Very often examiners pose questions that test candidates understanding of the subtle, but critical, differences between similar financial transactions.
A typical question might relate to a company which has contractual or constructive obligations to make post retirement annuity payments to its employees. The rights to these annuities are often set out in the employee’s service contracts.
Let us consider two similar, but different arrangements of this type:
- Employees are paid a fixed annual amount for a fixed term beginning on the first anniversary of their retirement. In this case, if the employee dies, an amount representing the present value of the future payment is paid to the employees estate.
- Employees are paid a fixed annual amount which ceases on death.
WE must look closely at the context of each of these transactions to assess which Financial Reporting Standard must be applied.
Case (a) represents a contractual obligation to deliver a fixed, known amount of cash. This annuity meets the definition of a financial liability under IAS32, as there is a contractual obligation to deliver cash or a financial asset. Thus this transaction is a Financial Liability and must be accounted for using IFRS 9. The initial amount recognised on the Statement of Financial position of the company is the PV of the future cashflows. Subsequently an expense, at the effective interest rate, is charged to P+L until the liability is fulfilled. As the rights to the annuities are earned over the period of the service of the directors, then the costs should have been recognised also over the service period.
On the surface, case (b) looks quite similar to case (a). However the critical difference between these two cases is that, in case (b) the obligation to pay cash ceases on the death of the employee. Since we do not know when the employee is going to die, case (b) represents a “liability of uncertain timing or amount”. This is commonly referred to as a provision and is treated under IAS 37. The correct treatment is that a provision should be recognised for the best estimate of the costs of the annuity and this would include any liability for post-retirement payments to directors earned to date. The liability should be built up over the service period rather than just when the director leaves. The liability should be recalculated on an annual basis, as for any provision; to take account of changes and any movements in the value of the provision should be recognised in P+L. The provision should be discounted where the effect is material.
Hence, two very similar arrangements require very different accounting treatments and will result is significantly different amounts being shown on the company SOFP and IS.