Employers’ accounting for defined benefit plans — alternatives for applying discount rates to measure benefit cost
Financial Reporting Alert 15-3 (Revised)
In September 2015, the SEC staff met with representatives of the Big Four accounting firms and expressed its views on applying an alternative approach for using discount rates to measure the components of net periodic benefit cost for a defined benefit retirement plan obligation (e.g., a pension or other postretirement obligation) under ASC 715. Specifically, the alternative approach focuses on measuring the service cost and interest cost components of net periodic benefit cost by using individual spot rates derived from an acceptable high-quality corporate bond yield curve and matched with separate cash flows for each future year. The SEC staff responded to inquiries from the Big Four firms by stating that it would not object to registrants’ use of such an approach instead of the single weighted-average discount rate approach that is usually employed. The change in approach would not alter the measurement of the related benefit obligation as of the reporting date. The SEC staff also stated that it would not object if a registrant treats the change in approach as a change in accounting estimate. This alert provides further background on this topic and describes in greater detail some of the relevant considerations in connection with such a change.
The “Change in Approach to Determining Discount Rates” section of this Financial Reporting Alert has been revised to reflect comments made by the SEC staff at the 2015 AICPA Conference on Current SEC and PCAOB Developments.
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Traditional Aggregated Approach
In accounting for a defined benefit plan under U.S. GAAP, an entity measures the benefit obligation (i.e., the projected benefit obligation for pension plans or the accumulated postretirement benefit obligation for other postretirement plans) at the end of each annual period, or more often if a significant event requires a plan remeasurement as of an interim date. The benefit obligation represents the present value of the benefits that employees are entitled to in the future for services already rendered as of the measurement date. Conceptually, entities measure the present value of these future benefits by projecting benefit payment cash flows for each future period and discounting these cash flows back to the measurement date. Traditionally, entities have used an aggregated single discount rate — the single rate that, when applied to the benefit obligation cash flows, reproduces the present value of those same payments. The resulting single rate can be viewed as a weighted average of the yield curve spot rates that are used to measure that present value. This rate is aligned with the payment timing and associated participant demographics related to already-earned benefits as of the measurement date. Under this approach, the single weighted-average discount rate is used for all net periodic benefit cost calculations — including the measurement of the service cost and interest cost components. While the service cost is similar to the benefit obligation in that it is determined as of the measurement date, the interest cost is intended to accrete the benefit obligation and service cost amounts from the beginning to the end of the year.
The single weighted-average discount rate approach, also referred to in this alert as the aggregated approach, is a common and generally accepted approach used under ASC 715 to measure the service cost and interest cost components of net periodic benefit cost for defined benefit plans.
Alternative Spot Rate Approach
Recently, entities and their actuaries have developed alternative approaches under which the yield curve spot rates are applied in a more granular way. (For more information about such alternative approaches, see the August 2015 Issue Brief newsletter released by the American Academy of Actuaries.) The critical difference is that the single weighted-average discount rate is used to measure service cost and interest cost components under the aggregated approach, while duration-specific rates from the yield curve are applied to measure service cost and interest cost components under the disaggregated approach. Except in the uncommon economic environment of an inverted or downward-sloping yield curve, the aggregated approach generally produces a higher value for interest cost associated with the benefit obligation than would be developed when spot rates from the yield curve are “more precisely” applied to disaggregated cash flows. Although there are a number of possible alternative approaches that entities might consider using to apply discount rates to measure service cost and interest cost components on a more granular or disaggregated basis, the SEC staff gave its views on one specific alternative approach to measuring interest cost (referred to in this alert as the spot rate approach). Under the spot rate approach, an entity measures interest cost by applying duration-specific spot rates to the year-by-year projected benefit payments.
The amounts of service cost, interest cost, and actuarial gains and losses recognized under the spot rate approach would generally differ from those recognized under the aggregated approach. For example, in an upward-sloping yield curve environment, the spot rate approach would generally result in lower interest cost and higher actuarial loss (or lower actuarial gain) than the aggregated approach. Because the measurement of the benefit obligation as of each measurement date under the aggregated approach is the same as that under the spot rate approach, any change in the service cost or interest cost component would result in a different expected benefit obligation, which — compared with the remeasured benefit obligation (as of the next measurement date) — would give rise to an additional actuarial gain or loss so that the beginning-of-the-year benefit obligation is reconciled to the end-of-the-year benefit obligation. This actuarial gain or loss would be included with the other gains or losses and would then be recognized in net income in accordance with the entity’s accounting policy for recognizing actuarial gains and losses in earnings (i.e., either immediate recognition or some other acceptable method of amortization under ASC 715). Accordingly, a change to the spot rate approach for measuring service cost and interest cost and the resulting differences in service cost, interest cost and actuarial gains and losses could materially affect an entity’s financial statements as well as a registrant’s non-GAAP financial performance disclosures.
The SEC staff discussed two issues related to the spot rate approach with the Big Four accounting firms.
The first issue is whether it is acceptable to use the alternative spot rate approach to measure interest cost. The SEC staff limited the scope of its views on this topic to situations in which a registrant uses a yield curve approach (rather than bond-matching or another method) to determine its benefit obligation discount rates but has historically used the aggregated approach to determine interest cost and wants to change to the spot rate approach. The staff confirmed that it would not object to the use of the spot rate approach in such cases.
The second issue is whether a change to the spot rate approach should be accounted for as a change in accounting principle, a change in estimate, or a change in accounting estimate that is inseparable from the effect of a related change in accounting principle. The SEC staff indicated that it would not object to accounting for such a change as a change in estimate on the basis of the situation described in the first issue above. The staff acknowledged that registrants that adopt the spot rate approach are likely to justify the change in estimate as a better estimate than an estimate under the historical aggregated approach on the basis of their belief that the spot rate calculation of interest cost is a more precise measurement of interest cost because it is performed on a disaggregated basis. The staff stated that because the spot rate approach is believed to result in a better estimate than the aggregated approach, the staff would generally not expect a registrant to change back to the aggregated approach in future periods once it has switched to the spot rate approach. As with a change in estimate under ASC 250, a registrant that changes to the spot rate approach will be required to recognize the effects of the change prospectively. Although the spot rate approach is considered more precise, the staff will not require a registrant to adopt this new approach. Under ASC 715-30-35-45, it will continue to be acceptable to apply the traditional approach of using a single weighted-average discount rate to measure interest cost.
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