Welcome to our article series on Finance for Analysts, Managers, Directors, Board members and even Accountants!
Part 1
Before we talk theory and define terms and discuss types of benefits to employees, let us do some practical accounting!
You have just hired David, an employee, on 1 January 20X0 and to keep the example simple for now (we will add complexities as we go along) suppose he is the only employee that you allowed to participate in the company’s new retirement benefit scheme, which we will refer to as Scheme No. 1.
The scheme design is simple:
This arrangement is an example of a defined benefit plan: the employment contract defines the amount to be received. We also assume that Scheme No. 1 is unfunded, i.e., the company is not setting aside funds to be invested in order to accumulate the retirement benefit as per contract.
David is now aged 60 and will reach the statutory retirement age in five years’ time. For simplicity, we ignore the risk that David may leave the company before he reaches retirement age and assume with certainty that he will work at the firm for the next five years, i.e. until 31 December 20X4. This would allow him to claim a lump sum of €10,000 (5 x €2,000) on 31 December 20X4. This lump sum is over and above his normal annual salary of €24,000.
The following diagram displays the pattern of benefits which David is expected to receive both during employment and on retirement:
From David’s point of view, each year of work earns him the right to his annual salary as well as an additional €2,000 in benefits payable on retirement.
What is the Accounting problem then?
Well, management have to report the company’s performance every year (in fact every three months also) and one relevant statement they have to report to the shareholders is the Income Statement. You will remember from previous articles that the profit reported is basically the income generated minus the cost needed to generate this income. In the case of David there is a risk that management may report in year 20X0 just David’s salary, similarly in years 20X1, 20X2 and 20X3. In year 20X4 they will have to report not only his annual salary but also the €10,000 lump sum payment.
What would happen in such a scenario is that management would report higher profits in the years of David’s employment and lower profits in the very last year (or perhaps the year following the end of his employment).
The analyst’s perspective:
As an analyst if you follow this company, you will be seeing good performance in years 20X0, 20X1, 20X2 and 20X3, probably advise your client investors to buy shares in the company and suddenly in 20X4 performance is not what investors would expect! Profits will be lower by a huge percentage, i.e., instead of having a cost of 24,000 there is a cost of 34,000, i.e., about 40% higher costs.
When viewed from the employer’s perspective, scheme No 1 allowed the company to enjoy the benefits of David’s service in years 20X0, 20X1, 20X2 and 20X3 while deferring (postponing) part of the remuneration associated with that service until a future date.
You may remember from previous articles that the €10,000 payment on retirement relates to all the years 20X0, 20X1, 20X2, 20X3 and 20X4 irrespective of the timing of the payment. It would, then, be necessary for the recognition of the expense to be brought forward in time and be spread over those periods in which the company actually benefits from David’s work. In other words it is necessary to apply the Matching Concept which is fundamental in accounting and financial reporting as required by all Generally Accepted Accounting Practices (GAAP) like IFRS, US GAAP, UK GAAP etc.
So the Matching Concept tells us, effectively, that the cost of a resource consumed should be matched with the income that this resource generates and the matching should be in the same period.
Let’s apply this to our scenario: in the case of David, I cannot show in year 20X4 the €10,000 as cost because it is not relevant in that year. The resource (David’s services) was used in years 20X0, 20X1, 20X2, 20X3 and 20X4 and so it is relevant to those years. So the €10,000 should be spread over the years that service was provided and income was generated from this service.
Spreading the €10,000 expense across David’s period of employment would mean charging a relevant portion of the €10,000 to profit or loss in each of the years 20X0 – 20X4. Let us take a simple approach and spread the €10,000 linearly over the five years, i.e., let us spread it linearly, €2,000 each year.
We see now that the profit is affected evenly by the same amount each year, i.e., by 26k each year. If you are advising a client investor to buy shares in this company and the investor buys shares in 20X3, this investor will not have any surprises the following year! Performance will be
as expected (assuming all else is equal of course!).
So the Matching Concept is actually a tool that helps us apply economic reality to our financial reporting, i.e., to show what resources are being consumed in a given period, what income these resources generate in that same period and what profit or loss is achieved in that period. It is not significant when the money flows!
And what happens to the other side of the coin, i.e., the
Balance Sheet? Well, since you have a contract with David and David is performing his part of the contract, then for each year that David works for the company an obligation to pay €2,000 is created and it accumulates each year until it reaches the €10,000 at the end of year 20X4. What is actually happening is that the company is delaying or deferring the payment to David.
As we know, obligations are shown in the Balance Sheet as Liabilities and if they are expected to be paid after more than one year then they are shown as Non-Current Liabilities.
So two things are happening at the same time:
1) Due to the fact that we are consuming a resource (David’s services) we are showing this resource consumption as cost in the Income Statement. This way we are reporting properly the performance of the company.
2) Due to the fact that we are not paying David his full salary (i.e., we are deferring payment of the €2,000 per annum due to him, we will show this as a liability in the Balance Sheet. This way we show the proper financial position of the company. In fact, a Balance Sheet is also known as the Statement of Financial Position (S.o.F.P.)
So the matching concept ensures that prospective and current investors (users of the financial statements) are properly informed to help them make the right decisions.
Although appealing due to its simplicity, this approach ignores one fact which will be the subject of the next part of this article. If you have not guessed what this matter is here is a little hint:
Today you are making an agreement to pay €10,000 after five years. But when the time comes will these €10,000 be the same as €10,000 today? In other words, is the value of €1.00 the same as the value of €1.00 in five years’ time? Or to put it differently, if I owed you €1.00 and came to you to ask you to wait for another day to receive this €1.00, would you agree? And if you were a shareholder would you need to know what the value of these liabilities is given the conditions today? Should the readers of the financial statements be given a clearer picture of future liabilities?
In the meantime, please feel free to reach out to us and ask any questions you may have!
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