Accounting for Long Term Employee Benefits

Long-term employee benefits are compensation and rewards that employees earn during their service but are paid out more than twelve months after the reporting period. These arrangements are a common feature of compensation packages designed to attract and retain talent. For a company, these future promises create financial obligations that must be accounted for accurately in the present. The financial reporting for these benefits, guided by Accounting Standards Codification (ASC) 715, requires companies to estimate the ultimate cost of promises made to employees. This accounting aims to match the cost of these benefits to the periods in which employees provide the service that earns them, providing transparency to investors and creditors about the true cost of its workforce.

Categories of Long-Term Employee Benefits

Long-term employee benefits encompass a variety of plans that provide rewards to employees well after their service is rendered. These plans are classified as long-term obligations because their settlement date is often many years in the future.

• Post-employment benefits: The most recognized category, this includes pensions that provide a stream of income to employees after they retire and post-employment medical plans that offer healthcare coverage to retirees.
• Long-service leave: Sometimes called sabbatical leave, this benefit grants employees an extended period of paid time off after they have completed a specified number of years of service.
• Jubilee or other long-service awards: These are one-time benefits, which could be in the form of cash or shares, paid to an employee upon reaching a significant service milestone, such as 20 or 25 years with the organization.
• Long-term disability benefits: These plans provide income protection to employees who become unable to work for an extended period due to illness or injury. When a company self-insures the plan, it creates a direct long-term obligation.

Fundamental Accounting Principles

The accounting for long-term benefits hinges on the distinction between two types of plans: defined contribution and defined benefit. This classification dictates the entire accounting approach and the level of financial obligation the company retains. For a defined contribution plan, such as a 401(k), the accounting is straightforward. The company promises to contribute a specific amount to an individual’s retirement account. The company’s obligation ends once it makes the required contribution for the period, and the accounting expense is simply the amount owed for employees’ services.

In contrast, a defined benefit plan promises a specific benefit amount to the employee upon retirement, often based on a formula considering factors like salary and years of service. Here, the company bears the investment risk and is responsible for ensuring there are enough funds to pay the promised benefits. This creates a long-term liability for the company known as the defined benefit obligation, which represents the present value of all future benefits employees have earned to date. To manage this obligation, companies often set aside funds in a separate legal entity, such as a trust. These funds are referred to as plan assets, and an actuary is needed to perform the complex task of estimating the future obligation.

Measurement of Obligations and Plan Assets

The measurement of long-term benefit obligations is a complex process centered on an actuarial valuation. This valuation uses a series of assumptions to estimate the present value of future benefit payments that employees have earned, arriving at a figure called the defined benefit obligation.

A primary assumption is the discount rate, used to convert estimated future benefit payments into their present value. The discount rate should be determined by referencing rates on high-quality corporate bonds with maturities that correspond to the timing of the expected benefit payments. A lower discount rate increases the present value of the obligation.

Other significant actuarial assumptions include:

• Projections of future salary increases, which directly impact the final benefit for plans based on final pay.
• Estimates of employee turnover, as not all employees will remain with the company long enough to become fully vested.
• Mortality rates to predict how long retirees will live and, therefore, how long benefits will need to be paid.
• The healthcare cost trend rate for post-employment medical plans, which estimates the future increase in the cost of medical services.

Separately, the plan assets set aside to fund these obligations are measured at their fair value at the reporting date.

Recognition in Financial Statements

Once the defined benefit obligation and plan assets are measured, the resulting figures are recognized in the company’s financial statements. The primary presentation is on the balance sheet, where the company reports the net funded status of the plan. This is calculated by subtracting the fair value of the plan assets from the projected benefit obligation. If the obligation exceeds the assets, the company reports a net defined benefit liability; if the assets exceed the obligation, it reports a net defined benefit asset.

The cost of the benefit plan is recognized over time in the company’s income statement and other comprehensive income (OCI). The portion recognized in the income statement is called the net periodic benefit cost. This cost has several components, including service cost, which is the value of benefits earned by employees in the current period, and net interest on the net defined benefit liability or asset.

A unique aspect of benefit accounting is the treatment of remeasurements. These are changes in the net defined benefit liability or asset resulting from shifts in actuarial assumptions or from differences between expected and actual returns on plan assets. These remeasurements, often called actuarial gains and losses, are not recorded in the income statement but are instead recognized in Other Comprehensive Income (OCI). This approach prevents the volatility from these estimate changes from directly impacting net income, while still ensuring that all changes are recognized.

Required Disclosures

Accounting standards require extensive disclosures in the notes to the financial statements to provide users with a clear understanding of a company’s long-term benefit plans. The objective is to present information about the nature of the benefits, the characteristics of the plans, and the financial impact on the company’s cash flows and financial position.

Companies must provide a detailed reconciliation of the opening and closing balances for both the benefit obligation and the fair value of plan assets. This reconciliation shows the effects of various components during the year, such as service cost, interest cost, contributions made, benefits paid, and the actuarial gains or losses recognized in OCI.

Furthermore, the disclosures must include a breakdown of the amounts recognized in the income statement and in other comprehensive income. Information about the plan’s assets is also required, including the allocation across different asset categories and the determination of their fair value. A sensitivity analysis for actuarial assumptions shows how the defined benefit obligation would have been affected by changes in assumptions like the discount rate or the healthcare cost trend rate.