Accounting by Employers for Employees Retirement Benefits - Essay Example

Accounting by Employers for Employees’ Retirement Benefits Part a) FRS 17- Retirement benefits became effective for accounting period starting from January 2005, and prior to that accounting of employees’ retirement benefits was regulated by SSAP 24- Accounting for pension costs. Both the standards serve the common cause but accounting approach of both is different in the sense that SSAP 24 conveys income statement approach and FRS 17 advocates balance sheet approach of accounting. Let us start with pension expense that comprises service cost, interest cost, adjustment of prior service costs, and recognized gain or losses of actuary valuations of plan assets and retirement liabilities. Actual returns on plan assets are reduced from this pension cost for purpose of its recognition on income statement. SSAP 24 requires that pension cost is the long term funding costs that is evaluated by actuaries and should be spread over the total period in order to smoothen the cost from year to year. Similarly actuary evaluated scheme surpluses are also spread out over the total period and the net charge of each year is expressed as percentage of payroll. On the other hand the approach under FRS 17 emphasis that ‘what is shown as the cost in the profit and loss account is the cost of buying one year’s benefits for the scheme members i.e., the benefit accrued during the current accounting period.’(Standard Life, page 4)1 SSAP 24 requires that a consistent valuation method be used to calculate best estimate of pension cost, and a regular and standard contribution rate is computed to meet the estimated pension costs. Surplus or deficits of pension costs are spread out over remaining working lifetime of current memberships. But SSAP 24 does not specify any amortization method. With the result there were prepayments on balance sheets when the company was in deficit and provisions when the company was in surplus. Accordingly a number of dubious assets and liabilities used to be created on application of this standard rate. Balance sheet was therefore not a fair representation of assets and liabilities under the pension plan. With implementation of FRS 17 ‘this spreading or accrual based approach was abandoned and instead proper recording of balance sheet assets and liabilities has become the focus of revised accounting standard.’(Robert Kirk, page 237)2 Every year the actual returns on plan assets are compared with the expected returns on plan assets. The expected return is generally equal to the fair value of the plan assets at the beginning of the period multiplied by the expected rate of return. When actual return on plan assets exceeds the expected return, the result is gain. Similarly when the actual return on plan assets is lower than the expected return, the result is loss. These gains and losses are spread out over the remaining working lifetime of current memberships under the scheme of SSAP 24 and yearly standard rate is adjusted accordingly. SSAP 24 in a way amortizes such gain or loss over the reaming working lifetime of current memberships. The SSAP 24 clearly is concerned with the fact resulting effect on profit and loss when gain or loss thus calculated is written off or written back in the same year of its occurrence. This is where the approach of FRS 17 differs from SSAP 24. The objective of FRS 17 is to ensure fair value presentation of plan assets and liabilities. Assets are valued at market rates at reporting date and liabilities are measured by the actuaries and present value thereof is arrived at by discounting the cash outflows. Pension costs charged to income statement include past and present service costs and interest cost. Estimated returns on plan assets are also recognized and actuarial gain and losses are recognized in separate income statement of recognized gains and losses. FRS 17 is considered radical in its approach of dealing with actuarial gains or losses of plan assets and pension liabilities. FRS 17 seeks that such gains and losses should be adjusted to profit or loss of in the same year of their occurrences. The adjustment is made not affecting the current year results; instead those are reflected in the other income statement called ‘Statement of recognized income and losses’. By adjusting the gains and losses through income statement in the same year of their occurrences the balance sheet will remain unaffected as there will be no more dubious provisions or surpluses as there is no application of standard rate of charging pension costs. Though in the final analysis all provisions and surpluses get settled among themselves, but it can be said that balance sheet has been taken care of by FRS 17. Accordingly there is a clear cut shift from income statement approach of SSAP 24 to balance sheet approach of FRS 17. However, there are far reaching consequences of the application of balance sheet approach of FRS 17. The standard is criticized because it introduces some level of volatility in the financial statements. Under FRS 17 assets are valued at market rates, whereas liabilities are valued on a projected unit method basis and then discounted at appropriate bond rate. ‘Thus the values of assets are more susceptible to market fluctuations, but there is unlikely to be a corresponding movement in the value of liabilities.’(Benfield Group, page 5)3 There is also controversy with regard to choice of discount rate of AA corporate bond yield; as such discount rate is lower than market determined cost of capital. With the result the pension deficit will be over estimated and surplus underestimated by use of such lower discount rate. Consequently the applicability of FRS 17 will create more deficits. Such deficits will further be accentuated as actuarial gains remain unrealized except to the extent of agreed plan refund. On the other hand losses would be considered as realized because of legal and constructive obligations. Deficits will have further adverse effects on distributable reserves and consequently on distribution of dividends. This may also challenge the pension fund investment policies of the company. There is other side of the picture as well. Even though FRS 17 is vulnerable to market volatility, but it exposes to the shareholders the inherent risks in plan assets and corresponding liabilities. Part b IAS19 was revised substantially in 1998 and thereafter amendments were made in 2002 and 2004 in the standard. The important feature of the standard is that it covers all employee benefits and not just the pensions or post retirement benefits. The employee benefits covered under IAS 19 are Short term employee benefits, post employment benefits, other long term employee benefits, and termination benefits. The standard seeks to recognize a liability of employee benefits only when employee has provided services in exchange of future benefits. Also the cost of employee benefits will be recognized when the company consumes economic benefits from the employer services for future benefits. So far as post employment benefits or pensions are concerned, the standard has classified plans either as ‘defined contribution plans’ or defined benefit plans’. The company subscribes a fixed periodic contribution towards defined contribution plans. Under these plans the company does not have any further obligation. Defined benefit plans are different from defined contribution plans in the sense that plan is not dependent upon the contributions, but the risks and obligations of post employment employee benefits remain with the company. The company undertakes to provide agreed benefits to provide post employment benefits to employees. Though the post employment benefits are determined by the contributions of employers and employees, but both actuarial risks and investment risks are to be borne by the employer. The entity has to meet out the losses on both actuarial and investment valuations. The entity will recognize expense and liability of the contribution payable to defined benefit plan only in exchange of services rendered by the employee. The company will recognize expense and liability for accrued expenses after adjusting the earlier contributions. If contributions paid exceed the contribution due the excess is treated as prepaid expense but only to the extent prepayment will lead to a reduction in future payments or cash refund. Under the defined benefit plans the fair value of the plan assets is assessed. Obligations of employee benefit against current and prior period services are assessed using actuarial techniques for demographic variables and financial variables that affect the estimates of obligation. Then the present value of employee benefits is computed by discounting the benefit using projected unit credit methods. Actuarial gains and losses are determined and recognized using a corridor approach. 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)4 Under this approach when gains or losses are not more than 10% of present value of plan obligation or fair value of plan assets, then such gains or losses are not recognized. When gains or losses exceed the corridor limit, the excess is amortized over the working lives of present work force. Unrecognized gains or losses falling within or outside the corridor are considered as part of plan obligation. Therefore the plan employee benefit obligations under DB plans are reported as under: (Present value of employee benefit obligation) +/ - (unrecognized gains or losses) – (unrecognized past service cost) – (fair value of plan assets) When the resultant figure is negative (i.e. assets) then that will be recognized as asset subject to a ceiling of sum of actuarial losses, unrecognized past service cost, and present value of plan refunds or restrictions in future contributions. Unrecognized losses and gains have a manipulative effect on profits and losses of the entity. This is because “when unrecognized losses (or equally gains) build up and breach the corridor, they need to be amortized through profit and loss. This would then mean reporting a higher (or possibly lower, if unrecognized gains) pension cost.” (Hewitt, June 2005)5 Amendments to IAS 19 made in December 2004 have now opened a number of options with entities to deal with gains and losses resulting from actuarial evaluation of plan assets and liabilities. The entities now have an additional option of recognition of such gains and losses in the year in which those occur. The adjustments are required to be made through Statement of Recognized Income and Expenses. This amendment is similar to UK standard FRS17. Such immediate recognition of gains or losses may some time have extraordinary effects on financial statements particularly when the quantum of gains or losses is large. This amount distributable to shareholders may fluctuate effectively from year to year and thereby affecting earning per share and consequently the market rates of company stocks. The issue of termination benefits has also been treated effectively in its amendments. Termination of employee takes place when an employee is terminated or fired by management before his retirement or when the employee seeks voluntary retirement. IAS 19 directs that expenses relating to termination benefits should be recognized immediately even when such benefits become due with 12 months of the reporting date. The important aspect of the IAS 19 is its disclosure requirements. In case of equity compensation benefits, IAS 19 has not provided any specific regulation for its treatment but equity compensation benefits are required to be disclosed effectively so that users of financial statements get the required information. Part C The IASB should try to remove the major limitations of IAS 19 and also bring in the advantageous features of other post employment benefit accounting regulations of other countries while developing a suitable and satisfactory standard for post- employment benefits. Few suggestions are detailed hereunder. Recognition of actuarial gains or losses in profit and loss each year on their occurrence through statement of recognized income and expenses, as promulgated by December 2004 amendment of IAS 19 and also under UK FRS 17 is not a very prudent approach. This is because each year the entity would be putting pressure on its financial statements affecting EPS and in turn the market price of its shares. The ideal solution is to deal with matter upon the culmination of defined benefit plan. This way in addition to solving the problem of each year effects on EPS, the issue of currency translations of subsidiaries will also be taken care of. As Mr. Yamada (page 1150)6 puts it “The cumulative actuarial gains and losses could be recognized in profit and loss when a plan is wound up or transferred outside the entity. The cumulative amount recognized in a separate component of equity would be transferred to retained earnings at the same time. This would also be consistent with the treatment of exchange gains and losses on subsidiaries that have a measurement currency different from presentation currency of the group.” An area of IAS 19 that has become a controversial issue is the selection of discount rate for computation of present value of pension liabilities. At present market rates of corporate bonds are considered for discounting the future cash out flow to compute present value of pension liabilities. This is unfair. A discount rate should be a fair rate that takes into account the duration or time factor involved in occurrence of actual payment of pension liabilities. In other words current corporate bond rates are required to be adjusted with factors like risks of time attached with actual liquidation of post employment liabilities. This is because current bond rates are results of interaction of current market factors, whereas post- employment benefits are to be liquidated in future. There is another option to deal with actuarial gains and losses. It is recommended that IASB should treat the actuarial gains and losses the way German has permitted to its non- listed companies. This is because International Accounting Standards are now applicable on all listed companies in European countries. The German rules seek valuation of pension liabilities on basis of current salary rates, and because of that both past services costs and actuarial gains and losses are required recognized immediately in profit and loss in order to mitigate their effects instantly. This will definitely reduce the volatility of profit and loss due to recurring effects of adjustment of actuarial gains and losses into profit and loss. Though such a treatment “contrasts with valuation method under IAS 19 (projected salaries and options to defer recognition of actuarial gains and losses)” (Juan Yermo and Fiona Steward, page 47) but it is effective in smoothening the volatility of profit and loss mainly because liabilities are measured at current costs of salaries and not the projected prices of salaries. The legal, social, and moral responsibilities of employers are different in different countries. That is why IAS 19 has recommended that employers should take care of not only legal obligations but also other obligations that are unavoidable while determining their contributions. It is suggested that IASB should stress more strongly on obligations other than legal obligations in determining the employers’ contributions towards post employment benefits of employees. These obligations other than legal compliances are called ‘constructive obligations’ and such constructive obligations arise from informal, social and moral responsibilities of the employer. It is suggested that IASB should bring in standards that put more specific responsibilities on employers to consider such social and moral factors in determining their obligations towards post- employment benefits. Word Count: 2538 References: Read More