyond the corridor the excess is amortized over the remaining working lives of the then employment force. This unrecognized gain or loss falling within or outside the corridor will form part of net defined obligations or assets. Taking this into account defined benefit liability on reporting date shall be constituted as under: Present value of defined benefit obligation adjusted with actuarial gains and losses falling outside the corridor minus ( –) unrecognized past service cost and the fair value of plan assets, if any, against which the obligations are to be settled directly. If from above calculations the resultant figure is negative then such resulting figure shall be recognized as asset in the balance sheet if it is lower than actuarial losses and unrecognized past service costs clubbed with present value of refunds from plan or reductions in future contributions; other wise this figure shall be recognized as asset in the balance sheet. Thus a ceiling has also been fixed in respect of recognition of such resultant assets. A careful study will reveal that interaction of Corridor approach of deferment of actuarial gain or losses and also fixation of a ceiling for asset recognition give rise to a situation where deferring of loss/gain may lead to recognition of gain/loss in the income statement. This can particularly happen under cases where surplus in defined benefit plan cannot be recovered through refunds or curtailment in contributions. In order to ease this complexity IAS 19 further introduced amended provisions where it has prevented the recognition of negative figure in above stated computations as asset when it occurs solely as a result of past services or actuarial losses/ gains during the period. Pension expense or employee benefit expenses that are required to be recognized in the income statement as per standard shall include the elements of current service costs, interest cost, actual return on plan assets or reimbursement rights, recognized actuarial gains or losses, past service costs, and effect of curtailment or settlement of defined benefit plan. In December 2004 IASB amended the IAS 19 to permit an option of recognition of actuarial gains and losses on the track of revolutionary FRS 17. In other words IAS 19 permitted the entities an option to recognize the actuarial gains and losses in the same year in which they occur. But this has to be done after the computation of profit or the loss for concerned accounting period and has to be reflected in the statement of recognized income and expenses. This amendment has changed the situation of developing a policy for dealing with employee pensions and other benefits. IAS 19 has based its calculations on market valuations of plan assets and liabilities. In fact IAS 19 is using projected benefit obligation (PBO) measures of pension liabilities. Present valued of defined benefit obligations are determined by using projected unit credit method; and estimated cash out flows are discounted as per market yield on balance sheet date on high quality suitable bonds. Options are now available to amortize actuarial gains and losses above corridor limits or immediately recognize in profit and loss account. Now with this amendment in 2004 a third option has been created for immediate recognition of actuarial gains or losses but in a separate income statement. Accordingly various options are there for a company to develop a pension liability policy. Though IAS 19 has opened a number of options to deal with actuarial gains or losses in the financial statements, but these options have given rise to some amount of difficulties particularly among European listed companies over applicability of IAS 19. In a research conducted by Fasshauer, Glaum, and Street (2008)11 it was found that companies face pressure from regulators, politician, and press, to incorporate more transparency into pension accounting, and this influence decision making in pension policy to be followed by the companies. There will also be lack of financial statement comparability that emerges from the flexibility of options available under IAS 19. Using corridor approach under IAS 19 the companies will overstate the equity and thus achieve material amounts of off balance sheet financing. Though IAS 19 has promoted flexibility but this may also help to serve the ulterior motives of companies. Amendments of IAS 19 also deal with termination benefits only when termination of employee or group of employees is before normal retiring date or it is a case of voluntary redundancy. Such expenses are required to be recognized immediately on termination of employee or group of employees. There may be a situation where such benefits become due 12 months of the reporting date. IAS 19 recommends immediate recognition of such termination benefit expenses discounting them at identified discount rate. Employee benefits may also include certain equity compensations benefits for employees. IAS 19 does not provide any regulations in this regard but seeks extensive disclosure of such equity compensation benefits. In respect of defined benefit plan the standard seek extensive disclosure for amount recognized as expense. There is no need to disclose long term employee benefits and employee equity benefits as stated above. c) Practical issues that IASB should consider in developing a satisfactory standard for post- employment benefits are detailed here under. Deferrement of actuarial gain and losses should be completely eliminated on the lines of FAS 17. Financial statements should reflect the real picture. Deferment of gain and losses wash away the fair presentation of financial statements to an extent. The pension expense should be recognized as single item as is being done in US GAAP, and that is computed as under: Service cost + Interest on PBO – expected return on fund assets +/- amortization of gain or losses. ‘IAS 19 does not specify if these items should be presented single or disaggregated items.’(Nick Antill and Kenneth Lee, p121)12 The choice of discount rate to compute present value of DB obligations should be as fair as possible. Use of market value of corporate bonds without providing any allowance for risky nature of pension liabilities has created more controversies. ‘In principle discount rate should reflect the duration of pension liabilities and take into account their stochastic nature. If assets are measured at fair value, benefits should also be discounted using stochastic, not fixed discount rates.’(Juan Yermo and others, page 50)13 The post employment benefits that are at present called defined contribution plans should be reclassified as contribution- based promises or defined benefit promises, and cash based plans that are currently known as Defined Benefit plans should be categorized as contribution- based promises (ASBJ, page 2)14. The disclosure of policies about defined benefit pension scheme should cover wide range of information. A report was published by Financial Reporting Review Panel of ASB (2006)15 on basis of a limited review of 20 listed companies on application of IAS 19. The recommendations of the panel justify the required disclosures for post employment DB schemes. The recommendations are: i) fuller disclosure of uncertainties surrounding estimates and their impact on pension liabilities, ii) consideration of inflation and mortality assumptions while evaluating pension liabilities, iii) greater clarity within mortality disclosures, iv) more information on non-standard assets in funds like derivative or hedge fund investments, v) description about calculations of expected returns, and vi) disclosure about maturity of schemes Word Count: 2770 References: Read More