Over the last few years, accounting standards for employee benefits around the world have begun to look similar. In the long term, convergence of accounting standards may be a positive step for employers, as there will be fewer sets of accounting rules to follow in the short term, local rules will change.
Accounting for employee benefits in the U.S. in the future will likely contribute much more volatility to corporate books. This added volatility will be another disincentive for employers offering defined benefit pension plans and post-retirement medical programs.
In many ways, the U.S. Statement of Financial Accounting Standards 87 (SFAS 87) and its related statements (numbers 88, 106, 112, 132) are no longer the trendsetters for employers’ accounting for employee benefits.
Newer standards outside the United States resemble the SFAS family but attempt to address SFAS shortcomings. Governing bodies for accounting standards in several countries have a review of benefits accounting high on their agendas. All these factors may be leading to one approach, or standard, for employee benefits accounting, regardless of where in the world an organization is headquartered or operates.
Historically, organizations took a simplified approach to benefits accounting, with no liabilities disclosed on the balance sheet or in related footnotes. The charge, or expense, to profits for a period was generally equal to the cash contributions to a fund or insurance policies, the amount directly paid to participants, or the amount set aside as an internal reserve if benefits were unfunded.
Accounting bodies concluded that there was a need to disclose liabilities on the organization’s balance sheet (or in financial statement footnotes), since they could be quite significant in some cases. Also, actuarial methods and assumptions for determining cash contributions to a benefits fund could vary considerably from one organization to another. Under certain circumstances, a country’s tax regime may allow no contributions in some years, even though benefits continue to accrue. As a result, expense amounts were not always comparable and could be subject to manipulation.
In December 1985, the Financial Accounting Standards Board (FASB) in the U.S. issued SFAS 87. At the same time, it issued SFAS 88, covering employers’ accounting for settlements and curtailments in defined benefit pension plans, as well as termination benefits.
A few years later, SFAS 106 and 112 were released, covering employers’ accounting for post-employment benefits other than pensions. For most U.S. employers, this primarily means retiree medical and retiree life insurance coverage.
The disclosure and expense requirements under these standards set the trend for most ensuing accounting statements for employee benefits around the world. The basic principles of disclosing the market value of assets and a current interest rate measure of liabilities in the footnotes to the balance sheet, and a prescribed method for calculating expense for the period have withstood the test of time.
The FASB approach to accounting for employee benefits spread quickly around the world because overseas subsidiaries of U.S. companies as well as non-U.S. companies wishing to do business or raise capital in the U.S. were required to report on that basis. Over the years, other countries adopted their own accounting standards for employee benefits that looked similar to the SFAS statements. In particular, Canada, Mexico and Japan followed the lead of the U.S.
Some observers felt that SFAS 87 as originally written allowed too much smoothing of changes in asset and liability values due to economic market fluctuations. Under the standard, employers are allowed to systematically recognize asset gains or losses over a period of up to five years when determining the market-related value of assets used for determining the return on assets component of the net periodic benefits cost.
Smoothing is also employed for gains or losses from both assets and liabilities, which must be recognized only to the extent that the net value exceeds 10 percent of the greater of assets and the projected benefit obligation, or PBO. In addition, the net value outside this corridor is further smoothed by gradually recognizing it in pension expense over the average expected working period of the covered employees assumed to benefit under the plan.
Primarily due to the extended bull markets of the 1990s, another criticism of SFAS 87 has surfaced over the last few years. When pension plans become well funded, an employer may actually have net periodic pension income and build up a prepaid pension cost as an asset on the balance sheet.
In the last few years, this created front-page headlines in the U.S. about large companies “inflating” their earnings by using pension income. This increased the pressure for more transparent accounting for benefits in the U.S.
In 1985, the predecessor to the International Accounting Standards Board introduced its version of an accounting standard for employee benefits (IAS 19). Some employers in countries with no formal accounting standards now use IAS 19. The standard was modified over the years, most significantly in 1998, so that the current version closely resembles the FASB approach, while attempting to address some of the perceived shortcomings of the FASB statements.
In particular, the standard places a limit on the buildup of a net pension asset on an organization’s balance sheet. Also, prior service costs are recognized over the period until benefits covered by a plan amendment are vested (in many cases, this may mean immediate recognition). Table 1 compares the primary provisions of the different standards.
The types of benefits covered by IAS 19 are quite broad. In general, post-employment benefits are included in the standard, as well as such benefits as vacations and sick leave. Because IAS 19 is intended to apply internationally, the IASB did a better job of anticipating the variety of benefits typically encountered outside North America.
In Regulation 1606/2002, the European Union has prescribed that International Accounting Standards will be required for the accounts of publicly traded employers in member countries starting in 2005, or 2007 in some cases. Other non-publicly traded employers may report under national accounting standards if such standards exist.
With much of Western Europe following the IASB standards and much of Eastern Europe set to join the EU within the next few years there will likely be strong pressure on North American accounting groups to change local standards to mirror IAS 19.
The one notable exception to the FASB/IASB accounting approach was, until recently, the United Kingdom. In 1998, the U.K. Accounting Standards Committee published a statement of standard accounting practice (SSAP 24) covering pension costs. SSAP 24 allowed more flexibility in the methods and assumptions used to determine the “regular” pension cost and variations during a financial period. Under the standard, it was not necessary for employers’ accounting for benefits to reflect the “market value” of liabilities or assets.
Over time, the clamor grew for better disclosure in employers’ accounting for employee benefits and more comparability among employers. It also became clear that many U.K. employers were manipulating the accounting for benefits so that the expense for the period was still roughly equal to the contributions made. As a result, the UK Accounting Standards Board introduced Financial Reporting Standard 17 (FRS 17) in late 2000, bringing a new market value approach to the U.K.
FRS 17 breaks new ground in the areas of transparency of reporting and immediate recognition of events in the profit and loss account. A net pension liability or asset to the extent that the employer can recover a surplus is to be listed explicitly on the employer’s balance sheet instead of being buried in footnotes.
Under the standard, most fluctuations in assets or liabilities are recognized immediately. This includes investment gains or losses due to changes in the economic environment, liability gains or losses due to changes in actuarial assumptions, the impact of changes in benefits on liabilities (to the extent vested), and settlements or curtailments resulting from corporate restructuring.
Actuarial gains and losses are actually reported in something unique to U.K. accounting called the Statement of Total Recognised Gains and Losses, instead of in operating income. Immediately recognizing all of these items in some type of income account, not smoothing their impact, may cause significant volatility. The table on page 19 compares FRS 17 with SFAS 87 and IAS 19.
The FRS 17 methodology has not been particularly popular with actuaries, employers or even accountants in the U.K. The standard has already been blamed for driving up the accounting cost for employee benefits by forcing employers to invest pension funds conservatively so as to limit volatility in asset values.
This effect, along with current market conditions, has been cited by many larger employers in the U.K. as the principal reason for closing their pension plans to new entrants. Perhaps partly for this reason, but primarily to coordinate with the EU’s schedule for using the IASB standard, full implementation of FRS 17 has been delayed until 2005.
Nearly any new accounting standard for employee benefits currently being introduced by the accounting authorities in any country follows a similar approach for valuing assets and liabilities as originally introduced by SFAS 87.
New standards adopt the best elements of IAS 19, often with a few minor revisions to fit the local accounting environment. In fact, major differences between a new standard and IAS 19 or the FASB standards must be justified to investors and financial analysts, causing more pressure for standards to converge.
The U.K. Accounting Standards Board believes it has found the solutions to two criticisms of the FASB standards in the U.S.: delayed recognition of asset or liability fluctuations and lack of transparency in benefits accounting. However, the price to pay for these answers is that employers are reluctant to offer traditional defined benefit pension plans to employees.
This leads to a philosophical question: Should benefits accounting drive an employer’s decisions on benefits, or should it simply give shareholders and other users of financial statements an accurate picture of the benefits an employer offers its employees and the impact of the cost to the organization?
The IASB is expected to review IAS 19 before the EU mandates its use in 2005. Since the chairman of the IASB one of the primary authors of FRS 17 in the U.K. publicly stated a preference for immediate recognition of changes in assets and liabilities, there is an expectation among practitioners that any revision to IAS 19 will incorporate this element.
Other members of the IASB, however, have voiced opposition to the immediate recognition approach. Because all major accounting standards bodies in the world give input to the IASB, the North American contingency also will be able to weigh in.
For now, any planned revisions to the FASB standards in the U.S. focus on increased disclosures and do not address the details of calculations or methodology. Revisions to IAS 19, coupled with the recent outcry for better corporate accounting, will likely cause the FASB to do a more comprehensive review of the FASB standards within the next few years. The chairman of the FASB fully supports the convergence of the FASB and IASB standards. Preliminary convergence discussions between the two groups are scheduled for April. Standards governing employers’ accounting for employee benefits will likely continue to converge.
A point at which one standard applies in all jurisdictions is possible. In the meantime, those charged with preparing financial statements should be aware of potential changes in the current standards and understand the implications. Preparation now will prevent unpleasant financial surprises later.
Carl I. Hansen, FSA, MAAA, is executive director of Milliman Global in the Seattle office of Milliman USA the U.S. member firm of Milliman Global. A version of this article previously appeared in the Milliman USA publication Benefits Perspectives.
Reproduced from National Underwriter Edition, April 19, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.