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November 2009

GAPs in GAAP – Discount rate for employee benefits (Proposed amendments to IAS 19)

By Dolphy D’Souza, Chartered Accountant
Reading Time 5 mins

Accounting Standards

IAS 19 Employee Benefits have required pension obligations to
be discounted at rates based on high quality corporate bond rates. However, in
countries with no deep market in such bonds the rate on government debt is to be

One of the effects of the current financial crisis has been a
significant widening of the spread between yields on government bonds and those
on high quality corporate bonds. In particular, the current market results in
otherwise identical obligations being measured at very different rates due
solely to the presence or absence of a deep corporate bond market. In light of
this, the IASB published an exposure draft aiming to remove this lack of
comparability. The proposal will require the use of corporate bond rates in all
circumstances. The intention of the amendment of IAS 19 seems to be to require
use of a consistent reference in choosing the rate for discounting employee
benefit obligations regardless of whether there is a deep market in high quality
corporate bonds in the country concerned. The Board envisages that there will be
improved comparability between reporting entities due to a reduction in the
range of rates used.

Should the Board eliminate the requirement to use government
bond rates to determine the discount rate for employee benefit obligations when
there is no deep market in high quality corporate bonds ?

Since market interest rates differ considerably from country
to country or from currency zone to currency zone, consistency in application is
primarily important among plans operated in the same country or currency zone.
The financial crisis has not only widened the spread between government bond
rate and the rate on high quality corporate bonds, it has also widened the range
of corporate bond rates generally considered to be of high quality. In
particular, now that we see evidence of the spread between government bond rate
and corporate bond rate narrowing again, the range of applied corporate bond
rates within a jurisdiction is a significantly bigger concern than the spread
between government bond rate and corporate bond rate.

Generally, government bond rates are more reliably
determinable and show a significantly narrower range than high quality corporate
bond rates. In countries or currency zones where there is no or no deep market
for high quality corporate bonds the range of applied discount rates may be even
wider. The proposed change may actually decrease comparability among entities
within a jurisdiction (such as India) that would have previously applied a
discount rate determined by reference to government bond rates, as the range of
available rates for high quality corporate bonds tends to be much wider than
that of government bond rates.

This is aggravated by the fact that the current IAS 19, as
well as the proposed amendment, do not contain any further guidance regarding
the meaning of the phrase ‘high quality corporate bond rate’. So even if the
Board proceeds with this ED despite the concerns, more detailed guidance is
needed on what constitutes ‘high quality’. This would avoid the risk of
continued significant variability in discount rates selected, even within those
jurisdictions having a deep market for high quality corporate bonds.

The Board reminds its constituencies that it intends to
review the accounting for employee benefits more broadly in due course and notes
that these proposals are not meant to pre-empt that. Perhaps more ominously, the
Board notes that “The Board has not yet considered whether the measurement of
employee benefit obligations could be improved more generally and, in
particular, the Board has not yet considered whether the yield on high quality
corporate bonds is the most appropriate discount rate for postemployment benefit

Rather than proceeding with this ‘quick fix’, it is
recommended that the Board works expeditiously on its comprehensive review of
IAS 19, including the choice of discount rate. This will avoid a disruption of
financial information for those entities operating in jurisdictions that
currently use government bond rates to discount defined benefit obligations. In
those jurisdictions where entities currently use government bond rates due to
the absence of a deep market for high quality corporate bonds, users are
accustomed to this practice, the discount rate can be determined reliably and is
applied consistently by entities in that jurisdiction. The ED would lead to a
considerable widening of the range of discount rates applied and a move from a
‘level 1 fair value’ discount rate to a ‘level 3 fair value’ discount rate.

One would generally support proposals to improve
comparability and consistency. However, it appears inappropriate to have
consistency without having considered whether corporate bond rate or government
bond rate is appropriate to use. This quick fix proposed change only for
purposes of consistency does not match well with numerous accounting options
under IFRS — particularly one that needs mention is the manner in which
actuarial gains and losses are recognised in IFRS. Besides, for reasons
mentioned above, it is highly questionable if consistency would be achieved by
the proposed amendments.

The author would therefore recommend status quo and no haphazard changes to
IAS 19 discount rate at this stage.

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