Converging Intl. Accounting Standards ForEB

Over the last few years, accounting standards for employeebenefits around the world have begun to look similar. In the longterm, convergence of accounting standards may be a positive stepfor employers, as there will be fewer sets of accounting rules tofollow in the short term, local rules will change.

Accounting for employee benefits in the U.S. in the future willlikely contribute much more volatility to corporate books. Thisadded volatility will be another disincentive for employersoffering defined benefit pension plans and post-retirement medicalprograms.

In many ways, the U.S. Statement of Financial AccountingStandards 87 (SFAS 87) and its related statements (numbers 88, 106,112, 132) are no longer the trendsetters for employers' accountingfor employee benefits.

Newer standards outside the United States resemble the SFASfamily but attempt to address SFAS shortcomings. Governing bodiesfor accounting standards in several countries have a review ofbenefits accounting high on their agendas. All these factors may beleading to one approach, or standard, for employee benefitsaccounting, regardless of where in the world an organization isheadquartered or operates.

Historically, organizations took a simplified approach tobenefits accounting, with no liabilities disclosed on the balancesheet or in related footnotes. The charge, or expense, to profitsfor a period was generally equal to the cash contributions to afund or insurance policies, the amount directly paid toparticipants, or the amount set aside as an internal reserve ifbenefits were unfunded.

Accounting bodies concluded that there was a need to discloseliabilities on the organization's balance sheet (or in financialstatement footnotes), since they could be quite significant in somecases. Also, actuarial methods and assumptions for determining cashcontributions to a benefits fund could vary considerably from oneorganization to another. Under certain circumstances, a country'stax regime may allow no contributions in some years, even thoughbenefits continue to accrue. As a result, expense amounts were notalways 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 SFAS88, covering employers' accounting for settlements and curtailmentsin defined benefit pension plans, as well as terminationbenefits.

A few years later, SFAS 106 and 112 were released, coveringemployers' accounting for post-employment benefits other thanpensions. For most U.S. employers, this primarily means retireemedical and retiree life insurance coverage.

The disclosure and expense requirements under these standardsset the trend for most ensuing accounting statements for employeebenefits around the world. The basic principles of disclosing themarket value of assets and a current interest rate measure ofliabilities in the footnotes to the balance sheet, and a prescribedmethod for calculating expense for the period have withstood thetest of time.

The FASB approach to accounting for employee benefits spreadquickly around the world because overseas subsidiaries of U.S.companies as well as non-U.S. companies wishing to do business orraise capital in the U.S. were required to report on that basis.Over the years, other countries adopted their own accountingstandards for employee benefits that looked similar to the SFASstatements. In particular, Canada, Mexico and Japan followed thelead of the U.S.

Some observers felt that SFAS 87 as originally written allowedtoo much smoothing of changes in asset and liability values due toeconomic market fluctuations. Under the standard, employers areallowed to systematically recognize asset gains or losses over aperiod of up to five years when determining the market-relatedvalue of assets used for determining the return on assets componentof the net periodic benefits cost.

Smoothing is also employed for gains or losses from both assetsand liabilities, which must be recognized only to the extent thatthe net value exceeds 10 percent of the greater of assets and theprojected benefit obligation, or PBO. In addition, the net valueoutside this corridor is further smoothed by gradually recognizingit in pension expense over the average expected working period ofthe covered employees assumed to benefit under the plan.

Primarily due to the extended bull markets of the 1990s, anothercriticism of SFAS 87 has surfaced over the last few years. Whenpension plans become well funded, an employer may actually have netperiodic pension income and build up a prepaid pension cost as anasset on the balance sheet.

In the last few years, this created front-page headlines in theU.S. about large companies “inflating” their earnings by usingpension income. This increased the pressure for more transparentaccounting for benefits in the U.S.

In 1985, the predecessor to the International AccountingStandards Board introduced its version of an accounting standardfor employee benefits (IAS 19). Some employers in countries with noformal accounting standards now use IAS 19. The standard wasmodified over the years, most significantly in 1998, so that thecurrent version closely resembles the FASB approach, whileattempting to address some of the perceived shortcomings of theFASB statements.

In particular, the standard places a limit on the buildup of anet pension asset on an organization's balance sheet. Also, priorservice costs are recognized over the period until benefits coveredby a plan amendment are vested (in many cases, this may meanimmediate recognition). Table 1 compares the primary provisions ofthe different standards.

The types of benefits covered by IAS 19 are quite broad. Ingeneral, post-employment benefits are included in the standard, aswell as such benefits as vacations and sick leave. Because IAS 19is intended to apply internationally, the IASB did a better job ofanticipating the variety of benefits typically encountered outsideNorth America.

In Regulation 1606/2002, the European Union has prescribed thatInternational Accounting Standards will be required for theaccounts of publicly traded employers in member countries startingin 2005, or 2007 in some cases. Other non-publicly traded employersmay report under national accounting standards if such standardsexist.

With much of Western Europe following the IASB standards andmuch of Eastern Europe set to join the EU within the next few yearsthere will likely be strong pressure on North American accountinggroups to change local standards to mirror IAS 19.

The one notable exception to the FASB/IASB accounting approachwas, until recently, the United Kingdom. In 1998, the U.K.Accounting Standards Committee published a statement of standardaccounting practice (SSAP 24) covering pension costs. SSAP 24allowed more flexibility in the methods and assumptions used todetermine the “regular” pension cost and variations during afinancial period. Under the standard, it was not necessary foremployers' accounting for benefits to reflect the “market value” ofliabilities or assets.

Over time, the clamor grew for better disclosure in employers'accounting for employee benefits and more comparability amongemployers. It also became clear that many U.K. employers weremanipulating the accounting for benefits so that the expense forthe period was still roughly equal to the contributions made. As aresult, the UK Accounting Standards Board introduced FinancialReporting Standard 17 (FRS 17) in late 2000, bringing a new marketvalue approach to the U.K.

FRS 17 breaks new ground in the areas of transparency ofreporting and immediate recognition of events in the profit andloss account. A net pension liability or asset to the extent thatthe employer can recover a surplus is to be listed explicitly onthe employer's balance sheet instead of being buried infootnotes.

Under the standard, most fluctuations in assets or liabilitiesare recognized immediately. This includes investment gains orlosses due to changes in the economic environment, liability gainsor losses due to changes in actuarial assumptions, the impact ofchanges in benefits on liabilities (to the extent vested), andsettlements or curtailments resulting from corporaterestructuring.

Actuarial gains and losses are actually reported in somethingunique to U.K. accounting called the Statement of Total RecognisedGains and Losses, instead of in operating income. Immediatelyrecognizing all of these items in some type of income account, notsmoothing their impact, may cause significant volatility. The tableon page 19 compares FRS 17 with SFAS 87 and IAS 19.

The FRS 17 methodology has not been particularly popular withactuaries, employers or even accountants in the U.K. The standardhas already been blamed for driving up the accounting cost foremployee benefits by forcing employers to invest pension fundsconservatively so as to limit volatility in asset values.

This effect, along with current market conditions, has beencited by many larger employers in the U.K. as the principal reasonfor closing their pension plans to new entrants. Perhaps partly forthis reason, but primarily to coordinate with the EU's schedule forusing the IASB standard, full implementation of FRS 17 has beendelayed until 2005.

Nearly any new accounting standard for employee benefitscurrently being introduced by the accounting authorities in anycountry follows a similar approach for valuing assets andliabilities as originally introduced by SFAS 87.

New standards adopt the best elements of IAS 19, often with afew minor revisions to fit the local accounting environment. Infact, major differences between a new standard and IAS 19 or theFASB standards must be justified to investors and financialanalysts, causing more pressure for standards to converge.

The U.K. Accounting Standards Board believes it has found thesolutions to two criticisms of the FASB standards in the U.S.:delayed recognition of asset or liability fluctuations and lack oftransparency in benefits accounting. However, the price to pay forthese answers is that employers are reluctant to offer traditionaldefined benefit pension plans to employees.

This leads to a philosophical question: Should benefitsaccounting drive an employer's decisions on benefits, or should itsimply give shareholders and other users of financial statements anaccurate picture of the benefits an employer offers its employeesand the impact of the cost to the organization?

The IASB is expected to review IAS 19 before the EU mandates itsuse in 2005. Since the chairman of the IASB one of the primaryauthors of FRS 17 in the U.K. publicly stated a preference forimmediate recognition of changes in assets and liabilities, thereis an expectation among practitioners that any revision to IAS 19will incorporate this element.

Other members of the IASB, however, have voiced opposition tothe immediate recognition approach. Because all major accountingstandards bodies in the world give input to the IASB, the NorthAmerican 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 ofcalculations or methodology. Revisions to IAS 19, coupled with therecent outcry for better corporate accounting, will likely causethe FASB to do a more comprehensive review of the FASB standardswithin the next few years. The chairman of the FASB fully supportsthe convergence of the FASB and IASB standards. Preliminaryconvergence discussions between the two groups are scheduled forApril. Standards governing employers' accounting for employeebenefits will likely continue to converge.

A point at which one standard applies in all jurisdictions ispossible. In the meantime, those charged with preparing financialstatements should be aware of potential changes in the currentstandards and understand the implications. Preparation now willprevent unpleasant financial surprises later.

Carl I. Hansen, FSA, MAAA, is executive director of MillimanGlobal in the Seattle office of Milliman USA the U.S. member firmof Milliman Global. A version of this article previously appearedin the Milliman USA publication Benefits Perspectives.

Reproduced from National Underwriter Edition, April 19, 2004.Copyright 2004 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.