(e) the effect of changes in the discount rate. [IAS 19.128].
Actuarial gains and losses are discussed further at 10.4.1 below.
7.6 Discount
rate
Due to the long timescales involved, post-employment benefit obligations are discounted.
The whole obligation should be discounted, even if part of it is expected to be settled
within twelve months of the end of the reporting period. [IAS 19.69]. The standard requires
that the discount rate reflect the time value of money but not the actuarial or investment
risk. Furthermore, the discount rate should not reflect the entity-specific credit risk borne
by the entity’s creditors, nor should it reflect the risk that future experience may differ
from actuarial assumptions. [IAS 19.84]. The discount rate should reflect the estimated
timing of benefit payments. For example, an appropriate rate may be quite different for a
payment due in, say, ten years as opposed to one due in twenty. The standard observes
that in practice, an acceptable answer can be obtained by applying a single weighted
average discount rate that reflects the estimated timing and amount of benefit payments
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and the currency in which the benefits are to be paid. [IAS 19.85]. The standard does not
preclude the use of a more granular approach in discounting cash flows at different
periods along the yield curve. Nor does it preclude the use of different discount rates for
different classes of participant in the interest of achieving a more precise measure of the
defined benefit obligation than the computational shortcut which is seemingly allowed by
the standard. An example of where discount rates may vary by class or participant is
where there are both active and pensioner members, discount rates will vary by each of
these classes purely as a result of their ages and the resultant timing of outflows associated
to these classes.
IAS 19 also stipulates that the discount rate (and other financial assumptions) should be
determined in nominal (stated) terms, unless estimates in real (inflation-adjusted) terms
are more reliable, for example, in a hyper-inflationary economy (see Chapter 16 for a
discussion of IAS 29 – Financial Reporting in Hyperinflationary Economies), or where
the benefit is index-linked and there is a deep market in index-linked bonds of the same
currency and term. [IAS 19.79].
The basic part of this requirement – that a nominal rate be used – is consistent with the
definition of the present value of a defined benefit obligation in that it should be ‘ ... the
present value ... of expected future payments required to settle the obligation ...’
(see 7.1 above). In other words, as the future cash flows are stated at the actual amounts
expected to be paid, the rate used to discount them should reflect that and not be
adjusted to remove the effects of expected inflation. In contrast, the reference to the
use of index-linked bonds seems to allow taking account of inflation through the
discount rate (which would require expressing cash flows in current prices). This
approach seems to be in conflict with the definition of the obligation. However, in
practice few index-linked corporate bonds exist (so it may be quite rare to have a deep
market in them) and a more reliable approach may often be to take account of inflation
via the projected cash flows.
The Interpretations Committee in July 2013 discussed whether the rate should be pre- or
post-tax. It observed that the discount rate used to calculate a defined benefit obligation
should be a pre-tax discount rate and decided not to add this issue to its agenda.10
7.6.1
High quality corporate bonds
The rate used should be determined ‘by reference to’ the yield (at the end of the
reporting period) on high quality corporate bonds of currency and term consistent with
the liabilities. For currencies in which there is no deep market in such bonds, the yields
on government bonds should be used instead (see 7.6.2 below). [IAS 19.83].
IAS 19 does not explain what is meant by the term ‘high quality’. In practice it is
considered, rightly in our view, to mean either: bonds rated AA, bonds rated AA or
higher by Standard and Poor’s, or an equivalent rating from another rating agency.
The requirement that the rate be determined ‘by reference to’ high quality bond rates
is an important one.
The standard gives an example of this in the context of the availability of bonds with
sufficiently long maturities. It notes that in some cases, there may be no deep market
in bonds with a sufficiently long maturity to match the estimated maturity of all the
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benefit payments. In such cases, the standard requires the use of current market rates
of the appropriate term to discount shorter-term payments, and estimation of the rate
for longer maturities by extrapolating current market rates along the yield curve. It
goes on to observe that the total present value of a defined benefit obligation is
unlikely to be particularly sensitive to the discount rate applied to the portion of
benefits that is payable beyond the final maturity of the available corporate or
government bonds. [IAS 19.86].
In November 2013, the Interpretations Committee was asked whether corporate bonds with
a rating lower than ‘AA’ can be considered to be ‘high quality corporate bonds’ (‘HQCB’).
The Interpretations Committee decided not to add the item to its agenda as issuing
additional guidance or changing the requirements would be too broad for it to achieve
in an efficient manner. The Interpretations Committee recommended that the IASB
should address the issue as part of its research project on discount rates.11 The
Interpretations Committee reported this conclusion to the IASB at its December 2013
meeting. The IASB noted that no further work is currently planned on the issue of
determining the discount rate for post-employment benefit obligations.12
The key observations of the Interpretations Committee were as follows.
• IAS 19 does not specify how to determine the market yields on HQCB, and in
particular what grade of bonds should be designated as high quality;
• that ‘high quality’ as used in IAS 19 reflects an absolute concept of credit quality
and not a concept of credit quality that is relative to a given population of corporate
bonds, which would be the case, for example, if the paragraph used the term ‘the
highest quality’. Consequently, the concept of high quality should not change over
time. Accordingly, a reduction in the number of HQCB should not result in a
change to the concept of high quality. The Committee does not expect that an
entity’s methods and techniques used for determining the discount rate so as to
reflect the yields on HQCB will change significantly from period to period;
• IAS 19 already contains requirements if the market in HQCB is no longer deep or
if the market remains deep overall, but there is an insufficient number of HQCB
beyond a certain maturity; and
• typically, the discount rate will be a significant actuarial assumption to be disclosed
with sensitivity analyses under IAS 19.
As required by IAS 1 – Presentation
of Financial Statements (see Chapter 3 at 5.1.1.B),
disclosure is required of the judgements that management has made in the process of
applying the entity’s accounting policies and that have the most significant effect on the
amounts recognised in the financial statements and that typically the identification of
the HQCB population used as a basis to determine the discount rate requires the use of
judgement, which may often have a significant effect on the entity’s financial statements.
In June 2005, the Interpretations Committee considered the question – when there is
no deep market in high quality corporate bonds in a country, whether the discount rate
could be determined by reference to a synthetically constructed equivalent instead of
using the yield on government bonds? At this time IAS 19 referred to ‘countries’ where
there was no deep market rather than ‘currencies’. The Interpretations Committee did
not add the issue onto its agenda and concluded that the standard ‘is clear that a
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synthetically constructed equivalent to a high quality corporate bond by reference to
the bond market in another country may not be used to determine the discount rate’.
The Interpretations Committee further observed that the reference to ‘in a country’
could reasonably be read as including high quality corporate bonds that are available in
a regional market to which the entity has access, provided that the currency of the
regional market and the country were the same (e.g. the euro). This would not apply if
the country currency differed from that of the regional market.13
It is more than a little difficult to know what to make of those observations. Without a
proper and detailed fact pattern one cannot know the details of the question being
addressed and quite what a ‘synthetically constructed equivalent’ actually means. Whilst
that may well be the case, there is no reason why employee benefits could not be
denominated in another currency. In our view, it would have been more helpful if the
Interpretations Committee had progressed to a formal interpretation to explore how
and to what extent observed bond yields could form a starting point to extrapolate a
discount rate. Whilst it would be wrong to understate the liabilities of the plan by using
an inappropriately high rate (say, because the only relevant bonds in issue are not ‘high
quality’), it would be equally wrong, in our view, to overstate them by using the default
rate of government debt when a reliable rate could be estimated by reference to market
yields. Indeed, the standard suggests this in its discussion of actuarial assumptions in
general, requiring that they be unbiased, that is neither imprudent nor excessively
conservative. [IAS 19.75, 77].
7.6.2
No deep market
In currencies where there is no deep market deep market in high quality corporate
bonds, the market yields (at the end of the reporting period) on government bonds shall
be used. [IAS 19.83].
In June 2017, the Interpretations Committee considered a question on how an entity
determines the rate to be used to discount post-employment benefit obligations in a country
(in this case Ecuador) which has adopted another currency as its official or legal currency
(in this case the US dollar). The entity’s post-employment benefit obligation is denominated
in US dollars. The submitter also confirmed that there was no deep market for high quality
bonds denominated in US dollars in the country in which it operates (Ecuador).
The question asked by the submitter was whether in this situation the entity should
consider the depth of the market in high quality corporate bonds denominated in US
dollars in other markets or countries in which those bonds are issued. They also asked
whether the entity can use market yields on bonds denominated in US dollars issued by
the Ecuadorian government, or whether it is required to use market yields on bonds
denominated in US dollars issued by a government in another market or country.
The Committee observed that applying paragraph 83 of IAS 19 (see 7.6.1 above) requires that:
• an entity with post-employment benefit obligations denominated in a particular
currency assesses the depth of the market in high quality corporate bonds
denominated in that currency, and does not limit this assessment to the market of
country in which it operates;
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• if there is a deep market in high quality corporate bonds denominated in that
currency, the discount rate is determined by reference to market yields on high
quality corporate bonds at the end of the reporting period;
• if there is no deep market in high quality corporate bonds in that currency, the
entity determines the discount rate using market yields on government bonds
denominated in that currency; and
• the entity applies judgement to determine the appropriate population of high
quality corporate bonds or government bonds to reference when determining the
discount rate. The currency and term of the bonds should be consistent with the
currency and estimated term of the post-employment benefit obligations.
The Committee noted that the discount rate does not reflect the expected return on
plan assets; the Basis of Conclusions IAS 19 confirms that the measurement of the
obligation should be independent of the measurement of any plan assets held by the
plan. [IAS 19.BC130].
The Committee also considered the interaction between the matters discussed above
and the requirement that actuarial assumptions be mutually compatible (see 7.5 above).
[IAS 19.75]. The Committee concluded that it is not possible to assess whether, and to
what extent, a discount rate derived by applying the specific requirements of IAS 19 is
compatible with other actuarial assumptions and that the specific requirements of
IAS 19 should be applied when determining the discount rate.
The overall conclusion of the Committee was that the requirements in IAS 19 provide an
adequate basis for the determination of a discount rate in the circumstances described
above. Consequently, the Committee decided not to add this matter to its agenda.
7.7
Frequency of valuations
When it addresses the frequency of valuations, IAS 19 does not give particularly
prescriptive guidance. Rather, its starting point is simply to require that the present
value of defined benefit obligations, and the fair value of plan assets, should be
determined frequently enough to ensure that the amounts recognised in the financial
statements do not differ materially from the amounts that would be determined at the
end of the reporting period. [IAS 19.58]. An argument could be launched that, without a
full valuation as at the end of the reporting period to compare with, it cannot be possible
to know whether any less precise approach is materially different. However, it is
reasonably clear that the intention of the standard is not necessarily to require full
actuarial updates as at the reporting date. This is because the standard goes on to
observe that for practical reasons a detailed valuation may be carried out before the end
of the reporting period and that if such amounts determined be
fore the end of the
reporting period are used, they should be updated to take account of any material
transactions or changes in circumstances up to the end of the reporting period. [IAS 19.59].
Much may depend on what is considered to be a ‘material change’, however it is
expressly to include changes in market prices (hence requiring asset values to be those
at the end of the reporting period) and interest rates, as well as financial actuarial
assumptions. [IAS 19.59, 80].
2800 Chapter 31
In this regard, it is also worth noting the observation in the standard that ‘[i]n some cases,
estimates, averages and computational shortcuts may provide a reliable approximation
of the detailed computations illustrated in this Standard’. [IAS 19.60]. It should be
remembered, though, that it is the amounts in the financial statements which must not
differ materially from what they would be based on a valuation at the end of the
reporting period. For funded schemes, the net surplus or deficit is usually the difference
between two very large figures – plan assets and plan liabilities. Such a net item is
inevitably highly sensitive, in percentage terms, to a given percentage change in the
gross amounts.
In summary, a detailed valuation will be required on an annual basis, but not necessarily
as at the end of the reporting period. A valuation undertaken other than as at the end of
the reporting period will need to be updated as at the end of the reporting period to
reflect at least changes in financial assumptions, asset values and discount rates. The
need for updates in respect of other elements of the valuation will depend on individual
circumstances.
8
DEFINED BENEFIT PLANS – TREATMENT OF THE PLAN
SURPLUS OR DEFICIT IN THE STATEMENT OF FINANCIAL
POSITION
8.1
Net defined benefit liability (asset)
IAS 19 defines the net defined benefit liability or asset as the deficit or surplus in the
plan adjusted for any effect of the asset ceiling (see 8.2 below).
The deficit or surplus is the present value of the defined benefit obligation (see 7 above)
less the fair value of the plan assets (if any) (see 6 above).
The standard requires that the net defined benefit liability (asset) be recognised in the
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 558
