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Should we delay accounting reform further?
December, 11th 2006

Post-retirement benefits, most important of which are pension and health care benefits, are integral components of employee compensation packages in the organised sector. 
 
The quality of these benefits is often an important determinant of an organisation's ability to acquire and retain talent. 
 
These schemes, however, poses difficult challenges for both accounting and management. 
 
An employees lifetime savings plan is influenced by two risks. The first is economic conditions, particularly asset returns, over his lifetime. The second is his own longevity and state of health. Pension and similar schemes differ in how these risks are shared between employers and employees. 
 
Defined-contribution (DC) schemes put the entire risk on employees and limit the employers liability to paying a fixed amount to a fund or trust. At the other extreme, Defined-Benefit (DB) schemes put all the risk on the employer, who is committed to pay a fixed amount. 
 
Traditional final-pay plans, which are a sub-class of DB schemes in which the benefits are a proportion of the final pay drawn by the employee, puts additional risk on the employer since an employees final pay and the proportion which will have to be paid out are not known for much of his working life. 
 
Measurement of the liability resulting from DB schemes is complex, made more difficult by the fact that pension liabilities are quite unlike traditional debt. They cannot be reliably quantified, legally traded, cheaply retired or easily transferred. 
 
Measuring them requires us to make two kinds of assumptions: economic assumptions dealing with current interest rates, salary increases, and inflation and investment markets; and demographic assumptions about the participant group's make-up, expected behaviour and life expectancy. 
 
These are known as actuarial assumptions. For pension funding, the law gives the plans actuary the responsibility of selecting actuarial assumptions. For pension accounting and accounting for other benefits under DB schemes, actuarial assumptions represent the management's best judgment. 
 
For long, the cash method (the pay-as-you-go method) has been replaced by the accrual basis of accounting. 
 
In India, Accounting Standard (AS)-15, Accounting for Retirement Benefits in the Financial Statements of Employers, came into effect for fiscal periods commenced on or after April 1, 1995. 
 
The standard stipulates that accruing liability in respect of a defined benefit scheme should be calculated according to actuarial valuation. 
 
However, the standard did not specify any specific method. Companies were required to disclose the method of calculation but no disclosure of components of the liability and expense was required. Developed countries followed similar practices. 
 
This was reformed at the international level in the 2000s. International Accounting Standard (IAS)-19, Employee Benefits, was made applicable from the period beginning on or after January 1, 1999. Financial Reporting Standard (FRS)-17, Retirement Benefits, issued by the Accounting Standards Board (ASB) of the UK was made applicable in respect of financial statements for the accounting periods ending on or after June 22, 2002. 
 
The most important changes in the accounting of DB schemes are the measurement of liability using the projected unit credit method (PUCM), measurement of plan assets at fair value, recognition of liability at net of asset value, allocation of cost to periods in which benefits are earned by employees (often called normal cost) and complete disclosure. 
 
Traditionally, the liability was calculated using the unit credit (cost) method (UCM). Under this, the liability is calculated taking into consideration benefits earned that are attributable to services rendered by the employee and the present compensation level. 
 
The liability calculated using UCM is known as Accumulated Benefit Obligation (ABO). Most Indian companies recognise ABO in the balance sheet. 
 
In a final-pay plan, the value of the accrued benefit, for each unit of pay raise, increases rapidly with increasing age and service. In order to recognise the ultimate projected benefit more evenly over an employees career, actuaries devised the projected unit credit method (PUCM) many years ago as one means of ensuring a relatively smoothed contribution flow in a final-pay plan. 
 
Under this, the contribution is calculated to meet the liability determined by taking into consideration benefits earned that are attributable to services rendered by the employee to the date of computation and the projected compensation level at the end of the service. The liability calculated using PUCM is called Projected Benefit Obligation (PBO). 
 
Financial Accounting Standards Board (FASB) of the US issued Statement of Financial Reporting Standard (SFAS)-87, Employer's Accounting for Pensions, in December 1985. It was made effective from the fiscal year beginning after December 15, 1986. SFAS-87 first recognised that PUCM was the most appropriate method of accounting for pension liabilities. 
 
However, it required recognition of the ABO, net of plan assets value, in the balance sheet and disclosure PBO, in footnotes. 
 
In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, which requires recognition of PBO in the balance sheet. SFAS-158 will be applicable to an employer with publicly traded equity securities in respect of the fiscal year ending after December 15, 2006. 
 
For an employer without publicly traded equity securities, it will be applicable in respect of the fiscal year ending after June 15, 2007. 
 
Reform in accounting for pension and benefits under other DB schemes has been a little delayed in India. AS-15 (revised) will be applicable to listed companies, financial institutions, and other commercial, industrial, and business reporting enterprises having a turnover of Rs. 50 crore and above. It is effective for accounting periods commencing on or after April 1, 2006. 
 
This will hit the bottom lines of companies badly. The PBO calculated under the new rules will be significantly higher than the liability calculated using UCM. But this should not delay the reform further. 
 
One of the reasons for pension crisis in the UK and the US is the obfuscation by the accounting system. 
 
Many companies did not provide for adequate liability and are now not able to meet their commitments. Such crisis may lead to bankruptcy of large companies and which in turn will affect the economy as a whole. The burden will fall on the people of India. 
 
The other reason for the crisis is the investment pattern. During the stock market bubble, the fair value of plan assets represented by equity was much higher than the liability. This prompted companies to take a contribution holiday. 
 
Now they find that the value of plan assets is not adequate. Our government is considering allowing pension funds to be invested in the equity market. Before we take such a decision we must carefully weight the consequences lest people's life's savings become hostages to the vagaries of speculative markets.  

Asish K Bhattacharyya 
(The writer is prof of finance and control at IIM-C)

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