International Public Sector Accounting Standards (IPSAS) are a set of accounting standards for use by public sector entities such as national, regional and local governments as well as related governmental entities in the preparation of financial statements. These standards are based on International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) and adapted to a public sector context by the IPSAS Board when appropriate.
Adoption of IPSAS have been encouraged by organizations such as the World Bank and OECD as part of measures designed to improve accountability, transparency, control and financial sustainability of public sector entities. Major countries such as United States of America, United Kingdom, Australia, Canada, Russia, and France have adopted IPSAS or accrual accounting standards broadly consistent with IPSAS while other countries and organizations such as Austria, Malaysia, Indonesia, Brazil, India and the United Nations, European Commission are in the process of doing so or have plans in place to do so.
This paper relates to IPSAS 25 Employee Benefits and highlights key principles under accrual accounting and actuarial cost recognition.
IPSAS 25 specifies a number of employee benefits that are covered under the standard but the ones that require actuarial techniques in estimating the costs are primarily defined benefit pensions, gratuity and post-retirement medical benefits.For ease of writing, this paper makes reference to a pension scheme sponsored by a government. The principles remain valid for the other benefits and other sponsoring entities.
An implication of adopting IPSAS 25 is that unfunded government pension or any other unfunded post-retirement benefit obligations which have been in the past an “off balance sheet” item will now appear on the balance sheet of the government. It is likely that such liability, quantified in accordance with the methodology prescribed under IPSAS 25, will be a huge amount. Without an offsetting increase in the assets section of the balance sheet the government financial position may register a deficit (or a reduced surplus) and this would, to some extent, have an effect on its credit rating.
Pension is an example of deferred benefits. Employees earn their pension throughout his career in the public sector but benefits will only start to be paid as pension upon occurrence of one of the pre-defined events such as retirement or death in service. Let’s take an example of a final salary pension with an accrual rate of 2% and a maximum pensionable service of 30 years. An employee earns 2% of his final salary as deferred pension after completing his first year of pensionable service. In his second year of pensionable service he earns a further 2% of his final salary. He continues earning his pension until a completion of 30 years of pensionable service. His additional service beyond the 30 years does not grant him any more additional pension although his pension will continue to increase in line with future increase in his salary. His pension will start to be paid to him when he attains his retirement age or to his spouse (if any) if he dies before retirement.
The key principles under accrual accounting for pension are that, a sponsoring entity is required to recognize:
- A liability when an employee has provided service in exchange for pension to be paid in the future, and
- An expense when the entity consumes the economic benefit arising from service provided by an employee in exchange for pension
To illustrate the above principles in terms of cost allocation, we look at the same pension example discussed previously. Assuming that at the accounting reporting date an employee has completed 20 years of pensionable service. He has another 15 years to go before he reaches his retirement age of which only 10 years are pensionable due to the pensionable service cap of 30 years. Under accrual accounting, the entity would recognize 2/3rd of the estimated pension costs for this employee as a liability in the balance sheet. A further 1/3rd of the pension costs will be recognized over the next 10 years. Of this 1/3rd of the pension costs, 1/10th is recognized in the current year as expense. The 2/3rd above is derived as a ratio of completed years at the reporting date which is 20 years over the total number of years until the pension is fully earned which is 30 years.
The above cost allocation is based on a straight forward example of a pension payable from normal retirement age. For other benefits such as death in service spouse pension the cost allocation is not as straight forward as above though the principles remain the same.
Under cash accounting, the pension benefits paid in a particular year are recorded as expense in the Government Budgetary Balance. Under accrual accounting, an actuarial cost method is used to arrive at the estimated cost of pension benefits accruing in that particular year and this amount is recorded as expense in Government Budgetary Balance (or an entity’s statement of financial performance). Continuing from the above example, the expense to be charged to the Government Budgetary Balance (or an entity’s statement of financial performance) in the current year is the 1/10th of the 1/3rd of the pension cost yet to accrue. For the cost of pensions related to service earned to date, to the extent that it is not funded, it forms a liability in the Government’s Accumulated Budgetary Surplus or Deficit (or an entity’s statement of financial position). From the above example this is the 2/3rd of the estimated pension costs assuming there is no corresponding funded assets.
With all the jargon and technical terms surrounding pension accounting, it’s easy to lose sight of what constitutes the ultimate cost of a pension plan. It is important to note that the ultimate total amount of pension benefits to be paid in the future are unknown and their ultimate costs depend on several factors such as future salary increases, future inflation (as salary increases are partly driven by inflation), future investment return (if it is funded), number of years benefits will be paid etc. Through an actuarial valuation process, an actuary estimates this ultimate cost and allocates that cost to accounting periods.
In an actuarial valuation, actuaries will need to make assumptions about future experience of a pension scheme. This includes future increases in pensionable salary, how long pensioners and their spouses are expected to live in the future, attrition rates whilst in service, proportion of members married at retirement, rates of investment return etc. IPSAS 25 requires such assumptions to be determined on best estimate unbiased basis.
A very conservative estimate, whilst prudent, means that pension liability and expense allocation will be higher than necessary now. Overprovision will be released as “surplus” in the future. Aggressive assumptions on the other hand will make the pension liability and expense lower than the true cost. Higher provision will be required in the future to make up for the “deficit”.
Pension obligations movement during an accounting year
The present value of pension benefits obligation is increased during an accounting year by the present value of pension benefits earned by employees during the year and net interest charges on the accrued liabilities. The present value of pension benefits increases further (or decreases) by actuarial losses (or gains) during the year. These increases are offset in part or whole by reductions in the liabilities for pensions paid during the year.
The above can be presented generally as below:
|Present value of pension benefits obligation accrued up to end of year t
= Present value of pension benefits obligation accrued up to start of year t
+ Present value of pension benefits obligation accrued during year t
+ Net interest charges on the accrued liabilities
+ Actuarial losses (or gains) during year t
‒ Pensions paid during year t
Components of pension expense
Components of pension costs which are recognized as an expense in the Government Budgetary Balance (or an entity’s statement of financial performance) in a particular year are made up of the following:
- Present value of pension benefits earned by employees during the year
- Interest charges on the present value of pension benefits obligation at the start of the year net of expected return on assets (if any) during the year
- Amortization of prior years’ actuarial losses (gains)
- Amortization of any increase (or decrease) in present value of pension benefits obligation due to benefit improvements (or cuts) made in that year and prior years
IPSAS 25 specifies in detail allowable methods of amortizing prior years’ actuarial losses (or gains) and amortizing the increase (or decrease) in present value of pensions due to any benefit improvements (or cuts).
First time adoption
On first time adoption of IPSAS 25, the present value of pensions obligation accrued as at the reporting date is compared with fair value of any plan assets which has been set aside to fund the pension obligations . Based on IPSAS 25 dated February 2008 government as the pension scheme sponsor shall recognize this difference in its opening Accumulated Budgetary Surplus or Deficit.
Liabilities movement during an accounting year
The above difference forms the government’s opening liability for pension benefits in the first year of adoption. This liability increases and decreases by the end of the first year of adoption (and indeed in the subsequent years) by an additional year of pension accruals, net interest on the present value of pension benefits accrued to date, expected return on assets (if any), amortization of actuarial gains or losses, amortization of increase (or decrease) in present value of pension benefits due to benefit improvements (or cuts), benefits and/or contributions paid during the year.
The above liability movement is presented generally as follows:
|Liabilities for pension benefits at end of year t
= Liabilities for pension benefits at start of year t
+ Present value of pension benefits accrued during year t
+ Interest charge on the present value of pension benefits obligation at start of year t
‒ Expected return on plan assets (if any) during year t
+/- Amortization of prior years’ actuarial losses (or gains)
+/- Amortization of any increase (or decrease) in present value of pension benefits due to benefit improvements (or cuts) made in the same year and in the prior years
‒ Pensions paid directly by the Government during year t
‒ Contributions paid (if any) by the Government during year t
Governments contemplating to adopt accrual accounting under IPSAS should be aware of its financial impact. The first step is for such governments to have an estimate of their pension and post-retirement benefit obligations. An actuarial valuation is a process that provides such estimates. A valuation of a government pension scheme requires months of preparation which include appointment of an actuary, collection of membership data, collection plan asset data, experience analysis and confirmation on valuation assumptions and accounting policy. It is imperative for governments and other public entities to engage professionals such as accountants and actuaries to advise them on the process, timeline and resources early and well before the effective date of the accrual accounting implementation. This engagement should also include a program providing trainings and workshops to equip public officers with the necessary knowledge in order to acquire better understanding of the management of the government’s pension and post retirement obligations when accrual accounting is implemented.
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