The accounting for employee benefits, and for pensions in particular, is complex. The liabilities in defined benefit pension plans are frequently material. They are long-term and difficult to measure, and this gives rise to difficulty in measuring the cost attributable to each year.
Employee benefits are all forms of consideration given or promised by an entity in exchange for services rendered by its employees. These benefits include salary-related benefits (such as wages, profit-sharing bonuses, and compensated absences, including paid holiday and long-service leave), termination benefits (such as severance and redundancy pay) and post-employment benefits (such as retirement benefit plans). IAS 19 is relevant for all employee benefits, except for those to which IFRS 2, ‘Share-based payments’, applies.
Post-employment benefits include pensions, post-employment life insurance and medical care. Pensions are provided to employees either through defined contribution plans or defined benefit plans.
Recognition and measurement for short-term benefits is relatively straightforward, because actuarial assumptions are not required and the obligations are not discounted. However, long-term benefits, particularly post-employment benefits, give rise to more complicated measurement issues.
Defined contribution plans
Accounting for defined contribution plans is straightforward: the cost of defined contribution plans is the contribution payable by the employer for that accounting period.
Defined benefit plans
Accounting for defined benefit plans is complex, because actuarial assumptions and valuation methods are required to measure the balance sheet obligation and the expense. The expense recognised generally differs from the contributions made in the period.
Subject to certain conditions, the net amount recognised on the balance sheet is the difference between the defined benefit obligation and the plan assets.
To calculate the defined benefit obligation, estimates (actuarial assumptions) regarding demographic variables (such as employee turnover and mortality) and financial variables (such as future increases in salaries and medical costs) are made and included in a valuation model. The resulting benefit obligation is then discounted to a present value. This normally requires the expertise of an actuary.
Where defined benefit plans are funded, the plan assets are measured at fair value. Where no market price is available, the fair value of plan assets is estimated (for example, by discounting expected future cash flows using a discount rate that reflects both the risk associated with the plan assets and the maturity of those assets). Plan assets are tightly defined, and only assets that meet a strict definition can be offset against the plan’s defined benefit obligations, resulting in a net surplus or net deficit that is shown on the balance sheet.
At each balance sheet date, the plan assets and the defined benefit obligation are remeasured. The income statement reflects the change in the surplus or deficit, except for contributions to the plan and benefits paid by the plan, along with business combinations and remeasurement gains and losses. Remeasurement gains and losses comprise actuarial gains and losses, return on plan assets (excluding amounts included in net interest on the net defined benefit liability or asset) and any change in the effect of the asset ceiling (excluding amounts included in net interest on the net defined benefit liability or asset). Remeasurements are recognised in other comprehensive income.
The amount of pension expense (income) to be recognised in profit or loss comprises the following individual components, unless they are required or permitted to be included in the costs of an asset:
- Service costs (that is, the present value of the benefits earned by active employees); and
- Net interest costs (that is, the unwinding of the discount on the defined benefit obligation and a theoretical return on plan assets).
Service costs comprises the ‘current service costs’, which is the increase in the present value of the defined benefit obligation resulting from employee services in the current period, ‘past-service costs’ (as defined below and including any gain or loss on curtailment) and any gain or loss on settlement.
Net interest on the net defined benefit liability (asset) is defined as ‘the change during the period in the net defined benefit liability (asset) that arises from the passage of time’. [IAS 19 para 8]. The net interest cost can be viewed as comprising theoretical interest income on plan assets, interest cost on the defined benefit obligation (that is, representing the unwinding of the discount on the plan obligation) and interest on the effect of the asset ceiling. [IAS 19 para 124].
The net interest on the net defined benefit liability (asset) is calculated by multiplying the net defined benefit liability (asset) by the discount rate (both as determined at the start of the annual reporting period), taking account of any changes in the net defined benefit liability (asset) during the period as a result of contribution and benefit payments. [IAS 19 para 123]. The discount rate applicable to any financial year is an appropriate high-quality corporate bond rate (or government bond rate, if appropriate) in the currency in which the liabilities are denominated. Net interest on the net defined benefit liability (asset) can be viewed as effectively including theoretical interest income on plan assets.
Past-service costs are defined as a change in the present value of the defined benefit obligation for employee services in prior periods, resulting from a plan amendment (the introduction or withdrawal of, or changes to, a defined benefit plan) or a curtailment (a significant reduction by the entity in the number of employees covered by a plan). Past-service costs need to be recognised as an expense generally when a plan amendment or curtailment occurs. Settlement gains or losses are recognised in the income statement when the settlement occurs.
IFRIC 14, ‘IAS 19 – The limit on a defined benefit asset, minimum funding requirements and their interaction’, provides guidance on assessing the amount that can be recognised as an asset when plan assets exceed the defined benefit obligation creating a net surplus. It also explains how the pension asset or liability might be affected by a statutory or contractual minimum funding requirement.