Concepts, Rules, and Examples

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 thirty years, and these arrangements are the most common "fringe benefit" offered by employers in many nations. For many employers, pension costs have become a very material component of compensation paid to employees and can represent an even bigger fraction of the reporting entity's net operating results. Unlike the case with wages, the timing of the payment of cash to either the plan's administrators or its beneficiaries can vary substantially from the underlying economic event. This creates the possibility of misleading financial statement presentation of the true costs of conducting business. For this reason, accounting for the cost of pension plans and similar schemes (postretirement 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

Need for pension accounting rules.

The principal objectives of pension accounting are to measure the compensation cost associated with employees' benefits and to recognize that cost over the employees' service period. The relevant international accounting standard, IAS 19, is concerned only with the accounting aspects of pensions (and other benefit plans); the funding of pension benefits is considered to be a financial management matter, and accordingly, is not addressed by this pronouncement.

When an entity provides benefits, the amounts of which can be estimated in advance, to its retired employees and their beneficiaries, the arrangement is deemed to be a pension plan. The typical plan is written and the amount of benefits can be determined by reference to the plan documents. However, the plan and its provisions can also be implied from unwritten but established past practices. The accounting for most types of retirement plans is suggested by, if not heavily detailed in, IAS 19. Plans may be unfunded, insured, trust fund, defined contribution and defined benefit plans, and deferred compensation contracts, if equivalent. Independent (not employer sponsored) deferred profit sharing plans and pension payments made to selected employees on a case-by-case basis, are not considered pension plans.

The establishment of a pension plan represents a long-term commitment to employees. Although some entities manage their own plans, this commitment usually takes the form of contributions that are made to an independent trustee or, in some countries, to a governmental agency. These contributions are used by the trustee to acquire plan assets of various kinds, although the available types of investments may be restricted by governmental regulations in certain jurisdictions. Plan assets are used to generate a return, which typically consists of earned interest and/or appreciation in asset value.

The earnings from the plan assets (and occasionally, the proceeds from their liquidation) provide the trustee with cash to pay the benefits to which the employees become entitled. These benefits in turn are defined by the terms of the pension plan, which is known as the plan's benefit formula. In the case of defined benefit plans, the benefit formula incorporates many factors, including employee compensation, employee service longevity, employee age, and so on, and is considered to provide the best indication of pension obligations and costs. It is used as the basis for determining the pension cost recognized each fiscal year.

Income statement vs. balance sheet objectives.

As the accounting requirements for pensions and other forms of postemployment benefits have evolved over the years, the primary objective has been to assign the periodic costs of such plans properly to the periods in which the related benefits are received by the employers incurring these costs. These benefits are obviously received when the workers are productively working on their jobs, not during the later years when they are enjoying their retirements. For that reason, accounting long ago recognized that the "pay-as-you-go" method of expense recognition, under which expense recognition would be deferred until the benefit payments to retirees were actually made, would cause an unacceptable mismatching of costs and benefits and a distortion of the income statement. The probable result of this mismatching would be the overstating of earlier years' results of operations and understating those of later years when large retirement payments are being made. As pensions and other fringe benefits expanded over the past generation to become a material and ever-increasing fraction of workers' compensation, this problem could no longer be ignored by accounting standards setters.

The reason that pay-as-you-go accounting was not eliminated completely long ago is that many pension plans and similar employee benefit plan arrangements are rather complex, and the accounting necessary to report on them properly is also difficult. Most significantly, in the case of defined benefit plans, actual costs may not be known for many years, even decades, since a variety of future events (employee turnover, performance of investments, salary increases, etc.) will affect the ultimate burden on the employer. Accordingly, the measurement of expense on a current basis demands that many complicated estimates be made, some involving actuarial computations, and accountants have often been reluctant to anchor the financial statements to estimates that are potentially very imprecise. Only when the impact of pay-as-you-go accounting became unacceptably distortive, due to the growing occurrence and magnitude of these benefit plans, were professional standards revised to prohibit continued use of that mode of accounting.

As pensions became an almost universal fixture of the employment landscape (in some nations, private pensions are mandated by law; in other countries, participation in government-sponsored plans is required), the failure to require such accounting became an impediment to meaningful financial reporting. Notwithstanding the limitations of actuarial and other estimates, financial statements incorporating the accrual of pension costs are vastly more accurate and useful than those based on a pay-as-you-go approach.

Evolution of international accounting standards on pension costs.

About thirty years ago, major accounting standard-setting bodies began urging that pension costs be accrued properly in financial statements. At first, a wide range of actuarial methods were permitted, each of which could produce more meaningful results than the pay-as-you-go method, but over time the range of options permitted has been narrowed in major jurisdictions.

As presently constituted, pension accounting rules have tended to focus overwhelmingly on the income statement. That is, the dominant objective has been to match income and expense properly on a current basis, so that the periodic measurement of operating performance is within the bounds of material accuracy.

It has been less clear that the meaningful presentation of the balance sheet has been a priority, however. Thus, even when an employer has retained full responsibility for the ultimate payment of pension benefits (as with defined benefit plans), the employer's statement of financial position has usually excluded a complete representation of the assets and obligations of the pension scheme. This has been due partly to the fact that various "smoothing" approaches have been made to expense measurement, causing the balance sheet (given the rigors of double entry bookkeeping) to become the repository for the resulting deferred charges and credits and thus making the overall picture from the balance sheet side less meaningful. Furthermore, accountants have been genuinely ambivalent about the validity of presenting information about the assets and obligations of the pension plan on the face of the employer's balance sheet, believing that the pension plan constitutes a separate economic and reporting entity.

IAS 19 is a substantial advance over its predecessor standards and is very similar in approach to the corresponding US GAAP standards (SFAS 87, 88, and 106). In fact, it offers broader coverage than the US standards, touching on compensated absences and stock compensation arrangements (subjects of more extensive coverage in separate US GAAP standards, however) and short-term arrangements as well. IAS 19 broke with the past practice of permitting a range of methodologies resulting in potentially quite different financial statement results. Finally, IAS 19 greatly expanded the disclosures required by employers having defined benefit plans, again largely mimicking the US requirements. By mandating one specific actuarial costing method, IAS 19 effectively required employers sponsoring defined benefit plans to engage in annual actuarial valuations, which has increased the cost of compliance for those with such plans. Overall, the effect of IAS 19 has been to significantly increase the comparability of financial statements of entities with a wide range of employee benefit plans.

Basic Principles of IAS 19

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 program with the periods in which the employees earn their benefits. Since contributions are formula-driven, typically the payments to the plan will be made currently; if they do not occur by the balance sheet date, an accrual will be recognized 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.

IAS 19 further provides that disclosure should be made of the amount of expense recognized in connection with the defined contribution pension plan. If not explicitly identified in the statement of income, 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 available 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. Actuarial determinations cannot be made by accountants, who lack the training and credentials, but the results of actuaries' efforts will be critical to the ability to properly account for defined benefit plan costs. Accounting for defined benefit plans is described at length in the following pages.

Applicability: other employee benefit plans.

IAS 19 explicitly addresses not merely pension plans (which were dealt with by earlier iterations of this standard as well, although in rather less detail), but also four other categories of employee and postemployment benefits. These are

Short-term employee benefits, which include normal wages and salaries as well as compensated absences, profit sharing and bonuses, and such nonmonetary fringe benefits as health insurance, housing subsidies, and employer-provided automobiles, to the extent these are granted to current (not retired) employees.
Other long-term employee benefits, such as long-term (sabbatical) leave, long-term disability benefits and, if payable after twelve months beyond the end of the reporting period, profit sharing and bonus arrangements and deferred compensation.
Termination benefits.
Equity compensation benefits, which are stock option plans, phantom stock plans, and similar compensation schemes which reward employees based upon the performance of the companies' share prices.

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

IAS 19 also addresses postemployment 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. While the predecessor standard IAS 19 nominally covered these plans, the new standard explicitly addresses them as being variants of defined benefit arrangements. These are 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, with the accounting and reporting complexities that this implies. Unless the employer's obligation is strictly limited to the amount of contribution currently due, typically driven by a formula based on enterprise performance or by employee wages or salaries, the obligations to the employees (and the amount of recognizable expense) will have to be estimated in accordance with actuarial principles.

Cost recognition distinguished from funding practices.

Although sound management practice may be 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 a useful guide to proper accounting for pension costs.

"Pay-as-you-go," accrued benefit, and projected benefit methods of accounting for postretirement benefits.

Before the establishment of strict accounting and financial reporting rules, it was not uncommon to account for pensions and other similar costs on the "pay-as-you-go" basis. Briefly, this methodology recognized current period expense equal to only the amounts of benefits actually paid out to retirees and other beneficiaries in the reporting period. In support of this approach, the argument was usually made (1) it was very difficult, or expensive, to accurately measure (i.e., on an actuarial basis) the real cost of such plans and (2) the effect on periodic earnings would not be much different in any event. However, pay-as-you-go obviously violates the concept of accrual basis accounting, and the presumption that periodic expense is not materially distorted is often not supported in fact. This method of accounting for pensions and other postretirement programs has accordingly been barred since the first version of IAS 19 was promulgated in 1983.

While adherence to the accrual concept precluded pay-as-you-go accounting for the cost of employee benefit plans, for plans other than those which qualify as defined contribution arrangements there remained a range of acceptable, accrual-basis-consistent methods. Earlier versions of IAS 19 granted wide discretion in selection of costing methods. The various techniques fall within two general groupings which are known as the "accrued benefit" and "projected benefit" methods. While the current IAS 19 has ended the acceptability of the projected benefit methods, an understanding of the two approaches will be helpful to gaining a fuller comprehension of the intricacies of the financial reporting of pension plan-related costs in the financial statements of the sponsoring enterprise.

The accrued (or accumulated) benefit methods are based on services provided by employees through the date of valuation (the balance sheet date), without considering future services to be rendered by them. Periodic pension cost is a function of services that are provided in the current period. Since the obligation for future pension payments is computed as the discounted present value of the amounts to be paid in later years, accrued benefit methods will calculate increasing charges (even if wage levels are constant) as employees approach retirement, since the present values of future payments will increase as the time to retirement shortens. Periodic charges also increase, in most actual instances, because attrition rates (employees who leave, thereby forfeiting their rights to retirement payments) decline over time, since older employees show less inclination to change employment. While wages will typically increase over time as employees age, both as a result of compensation increases due to seniority and performance improvements, and as a result (if the past is any guide) of ongoing wage inflation, this should not be the cause of increasing pension costs as time to retirement grows shorter, since even accrued benefit valuation methods must be based on assumptions about future salary progression. Notwithstanding that over time these assumptions and expectations cannot be precisely accurate, the presumption should be that "estimation errors" will be randomly distributed, and that over the long run, good-faith estimates of salary progression and the resultant effects on periodic pension costs will be fairly accurate. Consequently, periodic pension costs should not drift upward as employees age because of wage increases.

The projected benefit valuation method, on the other hand, uses actuarial estimation techniques that consider both the services already rendered as well as those to be rendered by the employees. The goal is to allocate the entire retirement cost smoothly over each employee's respective working life. The pension obligation at any point in time is computed as the present value of the aggregate future payments earned to the balance sheet date. As with accrued benefit valuation methods, future salary progression must be taken into account in determining periodic pension costs over the working lives of employees. The difference, however, is that future costs are spread more evenly over the full period of employment (although this does not imply that straight-line allocation is an absolute requirement) as compared to the accrued benefit valuation methods, and in particular, pension-related costs will not show the constantly increasing pattern exhibited by the alternative approach simply due to the shortening time horizon as retirement dates draw near.

Proponents of both accrued and projected benefit valuation approaches have claimed that the matching concept underlies their preferred method. For large employers having a workforce comprised of individuals of all ages, and that typically replace older retiring workers with younger ones, pension costs will be similar under either method on an aggregate basis. While pension costs relative to older workers will be higher and costs relating to younger workers will be lower, if the accrued benefit valuation method is used versus what would be reflected if the projected benefit valuation method were used, with a stable mix of ages of workers, this will not significantly vary. For smaller employers, or those with a workforce skewed toward younger or older workers, then holding all other considerations constant, the periodic pattern of pension costs will diverge under these two methods.

Example of accrued and projected benefit methods

To understand the essential difference between accrued benefit and projected benefit methods, consider a simple case of a single employee hired today with no expectation of future salary increases, and promised a total retirement benefit of $10,000 if he retires after at least 10 years' service, or $14,000 if after 20 years' service. Ignoring present valuing (which does have to be taken into account in the actual accounting for employee benefit costs, however), the accrued benefit method would allocate 1/10 of the $10,000 = $1,000 in promised benefits to each of the first 10 years of service, and then 1/10 of the $4,000 increment = $400 to each of the next 10 years, since accrued benefit methods would not assume the employee would continue employment beyond the tenth year until after that threshold is surpassed. Projected benefit methods, on the other hand, would assign 1/20 of the $14,000 = $700 to each of the first 20 years' employment, being based on service rendered and to be rendered until expected retirement. This all presumes the employee is expected to work at least 20 years (based on experience, the employee's age, etc.). In actual practice, with multiple employees, statistical estimates are used such that full accrual of benefits is normally not made for all employees, given that a certain fraction will opt out before becoming vested, etc.

Net Periodic Pension Cost

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 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 enterprise.

Periodic measurement of cost for defined contribution plans.

Under the terms of a defined contribution plan (in some cases referred to as a "money purchase" 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 ninety days after the end of the enterprise'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 balance sheet date, the long-term portion should be discounted at the rate applicable to long-term corporate bonds, if that information is known, or applicable to government bonds in the alternative.

Employers may make further discretionary contributions to benefit plans in certain periods. For example, if the entity enjoys a particularly profitable year, the board of directors may vote to grant another 2% of wages as a bonus contribution to the employees' benefit plan. The extent to which this is done will depend, among other factors, on the tax laws of the relevant jurisdiction. Normally, an enterprise making such a discretionary contribution does not do so simply to reward past performance by its workers. Rather, it does so in the belief that the gesture will cause its employees to be motivated to be more productive and loyal in the forthcoming years. IAS 19 addresses profit sharing and bonus plans as a subset of its requirements concerning short-term compensation arrangements; it stipulates that such a payment should be recognized only when paid or when the entity has a legal or constructive obligation to make it, and it can be reliably estimated. There appears to be no basis for deferring recognition of the expense after that point, however, even though longer-term benefits to the entity might be hoped for.

Past service costs arise when a plan is amended retroactively, so that additional contributions are made with respect to services rendered in past years. For example, if a plan formerly required contributions of 5% of salaries and is amended retroactively to provide for contributions of 6%, an extra 1 % of each employee's aggregate salary for all prior years will be transferred to the employee's pension account. When plans are amended in this fashion, it is generally management's belief that it will provide an incentive for greater efforts in the future. IAS 19 does not explicitly address retroactive amendments to defined contribution plans, but by analogizing from the requirements concerning similar amendments to defined benefit plans, it is clear that, if fully vested immediately (as would almost inevitably be the case), these would have to be expensed currently.

Terminations of defined contribution plans generally provide no difficulties from an accounting perspective, since costs have been recognized currently in most instances. However, if certain costs, such as those associated with past services and with discretionary bonus contributions made in past years, have not yet been fully amortized, the remaining unrecognized portions of those costs must be expensed in the period when it becomes probable that the plan is to be terminated. This should be the period when the decision to terminate is made, which on occasion may precede the actual termination of the plan.

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 recognized currently will need to be determined on an actuarial basis. While under an earlier version of IAS 19 both a benchmark treatment (using the accrued benefit valuation method) and an allowed alternative treatment (using the projected benefit valuation method) could be utilized, under the current IAS 19 only the former is permitted. Furthermore, only a single variant of the accrued benefit method—the "projected unit credit" method—will be permitted. Only this method will be discussed in the following presentation.

Conceptually (and, for the first time, actually under the current standard IAS 19), net periodic pension cost will consist of the sum of the following six components:

Current (pure) service cost
Interest cost for the current period on the accrued benefit obligation
The expected return on plan assets
Actuarial gains and losses, to the extent recognized
Past service costs, to the extent recognized
The effects of any curtailments or settlements

While the former IAS 19 did not separately address each of these elements, the current IAS 19 does follow closely the model under US GAAP and separately present these. Disclosures required by this standard effectively require that these cost components be displayed in the notes to the financial statements, while no such rule existed before under international accounting standards.

It is important to stress that current service cost, the core cost element of all defined benefit plans, must be determined by a qualified actuary. While the other items to be computed and presented are also developed by actuaries in most cases, they can be verified or even calculated directly by others, including the enterprise's internal or external accountants. The current service cost, however, is not an immediately apparent computation, as it relies upon a detailed census of employees (age, expected remaining working life, etc.) and the employer's experience (turnover, etc.), and is an intricate and elaborate computational exercise in many cases. Current service cost can only be developed by this careful, employee-by-employee analysis, and this is best left to those with the expertise to complete it.

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.

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 nonaccrual 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, lest an overaccrual of costs be made.

Example of service cost attribution

To explain the concept of service cost, assume a single employee is promised a pension of $1,000 per year for each year worked before retirement, for life, upon retirement at age sixty or thereafter. Further assume that this is the worker's first year on the job, and he is 30 years of age. The consulting actuary determines that if the worker, in fact, retires at age 60, he will have a life expectancy of 15 years, and at the present value of the required benefits ($1,000/yr x 15 years = $15,000) discounted at the long-term corporate bond rate, 8%, equals $8,560. In other words, based on the work performed thus far (1 year's worth), this employee has earned the right to a lump-sum settlement of $8,560 at age 60. Since this is 30 years into the future, this amount must be reduced to present value, which at 8% is a mere $851, which is the pension cost to be recognized currently.

In year 2, this worker earns the right to yet another annuity stream of $1,000 per year upon retirement, which again has a present value of $8,560 at the projected retirement age of 60. However, since age 60 is now only 29 years hence, the present value of that promised benefit at the end of the current (second) year is $919, which represents the service cost in year 2. This pattern will continue: As the employee ages, the current cost of pension benefits grows apace with, for example, the cost in the final working year being $8.560, before considering interest on the previously accumulated obligation—which would, however, add another $18,388 of expense, for a total cost for this one employee in his final working year of $26,948. It should be noted, however, that in "real-life" situations for employee groups in the aggregate, this may not hold, since new younger employees will be added as older employees die or retire, which will tend to smooth out the annual cost of the plan.

It should be noted, parenthetically, that if the projected benefit approach (the allowed alternative under former IAS 19) were employed in the foregoing example, greater cost would be recognized in the early years of the employee's working life, since the actuarial determination would have been based on service provided and service to be provided. In this example, it would have been projected that the employee would remain on the job for thirty years, thereby earning an annual pension of $30,000, which will have a discounted present value at retirement of $256,800. This amount would be spread evenly over the employee's working life, for an annual cost of about $8,560. That is, the pension cost associated with this worker would be $8,560 in the first year of his working life and every year thereafter. (There are a number of actuarial valuation methods, and this simplified illustration is intended only to contrast the former benchmark treatment—now the mandatory one—with the previously allowed alternative.)

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 recognized. 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.

Consider the example of service cost presented in the preceding section. The $851 obligation recorded in the first year of that example will have grown to $919 by the end of the second year. While former standard IAS 19 did not address this directly, the latest version of IAS 19 adopts the same approach as was established a decade earlier under US GAAP. This $68 increase in the obligation for future benefits due to the passage of time is reported as a component of pension cost, denoted as interest cost.

Other elements of benefit cost.

While the former standard IAS 19 presented only a brief description of the elements of pension cost other than current service cost, this has dramatically changed under the current standard. This 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 of the corresponding US standard in accepting the notion that since pension plan assets are intended as long-term investments, the random and perhaps sizable 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 a 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 (deferred to future periods or, if significant, partially recognized). Expected return for a given period is determined at the start of that period, and is based on long-term rates of return for assets to be held over the term of the related pension obligation. Expected return is to incorporate anticipated dividends, interest, and changes in fair value, and is furthermore to be reduced in respect of expected plan administration costs.

For example, assume that at the start of 2003 the plan administrator expects, over the long term, and based on historical performance of plan assets, that the plan's assets will receive annual interest and dividends of 6%, net of any taxes due by the fund itself, and will enjoy a market value gain of another 2.5%. It is also noted that plan administration costs average .75% of plan assets, measured by fair value. With this data, an expected rate of return for 2003 would be computed as 6.00% + 2.50% - .75% = 7.75%. This rate would be used to calculate the return on assets, which would be used to offset service cost and other benefit plan cost components for the year 2003.

The difference between this assumed rate of return, 7.75% in this example, and the actual return enjoyed by the plan's assets would be added to or subtracted from the cumulative actuarial gains and losses. In theory, over the long run, these gains and losses will largely offset, inasmuch as they are the result of random fluctuations in market returns and of demographic and other changes in the group covered by the plan (such as unusual turnover, mortality, or changes in salaries). Since these are expected to largely offset, and given the very long time horizon over which pension benefit plan performance is to be judged, the notion of deferring these net gains or losses is appealing.

Under the current IAS 19 as originally promulgated, assets were properly considered to be plan assets only if all of the following three conditions were met:

The pension or other benefit plan is an entity which is legally separate from the sponsoring employer or enterprise;
The assets of the plan are only to be used to settle employee benefit obligations, are not available to the sponsoring enterprise's creditors, and either cannot be returned to the sponsor at all or can be returned only to the extent that assets remaining in the fund are sufficient to meet the plan's obligations; and
The sponsor will have no legal or constructive obligation to directly pay the employee benefit obligations, assuming that the fund contains sufficient assets to satisfy those obligations.

An amendment effective in 2001 modified IAS 19's definition of plan assets to explicitly include certain insurance policies, and to eliminate the condition relating to sufficiency of assets in the funds. It also slightly amends and rewords the balance of the current definition. The new definition is assets held by a long-term employee benefit fund, and qualifying insurance policies. Regarding assets held by a fund, these are assets (other than nontransferable financial instruments issued by the reporting entity) that both

Are held by a fund that is legally separate from the reporting entity and exist solely to pay or fund employee benefits, and
Are available to be used only to pay or fund employee benefits, are not available to the reporting entity's own creditors (even in the event of bankruptcy), and cannot be returned to the reporting entity unless either
1. The remaining assets of the fund are sufficient to meet all related employee benefit obligations of the plan or the entity, or
2. The assets are returned to the reporting entity to reimburse it for employee benefits already paid by it.

Regarding the qualifying insurance policy, this must be issued by a nonrelated party if the proceeds of the policy both

Can be used only to pay or fund employee benefits under a defined benefit plan, and
Are not available to the reporting entity's own creditors (even in the event of bankruptcy), and cannot be returned to the reporting entity unless either
1. The proceeds represent surplus assets that are not needed for the policy to meet all related employee benefit obligations, or
2. The proceeds are returned to the reporting entity to reimburse it for employee benefits already paid by it.

It should be stressed that the definition of plan assets is significant for several reasons: plan assets are excluded from the sponsoring employer's balance sheet and will also serve as the basis for determining the actual and expected rates of return, which impact on the periodic determination of pension cost. By adopting a somewhat more expansive definition of plan assets, the amended IAS 19 causes some variations in the future computation of pension costs.

The IAS 19 amendment also added certain new requirements to the former standard. These additional requirements 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 recognize 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 income statement, defined benefit plan expense may be presented net of the reimbursement receivable recognized.

In some situations, a plan sponsor would be able to look to another entity to pay some or all of the cost to settle a defined benefit obligation, but the assets held by that other party were not deemed to be plan assets as defined in IAS 19 (prior to the most recent revision). For example, when an insurance policy would match postemployment benefits, the assets of the insurer were not included in plan assets because the insurer was not established solely to pay or fund employee benefits. In such cases, the sponsor recognized its right to reimbursement as a separate asset, rather than as a deduction in determining the defined benefit liability (i.e., no right of offset was deemed to exist in such instances); in all other respects (e.g., the use of the corridor), the sponsoring entity would treat that asset in the same way as plan assets. In particular, the defined benefit liability recognized under IAS 19 prior to the most recent amendment was to be increased (reduced) to the extent that net cumulative actuarial gains (losses) on the defined benefit obligation and on the related reimbursement remain unrecognized under this standard, as explained earlier in this chapter. A brief description of the link between the reimbursement and the related obligation would be required.

If the right to reimbursement arises under an insurance policy that exactly matches the amount and timing of some or all of the benefits payable under a defined benefit plan, the fair value of the reimbursement was formerly deemed to be present value of the related obligation (subject to any reduction required if the reimbursement was not recoverable in full).

As amended, however, qualifying insurance policies are now 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, to the extent recognized.

Changes in the amount of the actuarially determined pension obligation and differences in the actual versus the expected yield 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. While immediate recognition of these gains or losses could clearly be justified conceptually (because these are real and have already occurred), there are both theoretical arguments opposed to such immediate recognition (the distortive effects on the measure of current operating performance resulting from very long-term investments, much of which will reverse of their own accord over time), as well as great opposition by financial statement preparers and users. For this reason, IAS 19 does not require such immediate recognition, unless the fluctuations are so great that deferral is not deemed to be valid. It has essentially acceded to the US approach and defined a 10% corridor as representing the range of variation deemed to be "normal." While the use of a 10% threshold is arbitrary, it does have the advantage of apparent logic, since it has already been employed for over a decade in the US.

Thus, if the unrecognized actuarial gain or loss is no more than 10% of the larger of the present value of the defined benefit obligation or the fair value of plan assets, measured at the beginning of the reporting period, no recognition in the current period will be necessary (i.e., there will be continued deferral of the accumulated net actuarial gain or loss). On the other hand, if the accumulated net actuarial gain or loss exceeds this 10% corridor, the magnitude creates greater doubt that future losses or gains will offset these, and for that reason some recognition will be necessary. It is suggested by IAS 19 that this excess be amortized over the expected remaining working lives of the then-active employee participants, but the standard actually permits any reasonable method of amortization as long as (1) recognition is at no slower a pace than would result from amortization over the working lives of participants, and (2) that the same method is used for net gains and net losses. It would even be acceptable to fully recognize all actuarial gains or losses without regard to the 10% corridor immediately, if so desired, since such a practice would satisfy this criterion.

The corridor and the amount of any excess beyond this corridor must be computed anew each year, based on the present value of defined benefits and fair value of plan assets at the beginning of the year. Thus, there may have been an unrecognized actuarial gain of $450,000 at the end of year 1, which exceeds the 10% corridor boundary by $210,000, and is therefore to be amortized over the average twenty-one-year remaining working life of the plan participants, indicating a $10,000 reduction in pension cost in year 2. If, at the end of year 2, market losses or other actuarial losses reduce the accumulated actuarial gain below the threshold implied by the 10% corridor. Accordingly, in year 3 there will be no further amortization of the net actuarial gain. This determination, therefore, must be made at the beginning of each period. Depending on the amount of unrecognized actuarial gain or loss at the end of year 3, there may or may not be amortization in year 4, and so on.

In May 2002, the IASB published a proposed amendment to IAS 19 in response to concerns raised about the perceived interaction of the deferred recognition and the asset ceiling provisions of IAS 19, and the risk that this was creating counterintuitive results. The issue would affect only those entities that have, at the beginning or end of the accounting period, a surplus in a defined benefit plan that, based on the current terms of the plan, the entity cannot fully recover through refunds or reductions in future contributions. The anomalies of concern being reported by companies using IAS were the following:

Gains were being reported on the occurrence of actuarial losses in their pension plans, and
Losses were being reported on occurrence of actuarial gains (in their pension plans).

More specifically, the issue was that the wording of the asset ceiling would have the following consequence: sometimes deferring the recognition of an actuarial loss (gain) would lead to a gain (loss) being recognized in the income statement. The Exposure Draft proposed a limited amendment to IAS 19 that would have prevented gains (losses) from being recognized solely as a result of past service cost or actuarial losses (gains) arising in the period.

Upon study, the IASB concluded that there were inconsistencies between the IASB Framework and the discussion of the asset ceiling in the basis of conclusions to IAS 19. Given this, and the fact that the matter of the defined asset ceiling is planned for discussion by the IASB as part of its convergence project on postemployment benefits, it was agreed not to issue an Interpretation at this time.

Past service costs, to the extent recognized.

Past service costs refer to increases in the amount of a defined benefit liability which 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 cost as an expense when the added benefits vest immediately. However, when these are not immediately vested, recognition is to be on a straight-line basis over the period until vesting occurs. For example, if at January 1, 2003, the sponsoring entity grants an added $4,000 per employee in future benefits, and given the number of employees expected to receive these benefits this computes to a present value of $455,000, but vesting will not be until January 1, 2008, then a past service cost of $455,000 5 years = $91,000 per year will be recognized. (To this amount interest must be added, as with service cost as described above.)

The effects of any curtailments or settlements.

Periodic defined benefit plan expense is also affected by any curtailments or settlements which have been incurred. The standard defines a curtailment as arising in connection with isolated events such as plant closings, discontinuations of operations, or termination or suspension of a benefit plan. Often, corporate restructurings will be accompanied by curtailments in benefit plans. Recognition can be given to the effect of a curtailment when the sponsor is demonstrably committed to make a material reduction in the number of covered employees, or it amends the terms of the plan such that a material element of future service by existing employees will no longer be covered or will receive reduced benefits. The curtailment must actually occur for it to be given recognition.

Settlements occur when the enterprise 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.

The effect of a curtailment or settlement is measured with reference to the change in present value of the defined benefits, any change in fair value of related assets (normally there is none), and any related actuarial gains or losses and past service cost which had not yet been recognized. The net amount of these elements will be charged or credited to pension expense in the period the curtailment or settlement actually occurs. For example, if a curtailment reduces the present value of future benefits by $40,000, or 5% of the precurtailment obligation ($800,000), and there was also an unrecognized actuarial gain of $60,000 and an unrecognized transition amount (past service cost) of $50,000, the income statement in the curtailment period would be $40,000 + (.05 x $60,000) - (.05 x $50,000) = $41,000 reduction in pension cost for the year.

Transition adjustment.

The final element of periodic pension cost under IAS 19 relates to the effect of first adopting the accounting standard. The transition amount is the present value of the benefit obligation at the date the standard is adopted, less the fair value of plan assets at that date, less any past service cost to be deferred to later periods, if the criteria regarding vesting period are met. IAS 19 continues to offer reporting entities two alternatives, similar to those set forth in the predecessor standard, albeit with a minor alteration. If the transitional liability is greater than the liability which would have been recognized under the entity's previous policy for accounting for pension costs, it must make an irrevocable choice to either

Recognize the increase in the pension obligation immediately, with the expense included in employee benefit cost for the period; or
Amortize the transition amount over no longer than a five-year period, on the straight-line basis. (The earlier standard suggested amortization over the remaining working lives of employees working at the date of transition.) The unrecognized transition amount will not be formally included in the balance sheet, but must be disclosed.

If method (2) is elected, and the enterprise has a negative transitional liability (that is, an asset, resulting from an excess of pension assets over the related obligation), it is limited in the amount of such asset to present on its balance sheet to the total of any unrecognized actuarial losses plus past service cost, and the present value of economic benefits available as refunds from the plan or reductions in future contributions, with the present value determined by reference to the rate on high-quality corporate bonds. Furthermore, the amount of unrecognized transitional gain or loss as of each balance sheet date must be presented, as well as the amount recognized in the current period income statement.

Finally, if method (2) is employed, recognition of actuarial gains (which do not include negative past service cost) will be limited in two ways. If an actuarial gain is being recognized because it exceeds the 10% corridor or because the enterprise has elected a more rapid method of systematic recognition, then the actuarial gain should be recognized only to the extent the net cumulative gain exceeds the unrecognized transitional liability. And, in determining the gain or loss on any later settlement or curtailment, the related part of the unrecognized transitional liability must be incorporated.

IAS 19 also stipulates that if the transitional liability is lower than the amount which would have been recognized under previous accounting rules, the adjustment should be taken into income immediately (i.e., amortization is not permitted).

Upon adoption of the current IAS 19, the entity was not permitted to retrospectively compute the effect of the 10% corridor on actuarial gain or loss recognition. It is clear that retrospective application would be impracticable to accomplish and would not have generated useful information and was therefore prohibited.

Employer's Liabilities and Assets

IAS 19 has as its primary, possibly sole, concern the measurement of periodic expense incurred in connection with pension plans of employers. One source of dissatisfaction with the standard is its failure to address the assets or liabilities that may be recognized on the employers' balance sheets as a consequence of expense recognition, which may include deferral of certain items (e.g., past service costs). In fact, the amounts that may find their way onto the balance sheet will often not meet the strict definition of assets or liabilities, but rather, will be "deferred charges or credits." This will consist of the cumulative difference between the amount funded and the amount expensed over the life of the plan.

IAS 19 has been criticized for not requiring, under appropriate circumstances, recognition of an additional or minimum liability when plans are materially underfunded. The point of comparison is US GAAP standard SFAS 87, which does demand that this minimum liability, which results when the accumulated (accrued) benefit obligation exceeds the fair value of plan assets, and a liability in the amount of the difference is not already recorded as unfunded accrued pension cost. Under that standard, the additional minimum liability is recognized by an offset to an intangible asset up to the amount of unrecognized prior service cost. Any additional debit needed is considered a loss and is shown net of tax benefits as a separate component reducing equity. The IASC Board concluded that additional measures of liability were potentially confusing and did not promise to provide relevant information. Accordingly, with the exception of any liability to be accrued under IAS 37 (regarding contingencies), the decision was made to dispense with such an item.

Other Pension Considerations

Multiple and multiemployer 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 multiemployer plan (to which two or more unrelated employers contribute) requires that the contribution for the period be recognized as net pension cost and that any contributions due and unpaid be recognized 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 multiemployer 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 international accounting standards that address contingencies (IAS 10) 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.

Business combinations.

When an entity that sponsors a single-employer defined benefit plan is purchased in a manner that must be accounted for as an acquisition under the provisions of IAS 22, the purchaser should assign part of the purchase price to an asset if plan assets exceed the projected benefit obligation, or to a liability if the projected benefit obligation exceeds plan assets. The projected benefit obligation should include the effect of any expected plan curtailment or termination. This assignment eliminates any existing unrecognized components, and any future differences between contributions and net pension cost will affect the asset or liability recognized when the purchase took place.

Disclosure of Pension and Other Postemployment Benefit Costs

For defined contribution plans, IAS 19 requires only that the amount of expense included in current period earnings be disclosed. If further required under IAS 24 (related parties), disclosures should be made about contributions made for key management personnel. Good practice would suggest that there be disclosure of the general description of each plan identifying the employee groups covered, and of any other significant matters related to retirement benefits that affect comparability with the previous period reported on.

For defined benefit plans, as would be expected, much more expansive disclosures are mandated. These include

A general description of each plan identifying the employee groups covered
The accounting policy regarding recognition of actuarial gains or losses
A reconciliation of the plan-related assets and liabilities recognized in the balance sheet, showing at the minimum
1. The present value of wholly unfunded defined benefit obligations
2. The present value (gross, before deducting plan assets) of wholly or partly unfunded obligations
3. The fair value of plan assets
4. The net actuarial gain or loss not yet recognized in the balance sheet
5. The past service cost not yet recognized in the balance sheet
6. Any amount not recognized as an asset because of the limitation to the present value of economic benefits from refunds and future contribution reductions
7. The amounts which are recognized in the balance sheet
The amount of plan assets represented by each category of the reporting entity's own financial instruments or by property which is occupied by, or other assets used by, the entity itself
A reconciliation of movements (i.e., changes) during the reporting period in the net asset or liability reported in the balance sheet
The amount of, and location in the income statement of, the reported amounts of current service cost, interest cost, expected return on plan assets, actuarial gain or loss, past service cost, and effect of any curtailment or settlement
The actual return earned on plan assets for the reporting period
The principal actuarial assumptions used, including (if relevant) the discount rates, expected rates of return on plan assets, expected rates of salary increases or other index or variable specified in the pension arrangement, medical cost trend rates, and any other material actuarial assumptions utilized in computing benefit costs for the period. The actuarial assumptions are to be explicitly stated in absolute terms, not merely as references to other indices.

Amounts presented in the sponsor's balance sheet cannot be offset (presented on a net basis) unless legal rights of offset exist. Furthermore, even with a legal right to offset (which itself would be a rarity), unless the intent is to settle on a net basis, such presentation would not be acceptable. Thus, a sponsor of two plans, one being in a net asset position, and another in a net liability position, cannot be netted in most instances.

Postemployment Benefits Convergence Project

In mid-2002, the IASB agreed to add a limited convergence project on postemployment benefits to its active agenda. The stated objectives of the project do not extend to a comprehensive reexamination of the accounting for postemployment benefits. Rather, the goal is to build on the principles that are common to most existing national standards on benefit accounting, and to seek improvements to IAS 19 in certain specific areas.

The project will address the following issues:

Recognition of actuarial gains and losses
The "asset ceiling"
The impact of the asset ceiling, if any, on the components recognized in income.
The definitions of defined benefit plans, defined contribution plans, and plan assets
The allocation of cost to accounting periods
A review of the requirements in the US GAAP standards SFAS 106, Employers' Accounting for Postemployment Benefits, and SFAS 112, Employers' Accounting for Postretirement Benefits other than Pensions, to consider whether additional guidance in these standards should be included in IAS 19.
Mitigation of problems that may arise from the immediate recognition of actuarial gains and losses (if the Board proposes such a treatment) in connection with the presentation of actuarial gains and losses under the proposals for performance reporting, presentation of the pension asset or liability in the balance sheet, and multiemployer exemptions.

Other Benefit Plans

Short-term employee benefits.

Per IAS 19, short-term benefits are those falling due within twelve 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 twelve months after the end of the period in which these were earned, and such nonmonetary 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 will be needed and, since due currently, discounting will not be employed.

Compensated absences may provide some accounting complexities, if these accumulate and vest with the employees. Under the terms of the new employee benefits standard, accumulating 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 program, accumulation rights may be limited or unlimited; and, furthermore, the usage of benefits may be defined to occur on a last-in, first-out (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 (as when the plans subject employees to limitations on accumulation rights with or without the further restriction imposed by a LIFO pattern of usage), 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 utilize. 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.

Example of compensated absences

Consider an entity with 500 workers, each of whom earns 2 weeks' annual leave, with a carryforward option limited to a maximum of 6 weeks, to be carried forward no longer than 4 years. Also, this employer imposes a LIFO basis on any usages of annual leave (e.g., a worker with 2 weeks' carryforward and 2 weeks earned currently, taking a 3-week leave, will be deemed to have consumed the 2 currently earned weeks plus 1 of the carryforward weeks, thereby increasing the risk of ultimately losing the older carried-forward compensated absence time). Based on past experience, 80% of the workers will take no more than 2 weeks' leave in any year, while the other 20% take an average of 4 extra days. At the end of the year, each worker has an average of 5 days' carryforward of compensated absences. The amount accrued should be the cost equivalent of [(.80 x 0 days) + (.20 x 4 days)] x 500 workers = 400 days' leave.

Other long-term employee benefits.

These are defined by IAS 19 as including any benefits other than postemployment benefits (pensions, retiree medical care, etc.), termination benefits and equity compensation plans. Examples would include sabbatical leave, jubilee 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 postretirement benefits, although some actuarial measures may be needed.

Reportedly for simplicity, IAS 19 decided to not provide the corridor approach to non-recognition of actuarial gains and losses for other long-term benefits. It also requires that past service cost (resulting from the granting of enhanced benefits to participants on a retroactive basis) and transition gain or loss be reported in earnings in the period in which these are granted or occur. For liability measurement purposes, IAS 19 demands that the present value of the obligation be presented on the balance sheet, less the fair value of any assets which 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 actuarial gains and losses and past service cost must be recognized immediately, not amortized over a defined time horizon.

Termination benefits.

Termination benefits are to be recognized only when the employer has demonstrated its commitment to either terminate the employee or group of employees before normal retirement date, or provide benefits as part of an inducement to encourage early retirements. Generally, a detailed, formal plan will be necessary to support a representation that such a commitment exists. According to IAS 19, the plan should, as a minimum, set forth locations, functions, and numbers of employees to be terminated; the benefits for each job class or other pertinent category; and the time when the plan is to be implemented; with inception to be as soon as possible and completion soon enough to largely eliminate the chance that any material changes to the plan will be necessary.

Since termination benefits do not confer any future economic benefits on the employing enterprise, these must be expensed immediately. If the payments are to fall due more than twelve months after the balance sheet date, however, discounting to present value is required (again, using the long-term corporate bond rate). Estimates, such as the number of employees likely to accept voluntary early retirement, may need to be made in many cases involving termination benefits. To the extent that accrual is based on such estimates (the possibility that greater numbers may accept, thereby triggering additional costs) further disclosure of loss contingencies may be necessary to comply with IAS 37.

Equity compensation benefits.

Benefits based on stock option and similar plans have become extremely popular in certain nations; in some cases, in fact, the fraction of executive compensation represented by such plans overwhelms that payable currently in cash. However, the accounting for such plans (and for the compensation elements thereof, in particular) has been very controversial, largely because national accounting standards have long held these to be largely noncompensatory if certain conditions are met. For example, under US GAAP, the longstanding rule was that if the exercise price were no lower than fair value at grant date, no compensation was attributed to the options, notwithstanding that economic and finance theory clearly demonstrates that these are compensatory, and the huge demand by executives for such benefit plans strongly suggests that in their eyes, at least, these are obviously compensation arrangements.

An attempt to change US GAAP to require the attribution of compensation cost to option plans was met by unprecedented opposition, largely from corporations which have grown accustomed to having substantial amounts of executive compensation "off the income statement." Although a final rule requiring supplementary (footnote) disclosure of the effects of full compensation recognition was ultimately imposed (with the optional, almost never employed, ability to formally report this in the income statement), the experience probably left other standard setters, such as the IASC, with the impression that a strong stand on this issue would not be politically feasible. However, the impact of major financial reporting scandals, particularly in the US, has probably changed the climate so that more meaningful expense accrual rules can now be imposed. These are under active consideration by both IASB and the US FASB.

Accordingly, IAS 19 does not include recognition and measurement standards regarding equity compensation benefit plans. It simply requires that additional disclosures be made such that users of the financial statements will be assisted in their efforts to assess the impact of such benefit programs on the respective reporting entity's financial position, performance, and cash flows. Specifically, an enterprise's financial position may be affected if it is required to potentially issue equity financial instruments or convert other financial instruments, as when stock options vest and the employees are able to exercise these to acquire shares. Financial performance and cash flows, similarly, would be affected if exercise of options provides a source of cash to the enterprise, even as compensation costs are depressed (and profits are correspondingly elevated), because employees accept stock compensation in lieu of currently reportable salary and bonus.

To provide these limited insights, IAS 19 presently requires that an enterprise which provides equity compensation benefits must disclose the following:

The nature and terms of such plans, including any vesting provisions
The accounting policy regarding such plans
The amounts recognized in the financial statements for those plans
The number and terms of the reporting entity's shares or other equity instruments which are held by the plan and by employees at the beginning and end of the period with explanation of dividend, voting and conversion rights, exercise dates and prices and expiration dates; and the changes in rights to shares which have vested during the reporting period
The number and terms of the reporting entity's shares or other equity instruments which were issued to the plan and to employees, or distributed by the plan to employees during the period, with explanation of dividend, voting and conversion rights, exercise dates, and prices and expiration dates; and the fair value of consideration received by the entity during the period
The number, exercise dates and exercise prices of share options exercised under the terms of the plan during the period
The number of share options held by the plan, or by employees under terms of the plan, that lapsed (expired without being exercised) during the period
The amount and principal terms of any loans or guarantees by the entity to or for the plan or participants therein

The standard furthermore requires disclosure, as of the beginning and end of the period, of the fair value of the entity's own equity financial instruments, apart from share options, which are held by equity compensation plans. Finally, disclosure is required of the fair value, at issuance, of the entity's equity financial instruments, apart from options, issued to the plan or to employees, or by the plan to employees, during the period. If it is not practicable to develop or obtain fair value data, that fact may be stated in lieu of actual disclosure.

When a reporting entity has a multitude of plans, disclosures under IAS 19 may be made by plan, in the aggregate, or in such groupings as are deemed to be most useful. The objective is to convey the enterprise's obligations to issue equity instruments under terms of these plans, as well as to communicate changes in the obligations during the period. While disclosure requirements are flexible, it is important that aggregation not conceal the essential characteristics of these equity compensation arrangements.

As noted above, while the accounting for stock compensation plans (called "share-based payments") was not formally addressed by IAS 19, and was, in the opinions of many, unsuccessfully dealt with under US GAAP, recent events have caused a sea of change in public opinion, particularly in the US where such plans are widely employed, so that there may now be sufficient support for a mandate to expense such costs. The FASB had previously stated that it was not going to revisit this highly contentious matter, but most recently has been reported as seeking a means to transition from the currently most common financial reporting method (no expense recognition, but pro forma disclosures of the effect of full recognition) to mandatory expensing of employee stock options. IASB had already announced (at the time of its creation) that it would place this topic on its technical agenda, notwithstanding strong protests from the preparer community.

The IASB's project on the accounting to be applied to share-based payments to employees (including employee stock options), suppliers, creditors, and others tentatively has concluded that the payments should be recognized as expenses that should be deducted in measuring periodic earnings. The IASB has identified four measurement bases that potentially could be applied to these payments; historical cost, intrinsic value, minimum value, and fair value. Not surprisingly, fair value appears at this time to have the greatest support and may also be most stridently opposed by the preparer community. Intrinsic value is the failed method used under US GAAP, which generally results in no compensation being associated with these plans. Minimum value is a variant on fair value, but which would modify the options pricing models (such as Black-Scholes) to compensate for the fact that most employee stock options are not freely tradable and thus, arguably, have less value than do marketable options.

If the IASB were ultimately to require either full recognition or even just disclosure of the fair values of share-based payments, disclosure should be required of the type of model used to determine the fair value, as well as the inputs to that model, including which interest rate is used, the historical and expected price volatility and the reasons for any differences between them, and the historical and expected dividend yield and discussion of any differences between them.

See Chapter 17 for a further discussion of this topic and the IASB's project.