19 August 2009 CIRCULAR 2009 / 5 GUIDANCE ON THE APPLICATION OF IFRS TO PROVISIONS FOR SEVERANCE BENEFITS. Introduction With the coming into effect of the Labour Act, Act 11 of 2007 section S35(1)(c), the accounting profession is being inundated with questions regarding the obligation to provide for severance pay in the financial statements of employers. The Institute has already issued Circulars 2009 / 3 and 2009 / 4 dealing with the obligation to provide for severance benefits in general and in certain specific instances Issue This guide addresses the question of how the provisions of International Financial Reporting Standards ( IFRS ) should be applied to accounting for these types of severance benefits, and when should the amount be raised? Conclusion and guidance As the severance benefits are only payable on retirement or the involuntary termination of service from the side of the employer, it must be accounted for as a post-retirement service. An entity should apply the provisions of IAS 19 that cover post-employment benefits to severance payments (or portion therefore) that are payable both upon normal retirement, involuntary early retirement and retirement or resignation after the normal retirement age (in cases where requested by employer to remain in service after retirement). Since the level of benefit depends on the length of service, an obligation arises when the service is rendered. Measurement of the obligation should factor in an assumption about the number of current employees who remain employed until their normal retirement age, possible deaths or involuntary termination. A number of other factors, such as normal turnover and the likelihood of earlier voluntary termination must be taken into consideration. IAS 19, paragraph 57 encourages, but does not require, an entity to make use of the services of a qualified actuary in the measurement of all material postemployment benefit obligations. However, performing an actuarial valuation and
applying actuarial techniques without the input of a qualified actuary can be a complicated exercise. The IAS 19 principles of recognition and measurement and its disclosure requirements also apply. Any additional benefit payable upon involuntary termination (which excludes mandatory retirement based on age clauses) over the benefit payable upon a normal retirement is a termination benefit. Termination benefits should only be accrued when the entity can demonstrate that it intends to terminate a group of employees before their normal retirement age or provides termination benefits as a result of an offer made in order to encourage voluntary termination. The event that gives rise to an obligation is the termination rather than the employee service. The provisions of IAS 19 for termination benefits apply to the portion of termination benefits payable upon involuntary termination. An entity will only have a legal obligation from the effective date of the revised Labour Act, which is 1 November 2008. Therefore, the employer will not recognise any postemployment benefit plan obligation for severance pay in terms of the revised Labour Act in its financial statements before the effective date of 1 November 2008. Basis of conclusion and accounting references IAS 19 Employee benefits paragraph 4 states: Employee benefits include: (a) short-term employee benefits, such as wages, salaries and social security contributions, paid annual leave and paid sick leave, profit-sharing and bonuses (if payable within twelve months of the end of the period) and nonmonetary benefits (such as medical care, housing, cars and free or subsidised goods or services) for current employees; (b) post-employment benefits such as pensions, other retirement benefits, postemployment life insurance and post-employment medical care; (c) other long-term employee benefits, including long-service leave or sabbatical leave, jubilee or other long-service benefits, long-term disability benefits and, if they are not payable wholly within twelve months after the end of the period, profit-sharing, bonuses and deferred compensation; and (d) termination benefits. IAS 19 paragraph 7 defines the following: Employee benefits are all forms of consideration given by an entity in exchange for service rendered by employees. Post-employment benefits are employee benefits (other than termination benefits) which are payable after the completion of employment. Other long-term employee benefits are employee benefits (other than postemployment benefits and termination benefits) that are not due to be settled within twelve months after the end of the period in which the employees render the related service. Page 2 of 7
Termination benefits are employee benefits payable as a result of either: (a) an entity s decision to terminate an employee s employment before the normal retirement date; or (b) an employee s decision to accept voluntary redundancy in exchange for those benefits. Based on the above it is clear that the severance pay is not a short-term employee benefit as it does not fall due wholly within 12 months after the service has been delivered. The severance pay can be argued in terms of the following: Post-employment benefit When the employee retires he is entitled to the severance pay (if longer than 12 months service on retirement date). In this case the severance pay is a form of retirement benefit that is payable after the completion of the service. However, it is not only payable on retirement but also if an employee dies or is dismissed. Termination benefit If the employee is dismissed he will be entitled to the severance pay (if longer that 12 months service at that time). As it is paid as a result of the dismissal, the severance pay would be a termination benefit. However, it is not only paid on dismissal but also when an employee dies or retires. Termination benefits should only be accrued when the entity can demonstrate that it intends to terminate a group of employees before their normal retirement age or provides termination benefits as a result of an offer made in order to encourage voluntary termination. The event that gives rise to an obligation is the termination rather than the employee service. Other long-term employee benefit The employee is entitled to the severance pay in the future only if he has been in employment for at least 12 month. Therefore the payment could be after 12 month of the period in which the service was delivered. However, this will not be the case for the services rendered in the last 12 months as the full amount would be paid if the obligation event occurs. It can also not be other long-term employee benefit if it is a post-employment benefit or termination benefit. It is therefore possible to classify portions of the severance pay into all three categories. However, it is not practicable to split it between all these categories and try to account for it that way. These benefits are only payable on retirement, death or upon involuntary termination of service. The amount of the benefit is based on the number of years of service and is therefore similar to that of most post-employee benefits, e.g. pension plans normally operate on the same principle that it is payable on retirement but if the employee is dismissed, resign or dies, he is entitled to the benefit. Page 3 of 7
IAS 19 paragraph 24 states: Arrangements whereby an entity provides postemployment benefits are post-employment benefit plans. An entity applies this Standard to all such arrangements whether or not they involve the establishment of a separate entity to receive contributions and to pay benefits. IAS 19 paragraph 25 states: Post-employment benefit plans are classified as either defined contribution plans or defined benefit plans, depending on the economic substance of the plan as derived from its principal terms and conditions. IAS 19 paragraph 26 states: Examples of cases where an entity s obligation is not limited to the amount that it agrees to contribute to the fund are when the entity has a legal or constructive obligation through: (a) a plan benefit formula that is not linked solely to the amount of contributions; (b) a guarantee, either indirectly through a plan or directly, of a specified return on contributions; or (c) those informal practices that give rise to a constructive obligation. For example, a constructive obligation may arise where an entity has a history of increasing benefits for former employees to keep pace with inflation even where there is no legal obligation to do so. IAS 19 paragraph 27 states: Under defined benefit plans: (a) the entity s obligation is to provide the agreed benefits to current and former employees; and (b) actuarial risk (that benefits will cost more than expected) and investment risk fall, in substance, on the entity. If actuarial or investment experience are worse than expected, the entity s obligation may be increased. The best way to account for this severance pay would be to treat it as a post-employee benefit. The provisions in IAS 19 (paragraphs 48 to 125) that cover post-employment benefits must therefore be applied to the severance pay. IAS 19 paragraph 133 states: An entity shall recognise termination benefits as a liability and an expense when, and only when, the entity is demonstrably committed to either: (a) terminate the employment of an employee or group of employees before the normal retirement date; or (b) provide termination benefits as a result of an offer made in order to encourage voluntary redundancy. IAS 19 provides the following guidance on defined benefit accounting: IAS 19 paragraph 49 states: Accounting for defined benefit plans is complex because actuarial assumptions are required to measure the obligation and the expense and there is a possibility of actuarial gains and losses. Furthermore, the obligations are measured on a discounted basis because they may be settled many years after the employees render the related service. According to IAS 19 paragraph 50, accounting by an entity for defined benefit plans involves the following steps: (a) Using actuarial techniques to make a reliable estimate of the amount of benefit that employees have earned in return for their service in the current and prior Page 4 of 7
periods. This requires an entity to determine how much benefit is attributable to the current and prior periods and to make estimates (actuarial assumptions) about demographic variables (such as employee turnover and mortality) and financial variables (such as future increases in salaries and medical costs) that will influence the cost of the benefit; (b) Discounting that benefit using the Projected Unit Credit Method in order to determine the present value of the defined benefit obligation and the current service cost; (c) Determining the fair value of any plan assets; (d) Determining the total amount of actuarial gains and losses and the amount of those actuarial gains and losses to be recognised; (e) Where a plan has been introduced or changed, determining the resulting past service cost; and (f) Where a plan has been curtailed or settled, determining the resulting gain or loss. No termination benefit should be accounted for unless the employer has an obligation to pay severance pay. This obligation only exists once the employer is demonstrably committed to a termination. This is when, and only when, the employer has a detailed formal plan for the termination and is without realistic possibility of withdrawal. Only when this obligation exists, the termination benefit must be recognised in terms of the provisions of IAS 19 for termination benefits. However, the termination benefit would be any excess payable to the employee over and above the severance pay that he is entitled to in terms of the Labour Act section 35. Retrospective accounting is not applied, (i.e. adjusting retained earning), as IAS 8 requires retrospective accounting for change in accounting policies or error. IAS 8 paragraph 19 states: When an entity changes an accounting policy upon initial application of an IFRS that does not include specific transitional provisions applying to that change, or changes an accounting policy voluntarily, it shall apply the change retrospectively. IAS 8 paragraph 42 states: an entity shall correct material prior period errors retrospectively in the first set of financial statements authorised for issue after their discovery. The severance pay liability arising as a result of the revised Labour Act is not a change in accounting policy, nor is it the correction of a prior period error. Therefore, the financial statements will not be adjusted retrospectively. The total expense arising on the raising of the severance pay liability relating to vested benefits will be recognised in the same period in which the liability is raised. The total expense arising on the raising of the severance pay liability relating to benefits not yet vested, will be spread over the remaining working lives of employees. The above argument is further supported by the IAS 10: Events after balance sheet date, paragraph 3, which states: Events after the reporting period are those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue. Two types of events can be identified: Page 5 of 7
(a) Those that provide evidence of conditions that existed at the end of the reporting period (adjusting events); and (b) Those that are indicative of conditions that arose after the reporting period (non-adjusting events). The severance pay liability arose on the date that the revised Labour Act was introduced and is therefore indicative of conditions that arose after the prior reporting period (a nonadjusting event). IAS 19 paragraph 96 further supports the argument that the total expense arising on the raising of the severance pay liability will be recognised in the same period in which the liability is raised: In measuring its defined benefit liability, an entity shall recognise past service cost as an expense on a straight-line basis over the average period until the benefits become vested. To the extent that the benefits are already vested immediately following the introduction of a defined benefit plan, an entity shall recognise past service cost immediately. Disclosures in annual financial statements General disclosure: IAS 19 paragraph 120 states: an entity shall disclose information that enables users of financial statements to evaluate the nature of its defined benefit plans and the financial effects of changes in those plans during the period. IAS 19 paragraph 120A prescribes the relevant disclosure required in the annual financial statements regarding any defined benefit plans that may exist. Choice of accounting policy relating to actuarial gains and losses: As per IAS 19 paragraph 93, an entity has a choice regarding the accounting policy that it can elect in relation of recognising actuarial gains and losses in profit or loss, or alternatively immediately directly in equity. If actuarial gains or losses are recognised in profit or loss, then an entity may elect to recognise cumulative gains and losses using the corridor method or, alternatively, elect a method that results in faster recognition. The policy chosen should be applied consistently to all defined benefit plans and from period to period (IAS 19.93). For further details, refer to IAS 19 paragraphs 92 to 95. Tax deductibility Before such severance pay provision can be deducted for tax purposes it has to meet the requirements of both sections 17(1)(a) and 24(g) of the Income Tax Act 24 of 1981 ( the Act ). One of the requirements of section 17(1)(a) is that the provision must be actually incurred. The word incurred was held to not merely mean paid, it has been held that the word incurred means either paid or becoming liable for (refer Port Elizabeth Electric Page 6 of 7
Tramway Company Ltd V Commissioner for Inland Revenue 1936 CPD 241 and ITC 542 (1942) 13 SATC 116.) In Caltex Oil (SA) Limited v Secretary for Inland Revenue 37 SATC 1, it was held that expenditure actually incurred does not mean expenditure actually paid during the year of assessment, but means all expenditure for which a liability has been incurred during the year, whether the liability has been discharged during that year or not. In a recent Appellate Division case (CIR v Golden Dumps (Pty) Ltd 1993 (4) SA 110 (A)) it was held that the word actually could not be ignored and, as such, the liability could not in any way be contingent on any other occurrence. This means that it would be difficult for the taxpayer to argue that an amount could be deducted if the actual payment was dependant on some or other uncertain event. Based on the above, for an expenditure or loss to be actually incurred, an absolute and unconditional legal liability should exist at year end. The circumstances (mentioned above) in terms of which the severance pay arises are conditional and, in our view, an employer therefore does not have an unconditional liability in respect of the provision at year end and the provision would therefore not be tax deductible. Tax deduction is only available on the actual payment of severance benefits. Calculation of severance benefits provision and charges to income statement The Technical Committee of the Institute has developed a spreadsheet template for the calculation of the severance benefit obligation and related charges to the income statement. The template is available for use where an employer has not already obtained an actuarial valuation of the benefit and determined the appropriate charges to the income statement in terms of this guide. A copy of the template is available from www.icancpd.net/2007/ Council emphasizes that the use of any template or calculation model to provide an estimate of severance benefits will be highly dependent on the assumptions made and applied in the calculation of the severance benefits. Members are urged to ensure that due care is taken when setting such assumptions in order that the motivations for the assumptions are both reasonable and justifiable given the specific circumstances of the individual employer. J dlr du Toit CA(Nam) CEO Page 7 of 7