IAS 19 Example

Real world examples are complicated. However, to help you understand, in a simplified manner, the general workings of the Actuary in determining the DBO, we ignore decrements (mortality, attrition) and only allow for a benefit to be paid on a retirement date.

Let’s say that a company pays an End of Service Benefit (“EOSB”) upon normal retirement age of 60 years. The benefit is defined as one monthly salary per every year of service (e.g. 20 years’ work will give 20 months’ salary as a one-off lump sum payment).

Our assumptions are as follows:

  • Salaries will grow at 5% for each future year
  • Interest/asset return rate is 4% per annum, based on quality bonds, 20-year term, given Expected Future service
  • Guaranteed employment to retirement
  • Death is not allowed!

The personal details of the one single employee are as follows:

  • Age at Joining Company:                               30
  • Age at Valuation Date (Now):                      40
  • Current Monthly Salary is:                     5,000
  • Normal Retirement Age:                               60
  • This means Past service is 40 – 30      = 10 years
  • This means Future service is 60 – 40 = 20 years (Expected Future Service)
  • This means Total service is 60 – 30     = 30 years (or 10 + 20)

According to IAS 19, the International Accounting Standards for Employee Benefits, the actuarial funding cost or valuation method to be used is the Projected Unit Credit (“PUC”) Method.

The simplified calculation stages are as follows:

  • Projected Final Salary = Current Salary * (1 + Salary Escalation) ^ (Future Service)
  •                                                 = Current Salary * (1 + 5%) ^ (60 – 40)
  •                                                 = 5,000 * (1.05) ^ 20
  •                                                 = 13,266 at retirement

 

  • Retirement Benefit      = Projected Final Salary * Total years service
  •                                                 = 13,266 * (60 – 30)
  •                                                 = 13,266 * 30
  •                                                 = 397,980 as a lump sum
  • Projected (all service) Gratuity Amount = 397,980 undiscounted

 

  • Projected Gratuity Benefit accrued up to age 40
  •                                                 = Projected Final Salary * Past Service
  •                                                 = 13,266 * 10
  •                                                 = 132,660 as the undiscounted DBO

 

  • Liability/DBO                   = 132,660 * (1 + interest rate) ^ (- future service)
  •                                                 = 132,660 * (1.04) ^ (-20)
  •                                                 = 60,544 after discounting, reflected in FS

 

  • Unit Normal Service Cost = Projected Gratuity Amount / Total service
  •                                                 = 397,980 / 30
  •                                                 = 13,266 per annum undiscounted

 

  • Normal Service Cost    = 13,266 * (1.04) ^ (-20)
  •                                                 = 6,054 Normal or Current Service Cost

This valuation assumes that there will be no service termination or other decrements. However, in real life situations, the actuarial valuation exercise will also consider decrements such as terminations, early retirements, disability, death, and so on.

The computation gets complicated; the actuary is professionally trained to deal with the mathematical intricacies and probabilities of various exit states, and the resultant impact on Expected Future Service and Discount Rate assumption.

IAS 19

The Standard for accounting for Employee Benefits, including benefits payable after the employee has left employment, is IAS 19 (2011). This Standard outlines the accounting requirements for Employee Benefits and requires extensive disclosures in respect of defined benefit plans, such as End of Service Gratuity schemes, including narrative descriptions of the regulatory framework, funding arrangements (if applicable) and potential (non-) financial risks.

The objective of the Standard is to prescribe the accounting entries and disclosures for Employee Benefits; it concerns itself with reporting the financial impact and position of Employee Benefits. This is, generally speaking,easy for short-term employee benefits,such as salaries or sick pay, that are costed as they accrue and are expected to be fully settled within 12 months of the annual reporting-end. But longer-term employee benefits, which include employee benefit plans or benefits required by law, are far more onerous to cost and report on. Such employee benefit plans could be part of a corporate reward structure, or otherwise offered on an optional basis which could be funded for separately. As the case may be, the typical structure is to promise a set of post-employment benefits (lump sum, pension, leave accumulation) on retirement or earlier termination or death of an employee. This means that cost is accrued over many years – and predictions made for future outcomes – which typically requires the involvement of a qualified and experienced actuary.

An IAS 19 Actuarial Valuation is required to cost these future, long-term employee benefit promises. An actuarial technique, called the Projected Unit Credit method, together with a set of actuarial assumptions,are used to make a reliable estimate of the ultimate cost to an entity of a benefit that employees have earned in return for their service.

The IAS 19 disclosure requirements are extensive and complex, for both financial performance and position requirements; typical disclosure elements include:

  • Annual employee benefit plan cost- split into numerous elements and booked in various ways. This includes past service cost or gain, current service cost, interest cost, benefits paid, actuarial gains or losses, exchange rate costs and more, booked to either P&L or OCI
  • Employee Benefit plan position, again with various elements, including Defined Benefit Obligation, and split between current and non-current liabilities
  • Methodology and assumptions bases, including long-term views on discount rates and salary escalation, where relevant
  • Various sensitivity and scenario tests, to illustrate possible or even likely divergence from the assumes basis and methodology.

IAS19 includes valuation and treatment of such benefits as provided:

Short-term employee benefits

The benefits to be settled within 12 months, other than termination benefits. Examples include wages, salaries, profit-sharing and bonuses and non-monetary benefits paid to current employees.

Post-employment benefits

The benefits that are payable after the completion of the employment. Examples include Gratuity, Pensions, Lump sum payments, life insurance and medical care etc.

Plans providing post-employment benefits are classified as either defined contribution plans or defined benefit plans, depending on the economic substance of the plan as derived from its principal terms and conditions:

  • A defined contribution plan is a post-employment benefit plan under which an entity pays fixed contributions into a separate entity (a fund) and will have no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to employee service in the current and prior periods. Under IAS 19, when an employee has rendered service to an entity during a period, the entity recognises the contribution payable to a defined contribution plan in exchange for that service as a liability (accrued expense) and as an expense, unless another Standard requires or permits the inclusion of the contribution in the cost of an asset.
  • A defined benefit plan, where a benefit is defined typically in terms of length of service and some form of final salary – such as the End of Service Gratuity prevalent in the GCC. Under IAS 19, an entity uses an actuarial technique (the projected unit credit or PUC method) to estimate the ultimate cost to the entity of the benefits that employees have earned in return for their service in the current and prior periods; discounts that benefit in order to determine the present value of the defined benefit obligation and the current service cost; deducts the fair value of any plan assets from the present value of the defined benefit obligation; determines the amount of the deficit or surplus; and determines the amount to be recognized in profit and loss and other comprehensive income in the current period. Those measurements are updated each period.