16 June 2002

 

Sir David Tweedie
International Accounting Standards Board
30 Cannon Street
London EC4M 6XH
United Kingdom

 

RE: Improvement of IAS 19, Employee Benefits

 

Dear Sir David:

 

The Global Financial Reporting Advocacy Committee (GFRAC)¹ of the Association for Investment Management and Research (AIMR)² respectfully requests that the International Accounting Standards Board consider amending the current International Accounting Standard (IAS) 19, Employee Benefits to improve the accounting of defined benefit plans.

 

At present, the GFRAC is reviewing the recently issued IASB Exposure Draft of Proposed Improvements to International Accounting Standards relating to the IASB Improvements project. The Committee plans to submit comments in regards to the proposed amendments. Although IAS 19 is not currently addressed in this particular ED, we wish to strongly encourage the IASB to (1) reopen IAS 19 to eliminate the deferral and amortization of past events and (2) disaggregate the activity relating to pension plans.

 

It is within the context of the Improvements project that we draw attention to the firmly expressed view of our profession. Our view challenges the current accounting treatment to smooth the effects of actuarial gains and losses. In particular, the following paragraphs in IAS 19 (revised 1998):

 

92. In measuring its defined benefit liability under paragraph 54, an enterprise should recognize a portion (as specified in paragraph 93) of its actuarial gains and losses as income or expense if the net cumulative unrecognized actuarial gains or losses at the end of the previous reporting period exceeded the greater of:

(a) 10% of the present value of the defined benefit obligation at that date (before deducting plan assets); and

(b) 10% of the fair value of any plan assets to date.

These limits should be calculated and applied separately for each defined benefit plan.

93. The portion of actuarial gains and losses to be recognized for each defined benefit plan is the excess determined under paragraph 92, divided by the expected average remaining working lives of the employees participating in that plan. However, an enterprise may adopt any systematic method that results in faster recognition of actuarial gains or losses, provided that the same basis is applied to both gains and losses and the basis is applied consistently from period to period. An enterprise may apply systematic methods to actuarial gains and losses even if they fall within limits specified in paragraph 92.

 

In 1997, the AIMR Financial Accounting Policy Committee (FAPC) responded to the International Accounting Standards Committee's E54, proposing amendments to the current International Accounting Standard, Employee Benefits. In response to this proposal, the FAPC stated the following in its comment letter to the Secretary General dated 31 January 1997:

 

"…[W]e are not in favor of accounting practices which allow or encourage postponing recognition of gains or losses that have already occurred. Consequently, we do not favor the practice proposed in paragraphs 87-89. We realize that the effect of that practice is to "smooth out" the recognition of pension costs and, in turn, reduce the volatility of reported earnings. Thus we recognize that it may be viewed favorably by enough IASC Board members to become part of the final standard. If that should occur, the Board needs to provide additional disclosures sufficient for users to understand the actions that have occurred and to ensure that the economic reality is fully understood. The combination of less-than-ideal accounting together with disclosure which compensates for it, will result in substantial increases in the size and complexity of the notes to the financial statements, but that is the price of adopting an accounting standard with inadequate recognition requirements."

 

When the IASC Board discussed the proposed amendments to IAS 19, the Delegation of the International Council of Investment Associations voted against the smoothing clauses because such clauses are inconsistent with the Framework. These smoothing clauses do not fulfill the current definition of assets or liabilities in the Framework, which we believe requires such valuation gains and losses to be reflected in the carrying values of assets and liabilities. Moreover, this accounting treatment of valuation gains and losses is inconsistent with other recently issued IAS dealing with financial instruments, investment properties, and agricultural activities, as well as the preliminary proposal for insurance contracts.

 

Opponents to the approach we advocate should consider that various jurisdictions around the world, which regulate pension schemes, determine if a pension is properly funded or has a deficit based on other information not presented in the enterprise's financial statements. Therefore, we believe that the primary purpose of financial statements, prepared in accordance to IAS, should be to enable the users of these statements to make well-informed investment decisions. These decisions should be based on a complete analysis of an enterprise's capacity to generate future cash flows, including the inherent risks and uncertainties associated with these future cash flows.

 

We realize that pension costs are volatile due to period-to-period fluctuations in the underlying assumptions, e.g., investment return, employee turnover, salary base, inflation, etc. The current accounting techniques to smooth these fluctuations, resulting from economic events, simply ignore this volatility. Reporting these changes over several reporting periods, or smoothing this volatility, produces synthetic financial information that: (1) does not meet the definition of assets and liabilities and (2) provides inadequate information for predicting future cash flows. To compound this issue further, enterprises often use this volatility (the resulting pension fund surpluses and deficits) in determining the level of plan contributions, which may not be appropriate given the current economics. Corporate managers also use this permitted smoothing to manage the performance and financial condition of the enterprise.

 

Generally, we have opposed accounting standards based on management intent rather than the economic substance of the transaction or activity. Therefore, we strongly encourage the IASB to (1) reopen IAS 19 to eliminate the deferral and amortization of past events and (2) disaggregate the activity relating to pension plans. That is, components of net pension costs (income) should be displayed separately from other operating expenses (income).

 

In the interim, the following costs under IAS 19 should be displayed separately from other operating expenses (income) and included in the results of operating activities:

 

PERIODIC COSTS
a) the current service costs;
b) the interest cost;
c) the expected return on assets;
d) actuarial gains and losses;

NON-PERIODIC COSTS -
e) past service costs ; and
f) gains and losses on settlements and curtailments.

 

We believe that costs related to pension and other employee benefits should be part of cost of goods sold (COGS) if operating costs are reported as such. If companies do not separately report COGS, then a separate line within operating expenses is adequate.

 

Once the smoothing effect is removed from IAS 19, the actual return on assets should be presented rather than the expected return. This presentation would be consistent with the recognition of any actuarial gains and losses in the period in which they occur.

 

Additionally, we believe that non-periodic costs, such as past service costs and gains and losses on settlements and curtailments, should be recognized immediately. These costs represent discrete transactions initiated by management, which result in an immediate recognition of the change in net assets.

 

Closing Remarks

 

We believe that the only possible way to proceed is with all accounting standards being aligned completely with the Framework. If the Principles contained in the Framework are incorrect, they should be revisited. However, we see no reason to revisit the Framework in order to amend IAS 19 with the removal of the smoothing effect. Thus, we recommend that IASB consider adding, with a sense of urgency, a project to its agenda to improve IAS 19, Employee Benefits. If you have any questions or seek elaboration of our views, please do not hesitate to contact Georgene Palacky at 1.434.951.5334 or georgene.palacky@cfainstitute.org.

 

Sincerely,

 

Patricia A. McConnell, CPA Chair, Global Financial Reporting Advocacy Committee

Georgene B. Palacky, CPA Associate, Advocacy

 

¹ The GFRAC is a standing committee of AIMR charged with representing the views of investors to and maintaining a liaison with bodies that set financial accounting and reporting standards in a global context, particularly the IASB. The committee is also charged with responding to requests for comment from national standard setters and regulators on international financial reporting issues.

² The Association for Investment Management and Research (AIMR) is a global, not-for-profit organization of over 58,000 investment professionals in more than 100 countries. Through its offices in Charlottesville, VA, Hong Kong, and London, as well as 115 Member Societies and Chapters throughout the world, AIMR provides global leadership in investment education, professional standards, and advocacy programs.