It is now 18 months since International Accounting Standard IAS 19 (revised 1998) was issued. The revised standard became effective for accounting periods beginning on or after January 1 this year. As many Europeans return from their summer holidays, it seems a good time to reflect on the implications of the new accounting standard in the current fiscal year and some potential long-term results.
Prior to the mid-1980s, the accounting charge for many pension arrangements was equal to the cash cost, whether it be the cash contribution to a funded pension plan or the pay-as-you-go expenditure of an unfunded arrangement. Since this was felt to be unsatisfactory – in that the investment community was unable to make a fair and objective comparison of the pension charges for different companies – new accounting standards were introduced that were designed to assist such comparability. For example, the original IAS 19 was issued in January 1983, with effect from January 1985, FAS 87 for US accounting was issued in December 1985 and followed soon after in the UK by SSAP 24.
Since that time, there has been a massive increase in globalisation as companies look to deploy their capital around the world and investors also seek out a greater investment return through international diversification. This globalisation has fuelled pressure for the development of international accounting standards in a number of core areas, one of which is pensions and employee benefit costs. The International Accounting Standards Committee (IASC) has been charged with this task and, as the table shows, it has been successful in that many companies, particularly foreign companies, can adopt IAS as their accounting standard when listing on many of the stock exchanges of the EU. For those interested in stock exchange listings of other countries, relevant information can be found on the IASC’s website at The website also contains an impressive list of more than 800 public companies that comply with international accounting standards.
The standard adopts a market-based approach to pension accounting that is similar to FAS 87. Under a market-based approach the measurement of assets is relatively straightforward, as market values can generally be readily ascertained. However, the assessment of a market price for the liabilities is much more subjective. The statement asserts that actuarial assumptions used to place a present value on the future cashflows should be unbiased and mutually compatible. The statement subsequently says that, “financial assumptions should be based on market expectations, at the balance sheet date, for the period over which the obligations are to be settled”.
The most important of these financial assumptions is the discount rate, which must be determined by reference to market yields on high-quality corporate bonds at the balance sheet date. In countries where there is no deep market in such bonds, the yields on government bonds must be used. The requirement to use market yields will affect a company’s expense in a number of ways:
q First, companies will be required to recognise pension costs on something approximating a true market cost. This market cost can shift dramatically over a number of years. For example, a company that established a pension plan or significant enhancements to benefits a decade or so ago when yields were more or less double their current levels would find that the cost today could have doubled. Further, in some countries like the UK, the cost of a basic 60ths pension scheme has dramatically increased due to increasing legislative requirements such as statutory pension increases, increases in deferment and enhanced preservation, among other things. Consequently, a finance director will find that the company’s pension plan costs a lot more in 1999 for the same benefit than it did in 1989.
q Besides the long-term shifts that have occurred in pension costs, there is short-term volatility to consider. Although interest rates have been in general decline during the 1990s, the current year has seen the reverse. For example, at the end of 1998, the yield on Moody’s Aa corporate bonds in the US was 6.65%. That yield had increased by exactly 100 basis points by the end of July. Given that a 1% change in discount rate can change the ongoing cost of a pension plan by as much as 20%, dramatic shifts in employee costs can arise on an annual basis.
It seems that there are two potential implications arising from the effects of these changes in market yields. The first is a shift from defined benefit plans to defined contribution as finance directors aim to control their costs. For a number of reasons, such as trend setting by the technology companies, increases in legislative complexity, a shift towards equity-based compensation and a rapidly rising stock market, this phenomenon has occurred to a large degree in the US already.
The second implication is that there will be increased pressure for pension fund assets to be invested in bonds, particularly corporate bonds, as companies try to minimise the effect of yield changes upon their profit and loss account and balance sheet. Evidence of a similar effect has occurred in the UK where the introduction in 1997 of the minimum funding requirement has caused many trustees and companies to change their investment policy and increase the proportion of fund assets invested in bonds, particularly index-linked bonds, rather than equities.
However, before companies go rushing around making dramatic overhauls in their pension arrangements and investment policies, there are a number of mechanisms provided under IAS 19 that will help to reduce volatility in pension expense.
The first item that works to redress the volatility of liabilities is the use of market value of assets. Intuitively, it seems that valuation of assets at market prices will increase volatility in pension cost. However, the increase in correlation between equity values, which are often plan assets, and bond prices, which drive liability values, during the 1980s and 1990s suggest that the swings on the assets will often be cancelled out by the roundabouts on the liabilities. Obviously, this will not always be true, since there is not a perfect correlation, but analysis indicates that net volatility will be reduced.
Second, the effect of assumption changes and experience gains and losses are not recognised immediately but will be subject to deferred recognition in future accounting periods. In fact, a 10% corridor similar to that available under FAS 87 is permitted, under which cumulative gains and losses only become subject to recognition when they exceed the greater of 10% of the value of the liabilities and 10% of the value of the assets. Even then, the portion of the cumulative gain that falls outside this corridor would only be recognised gradually.
To consider a worst-case scenario, look back to 1987 when stock markets crashed by about 20%. Despite the general correlation in movements between bonds and equities, such correlation often disappears in moments of crisis. In October 1987 bond yields were virtually unchanged as stock markets fell.
In the absence of other changes and gains and losses, the amount subject to recognition in the next year’s pension expense calculation would have been 10% of the assets (being the excess of the 20% loss over the 10% corridor) for a fund totally in equities.
This excess would then be divided by the expected future working lifetime of employees, which is typically up to 15 years. Consequently, less than 1% of the loss in assets would be recognised in the next year’s expense, rather than the full 20%. Clearly, the recognition of gains and losses permitted under IAS 19 can have a dramatic stabilising effect on the overall pension cost.
One other area where long-term change may arise due to accounting requirements is in the effect of benefit improvements. Benefit improvements, where vested, must be recognised immediately. This means that increases for pensioners (over and above any regular increases that are anticipated in the actuarial assumptions) must be recognised immediately in the accounting cost and in many countries any benefit improvements for active employees will also be substantially recognised immediately as the non vested portion of the cost will generally be very small. It seems that this is one area in which those countries that follow a balance sheet approach have won out over countries that focus more on the income statement.
By contrast, there will be no minimum balance sheet liability similar to the requirement of FAS 87 for unfunded and poorly funded pension plans. Under FAS 87, poorly funded plans must carry a balance sheet reserve that is equal to the accumulated benefit obligation less the value of any pension assets. Although such liabilities may arise off-balance sheet under IAS 19, the significant disclosure requirements should ensure that investors are aware of their existence.
Although actuaries and accountants have engaged in fierce debate over the appropriate accounting recognition of pension plans, it seems likely that the adoption of IAS 19 as revised will be a boon to investors and other readers of corporate accounts because of the full and explicit disclosure requirements.
The disclosure requirements should provide investors with sufficient information to form their own opinion regarding the impact of employee benefit costs upon a company’s intrinsic value. This statement requires an explicit reconciliation of amounts recognised in the balance sheet, movements in those amounts and a detailed breakdown of the expense charged to the income statement. Further, the principal actuarial assumptions used in the calculations must also be disclosed. In this respect it is similar to FAS 87 and vastly superior to many older accounting statements.
UK investors should note that the accounting for pensions in that country are also undergoing a major review and are likely to follow a broadly similar approach.
Finally, the statement is applicable to all forms of employee benefits, not just post employment benefit plans, including equity compensation benefits such as stock options. Although the standard requires certain disclosures about such benefits, it does not specify any recognition requirements. In view of the propensity for companies to reward more employees through the provision of stock options, it seems that the accounting for employee benefit costs will not be complete until one of the major accounting organisations such as IASC or FASB address their appropriate recognition.
Gary Jackson is a principal at London-based consultants Punter Southall & Co

EU stock exchanges that allow companies to prepare IAS financial statement
IAS financial statements allowed for foreign listed companies; domestic listed companies must follow national GAAP unless otherwise noted.
Either IAS or US GAAP financial statements are required, starting 2000 for domestic companies, as well as foreign registrants
Foreign companies may follow IAS. Domestic companies with significant foreign operations or foreign capital sources also may follow IAS for consolidated financial statements
Danish companies may use IAS or US or UK GAAP with a reconciliation to Danish GAAP. Foreign companies may use:
(a) their national GAAP with a reconciliation to Danish GAAP or
(b) if their own national law allows the use of IAS, US, or UK GAAP, the foreign company may use that GAAP without reconciliation to Danish GAAP
All listed companies, including domestic, may follow IAS.
Foreign listed companies may follow IAS or US or UK GAAP or their national GAAP, with advance permission of the regulatory authority and with reconciliation to Finnish GAAP. Also, domestic listed companies may follow IAS if more than 50% of the shares are owned by foreigners or if the company is listed in an OECD country outside the European Economic Area, again with reconciliation to Finnish GAAP
Foreign and domestic companies may follow IAS for consolidated financial statements
Foreign listed companies may follow German GAAP, IAS, or US GAAP. Domestic companies also may follow IAS, US GAAP, UK GAAP, or their national GAAP for consolidated financial statements. Neuer Markt companies must follow IAS or US GAAP
Foreign and domestic companies may follow IAS for consolidated financial statements
Foreign listed companies may follow IAS, provided that the EU directives are also complied with. Foreign listed companies may also follow UK or US GAAP. Foreign listed companies may also follow their national GAAP if they include a reconciliation of significant differences with IAS
Domestic listed companies must follow Dutch GAAP. Foreign listed companies may follow IAS
Spanish companies must follow Spanish accounting principles. Listed companies that are domiciled in another European Union country may submit financial statements using their own national GAAP without reconciliation to Spanish GAAP. Listed companies from other countries may submit financial statements using IAS, US GAAP, or their own national GAAP but with an audited reconciliation to Spanish GAAP
Foreign listed companies may follow IAS
Domestic listed companies must follow UK GAAP. Foreign listed companies may follow IAS or US or UK GAAP. Foreign companies may follow other national GAAP, in which case a reconciliation to UK GAAP may be required
A note reconciling income statement and balance sheet items to US GAAP is required by regulation of the US Securities and Exchange Commission