Employment benefit obligations are often incurred years before benefit payments are due. Many would agree that the benefit obligation reported in the financial statements should reflect the present value of the estimated future benefit payments at the reporting date. However, there is widespread disagreement about which discount rate would best reflect the time value of money in determining the benefit obligation.
Why does it matter?
The choice of discount rate could have significant effects on the benefit obligation reported by entities at each reporting date. The longer the benefit accrual and payment periods, the more sensitive the valuation of benefit obligation would be to the discount rate assumption; for example, a 1 per cent difference in the discount rate may mean a 12 to 18 per cent difference in the benefit obligation and a 15 to 25 per cent difference in the current service cost.
Why is discount rate controversial?
The time value of money concept is that money available today is worth more than the same amount in the future because of its potential earning capacity, the risk of losing its purchasing power due to inflation, and other risks such as credit risk of the counterparty.
Many focus on the potential earning capacity of money in considering discount rate. The emerging thought is that a discount rate should reflect the risks related to the future cash flows. When considering discount rates for benefit obligations, there are also other views about what the benefit obligation reported in entities’ financial statements should represent.
Who is right?
Some believe that benefit obligation reported in financial statements should represent the money an entity needs to set aside to invest at the reporting date, to meet the benefit payments when due. Others believe that it should represent the money an entity needs to borrow to meet the benefit payments. There are also people that believe that it should represent how much an entity needs to settle its benefit obligation at the reporting date.
In their views, the respective discount rate that best reflects the time value of money in determining the benefit obligation would be:
- the investment returns of a given portfolio of assets
- the entity cost of borrowing
- the effective rate to settle the benefit obligation
What do you think?
You can participate in this debate and influence the Public Sector Accounting Board’s (PSAB) deliberations on this issue by responding to the Invitation to Comment, “Employment Benefits: Discount Rate Guidance in Section PS 3250,” by March 9, 2018. Also register for the webinar to learn about the key features of the Invitation to Comment from members of PSAB’s Employment Benefits Task Force.
Stay tuned for the following two related articles:
- “Employment Benefits Discount Rate: Anything wrong with expected return on plan assets?” (January 2018)
- “Employment Benefits Discount Rate: Any case for a current rate?” (February 2018)
Lydia P. So, MBA, CPA, CA
Principal, Public Sector Accounting Board