Saudi Arabia - Part Two: IFRS Implementation
December 2017, the Kingdom was soon set to join 130+ countries across the world in the application of International Financial Reporting Standards (“IFRS”). Up until this moment, Saudi operated a unique national accounting practice under local GAAP and Sharia law. It was recognized that, in the era of globalization of businesses and markets with growing international shareholding and trade, financial information prepared and audited according to national accounting standards no longer satisfied the needs of users whose decisions were more international in scope.
In this second article of the Saudi Arabia Series, we will address the impact of the transition from local accounting standards to IFRS, with particular emphasis on disclosure of Employee Benefit liabilities.
Acknowledging that IFRS is designed as a common global language for business affairs, the Saudi Organization for Certified Public Accountants (“SOCPA”) approved an IFRS convergence plan called the “SOCPA Project for Transition to International & Auditing Standards”. Under this plan all companies were required to adopt IFRS for financial periods beginning on or after 1st January 2018.
IFRS reporting is significantly more onerous than Saudi GAAP, in that its application necessitates additional disclosures. However, with additional disclosure comes greater transparency, which results in more informed users of financial statements and improved decision making. With companies applying the same accounting standard from 2018, proper assessments can now be made on the relative financial strengths of various organisations. This is especially important for companies that are listed on the Saudi Arabian Stock Exchange (“Tadawul”) or those involved in M&A activities.
The view that implementation of IFRS improves quality of financial information was critical to its adoption. Companies that did not consider the application of IFRS as beneficial to their business, inevitably faced greater challenges in complying. Admittedly, SMEs were slow to align their accounting standards with IFRS because the benefits to them were not immediate.
Impact on Employee Benefits
Since the implementation of IFRS in 2018, End of Service Benefits (“EOSB”), which are cash lump-sum, termination payments and one of the few long-term post-employment benefits in the region, have needed to be properly accounted for in conformity with IFRS. The specific accounting standard under IFRS is IAS 19, which outlines how to calculate:
- Employee Benefit (“EB”) costs that should be recorded as expenditure in the P&L account, and
- the liabilities, referred to as “defined benefit obligations”, that should be shown on the Balance Sheet.
EOSB Scheme Rules in Saudi
The EOSB paid by a company, in the event of an employee’s termination, retirement or death, is as per Article 84/85 of Saudi Labour Law, which is 15 days’ Scheme Salary for each of the first five years of service and 30 days’ Scheme Salary for each year thereafter. Partial years count towards a period of service and Scheme Salary is defined as “the last basic pay”.
In the case of the resignation of an employee, he/she is entitled to the following benefit:
NUMBER OF YEARS’ SERVICE
FRACTION OF FULL BENEFIT
Less than 2 years
Between 2 years and 5 years
Between 5 years and 10 years
Ten or more years
No EOSB are payable to any employee who is dismissed/terminated from service for misconduct, disobedience or violation of any existing rules and regulations of the company.
Described above are the statutory minimum benefits that are required to be paid. For many KSA companies their EOSB Scheme Rules are identical to the Law. However, for a small minority of companies, their Rules are slightly more generous, e.g. in relation to the definition of Scheme Salary and/or in allowing for Advance Payments to be made against accrued EOSB.
IFRS Implementation – Initial Challenges
The calculation methodology prescribed under IAS 19 (“the actuarial method” or “future cash-flow projection method”) differs to the method that companies use internally to make provision for their EB liabilities and enter into their books of accounts (“the accrued method” or “formulaic method”).
The actuarial liability is computed using the projected unit credit method, which encapsulates the timing of future cashflow and the probability of payment at future dates. In contrast, the accrued liability is computed using a simpler method, wherein the computation simply determines the liability that employees have accrued to date.
Accordingly, when companies first adopted IAS 19 under IFRS it was found that, in a number of cases, there was a difference between the two liability amounts. Such a mis-match needed to be explained to the companies’ Finance teams and C-Suite personnel. This was a role that, by default, was jointly taken on by the audit and actuarial profession. For some companies, the difference was so significant that their Balance Sheets were severely hit. They also found that the provision booked was woefully inadequate, leading to a cash-flow risk.
IAS 19 vs Formulaic Method of Accruing Provision
The provisions of IAS 19 require a determination as to whether an employee’s service in later years will lead to materially higher benefit than in earlier years. This refers to benefits that do not accrue uniformly over an employee’s service. The EOSB under Saudi Labour Law gives materially higher benefit to the later years (starting from the 6th year of service) where the benefit is 2 (30/15) times the benefit accrued over the first five years of service (see EOSB Scheme Rules above).
Thus, Paragraph BC 114 (a) of IAS 19 becomes applicable, which requires the liability to be apportioned under a straight-line method, resulting in a higher liability than the straight-forward formulaic method of accruing provision.
Under the accrued method, for the first five years of service an employee accrues half a month’s salary for each year of service and thereafter one-month’s salary. In contrast to this, when conducting an actuarial valuation under IAS 19, the expected present value of the liability payable to an employee on termination is estimated, using the expected cash-flow method and the expected years of total service, accounting for the probability that the employee will leave (attrition) prior to Normal Retirement Age (“NRA”). The expected present value of the lifetime liability is divided by expected years of service to arrive at the cost of service for each year. Then the cost of service for each year is multiplied by the years of service an employee has served up to the valuation date to obtain his/her liability as on the valuation date. Due to this, under the IAS 19 method, the first five years of service bear a higher and disproportionate cost, when compared to the later years of service.
To explain this further with a simple example, assume an employee aged 32 has served the company for 2 years as at 31 December 2020 (valuation date) and is expected to continue in service for 9 more years (reduced due to the attrition assumption rather than remain in employment to NRA).
Under the formulaic method, the accrued liability will be equivalent to one-month’s salary (2 years of service*0.5) = 1 month’s salary.
Under IAS 19, the actuarial liability will be as follows:
Total Expected Period of Service: 2+9 = 11 years
Total Lifetime Liability: (5*0.5) + (1*(11-5)) = 8.5 months’ salary
Per Year Service Cost: 8.5/11 = 0.7727 month’s salary
Actuarial Liability as at 31 December 2020 = 0.7727*2 (period of service up to the valuation date) = 1.54 month’s salary
Thus, under the formulaic method, an employee will accrue one-month’s salary whilst, for the same employee, IAS 19 requires 1.54 month’s salary to be accrued as at the same valuation date.
This example has been provided simply to help explain the concept and illustrate the fact that, in a number of cases, companies experienced a significant increase in their EB liabilities in the first year of IFRS implementation due to adoption of a different methodology.
For companies adopting IFRS for the first time in 2018, they needed to understand that their opening balance of the EOSB liability had to be restated, in order to match with the liability computed by the appointed actuary. To add to the complexity of the treatment, the difference between the actuarial computed liability and the company’s accrued liability, needed to be accounted for under “Past Service Cost” or “Past Service Gain” (depending on whether the difference between the actuarial liability and accrued liability was positive or negative) and recognised in the P&L. Communicating this fact was clearly a challenge faced by the appointed external actuaries and auditors.
Initially, the transition from local market practice to IFRS typically led to increased liabilities, including EB liabilities, thereby negatively impacting on Balance Sheets and P&L statements in some cases.
However, the adoption of IFRS has been viewed as an important milestone in the country’s future economic development. Increased foreign direct investment and enhanced quality reporting, transparency and comparability are some of the key benefits that the Kingdom has enjoyed from implementation of IFRS.
In the next part of the Series of Saudi Articles, we will look at IFRS from a purely actuarial perspective and consider the various assumptions that need to be set as part of conducting an IFRS actuarial valuation.