ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)
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Chapter 14: Employee benefits and share based payments
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Benefits paid to scheme members 32
Contributions paid into the scheme 43
31 December Present value of scheme obligations 920
Fair value of scheme assets 836
The employer has a net liability at 1 January of $70 million (= 850 – 780) and a net
liability of $84 million at 31 December (= 920 – 836).
The total actuarial gain or loss in the year is calculated as follows:
$m
Pension scheme assets at the beginning of the year (fair value) 780
Expected return from the fund’s investments during the year at 5% 39
Contributions paid into the fund 43
Benefits paid from the fund (32)
Expected pension scheme assets at the end of the year 830
Actuarial gain (balance) 6
Pension scheme assets at the end of the year (fair value) 836
The actuarial difference is a gain because the actual value of the scheme assets at the
end of the year is more than would be expected using the actuaries’ assumptions.
$m
PV of pension scheme obligations at the beginning of the year 850
Interest cost (discount unwinds) at 6% 51
Add: Current service cost (increase in obligations in the year) 40
Minus: Benefits paid from the fund (= liabilities paid) (32)
Expected PV of pension scheme obligations at the end of the year 909
Actuarial loss (balance) 11
PV of pension scheme obligations at the end of the year 920
The actuarial difference is a loss because the actual PV of the scheme obligations at
the end of the year is more than would be expected using the actuaries’
assumptions.
The total (net) actuarial difference for the year is an actuarial loss of $5 million (=
$11 million loss and $6 million gain).
1.9 Accounting for the actuarial difference
IAS 19 allows three possible accounting treatments of the actuarial difference.
Option 1: report the difference in full through the income statement
IAS 19 allows the actuarial difference to be taken to the profit or loss (the income
statement) immediately. This would adjust the pension deficit in the company’s
statement of financial position to its true position.
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In the above example the actuarial difference could be written off as an expense of
$43,000 in 20X6. The liability of the company to its pension scheme will be shown in
the statement of financial position as $1,110,000.
The journal entry to record this is the company’s accounts are as follows:
$000 $000
DR
Incomestatement 43
CR Pensionliability
43
Option 2: the corridor approach
The accounting treatment in Option 1 will lead to large variations in the reported
profits of a company from one year to the next, because the actuarial difference
could be quite large. Actuaries might change their assumptions drastically (for
example, after an equity market ‘crash’ has reduced the value of investments in the
scheme, or after the actuary has increased his estimate of the life expectancy of
retired employees).
If there is a large actuarial difference each year, a company with stable operating
profits could report profits that fluctuate each year. The actuarial differences could
hide the company’s operating performance.
It was therefore considered necessary to allow companies a way of managing the
actuarial differences, so that reported profits are not increased in one year and
reduced in the next year by actuarial differences each year. Over time, favourable
and adverse actuarial differences might largely cancel each other out.
Therefore IAS 19 allows the use of a materiality test, called the ‘corridor approach’
to decide how much (if any) of the actuarial difference must be recognised in profit
or loss (the income statement) each year. A company can choose to adopt the
corridor approach as its accounting policy. When it adopts the corridor approach,
the only actuarial difference that is taken to the income statement is that part of the
difference that ‘falls outside the corridor’ – (exceeds the limits set by the corridor).
The corridor is the higher of:
10% of the fair value of the scheme’s assets at the beginning of the year
10% of the present value of the scheme’s liabilities at the beginning of the year.
So in the example above, the corridor is the higher of:
10% × $900,000 = $90,000
10% × $1,850,000 = $185,000
Therefore the corridor is $185,000.
Given that the actuarial difference is $43,000 and smaller than the corridor, no
actuarial difference is recognised in the income statement, using Option 2 as the
accounting policy.
Chapter 14: Employee benefits and share based payments
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$000
Netdeficitatyearend(actuary’slatestestimate)
1,110
Minusunrecognisedactuarialloss (43)
Netliability(schemedeficit)tobereportedinthecompany’sstatementof
financialposition
1,067
Further rules on the corridor method
A company must recognise in its income statement, as a minimum, the amount of
the actuarial difference that falls outside the corridor. The company could use a
smaller corridor than 10% – say 5%.
The excess actuarial difference that falls outside the corridor should be recognised
in the income statement over the average remaining service lives of the
employees concerned.
Recognition should start from the next year. IAS 19 permits faster recognition, so the
actuarial difference could be taken in full immediately.
However the company chooses to apply the corridor approach, they must be
consistent in their accounting policy from one year to the next.
Example
The earlier example will now be continued into the next two years:
Openingpositionat1January:
20X7 20X8
$000 $000
Fairvalueoftheplanassets 850 879
Presentvalueoftheplanobligations
1,960 2,400
Unrecognisedactuariallossbroughtforward
43 ?
Duringtheperiod:
$000 $000
Currentservicecost
100 110
Contributionspaidintotheplan 140 120
Benefitspaidoutbytheplan
150 100
Actuarialassumptions:
Discountrate
11% 11%
Expectedreturnonplanassets 3% 3%
Theactuarialvaluationat31December: 20X7 20X8
$000 $000
Fairvalueoftheplanassets 879 980
Presentvalueoftheplanobligations
2,400 2,780
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The company has a policy of applying a 10% corridor, any excess being amortised
over the average remaining service lives of ten years.
Required
For each year:
(1) Calculate the actuarial gain or loss arising in the year.
(2) Applying the corridor approach, calculate the amount of the difference to be
recognised.
(3) Calculate the liability to be disclosed in the statement of financial position.
(4) Prepare an analysis of the expense taken to the income statement.
Answer
Fund
position
Company
position
Requirement1
Workings Liability Assets Net
$000 $000 $000
At1stJanuary20X6
(1,960) 850 (1,110)
1.Interestexpense
11%×1,960 (216)
(216)
2.Interestearned
3%×850
26 26
3.Currentservicecost
Given (100)
(100)
4.Contributionspaid
140 140
5.Benefitspaidout
150 (150) 0
–––––––––––––– –––––––––––––– ––––––––––––––
Expectedyearendposition
(2,126) 866 (1,260)
Actuarialdifference
Balance (274) 13 (261)
–––––––––––––– –––––––––––––– ––––––––––––––
Actualposition31stDec20X7 (2,400) 879 (1,521)
–––––––––––––– –––––––––––––– ––––––––––––––
At1stJanuary20X8
(2,400) 879 (1,521)
1.Interestexpense
11%×2,400 (264)
(264)
2.Interestearned
3%×879
26 26
3.Currentservicecost
Given (110)
(110)
4.Contributionspaid
120 120
5.Benefitspaidout
100 (100) 0
–––––––––––––– –––––––––––––– ––––––––––––––
Expectedyearendposition
(2,674) 925 (1,749)
Actuarialdifference
(106) 55
(51)
–––––––––––––– –––––––––––––– ––––––––––––––
Actualposition31stDec20X8 (2,780) 980 (1,800)
–––––––––––––– –––––––––––––– ––––––––––––––
Chapter 14: Employee benefits and share based payments
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Thecorridor=greaterof: 20X7
20X8
$000
$000
10%ofschemeassetsatbeginningoftheyear 85
87.9
10%ofliabilityatbeginningoftheyear
196
240.0
Corridor(thehigherofthetwoamounts)
196
240.0
Requirement2
Actuarialdifferencetoberecognised
20X7
20X8
$000 $000
Cumulativeunrecognisedactuariallossb/fwd 43 304.0
(For20X8=43unrecognisedin20X6+261actuarial
differencein20X7)
Corridor
196 240.0
–––––––––––– ––
–
––––
–
––––––
Actuarialdifferencetoberecognised
0 64.0
Averageremainingservicelives 10 10.0
–––––––––––– ––
–
–––
–
––––––
Actuarialdifferencetoberecognisedinyear
0 6.4
–––––––––––– ––
–
–––
–
––––––
Unrecognisedactuarialloss1January 43 304.0
Actuariallossforyear 261 51.0
Actuariallossrecognised 0 (6.4)
–––––––––––– ––
–
–––
–
––––––
Unrecognisedlossesat31December
304 348.6
–––––––––––– ––
–
–––
–
––––––
Requirement3
Liabilityinstatementoffinancialposition
20X7
20X8
$000 $000
Netliabilityatyearend
1,521 1,800.0
Unrecognisedlosses
(304) (348.6)
–––––––––––– ––––––
–
–
–––
–
–––––
Netliabilitytobereported
1,217 1,451.4
–––––––––––– ––––––
–
–
–––
–
–––––
Requirement4
Incomestatementexpense
20X7
20X8
$000 $000
Interestexpense
(216) (264.0)
Interestearned
26 26.0
Currentservicecost
(100) (110.0)
Actuariallossrecognised
0 (6.4)
–––––––––––– ––
–
–––
–
––––––
Expensetoberecognised
(290) (354.4)
–––––––––––– ––
–
–––
–
––––––
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Option 3: report the difference in full through equity reserves
A third option for accounting for the actuarial difference was introduced from
December 2004. This was due to problems with IAS 19 (which have not been
resolved).
IAS 19 adopts an approach that measures a company’s pension obligations to a
defined benefit scheme by comparing the fair value of the assets and the present
value of the liabilities. The assets will include investments in financial instruments,
whose price may be volatile and move up and down by large amounts in any year.
The Option 1 approach to reporting the actuarial difference can therefore result in
significant fluctuations in the reported profit each year.
Using the corridor approach, a part of the ‘actuarial difference’ may be deferred.
Companies are able to choose whether to adopt the corridor approach and how it
should apply. Unfortunately, giving companies a choice of accounting method does
not help with the IASB’s goal of comparability of financial statements between
entities.
The ability to defer the actuarial differences (using the corridor method) deals with
the volatility problem, but results in items being shown in the statement of financial
position that do not meet the IASB Framework definition of an asset or liability.
A third approach to reporting actuarial differences was therefore introduced as an
acceptable option from December 2004, by means of an amendment to IAS 19. By
this method, companies are allowed to recognise actuarial gains and losses
immediately in full in the period in which they occur, but do not have to report
these gains or losses through profit or loss (the income statement). Instead, they can
be taken directly to reserves.
A company adopting this accounting policy must apply the policy to all its defined
benefits plans and all its actuarial gains and losses.
1.8 Past service costs
A company may change the terms of its pension plan once it is in operation, so that
the future benefits payable to retired employees are changed. This affects the future
pension payments, and so changes the present value of the liabilities of the scheme.
Past service costs could cause the pension liability to increase or decrease,
depending on the changes made and these are also recognised in the income
statement.
If the benefits have ‘vested’ and the employees are entitled to the new benefits
immediately, then the increase in the scheme’s liabilities should be expensed
immediately (charged as an expense in the income statement).
If the benefits ‘vest’ in the future, and the employees are therefore not entitled to
the benefits until a later date, then the costs to the company of the increase in the
obligations/liabilities of the scheme should be spread over this vesting period.
Chapter 14: Employee benefits and share based payments
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Example
An enterprise operates a pension plan that provides a pension of 2% of final salary
for each year of employment. The employees are eligible to join the pension scheme
after five years of service. On 1 January 20X7 the enterprise improves the pension to
2.5% of final salary for each year of service starting from 1 January 20X3. At the date
of the improvement, the present value of the additional benefits for service from 1
January 20X3 to 1 January 20X7 is as follows:
$000
Employeeswithmorethanfiveyears’serviceat1January20X7
150
Employeeswithlessthanfiveyears’serviceat1January20X7
(averageperioduntilvesting:threeyears)
120
270
The enterprise recognises $150,000 immediately because those benefits are
already vested.
The enterprise recognises $120,000 on a straight-line basis over three years from
1 January 20X7.
1.9 ED 2009/10 Discount rate for employee benefits: Proposed amendments
The IASB withdrew this ED in October 2009. The reason given for its withdrawal
was that responses to the ED had shown that the proposed change would lead to
unexpected complications. IASB will now proceed with a longer term project to
redraft IAS 19.
The ED was an attempt to solve a particular problem. This problem still exists
though now there is no solution expected. This text contains the following brief
explanation of the issue for the sake of completeness.
IAS 19 requires an entity to determine the rate used to discount employee benefit
obligations with reference to market yields on high quality corporate bonds. In
some countries there is no deep market in such bonds. In this case, IAS 19 requires
the use of market yields on government bonds instead.
This requirement means that entities with similar employee benefit obligations can
report them at very different amounts. This effect has been much greater as a result
of the global financial crisis because of the significant widening of the spread
between yields on corporate bonds and yields on government bonds.
The ED proposed to eliminate the requirement to use government bond rates to
determine the discount rate for employee benefit obligations when there is no deep
market in high quality corporate bonds. This was to be replaced by a principles
based approach.
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IFRS 2: Share-based payment
The objective of IFRS 2
The nature of share options and the accounting problem
Accounting for equity-settled share-based payment transactions
Cash-settled share based payments
Share based payments and deferred tax
IFRS 2: disclosure requirements
Comments on IFRS 2
IFRIC Interpretation 11: IFRS 2 - Group and treasury share transactions
IFRIC Interpretation 8: Scope of IFRS 2
2 IFRS 2: Share-based payment
2.1 The objective of IFRS 2
IFRS 2 Share-based payment specifies how entities should account for share-based
payment transactions. A share-based payment transaction is defined as a transaction
in which an entity:
receives goods or services as consideration for equity instruments of the entity,
or
receives goods or services from a supplier by incurring a liability to the supplier
for an amount that is based on the entity’s share price.
This can include inventories, property, plant and equipment, intangible assets and
other non-financial assets. It excludes shares issued in a business combination (IFRS
3) and contracts for the purchase of goods under IAS 32 and 39.
An important example of a share-based payment transaction is the award of share
options to employees (often senior managers and directors). An award of share
options to an employee is seen as consideration given by the entity to the employee
in return for the employee’s services and IFRS 2 requires an expense to be
recognised in respect of this.
Occasionally shares may also be used instead of cash to pay suppliers for goods or
services. These are described as share based payments, and until IFRS 2, there was
no accounting standard addressing the recognition and measurement of these
transactions.
IFRS 2 recognises three types of share-based payment transaction:
Equity-settled shared based payment – This is where the entity provides shares
or share options in return for goods and services.
Cash-settled share based payment – This is where the entity makes a cash
payment in return for goods and services, and the amount of the payment is
linked to linked to its share price.
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Choice of settlement – This is where the transaction can be settled in cash or
shares.
IFRS 2 requires an expense to be recognised for the goods or services received by a
company. The corresponding entry is a liability or an increase in equity depending
on whether it is a cash-settled or equity-settled transaction
IFRS 2 requires that the cost of goods and services should be recognised when they
are received. With goods, it is the date they are received. This could result in an
asset or an expense, depending on the nature of the transaction. Recognition of the
expense might be immediate or spread over a ‘vesting period’ if the shares are
issued in the future.
2.2 The nature of share options and the accounting problem
The nature of employee share options
In an employee share option scheme, an employee is given the right to subscribe for
new shares in the company at a future date, at a price that is usually fixed when the
share options are awarded.
There are often some conditions attached to the right of the employee to exercise the
options and buy the new shares. These conditions are called vesting conditions.
When these conditions have been met, the right to subscribe for new shares vests in
the employee. In other words, the right to buy the new shares becomes an
unconditional entitlement.
The vesting conditions may have to be satisfied within a period of time, known as a
vesting period. For example, an employee may be granted a number of share
options, giving him the right to subscribe for new shares in the company on a future
date, on condition that the individual remains an employee of the company for at
least the next three years. In this example, the vesting conditions are the
requirement to serve at least three more years with the company, and the vesting
period is three years.
The accounting problem
The award of share options to an employee is a reward for services given by the
employee.
If the employee is rewarded with a cash bonus, the cost of the cash bonus would
be included in total employment costs and charged as an expense in the relevant
accounting period.
A problem in the past with accounting for share options was that although share
options are a similar type of reward for service, the cost of the options were not
charged as an expense in the income statement.
Accounting for share options was therefore illogical. Employees were given
rewards, but the cost of those rewards was not recognised in the income statement.
The company incurred a liability to issue new shares at a price below current
market value, but no liability was shown in the statement of financial position.
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IFRS 2 requires a cost to be accounted for when share options are granted, because a
transaction has occurred and so a cost should be matched against the benefits
provided by the employees. The question is how to calculate the cost and how to
recognise it in the financial statements.
Why are share options an expense?
When a company issues share options, it incurs an expense. It gives employees the
right to subscribe for new shares at a future date, at a price that is expected to be
lower than the market price of the shares when the options are exercised.
Share options therefore have a value. When share options are awarded to an
employee, the employee is therefore given something of value.
2.3 Accounting for equity-settled share-based payment transactions
IFRS 2 states that share-based payment transactions, such as the award of share
options, should recognise the cost when the transaction is made.
An entity should recognise the services (or goods) received in a share-based
payment transaction when it obtains the services (or goods).
If the goods or services received do not qualify for recognition as assets, they
should be recognised as expenses.
This means that when a company receives services from an employee, in return for
which share options are awarded, the cost of the share options should normally be
recognised immediately as an expense, because employee costs do not normally
qualify for recognition as an asset.
The basic rule
For share-based payment transactions, an entity should measure the cost of the
services (or goods) received at their fair value, with a corresponding increase in
equity.
If a fair value cannot be reliably measured for the services or goods, the fair value
of the equity instruments should be used instead.
When share options are granted to an employee, the fair value of the employment
services provided in return for the options cannot be measured reliably; therefore
the cost of the services should be measured as the fair value of the share options.
A value for share options can be obtained using a share option pricing model, such
as the Black-Scholes model.
In the case of share options to employees, the cost of the options should be
recognised in the accounts of the company at the grant date. This is the date that the
options are awarded to the employee, not the date that they can be exercised (which
may be three or more years later).
This is an important point. The fair value of the options at the date of the grant of
the options is used to account for transaction. The fair value of the options at