Overhaul end-of-service liability

As we approach the end of 2009, finance managers and their auditors are bracing themselves for long nights ploughing through their company's accounts and making sure all balance sheet and income statement entries are at pin-point accuracy before sign off.

Their jobs have been made harder with the increased scrutiny by all the various company stakeholders as statements are looking much less rosy than in previous years.

To increase transparency as part of the broader development of corporate governance standards in the region, locally-based companies have adopted International Financial Reporting Standards (IFRS) for nearly all of their financial entries, albeit making a few exceptions for some entries that were considered immaterial. One of these insignificant entries was the end-of-service liability.

The region, however, has transformed economically over the past decade or so and companies have grown in size and headcount, leading to increases in the end-of-service liabilities. The combination of a higher number of (in the case of the UAE, expatriate) employees, working for extended periods of time and earning high salaries has compounded these liabilities so that they are no longer insignificant for large scale companies. Yet few large scale companies have evolved their practices and properly accounted for these increasing liabilities in conformity with IFRS – specifically under IAS 19, which outlines how to calculate employee benefit costs that should be recorded as expenditure and the liabilities that should be shown on balance sheets. The current market practice is to value the end-of-service liability as a "settlement" liability, which is the sum of all employees' accrued end of service benefits based on salary and service at year end.

The implicit assumption here is that the company becomes insolvent on the balance sheet date and would be obliged to pay end-of-service benefits to all employees. The difference between the settlement liability at the beginning and end of the year is the benefit expense which is entered in the profit or loss account.

IAS 19 is clear that end of service liabilities – defined as "defined benefit obligations" – should be valued as a going-concern, with an underlying assumption that the company will remain in business indefinitely. The standard describes an actuarial method of valuing these liabilities and specifically discusses the projection of benefits and a market-based discounting method to determine present values. The cost, in the profit or loss statement, of providing employee benefits is recognised in the period in which the benefit is earned by the employee, rather than when it is paid. IAS 19 has therefore defined all the components that make up the cost and outlines a method of calculating and disclosing these components. The graph shows projection of the liability of a 30-year-old employee with five years of service in the UAE, earning a basic monthly salary of Dh20,000 and promised by his employer to receive the minimum required by UAE labour law.

Under a discount rate of six per cent and a salary increase assumption of five per cent, the liability is expected to grow from Dh75,000 at age 30 (with five years service) to Dh950,000 at age 50 (with 25 years service), a 13-fold increase over the member's career and a substantial increase in the company's obligation over time.

The advantage of applying IAS 19 is two fold. The first is transparency. With the region developing into an economic hub and attracting investors globally, all financial entries on company statements would be clear and in full compliance with IFRS.

Secondly, with organisations all applying the same accounting standard, proper assessments can be made on the relative financial strengths of various organisations. This is especially important for companies that are listed on stock exchanges or involved in mergers and acquisitions.

Recently many accounting standard boards have taken active steps to promote increased transparency of financial statements and discussions between the different boards have taken place to harmonise the recognition and measurement of employee benefit obligations.

Eventually this will lead to a single set of standards around the globe, most probably under IAS 19, which has already been adopted by more than 120 countries worldwide, including most of the G8 countries.

The transition from current market practice to IAS 19 will invariably have an impact on balance sheets and profit or loss statements and may or may not lead to increased liabilities.

The process will also require a collaborative effort between the company's finance managers, auditors and needs actuarial expertise that will accurately value the end-of-service liabilities and provide all the necessary entries and disclosures.


- Mazen Abukhater is a senior associate and actuary at Mercer's Dubai office

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