A comparison and contrast of German and international financial reporting issues. Accounting for pensions - IAS 19 versus German law

Contents

Table of figures

List of abbreviations

1 Introduction
1.1 Economic problem
1.2 Objective and structure of the paper

2 Bases
2.1 Definitions
2.2 Forms of company pension schemes
2.3 General problems in accounting for pensions

3 Accounting for pensions – German law
3.1 Recognition
3.2 Appraisal
3.2.1 Actuarial bases
3.2.2 Valuation methods
3.3 Further aspects

4 Accounting for pensions - IAS 19
4.1 Recognition
4.2 Appraisal
4.2.1 Actuarial bases
4.2.2 Valuation method
4.2.3 Plan assets
4.3 Cost recognition
4.4 Further aspects

5 Economic analysis of HGB and IAS pension regulations
5.1 Comparison
5.2 Conclusion

Bibliography

List of statute law and jurisdiction

Other sources

Table of figures

Fig. 1: Types of Company Pension Schemes

Fig. 2: Financing of Pension Provisions

Fig. 3: Provisions for Pensions and Similar Obligations

Fig. 4: Fractional value and current cost accounting method

Fig. 5: Components of the defined benefit liability

Fig. 6: Components of net periodic pension cost.

Fig. 7: Comparison of determined accounting aspects between HGB – IAS

Fig. 8: Comparing example of PUC- and fractional value method

List of abbreviations

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1 Introduction

1.1 Economic problem

Although accounting for company pension schemes is one of the most controversial topics of discussion in the international accounting trade^[1], many investors do not pay it due attention. In future, even more so than now, annual results will be influenced by latent reserves and obligations, resulting from different ways of accounting for pension benefit schemes^[2]. German financial statements and those following either IAS or US-GAAP often differ significantly on this point.^[3] The International Accounting Standards and the German Commercial Code are based on different principles. Whereas German regulations are dominated by the imperative of the protection of creditors, IAS lay the focus of accounting on a true and fair view of financial statements in order to provide a suitable basis for investment decisions.^[4] These divergent priorities are reflected in the accounting for pensions as well. The two main problems in accounting for pensions are the recognition and the appraisal of pension provisions. Eventually both accounting systems face the same problems and each one has a different way of resolving them. On the other hand, HGB and IAS unanimously agree on the fact that company pension schemes that do not require pension provisions, do not represent an accounting problem.

1.2 Objective and structure of the paper

The objective of the treatise on hand is the depiction of the difference between IAS amd HGB regarding the recognition and accounting for pension as well as the resulting accounting-effects on the balance-sheet.

The paper will first try to give an overview of the term “pensions” as it is used in German law^[5] and in the IAS, and then – in the second part of the bases– explain the underlying problematic nature of accounting for pensions. In the third and fourth part the respective regulations, first according to German law and then IAS, will be particularized. The conclusion will provied an extensive comparison between the two systems as well as a critical appraisal of the differences and possible financial effects.

2 Bases

2.1 Definitions

Different way exist for businesses in which to provide for an employee’s retirement. This chapter will try to enclose the provisions for retirement, first according to German regulations and then according to IAS.

German income tax law provides a legal definition of the term “pension reserves” in § 6a EStG by defining “reserves for a pension obligation”.^[6] The HGB however, lacks an exact definition. Instead, pension obligations are commonly described as all “obligations for company pension schemes”.^[7] According to § 1, I of the Employee Pension Act (BetrAVG)^[8] this includes all provisions for retirement-, disability- and survivor’s benefits an employer grants his employees and that arise out of the employment condition. Following the German Federal Labour Court three characteristics for company pensions schemes can be deduced:^[9]

The benefits a (former) employee receives must have provisionary character,

they have to be connected to a biological incident such as age, invalidity or death and

they must arise out of the employment condition.

In contrast, the International Accounting Standards provide detailed definitions of employee benefits and retirement provisions. IAS 19 provides rules for the accounting, recognition and appraisal of employee benefits which are divided up into five categories^[10]:

Short-term benefits due in 12 months after the reporting period, such as wages and bonuses;

post-employment benefits, especially company pension schemes;

other long-term benefits such as sabbatical leave;

termination benefits, including severance pay, job training and counselling;

equity compensation arrangements, which include stock option plans, employee share ownership and similar compensation schemes.

Whereas IAS 19 includes accounting directions on all of the above, the most detailed instructions are given for post-employment benefits.^[11]

2.2 Forms of company pension schemes

In order to comply with pension obligations towards its employees an enterprise can choose to make the necessary allocations itself, or to contract the services of an external pension fund – to a large extent this decision will depend on how the business is best funded.^[12] Furthermore can a businesses’ pension obligations be divided into running pension payments and future pension obligations.^[13] The following figure summarizes the possibilities an enterprise has:

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Fig. 1: Types of Company Pension Schemes

Direct Commitments make it binding for the employer to provide the contractual obligation himself at maturity. Company Welfare funds periodically receive a certain amount of money from the respective enterprises in order to provide the pension payments. Neither has the enterprise an obligation to pay the welfare fund nor has the beneficiary any claim against the latter. This type of pension scheme thus is equivalent to a direct commitment. Independent pension funds are similar, yet in this case the beneficiary has a claim against the fund. External funding means that an enterprise transfers assets to a third, legally independent party in order for it to provide pensions for the beneficiaries. An enterprise using direct insurance policies buys life insurance policies for its employees and has to pay the life underwriter.^[14]

Only direct pension obligations or defined benefit plans make it necessary for an enterprise to build up pension provisions.^[15]

Contrary to German law, IAS 19 does not differentiate between direct and indirect pension obligations but between defined benefit plans and defined contribution plans:^[16]

Defined contribution plans limit an employer’s legal or constructive obligation to the periodical payments he has agreed to make to an independent institution according to the contribution formula.^[17] The employer thus transfers the actuarial and investment risk to the employee. The incurred expenses during a period equal the fixed contributions, the subsequent pension results from the contributions and the investment profits.^[18] Of the five different types of company pension schemes in the sense of § 1 BetrAVG pension funds, direct insurance policies and external funding can be subsumed as defined contribution plans.^[19]

All benefit plans that can not be described as defined contribution plans are commonly referred to as defined benefit plans and are usually characterized as the employers’ service commitments.^[20] Within these plans, benefits are normally based on time of service, age and income of the employee; actuarial and investment risk remain with the employer. In order to secure the promised benefit, corrections may have to be made if actuarial assumptions or investment profits differ from the expectations.^[21]

In opposition to defined contribution plans, which do not represent an accounting problem^[22], defined benefit plans require an appraisal of the future pension provision and thus will be the focus of the following chapters.

2.3 General problems in accounting for pensions

As mentioned above, the problem of accounting for pensions can be reduced to the problem of accounting for pension provisions. The two main issues in accounting for pension provisions are their recognition and appraisal, because pension commitments have to be regarded as uncertain liabilities. This classification implies their uncertainty regarding the point of time and amount at maturity, as well as the possibility of their disposition if the reason for their creation is no longer likely enough to occur or ceases to exist.^[23]

In order to present a picture of an enterprises’ pension obligations that is as realistic as possible at the balance-sheet date, several estimations have to be made concerning:

biometric probabilities such as the probability of marriage, invalidity and death, whose sum defines the over-all probability for the fulfilment of the pension obligation,

retirement age,

fluctuation,

the discount rate to be used and

the valuation methods used to calculate the amount of pension obligations.^[24]

Whereas the two first points do not represent a significant problem for accounting, there exists an ongoing debate about the consideration of fluctuation, adequate discount rates^[25] and which actuarial method should be chosen. Therefore the following chapters will focus on the latter.

The figure below gives an overview of possible valuation methods used to calculate the financing of pension provisions:

[...]

^[1] See Schmidtbauer, R. (2003), p. 795.

^[2] For a detailed analysis of this influence see Zimmermann/Schilling (2003), p. 865 ff.

^[3] See Wolz, M. (2000), p. 1390. The paper on hand will focus on HGB and IAS regulations, however, regarding pensions most IAS regulations agree with US-GAAP.

^[4] See IAS 1.7 ff.

^[5] Although the regulations in the German Commercial Code are often influenced significantly by income tax law because of the authoritative principle, this paper will focus mainly on the HGB.

^[6] See, Heubeck, K. (1987), p. 9.

^[7] See, Thoms- Meyer, D. (1996), Petersen, J. (2002), p. 11.

^[8] Gesetz zur Verbesserung der betrieblichen Altersvorsorge, dating from 19.12.1974, BGB1. I 1974, p. 3610.

^[9] Compare with judgments from the 08.05.1990 – 3 AZR 121/89 in: Der Betrieb (1990), p. 2375 and from 25.10.1994 – 3AZR 279/94, in: Der Betrieb (1995), p. 573 f.

^[10] See IAS 19.4.

^[11] See Förschle et al. (2003), p. 57.

^[12] See Trägner, G. (1977), p. 28.

^[13] See, for example, Eggloff, F. (1999), p. 30.

^[14] For further details see, for example, Kremin-Buch, B. (2002), p. 191 ff.; Petersen, J. (2002), p. 16 ff.

^[15] Following German regulations company welfare funds have to build up provisions incase of insuffiecient funds. The amount of the provisions equals the shoestring margin.

^[16] See IAS 19.7 and, for example, Graf Waldersee/Hayn (2002), p. 173; Baetge et al. (2002), p. 408.

^[17] See, instead of many, Heno, R. (2003), p. 415; Epstein/Mirza (2003), p. 619; Born, K. (2002), p. 124.

^[18] See, for example, PricewaterhouseCoopers (1998), p. 19-5; Förschle et al. (2003), p. 57.

^[19] See, for example, Baetge et al. (2003), p. IAS 19-9; Heno, R. (2003), p. 415.

^[20] A positive definition was not given, see Baetge et al. (2003), p. IAS 19-9.

^[21] See, instead of many, Förschle et al. (2003), p. 58, in whose opinion a difference between the provision and the defined benefit obligation is the normal case.

^[22] This is due to the fix expenses per period.

^[23] Instead of all, see Glade A. (1995), p. 529; Förschle/Klein (1987), p. 341; Neumann, H. (1998), p. 405.

^[24] See, for example, Thoms-Meyer, D. (1996), p. 63 ff.; Baetge et al. (2002), p.408;Petersen, J. (2002), p. 45 ff.

^[25] The importance of the interest rate shows in the fact that a change of one percent of the interest rate per period can result in 25% raise of the pension cost. In the USA changes over 5% have occurred. See Wolz, M. (2000), p. 1376.