This post relates to some prior threads.  Its main basis is the IASB’s amended pension guidance (Phil’s post).  It is also about what goes to OCI (my post).  And finally it considers another type of intangible that may or may not be an asset (Jeff W’s post).

My curiosity is how the new IASB guidance treats prior service cost.  Prior service costs typically arise when an employer “sweetens” a pension plan by increasing its payout, and the employer grants the increase retroactively.  Thus if a company promises a retiree a check in each retirement year worth 2% x highest salary x years worked, and if the company increases its multiple to 2.5% with retroactive credit, then its annual pension promise to an employee with a $100,000 salary and 7 years of prior work increases  from $14,000 to $17,500.  How should we account for the bump in the employer’s obligation?

I looked for the pension amendment on the IASB website, but got an error message that since I did not have a subscription to eIFRS, I could not see the new guidance until a finalized amended standard is released on the IASB’s website.  Is this acceptable transparency for a global standard setter?  Or am I just looking in the wrong place?

Some additional browsing uncovered a summary of the amendments.  It states, “amounts related to plan amendments and curtailments should be included in profit or loss.”  So we can expect immediate expensing for prior service costs.  This makes some sense – the employee has already provided service, so why would that past service produce new future benefits (assets)?

But good accounting generally needs to understand the transaction.  Why grant retroactive credit when sweetening a plan? I have been told this is an HR ploy to retain employees by increasing the deferred portion of their compensation.   In essence, the future benefit from sweetening the plan is keeping people around and having them do better work because they like their job, or at least they like the salary and benefits they get from the job.  So here is the question – is a happy workforce an asset?

In SFAS 87, the FASB’s first major change in pension accounting, the Board allowed a lot of the pension economics to remain off of the balance sheet.  However, a minimum liability rule required some of the off balance sheet liability to be recorded in some circumstances; if the additional liability was due to prior service costs, the company debited an intangible asset.  So at that time, it appeared that a happy workforce might be an asset.

When the FASB reexamined pension accounting in SFAS 158, they moved the economics to the balance sheet, meaning the pension liability immediately increased upon sweetening the plan.  But FASB could not bring itself to put the debit for a happy workforce on the asset side of the balance sheet.  On the other hand, immediately expensing prior service cost in earnings would be a big change from existing practice.  So SFAS 158 put the debit in OCI.

In comparing US GAAP and the amended IAS guidance, the net effect is that companies making identical amendments (and using the same measurement methods) will end up with identical reported liability balances and total shareholder equity balances.  The components of shareholders’ equity (OCI versus retained earnings) will differ.  The net income line in the statement of income will be smaller in the sweetening year for those using IFRS, but amortization will cause US GAAP net income to be lower in subsequent years.

But the issue can get more interesting — the discussion above considers the extra expense from sweetening plans.  These days, most changes in post-employment benefits are cut backs.  Under amended IAS 19, a company that needs a few pennies to make an earnings target this year simply increases the co-pay on its post-employment insurance package, and voila, liability is reduced, income is increased, and the target is met.  Under US GAAP, the gain from a cut back in benefits is spread over the remaining service period of active employees.

I guess future research papers on real earnings management will have another transaction to consider for companies using IFRS.