Emmanuel Eragne

Lille University - M2 CCA US GAAP Year 2010 - 2011

IAS 19

Employee Benefits Post-employment benefits Defined Benefit Plans

Introduction
The International Accounting Standard 19 prescribes the accounting method and disclosure by employers for employee benefits. This standard is currently being revised by the IASB, which has issued an exposure draft in April 2010. We will by default refer to the current version of the standard, and later we will discuss the potential impact of the proposed amendments. The current IAS 19 identifies four different types of employee benefits: Short-term employee benefits are the wages, salaries and social security contributions, and all other forms of benefits (whether monetary or not) payable within 12 months to current employees. Post-employment benefits are essentially pensions, life insurance and healthcare plans. Other long-term employee benefits refers to benefits that are payable 12 months or more after the end of the reporting period. Termination benefits are benefits payable upon termination of the employment contract (regardless of whether it results from a decision of the employer or the employee).

Also, post-employment benefit plans are divided into two types of plans: defined contribution plans and defined benefit plans. When the former applies, the employer pays a fixed amount of money to a third-party fund. In return, this entity assumes full responsibility for providing retired employees with benefits. The employer bears no obligation to pay the benefits if the fund happens to default. Other plans are defined benefit plans. Here, the employer remains responsible for paying employee benefits. The IAS 19 therefore requires that companies account for defined benefit obligations as a liability, and provides the method for valuating it. Under a defined benefit plan, the amount to which current and former employees are entitled results from a formula (e.g. employees are entitled to 1% of their last annual salary per year of service.) The employer thus bears an actuarial risk, i.e. the risk that benefits will actually cost more than what is currently expected, and the risk that investments aimed at financing the employers obligation will yield less than anticipated.

Table of contents

IAS 19: Employee Benefits - Post-employment benefits - Defined Benefit Plans Introduction Implementation of IAS 19 Post-employment benefits - Defined Benefit plans Defined benefit obligation Plan assets Actuarial gains and losses Past service cost Disclosure Conclusion: IAS 19 proposed amendments 1 2 4 5 7 8 10 12 15

Implementation of IAS 19 Post-employment benefits - Defined Benefit plans

Because the employers liability will be settled in the future, several actuarial assumptions need to be made in order to evaluate it. 1) The first step consists in estimating the defined benefit obligation, i.e. the amount to which current and former employees are eligible to in return for their services in the past and current reporting periods. The reporting entity then splits this amount into what is attributable to past periods and to the current period, using the Projected Credit Unit Method (PCUM). Because the employers liability will be settled in the future, the gross obligation must be discounted to reflect: The time value of money The fact that all of the current employees will not necessarily be employed by the entity by the time they reach the retirement age. Several actuarial assumptions need to be made in order to perform this calculation. 2) If the employer has committed money to funding the obligation, the fair value of these investments (called plan assets) must be determined. 3) The third step consists in calculating actuarial gains and losses. Actuarial gains and losses are linked to the assumptions made by the reporting entity, and arise in two cases: Actual experience differs from assumptions. For example, as will be seen later, the employer needs to estimate its turnover rate. If it turns out that this parameter had been over/underestimated, actuarial losses or gains will ensue. Revision of the assumptions (thanks to actual experience, the entity may decide to lower or raise its turnover rate estimate for the years ahead.) When actuarial gains and losses are determined, the entity may also have to calculate what part of these gains/losses has to be recognized over the current period. 4) Finally, the company determines the result of amendments made to the plan, as well as the impact from curtailments and settlements. The Standard mentions that informal practices must also be taken into account, if the entity has actually no choice but to comply with that informal practice. The entity will report post-employment benefits as a liability in its statement of financial position, for the amount defined as follows: [EQ.1] Liability = + Present value of the defined benefit at the end of the reporting period (i.e. the amount calculated in 1.) + Actuarial gains (minus actuarial loss) not yet recognized - Any past service cost not yet recognized - The fair value of plan assets (if any) held in order to cover the defined benefit obligation If the total is negative, an asset may be recognized under certain conditions, as will be seen later.

Defined benefit obligation

The company shall use the PCUM to spread the total obligation over the time of service of the related employees. Example: a company has one employee on its payroll. His current salary is 20,000 and we assume that it increases by 3% a year. He has been employed by the entity for 5 years and is expected to retire in 10 years. According to the defined benefit plan, he is entitled to 1% of his final annual salary per year of service. The estimated benefit payable 10 years from now is: !! = 20,000 1.03!" 5 + 10 0.01 = 4,032 Because at this point in time the employee has been rendering services for 5 years, the gross obligation is scaled to reflect the part already earned: !!! = 4,032 5 = 1,344 15

The service cost is the additional benefit earned by the employee during the reporting !,!"# period. It is thus = 269 in our example.
!"

Future value of benefits attributable to prior and current years:

Dec. 31 Obligation by 2020 Benefit attributed to current and prior years Benefit attributed to current year Benefit attributed to prior years 2010 4,032 1,344 269 1,075 2011 4,032 1,613 269 1,344 2012 4,032 1,882 269 1,613 2013 4,032 2,151 269 1,882 2014 4,032 2,420 269 2,151

The PCUM require that the company recognize the benefits over the period during which they arise. This time frame may differ from the employment period. For instance, if in our example the defined benefit is capped at 12% of the final salary: !! = 20,000 1.03!" 12 0.01 = 3,225 The 3,225 benefit will be attributed to the prior 5 years and next 7 years. The service cost related to the 2018-2020 period will be zero. The future value must then be discounted in order to reflect the time value of money and the probability that current employees will actually be eligible to the benefits. It is recommended that companies use the services of an actuary, because several assumptions need to be made in order to perform the calculation: Demographic assumptions: o Mortality, both during and after employment; o Rates of turnover, disability and early retirement; o The proportion of plan members with dependents who will be eligible for plan benefits; o Claim rates if the plan covers healthcare costs.

Financial assumptions: o Discount rate; o Future salary and benefit levels; o Future medical costs, if covered.

The assumptions must be unbiased (i.e. neither excessive or too conservative) and mutually compatible. Mutual compatibility means that assumptions must be consistent with one another. For instance, a salary increase of .5% a year implies low inflation, so the discount rate should also reflect an anticipation of low inflation. Example: the 4,032 is a lump-sum payment on Dec. 31, 2020. The plan does not cover healthcare costs, and we take the following values for our parameters: Mortality rate 3% (flat) Turnover, disability, early retirement 5.5% Discount rate 7% Annual salary increase 3% (see supra) The actuarial value of the obligation at the end of the reporting period is thus: 1,344 (1 .03)!" (1 .055)!" (1 + .07)!!" = 286 The discounting factors are raised to the tenth power because the obligation is payable ten years from now. All things staying equal, in 2011 the discounting factor will be (1 .03)! (1 .055)! (1 + .07)!! . As the settlement date approaches, the impact of discounting fades off, and the company recognizes an interest cost on its obligation.
Dec. 31 Obligation by 2020 Benefit attributed to current and prior years Benefit attributed to current year Benefit attributed to prior years Discounting factor (Mortality + Turnover + Time Value of Money) Present Value of Defined Benefit attributed to prior and current year Present Value of Defined Benefit attributed to prior year Interest on prior years Defined Benefit Present Value of prior years Defined Benefit Present value of service cost Present Value of Defined Benefit attributed to prior and current year 2010 4032 1344 269 1075 21% 286 196 33 229 57 286 2011 4032 1613 269 1344 25% 401 286 48 334 67 401 2012 4032 1882 269 1613 29% 546 401 67 468 78 546 2013 4032 2151 269 1882 34% 728 546 91 637 91 728 2014 4032 2420 269 2151 40% 957 728 122 850 106 957

The company shall use as its discounting rate the market yield on high quality corporate bonds. These bonds should also be traded in the same currency as the defined benefit, and have the same maturity date. When national financial markets do not provide reliable yield curve for corporate bonds, government bonds (which are more liquid) can be used instead. If there is no match in terms of maturity, the entity can extrapolate long-term rates from the known short-term rates.

According to the IAS 19 Estimates of future salary increases take account of inflation, seniority, promotion and other relevant factors, such as supply and demand in the employment market.

Plan assets
The fair value of plan assets offsets the defined benefit obligation. Plan assets comprise assets held by a long-term employee benefit fund, and insurance policies. The assets must be held by a separate, bankruptcy-remote, entity and they must be exclusively available for payment of the employee benefits. In the same way, insurance policies are eligible only if proceeds can only be used for payment of the benefits. Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms length transaction. When no market price is available, the fair value is estimated. The standard suggest using the discounted cash-flow method, with a discount rate that reflects the risk of the assets and the maturity of the obligation. With regards to insurance policies that qualify as plan assets: If the contract stipulates it matches euro for euro the obligation that has arisen from one defined benefit plan, then the fair value is the present value of the obligation (it would thus be 286 in our illustration) If the right to reimbursement from the insurance company is a nominal amount, it is the fair value.

Besides the fair value of plan assets, the entity deducts the expected return on assets from the defined benefit obligation. The return on plan assets comprises interests, dividends, and other revenues derived from plan assets, together with realized and unrealized gains and losses on assets. Administration costs related to the fund holding the assets that are not included in other actuarial assumptions are deducted from expected return. Example: every year, the employer invests in plan assets in order to partially fund its defined benefit obligation. The expected rate of return on assets is 10% after tax. There is no significant administration cost. Dec. 31 Present value of Defined Benefit (+) Fair value of plan assets (-) Expected return on plan assets, net of tax (-) Additional contribution on Dec. 31 (-) Net defined benefit obligation 2010 286 100 10 20 156 2011 401 130 13 25 233 2012 546 168 17 35 326 2013 728 220 22 50 436 2014 957 292 29 100 536

Actuarial gains and losses

Because actuarial assumptions are estimates, they will probably differ from observed values. Actuarial gains and losses will arise as a result of: Experience adjustments the difference between the anticipated and the actual value of parameters. Change in actuarial assumptions thanks to additional information, the company may decide to increase or lower the value of some parameters for future estimates.

All assumptions are concerned: salary increase rate, turnover, discounting rate, expected return on plan assets, etc. Example: in 2011 salaries went up by 6% and assets returned 70%. Actuarial assumptions remain the same. The defined benefit payable on Dec. 31, 2020 is now: 21,200 1.03! 6 + 9 0.01 = 4,149 The part attributable to current and prior years (as at Dec. 31, 2011) is therefore: 4,149 6 (1 .03)! (1 .055)! (1 + .07)!! = 412 15

There is a 11 actuarial loss, since the present value of the defined benefit obligation is 412, while the expectation on Jan. 1, 2011 was 401. With regards to the return on assets, we observe an actuarial gain of 78 (actual: 130 .7 = 91 vs. expected 13), so the net effect is a gain of 67. Table 4 - Revised plan on Dec. 31, 2011
Dec. 31 Present value of Defined Benefit Fair value of plan assets Unrecognized actuarial gain of return of assets Net defined benefit obligation 2011 412 246 0 166 2012 561 306 ? 255 2013 749 387 ? 363 2014 984 525 ? 459 2015 1 276 727 ? 549

Accounting for actuarial gains and losses

The IAS 19 allows for two accounting methods: the entity can recognize actuarial gains and losses as profit or expense, or in other comprehensive income (OCI). In the first case, actuarial gains and losses and be recognized: o Immediately; o Or over the average remaining working time of the employees, using the corridor method. Example: according to [EQ.1], if actuarial gains and losses are recognized immediately, the company will account for a defined benefit liability of 1661 in its statement of financial position (assuming there is no unrecognized past service cost). This method induces little overhead in the accounting process but brings volatility

1 Table 4, line 7, col. 2

into the income statement, since actuarial gains and losses are by essence unpredictable. The 2011 defined benefit expense would be 10 as detailed below:

Current service cost Interest on Obligation Actuarial loss (on current service cost) Contribution paid into the plan Expected return on plan assets Actuarial gain (on return on assets) Total

(67) (48) (11) 25 13 78 (10)

This is consistent with a 166 liability, given that it was at 156 on Jan. 1st. The corridor method consist in: 1. Determining the net cumulative actuarial gain/loss (i.e. the sum of all gains since inception of the plan minus the sum of all losses) 2. Comparing the net cumulative actuarial gain/loss with the greater of: 10% of the present value of the defined benefit obligation on Dec. 31 10% of the fair value of plan assets on Dec. 31 3. If the net cumulative actuarial gain/loss is less than the 10%; then no actuarial gain or loss is recognized in the financial statements. If not, the fraction above the 10% is recognized over the average remaining working time frame of the employees. Example: assuming this is the first year the company experience an actuarial gain or loss, the net cumulative actuarial result is equal to the 2011 actuarial gain of 67. The defined benefit obligation on Dec. 31 is 412 and the fair value of plan assets is 246. The corridor is 41.20, so a 25.80 gain will be recognized over 10 years (25.80 = 67 41.20). In this case, the entity accounts for a 230.42 liability:
Dec. 31 Present value of Defined Benefit (+) Fair value of plan assets (-) Unrecognized actuarial gain (+) Net defined benefit obligation 2011 412 246 41.20 + 25.80*9/10 = 64.42 230.42

The year-over-over increase in liability of 74.42 (230.42 156 = 74.42) implies a 74.42 benefit expense. This result can also be obtained as shown below:

Current service cost Interest on Obligation Contribution paid into the plan Expected return on plan assets Actuarial gain (25.80*1/10) Total

(67) (48) 25 13 2.58 (74.42)

Every year, the net cumulative actuarial gain/loss is recalculated, as is the corridor. If the present value as at Dec. 31, 2012 of the defined benefit obligation is 600 instead of 561 as expected on Jan. 1st, 2012; then the net cumulative gain will be: 64.42 - (600 561) = 25.42. With a 60 corridor (600*10%) no actuarial gain or loss will be recognized. This method reduces income volatility, as gains and losses will likely offset each other in the long term, and will thus stay within the limits of the corridor. If the entity has opted for recognizing actuarial gains and losses in OCI, it must do so for ALL actuarial gains and losses and across ALL defined benefit plans. Actuarial and losses must be presented distinctively in the statement of comprehensive income, and in the statement of retained earnings. In any case, the entity shall not recycle them later through the income statement. The standard states: They shall not be reclassified to profit or loss in a subsequent period.

Past service cost

The last item involved in the determination of the defined benefit obligation is the Past Service Cost. Past service cost can arise when the employer changes the terms of a defined benefit plan, or when a plan is introduced. If, under the new plan, benefits are attributable to services rendered by the employees in previous years, these benefits are considered past service cost (even if they are not vested at that time). If the defined benefit obligation decreases as a result of the new plan terms, the entity will account for negative past service cost. Example: in 2011, our company changes the terms of the defined benefit plan. Employees listed on the payroll as of Jan. 1st, 2011 are entitled to 1,5% of final salary per year of service instead of 1%. The present value of the obligation as at Dec. 31, 2011 is now 618 instead of 412. The total impact of the change is a 206 expense (206 = 618 412). The 2011 current service cost becomes 100.50 (100.50 = 67*1.50), so the past service cost is 172.50 (172.50 = 206 [100.50 67]).

Recognition of past service cost

The standard states Such changes are in return for employee service over the period until the benefits concerned are vested. Consequently, past service cost must be recognized over that period. In our example, since the employee becomes entitled to the benefit 10 years from Jan. 1st 2011, the company amortizes the 172.50 expense over 10 years, starting from 2011. Now that all components of [EQ.1] have been defined, we can determine the actual liability on Dec. 31, 2011:

Dec. 31 Present value of Defined Benefit (+) Fair value of plan assets (-) Unrecognized actuarial gain (+) Unrecognized past service cost (-) Net defined benefit obligation

2011 618 246 41.20 + 25.80*9/10 = 64.42 172.50*9/10 = 155.25 281.17

The implied expense of 125.17 (125.17 = 281.17 156) can also be determined as shown below:

Current service cost Interest on Obligation Contribution paid into the plan Expected return on plan assets Actuarial gain (25.80*1/10) Past service cost (172.50/10) Total

(100.50) (48) 25 13 2.58 (17.25) (125.17)

Because of the complexity of managing the past service cost amortization schedule, it should only be amended in the case of material subsequent changes. The IAS 19 cites settlements and curtailments as events in which the amortization schedule can be modified (settlements and curtailments occur when the employer extinguishes part or all of its defined benefit obligation, by means of a cash settlement or changes in the terms of the plan). In some cases, the net defined benefit obligation can be negative. It can appear in the statement of financial conditions as an asset, under certain circumstances. Precisely, the asset recognized must be less or equal to: AND The present value of refunds or future reduction in contributions available from the fund that manages the plan assets (if the excess funding is not available to the reporting entity, it cant be recognized as an asset) The cumulative unrecognized actuarial loss and past service cost

Example: lets assume that the employer made a 1,025 contribution on Dec. 31, 2011 instead of 25.
Dec. 31 Present value of Defined Benefit (+) Fair value of plan assets (-) Unrecognized actuarial gain (+) Unrecognized past service cost (-) Net defined benefit obligation 2011 618 1,246 41.20 + 25.80*9/10 = 64.42 172.50*9/10 = 155.25 (718.83)

There is no unrecognized actuarial loss, so, assuming there is no restraining conditions with regards to the availability of excess funding, the entity will account for a 718.83 asset.

If actuarial gains and losses are in OCI they are considered as unrecognized.

Disclosure
The standard requires the employer to disclose information that enables users of financial statements to evaluate the nature of its defined benefit plans and the financial effects of changes in those plans during the period ( 120). In the next pages we will present the main required disclosure and illustrate them with the 2009 Heineken NV consolidated financial statements (Heineken NV is listed on the Amsterdam Stock Exchange and is thus required to issue IAS/IFRS compliant financial statements). The entity shall disclose [its] accounting policy for recognizing actuarial gains and losses ( 120 (a))
In respect of actuarial gains and losses that arise, Heineken applies the corridor method in calculating the obligation in respect of a plan. To the extent that any cumulative unrecognized actuarial gain or loss exceeds ten per cent of the greater of the present value of the defined benefit obligation and the fair value of plan assets, that portion is recognized in the income statement over the expected average remaining working lives of the employees participating in the plan. Otherwise, the actuarial gain or loss is not recognized. (Heineken NV 2009 consolidated financial statements, note 3-m-ii)

The entity shall disclose a reconciliation of opening and closing balances of the defined benefit obligation showing separately, if applicable, the effects during the period attributable to each of the following: (i) current service cost, (ii) interest cost, (iii) contributions by plan participants, (iv) actuarial gains and losses, (v) foreign currency exchange rate changes on plans measured in a currency different from the entitys presentation currency, (vi) benefits paid, (vii) past service cost, (viii) business combinations, (ix) curtailments and (x) settlements. ( 120 (c))

(Heineken NV 2009 consolidated financial statements, note 28)

The entity shall disclose an analysis of the defined benefit obligation into amounts arising from plans that are wholly unfunded and amounts arising from plans that are wholly or partly funded ( 120 (d))

(Heineken NV 2009 consolidated financial statements, note 28)

The entity shall disclose a reconciliation of the opening and closing balances of the fair value of plan assets and of the opening and closing balances of any reimbursement right recognized as an asset [] showing separately, if applicable, the effects during the period attributable to each of the following: (i) expected return on plan assets, (ii) actuarial gains and losses, (iii) foreign currency exchange rate changes on plans measured in a currency different from the entitys presentation currency, (iv) contributions by the employer, (v) contributions by plan participants, (vi) benefits paid, (vii) business combinations and (viii) settlements ( 120 (e))

(Heineken NV 2009 consolidated financial statements, note 28)

The entity shall disclose the total expense recognized in profit or loss for each of the following, and the line item(s) in which they are included: (i) current service cost; (ii) interest cost; (iii) expected return on plan assets; (iv) expected return on any reimbursement right recognized as an asset []; (v) actuarial gains and losses; (vi) past service cost; (vii) the effect of any curtailment or settlement []( 120 (g))

The entity shall disclose the principal actuarial assumptions used as at the end of the reporting period []( 120 (n))

(Heineken NV 2009 consolidated financial statements, note 28)

Conclusion: IAS 19 proposed amendments

The IAS 19 is currently being revised. The IASB issued a discussion paper in 2008, followed by the exposure draft in April 2010. The window period for sending comments ended in September 2010. The new approach offers less accounting options but makes recognition and measurement simpler. The entity would necessarily recognize actuarial gains and losses and past service cost in OCI. The year-over-year change in the defined benefit liability would be split into: Service cost (still recognized as profit or expense) Finance cost (expense generated by the lesser impact of discounting from one year to the next) Remeasurement (actuarial gains/losses, past service costs, gains and losses arising from settlements or curtailments of the defined benefit plan). The remeasurement component should be recognized in OCI and then transferred immediately in retained earnings. It should not be reclassified as profit or loss in subsequent reporting periods. The proposed new standard also requires additional disclosure about the characteristics of the defined benefit plans, and about financial risk related to the plan assets. This would bring back volatility into net income, but the entity would no longer need to keep track of accumulated unrecognized actuarial gains/losses and past service cost. As a result, it would make financial information more accessible to non-initiated users.

Bibliography
International Accounting Standards Board, IAS 19 Employee Benefits (version with amendments up to December 31, 2009). Available for download at http://www.ifrs.org/IFRSs/IFRS.htm International Accounting Standards Board, Exposure Draft ED/2010/3: Defined Benefit Plans - Proposed Amendments to IAS 19, 2010 Heineken NV, Annual Report 2009 Available for download at http://www.annualreport.heineken.com/