Employee benefits are an essential part of any business. They not only help attract and retain talent but also form a significant part of a company’s financial obligations. For companies that prepare their financial statements in accordance with International Financial Reporting Standards (IFRS), understanding and correctly applying the principles of IAS 19 – Employee Benefits is critical.
In this article, we’ll break down the key aspects of IAS 19, provide practical examples, and explain how companies should account for various types of employee benefits in their financial statements.
What is IAS 19?
IAS 19 prescribes the accounting treatment and disclosure requirements for employee benefits. The goal is to ensure that employers recognize employee-related expenses and obligations in the periods in which they are incurred, providing a clearer picture of the company’s financial position.
1. Objective of IAS 19
The main objective of IAS 19 is to define how companies should account for and disclose employee benefits, which can include anything from wages and salaries to retirement benefits and severance payments.
Companies must recognize:
- A liability when an employee provides services that entitle them to future benefits.
- An expense when the company consumes the economic benefits provided by those services.
2. Scope of IAS 19
IAS 19 covers all employee benefits, except for those involving share-based payments (covered under IFRS 2). This means that employee benefits arising from formal agreements, informal practices, or even legislative requirements must be accounted for.
For instance:
- Formal agreements include pension plans or group insurance policies.
- Legislative requirements might involve state-mandated contributions to retirement funds.
- Informal practices could include bonuses that the company regularly pays, even without a legal obligation to do so.
3. Types of Employee Benefits Under IAS 19
A. Short-term Employee Benefits
These are benefits expected to be settled within 12 months after the period in which the employee provides the service. Common examples include:
- Wages and salaries
- Paid annual leave
- Sick leave
- Profit-sharing bonuses
Practical Example: A company pays an annual bonus based on employee performance. This bonus is accrued throughout the year and recognized as an expense in the financial statements during the year in which the employees earned it.
B. Post-employment Benefits
These are benefits payable after the completion of employment, such as pensions and retirement medical care. IAS 19 distinguishes between:
- Defined Contribution Plans, where the employer’s obligation is limited to fixed contributions.
- Defined Benefit Plans, where the company is responsible for ensuring sufficient funds to meet future obligations.
Practical Example: In a defined contribution plan, a company contributes 5% of each employee’s salary into a retirement fund. Once the contribution is paid, the company has no further obligation. On the other hand, in a defined benefit plan, a company promises to pay employees a pension equal to 2% of their final salary for every year of service. The company is responsible for ensuring there are enough funds to meet this obligation, even if investment returns are lower than expected.
C. Other Long-term Employee Benefits
These include benefits such as long-service leave, jubilee benefits, and long-term disability benefits. These obligations are usually measured in a similar way to defined benefit plans but are settled over a longer term.
Practical Example: A company offers a sabbatical leave after 10 years of service. The cost of this benefit is spread across the years leading up to the employee becoming eligible for it.
D. Termination Benefits
Termination benefits arise when an employee’s contract is terminated before retirement or when the company offers incentives for voluntary redundancy. These benefits are recognized when the company is demonstrably committed to a termination plan.
Practical Example: A company offers employees a severance package as part of a downsizing plan. As soon as the company communicates the decision to the employees and they accept the offer, the company must recognize the cost of the severance as a liability in its financial statements.
4. Key Definitions in IAS 19
IAS 19 introduces a few important terms:
- Short-term employee benefits: Settled within 12 months, such as wages and annual leave.
- Defined contribution plans: Where the company’s obligation is limited to a fixed contribution.
- Defined benefit plans: Where the company must ensure funds are available to meet future payments.
- Constructive obligation: Even if a company isn’t legally bound to pay a benefit, informal practices may create an expectation that the benefit will be paid, resulting in a liability.
5. Accounting for Post-employment Benefit Plans
A. Defined Contribution Plans
In defined contribution plans, the company’s obligation is limited to the contributions it has agreed to make. The company has no further responsibility for the fund’s performance or the benefits employees receive.
Practical Example: A company contributes $5,000 annually to an employee’s retirement account. Once this contribution is made, the company has no further obligation, and the employee bears the investment risk.
B. Defined Benefit Plans
Accounting for defined benefit plans is more complex because the company must estimate its future obligations, taking into account factors like employee turnover, mortality rates, and future salary increases. These estimates require actuarial calculations to determine the present value of the obligations.
Practical Example: A company offers pensions based on the final salary at retirement. If an employee has 30 years of service, the company is responsible for calculating the pension obligation and ensuring the funds are available to meet this promise.
6. Recognition and Measurement of Defined Benefit Plans
When recognizing and measuring defined benefit obligations, companies follow these steps:
- Measure the Defined Benefit Obligation (DBO) using the projected unit credit method.
- This involves estimating the present value of future benefits.
- Determine the fair value of plan assets (if any), which will be deducted from the DBO to calculate the net liability.
- Recognize the net defined benefit liability in the financial statements.
7. Constructive Obligations
Companies must account for constructive obligations, even when they’re not legally required to pay benefits. These obligations can arise from informal company practices, such as regularly paying discretionary bonuses.
Practical Example: A company has a history of paying an annual bonus based on profits. Even though the bonus is not contractually guaranteed, employees expect it. Therefore, the company must recognize the bonus as a liability if it’s likely to be paid.
8. Accounting for Short-term Employee Benefits
When employees earn benefits, such as paid vacation or bonuses, that are not used within the same year, the company must recognize a liability for those benefits.
Practical Example: If an employee earns 10 days of vacation in one year but only takes 5, the company recognizes the cost of the unused vacation as a liability on its balance sheet.
9. Accounting for Termination Benefits
Termination benefits are recognized once the company is committed to the termination plan and has no option to withdraw. These expenses are recognized immediately, even if the payments are made in the future.
Practical Example: If a company lays off employees and offers severance packages, the entire severance cost is recognized as soon as the employees are notified.
10. Disclosure Requirements
Companies must provide detailed disclosures about their employee benefit plans, including:
- The types of benefits offered.
- Assumptions used in calculating benefit obligations (e.g., discount rates, salary growth).
- The financial position of the benefit plans, especially for defined benefit plans.
11. Actuarial Assumptions and Calculations
The measurement of post-employment benefits relies on various actuarial assumptions, including:
- Discount rates based on market yields.
- Mortality rates, to estimate the lifespan of retirees.
- Salary growth rates, to estimate future benefit amounts.
12. Settlements and Curtailments
If a company eliminates its obligations under a defined benefit plan (e.g., by purchasing an annuity to cover future pension payments), this is considered a settlement. A curtailment occurs when the company significantly reduces the number of employees covered by a benefit plan.
Practical Example: A company decides to close a division and offers to buy out the pensions of the affected employees, transferring the obligation to an insurance company. This would be treated as a settlement.
Final Thoughts
IAS 19 provides the framework for recognizing, measuring, and disclosing employee benefits, ensuring that financial statements reflect the true cost of employee services. By properly accounting for these benefits, companies not only comply with IFRS but also give stakeholders a clearer understanding of the company’s financial obligations.
Whether you’re dealing with short-term bonuses, long-term pension obligations, or termination benefits, the principles of IAS 19 ensure transparency and accountability in employee benefit reporting.