On June 16, 2011, the International Accounting Standards Board (IASB) released final amendments to IAS 19 Employee Benefits. The new rule dramatically revises accounting for defined benefit plans, moving plan sponsors away from the current approach, which involves considerable “smoothing” of period-to-period measurements. It does not, however, require marking to market DB performance in operating income. Instead it takes a “middle” approach of booking returns on the net plan asset (liability) to the income statement calculated using the plan’s discount rate assumption and marking actual performance to other comprehensive income.
We do not discuss other elements of IAS 19, e.g., disclosure of information about plan assets. FASB has already made detailed revisions to US rules with respect to these requirements.
Generally: the new rule requires companies to book: (1) the plan’s current service cost (normal cost) to profit and loss; (2) a fixed rate of return (generally, the plan’s discount rate) on the net of plan assets and liabilities (AKA “net interest”) to profit and loss; and actual (i.e., mark-to-market) returns (AKA remeasurement) along with actuarial gains and losses to “other comprehensive income.”
This approach is similar to the proposal included in the exposure draft. The only “headline” change is that the exposure draft proposed booking net interest to profit and loss as a finance charge. The final rule does not specify where in profit or loss an entity should present the net interest component.
To be clear, we are discussing how a reporting entity (e.g., a plan sponsor/issuer of securities) reflects, on its balance sheet and income statement, the cost of maintaining a DB plan.
FASB and (old) IASB accounting for DB benefits are very similar. FASB, in 2006, adopted (in FAS 158) a mark-to-market approach to balance sheet disclosure of DB funding. While there was some controversy over FAS 158 (particularly over the use of the “projected benefit obligation” (PBO) for the plan liability number), as the mark-to-market balance sheet numbers had already been in a balance sheet footnote, the changes made by FAS 158 were generally not regarded as particularly radical.
Since the adoption of FAS 158, the focus of DB accounting reform advocates has been on income statement treatment. Under current FASB (and old IASB rules), generally, companies report with respect to a sponsored DB plan: (1) service cost; (2) an interest charge on the plan’s PBO; (3) a charge for amortization of unrecognized prior service cost; (4) a credit/charge for experience gains and losses.
Under these rules there is a lot of “buffering” of period to period results with respect to these income statement numbers. (The following is a description of FASB rules, but old IASB rules were generally similar.)
First, the value of plan assets may be smoothed for a period of up to five years. An expected rate of return on this smoothed amount is then credited to the income statement. The expected rate of return is based on the makeup of the plan’s asset portfolio.
Second, gains and losses are netted, and net gains/losses are only recognized to the extent they exceed 10 percent of the higher of the (smoothed) value of plan assets or the plan’s PBO. If gains/losses do exceed this 10 percent “non-recognition corridor,” that excess is not charged to the current year but is amortized in future years over the “average remaining service of active plan participants.”
Third, the recognition of past service benefits (resulting, e.g., from a plan amendment) is also delayed.
Criticisms of current accounting rules
The accounting community and the “users of financial statements” (e.g., investors and analysts) have been critical of current accounting treatment of DB plans. Summarizing: they believe that current rules to some extent (in the buffering provisions described above) obscure plan “performance” and make it harder than necessary for users to understand the plan’s effect on the company. They advocate moving to a mark-to-market approach under which period to period changes in liabilities (including changes in discount rate) and assets are booked to the income statement. Such an approach would significantly increase the volatility of income statement numbers.
In this regard, it is useful to keep in mind the critique of mark-to-market accounting that emerged in the global financial crisis, not just in the US but in Europe as well. While that critique may be less applicable to pension accounting than it is to financial institution accounting, it has had some effect on the DB accounting debate. Large 2008-2009 asset losses also give a particular urgency and consequence to the argument over booking plan asset-liability changes to company income statements currently. We note, however, that some companies in the US have voluntarily moved to mark-to-market accounting.
One particular feature of current FASB (and old IASB) accounting has been singled out for special criticism — the rule that allows companies to book as income the “expected long term rate of return” on plan assets. Critics have argued that this rule encourages companies to take on more asset risk in order to improve the “expected” return, while buffering rules in many cases allow them to ignore actual poor performance.
The IASB solution, generally
In this context, the changes IASB has made to DB accounting in the new rule 19 are particularly interesting and represent something of a “third way” (between buffering and mark-to-market). Briefly, new IAS 19 requires that companies book to profit and loss a fixed rate of return (generally, the plan’s discount rate) on the net of plan assets and liabilities, and book actual (i.e., mark-to-market) return to “other comprehensive income.” This approach:
Returns on “surplus” capped
Under new IAS 19, returns on plan surplus must be reduced (“capped”) to take into account limits on the ability of the company to use or recover the surplus. Specifically, the new rule applies an “asset ceiling,” defined as “the present value of any economic benefits available in the form of refunds from the plan or reductions in future contributions to the plan.” Thus, if, e.g., regulatory restrictions effectively prevent a company from using all or part of a plan surplus, it may not be taken into account in calculating the net interest credit for an overfunded plan.
New IAS 19 is generally effective for annual periods beginning on or after January 1, 2013.
Impact on US companies
Obviously, these are IASB rules and are not applicable to US reporting (although they will apply to US companies that are also subject to an IASB regime). But US (FASB) accounting is moving in the same direction. Moreover, at this stage in the globalization of commerce, it’s close to inconceivable that US accounting would take an approach that is radically different than that taken by the rest of the economically advanced world.
We will continue to follow these issues, particularly the response of FASB and of US plan sponsors.