Importance of Pension and Other Benefit Plan Accounting

For a variety of cultural, economic and political reasons, the existence of private pension plans has increased tremendously over the past 40 years, and these arrangements are the most common and desired of the assorted “fringe benefits” offered by employers in many nations. Under the laws of some nations, employers may be required to have such programmes in place for their permanent employees. For many entities, pension costs have become a very material component of the total compensation paid to employees. Unlike for wages and other fringe benefits, the timing of the payment of cash to either the plan's administrators or to the plan beneficiaries can vary substantially from the underlying economic event (that is, the plans are not always fully funded on a current basis). This creates the possibility of misleading financial statement representation of the true costs of conducting business, unless a valid accrual method is employed. For this reason, and also because of the complexity of these arrangements and the impact they have on the welfare of the workers, accounting for the cost of pension plans and similar schemes (post‐retirement benefits other than pensions, etc.) has received a great deal of attention from national and international standards setters.

Basic Objectives of Accounting for Pension and Other Benefit Plan Costs

Applicability: Pension Plans

IAS 19 is applicable to both defined contribution and defined benefit pension plans. The accounting for defined contribution plans is normally straightforward, with the objective of matching the cost of the programme with the periods in which the employees earn their benefits. Since contributions are formula‐driven (e.g., as a percentage of wages paid), typically the payments to the plan will be made currently; if they do not occur by the end of the reporting period, an accrual will be recognised for any unpaid current contribution liability. Once made or accrued, the employer has no further obligation for the value of the assets held by the plan or for the sufficiency of fund assets for payment of the benefits, absent any violation of the terms of the agreement by the employer. Employees thus suffer or benefit from the performance of the assets in which the contributions made on their behalf were invested; often the employees themselves are charged with responsibility for selecting those investments.

IAS 19 requires that disclosure be made of the amount of expense recognised in connection with a defined contribution pension plan. If not explicitly identified in the statement of profit or loss, this should therefore be disclosed in the notes to the financial statements.

Compared to defined contribution plans, the accounting for defined benefit plans is vastly more complex, because the employer (sponsor) is responsible not merely for the current contribution to be made to the plan on behalf of participants, but additionally for the sufficiency of the assets in the plan for the ultimate payments of benefits promised to the participants. Thus, the current contribution is at best a partial satisfaction of its obligation, and the amount of actual cost incurred is not measured by this alone. The measurement of pension cost under a defined benefit plan necessarily involves the expertise of actuaries—persons who are qualified to estimate the numbers of employees who will survive (both as employees, in the case of vesting requirements which some of them may not yet have met, and as living persons who will be present to receive the promised retirement benefits), the salary levels at which they will retire (if these are incorporated into the benefit formula, as is commonly the case), their expected life expectancy (since benefits are typically payable for life) and other factors which will influence the amount of resources needed to satisfy the employer's promises. Accounting for defined benefit plans is described at length in the following pages.

Applicability: Other Employee Benefit Plans

IAS 19 explicitly applies not merely to pension plans, but also three other categories of employee and post‐employment benefits. These are:

1. Short‐term employee benefits, which include normal wages and salaries as well as compensated absences, profit sharing and bonuses, and such non‐monetary fringe benefits as health insurance, housing subsidies and employer‐provided automobiles, to the extent these are granted to current (not retired) employees.
2. Other long‐term employee benefits, such as long‐term (sabbatical) leave, long‐term disability benefits and, if payable after 12 months beyond the end of the reporting period, profit sharing and bonus arrangements and deferred compensation.
3. Termination benefits, which are payments to be made upon termination of employment under defined circumstances, generally when employees are induced to leave employment before normal retirement age.

Each of the foregoing categories of employee benefits will be explained later in this chapter.

IAS 19 also addresses post‐employment benefits other than pensions, such as retiree medical plan coverage, as part of its requirements for pension plans, since these are essentially similar in nature. These are also discussed further later in this chapter.

IAS 19 considers all plans other than those explicitly structured as defined contribution plans to be defined benefit plans. Unless the employer's obligation is strictly limited to the amount of contribution currently due, typically driven by a formula based on entity performance or by employee wages or salaries, the obligations to the employees (and the amount of recognisable expense) will have to be estimated in accordance with actuarial principles.

Cost Recognition Distinguished from Funding Practices

Although it is arguably a sound management practice to fund retirement benefit plans on a current basis, in some jurisdictions the requirement to do this is either limited or absent entirely. Furthermore, in some jurisdictions the currently available tax deduction for contributions to pension plans may be limited, reducing the incentive to make such contributions until such time as the funds are actually needed for making payouts to retirees. Since the objective of periodic financial reporting is to match costs and revenues properly on a current basis, the pattern of funding is obviously not always going to be a useful guide to proper accounting for pension costs.

General Discussion

Absent specific information to the contrary, it is assumed that a company will continue to provide retirement benefits well into the future. The accounting for the plan's costs should be reflected in the financial statements and these amounts should not be discretionary. All pension costs—with the exception noted below—should be charged against income. No amounts should be charged directly to retained earnings. The principal focus of IAS 19 is on the allocation of cost to the periods being benefited, which are the periods in which the covered employees provide service to the reporting entity.

Periodic Measurement of Cost for Defined Contribution Plans

Under the terms of a defined contribution plan, the employer will be obligated for fixed or determinable contributions in each period, often computed as a percentage of the wage and salary base paid to the covered employees during the period. For one example, contributions might be set at 4% of each employee's wages and salaries, up to €50,000 wages per annum. Generally, the contributions must actually be made by a specific date, such as 90 days after the end of the reporting entity's fiscal year, consistent with local law. The expense must be accrued for accounting purposes in the year the cost is incurred, whether the contribution is made currently or not.

IAS 19 requires that contributions payable to a defined contribution plan be accrued currently, even if not paid by year‐end. If the amount is due over a period extending more than one year from the end of the reporting period, the long‐term portion should be discounted at the rate applicable to high quality long‐term corporate bonds. For currencies, where a deep market for high‐quality corporate bonds is not available, the market yields applicable to government bonds of the appropriate term consistent with the estimated term of the obligation denominated in the respective currencies are used as the alternative discount rate.

Past service costs arise when a plan is amended retroactively, so that additional attribution for benefits is given to services rendered in past years. The expense related to past service cost is recognised in income when the related plan amendment, curtailment or settlement occurs.

Periodic Measurement of Cost for Defined Benefit Plans

Defined benefit plans present a far greater challenge to accountants than do defined contribution plans, since the amount of expense to be recognised currently will need to be determined on an actuarial basis. Under current IFRS, only the accrued benefit valuation method may be used to measure defined benefit plan pension cost. Furthermore, only a single variant of the accrued benefit method—the “projected unit credit” method—is permitted.

Net periodic pension cost will consist of the sum of the following components:

1. Service costs:
   1. Current service costs.
   2. Past service costs.
   3. Gain or loss on settlement.
2. Net interest cost for the current period on the net defined benefit liability (asset).
3. Remeasurement of the net defined benefit liability (asset):
   1. Actuarial gains and losses. Return on plan assets, excluding amounts included in net interest on the net defined benefit liability (asset); and
   2. Any change in the effect of the asset ceiling, excluding amounts included in net interest on the net defined benefit liability (asset).

Disclosures required by IAS 19 effectively require that these cost components be displayed in the notes to the financial statements.

Current Service Cost

Current service cost must be determined by an actuarial valuation and will be affected by assumptions such as expected turnover of staff, average retirement age, the plan's vesting schedule and life expectancy after retirement. The probable progression of wages over the employees' remaining working lives will also have to be taken into consideration if retirement benefits will be affected by levels of compensation in later years, as will be true in the case of career‐average and final‐pay plans, among others.

It is worth stressing this last point: when pension arrangements call for benefits to be based on the employees' ultimate salary levels, experience will show that those benefits will increase, and any computation based on current salary levels will surely understate the actual economic commitment to the future retirees. Accordingly, IFRS requires that, for such plans, future salary progression must be considered in determining current period pension costs. While future salary progression (where appropriate to the plan's benefit formula) must be incorporated (via estimated wage increase rates), current pension cost is a function of the services provided by the employee in the reporting period, emphatically not including services to be provided in later periods.

Under IAS 19, service cost is based on the present value of the defined benefit obligation and is attributed to periods of service without regard to conditional requirements under the plan calling for further service. Thus, vesting is not taken into account in the sense that there is no justification for non‐accrual prior to vesting. However, in the actuarial determination of pension cost, the statistical probability of employees leaving employment prior to vesting must be taken into account.

In December 2020, IFRIC Committee has taken a decision about the periods of service to which an entity attributes benefit for a particular defined benefit plan.

Paragraph 70 of IAS 19 specifies the principle for attributing benefit to periods of service and paragraphs 71–74 of IAS 19 include requirements that specify how an entity applies that principle. Paragraph 71 requires an entity to attribute benefit to periods in which the obligation to provide post‐employment benefits arises. That paragraph also specifies that the obligation arises as employees render services in return for post‐employment benefits an entity expects to pay in future reporting periods. Paragraph 72 specifies that employee service before any vesting date gives rise to a constructive obligation because, at the end of each successive reporting period, the amount of future service an employee will have to render before becoming entitled to the benefit is reduced.

The Committee concluded that the principles and requirements in IFRS Standards provide an adequate basis for an entity to determine the periods to which retirement benefit is attributed.

An example to help understand the above is presented:

Under the terms of the plan:

1. Employees are entitled to a retirement benefit only when they reach the retirement age of 62 provided they are employed by the entity when they reach that retirement age;
2. The amount of the retirement benefit is calculated as one month of final salary for each year of service before the retirement age;
3. The retirement benefit is capped at 16 years of service (i.e. the maximum retirement benefit an employee is entitled to is 16 months of final salary); and
4. The retirement benefit is calculated using only the number of consecutive years of employee service immediately before the retirement age.

For the defined benefit plan illustrated:

1. If an employee joins the entity before the age of 46 (i.e. there are more than 16 years before the employee's retirement age), any service the employee renders before the age of 46 does not reduce the amount of future service the employee will have to render in each successive reporting period before becoming entitled to the retirement benefit. Employee service before the age of 46 affects neither the timing nor the amount of the retirement benefit. Accordingly, the entity's obligation to provide retirement benefits arises only from the age of 46.
2. If an employee joins the entity on or after the age of 46, the amount of future service the employee will have to render before becoming entitled to the retirement benefit is reduced at the end of each successive reporting period. Accordingly, the entity's obligation to provide retirement benefits arises from the date the employee first renders service.

Paragraph 73 of IAS 19 specifies that an entity's obligation increases until the date when further service by the employee will lead to no material amount of further benefits under the plan. Thus in substance:

1. Each year of service between the age of 46 and the age of 62 leads to further benefits because service rendered in each of those years reduces the amount of future service an employee will have to render before becoming entitled to the retirement benefit; and
2. An employee will receive no material amount of further benefits from the age of 62, regardless of the age at which the employee joins the entity. The entity therefore attributes retirement benefit only until the age of 62.
3. The entity attributes retirement benefit to each year in which the employee renders service from the age of 46 to the age of 62 (or, if employment commences on or after the age of 46, from the date the employee first renders service to the age of 62).

Interest on the Accrued Benefit Obligation

As noted, since the actuarial determination of current period cost is the present value of the future pension benefits to be paid to retirees by virtue of their service in the current period, the longer the time until the expected retirement date, the lower will be the service cost recognised. However, over time this accrued cost must be further increased, until at the employees' respective retirement dates the full amounts of the promised payments have been accreted. In this regard, the accrued pension liability is much like a sinking fund that grows from contributions plus the earnings thereon.

While service cost and interest are often the major components of expense recognised in connection with defined benefit plans, there are other important elements of benefit cost to be accounted for. IAS 19 identifies the expected return on plan assets, actuarial gains and losses, past service costs and the effects of any curtailments or settlements as categories to be explicitly addressed in the disclosure of the details of annual pension cost for defined benefit plans. These will be discussed in the following sections in turn.

The Expected Return on Plan Assets

IAS 19 has adopted the approach that since pension plan assets are intended as long‐term investments, the random and perhaps sizeable fluctuations from period to period should not be allowed to excessively distort the operating results reported by the sponsoring entity. This standard identifies the expected return rather than the actual return on plan assets as the salient component of pension cost, with the difference between actual and expected return being an actuarial gain or loss to be dealt with as described below. Expected return for a given period is determined at the same rate that the discount rate applied to determine the defined benefit pension obligation.

The IAS 19 amendment adopted in 2000 also added certain new requirements which relate to recognition and measurement of the right of reimbursement of all or part of the expenditure to settle a defined benefit obligation. It established that only when it is virtually certain that another party will reimburse some or all of the expenditure required to settle a defined benefit obligation, the sponsoring entity would recognise its right to reimbursement as a separate asset, which would be measured at fair value. In all other respects, however, the asset (amount due from the pension plan) is to be treated in the same way as plan assets. In the statement of profit or loss and other comprehensive income or separate income statement presented, defined benefit plan expense may be presented net of the reimbursement receivable recognised.

After the amendment in 2000, qualifying insurance policies are to be included in plan assets, arguably because those plans have similar economic effects to funds whose assets qualify as plan assets under the revised definition.

Actuarial Gains and Losses

Changes in the amount of the actuarially determined defined benefit pension obligation, and differences in the actual versus the expected return on plan assets, as well as demographic changes (e.g., composition of the workforce, changes in life expectancy, etc.) contribute to actuarial (or “experience”) gains and losses and are immediately recognised in other comprehensive income, without deferral or any off‐balance‐sheet treatment previously permitted under the “corridor approach.”

Past Service Costs

Past service costs refer to increases in the amount of a defined benefit liability that results from the initial adoption of a plan, or from a change or amendment to an existing plan which increases the benefits promised to the participants with respect to previous service rendered. Less commonly, a plan amendment could reduce the benefits for past services, if local laws permit this. Employers will amend plans for a variety of reasons, including competitive factors in the employment marketplace, but often it is done with the hope and expectation that it will engender goodwill among the workers and thus increase future productivity. For this reason, it is sometimes the case that these added benefits will not vest immediately, but rather must be earned over some defined time period.

IAS 19 requires immediate recognition of past service costs when they occur as a result of a plan amendment, curtailment or settlement as the case may be.

Settlements occur when the entity enters into a transaction which effectively transfers the obligation to another entity, such as an insurance company, so that the sponsor has no legal or constructive obligation to fund any benefit shortfall. Merely acquiring insurance which is intended to cover the benefit payments does not constitute a settlement, since a funding mechanism does not relieve the underlying obligation.

With the issuance of an amendment to IAS 19 in February 2018, an entity is also required to use updated assumptions to determine current service cost and net interest for the period after a plan amendment, curtailment or settlement.

Transition Adjustment

Where an entity has to change its accounting policy to bring these accounting requirements into effect it shall do so on a fully retroactive basis. However, an entity need not adjust the carrying amount of assets outside the scope of IAS 19 for changes in employee benefit costs that were included in the carrying amount before the date of initial application. The date of initial application is the beginning of the earliest prior period presented in the first financial statements in which the entity adopts this standard.

IFRIC 14: IAS 19—The Limit on a Defined Benefit Asset, Minimum Funding Requirements and Their Interaction

In July 2007, IFRIC issued Interpretation 14 to provide guidance on the limitation on asset recognition and the statutory minimum funding requirements. IFRIC 14 was amended in November 2009, effective for annual periods beginning on or after January 1, 2011. The amendment is applicable to limited circumstances where an entity is subject to minimum funding requirements and makes an early payment of contributions to cover the funding requirements. The benefit of such an early payment is regarded as an asset.

According to IASB, the interaction of this limit and minimum funding requirement has two possible effects:

1. The minimum funding requirement may restrict the economic benefits available as a reduction in future contributions; and
2. The limit may make the minimum funding requirement onerous because contributions payable under the requirement for services already received may not be available once they have been paid, either as a refund or as a reduction in future contributions.

In some jurisdictions, there are statutory (or contractual) minimum funding requirements that require sponsors to make future contributions. This is an increasingly common phenomenon, given the public's growing awareness that many defined benefit plans have been underfunded, raising concerns that retirees will find insufficient assets to pay their benefits after, for example, the plan sponsor has ceased operations or been sold. The question raised was whether those requirements should limit the amount of plan assets the employer may report in its statement of financial position in those situations where application of IAS 19 would otherwise permit asset recognition, as discussed in the preceding paragraphs. In other words, the problem was that the IAS 19‐based asset might not be available to the entity (and thus not be an asset of the reporting entity) in certain situations where future minimum funding requirements exist.

IFRIC 14 addresses the extent to which the economic benefit, via refund or reduction in future contributions, is constrained by contractual or statutory minimum funding obligations. It also addresses the calculation of the available benefits under such circumstances, as well as the effect of the minimum funding requirement on the measurement of defined benefit plan asset or liability.

IFRIC 14 addresses the following issues:

1. When refunds or reductions in future contributions should be regarded as “available to the employer”;
2. The effect of a minimum funding requirement on the economic benefit available as a reduction in future contributions; and
3. When a minimum funding requirement may give rise to a liability.

Multiple and Multi‐Employer Plans

If an entity has more than one plan, IAS 19 provisions should be applied separately to each plan. Offsets or eliminations are not allowed unless there clearly is the right to use the assets in one plan to pay the benefits of another plan.

Participation in a multi‐employer plan (to which two or more unrelated employers contribute) requires that the contribution for the period be recognised as net pension cost and that any contributions due and unpaid be recognised as a liability. Assets in this type of plan are usually commingled and are not segregated or restricted. A board of trustees usually administers these plans, and multi‐employer plans are generally subject to a collective bargaining agreement. If there is a withdrawal from this type of plan and if an arising obligation is either probable or reasonably possible, the provisions of IFRS that address contingencies (IAS 37) apply.

Some plans are, in substance, a pooling or aggregation of single employer plans and are ordinarily without collective bargaining agreements. Contributions are usually based on a selected benefit formula. These plans are not considered multi‐employer plans, and the accounting is based on the respective interest in the plan.

Short‐Term Employee Benefits

According to IAS 19, short‐term benefits are those falling due within 12 months from the end of the period in which the employees render their services. These include wages and salaries, as well as short‐term compensated absences (vacations, annual holiday, paid sick days, etc.), profit sharing and bonuses if due within 12 months after the end of the period in which these were earned, and such non‐monetary benefits as health insurance and housing or automobiles. The standard requires that these be reported as incurred. Since they are accrued currently, no actuarial assumptions or computations are needed and, since they are due currently, discounting is not to be applied.

Compensated absences may provide some accounting complexities, if they accumulate and vest with the employees. Accumulated benefits can be carried forward to later periods when not fully consumed currently; for example, when employees are granted two weeks' leave per year, but can carry forward to later years an amount equal to no more than six weeks, the compensated absence benefit can be said to be subject to limited accumulation. Depending on the programme, accumulation rights may be limited or unlimited; and, furthermore, the usage of benefits may be defined to occur on a LIFO basis, which in conjunction with limited accumulation rights further limits the amount of benefits which employees are likely to use, if not fully used in the period earned.

The cost of compensated absences should be accrued in the periods earned. In some cases it will be understood that the amounts of compensated absences to which employees are contractually entitled will exceed the amount that they are likely to actually utilise. In such circumstances, the accrual should be based on the expected usage, based on past experience and, if relevant, changes in the plan's provisions since the last reporting period.

Other Post‐Retirement Benefits

Other post‐retirement benefits include medical care and other benefits offered to retirees partially or entirely at the expense of the former employer. These are essentially defined benefit plans very much like defined benefit pension plans. Like the pension plans, these require the services of a qualified actuary to estimate the true cost of the promises made currently for benefits to be delivered in the future. As with pensions, a variety of determinants, including the age composition, life expectancies and other demographic factors pertaining to the present and future retiree groups, and the course of future inflation of medical care (or other covered) costs (coupled with predicted utilisation factors), need to be projected to compute current period costs. Developing these projections requires the skills and training of actuaries; the projected pattern of future medical costs has been particularly difficult to achieve with anything approaching accuracy. Unlike most defined benefit pension plans, other post‐retirement benefit plans are more commonly funded on a pay‐as‐you‐go basis, which does not alter the accounting but does eliminate earnings on plan assets as a cost offset.

Other Long‐Term Employee Benefits

These are defined by IAS 19 as including any benefits other than post‐employment benefits (pensions, retiree medical care, etc.), termination benefits and equity compensation plans. Examples would include sabbatical leave, “jubilee” or other long‐service benefits, long‐term profit‐sharing payments and deferred compensation arrangements. Executive deferred compensation plans have become common in nations where these are tax‐advantaged (i.e., not taxed to the employee until paid), and these give rise to deferred tax accounting issues as well as measurement and reporting questions, as benefit plans. In general, measurement will be less complex than for defined benefit pension or other post‐retirement benefits, although some actuarial measures may be needed.

IAS 19 requires that past service cost (resulting from the granting of enhanced benefits to participants on a retroactive basis) must be reported in profit or loss in the period in which these are granted or occur.

For liability measurement purposes, IAS 19 stipulates that the present value of the obligation be presented in the statement of financial position, less the fair value of any assets that have been set aside for settlement thereof. The long‐term corporate bond rate is used here, as with defined benefit pension obligations, to discount the expected future payments to present value. As to expense recognition, the same cost elements as are set forth for pension plan expense should be included, with the exceptions that, as noted, actuarial gains and losses and past service cost must be recognised immediately, not amortised over a defined time horizon.

Termination Benefits

Termination benefits are to be recognised at the earlier of when the entity can no longer withdraw the offer of those benefits, and when the entity recognises costs for a restructuring that is within the scope of IAS 37.

Since termination benefits do not confer any future economic benefits on the employing entity, these must be expensed immediately.