Accounting for the Labour Contract Law of the People's Republic of China

Introduction
On 29 June 2007, the Standing Committee of the National People's Congress adopted the Labour Contract Law of the People's Republic of China <中華人民共和國勞動合同法> (the "Law"). Among its objectives, the Law was formulated to improve the labour contract system and make explicit the rights and obligations of both parties of a labour contract (Article 1 of the Labour Contract Law). The Law became effective on 1 January 2008. 

The Law has introduced significant developments in various areas, namely the mandatory requirements of written employment contracts, the detailed regulation of probationary periods, the non-competition provisions, and the conditions to rescind and terminate employment contracts and provide compensation to employees. All these developments are expected to have financial impacts on enterprises and affect the way in which they are administered. The expanded employers' obligations to compensate employees on rescission and termination of employment contracts also have financial accounting impacts. The purpose of this article is to provide guidance on how to account for these employers' obligations under the Hong Kong Financial Reporting Standards and International Financial Reporting Standards.

Employer's obligation to compensate employees on the termination of an employment contract
There are seven circumstances under which the Law requires the employer to compensate an employee (Article 46 of the Law):

Does this compensation fall within the definition of "termination benefit" in accounting literature? 
The Law requires employers to compensate employees when one or more of the seven conditions prescribed in Article 46 of the Law apply. The paragraphs that follow analyse whether this compensation meets the definition of termination benefits or post-employment benefits in Hong Kong Accounting Standard or International Accounting Standard 19 (HKAS/IAS 19) Employee Benefits. 

HKAS and IAS 19 define "post-employment benefits" and "termination benefits" as follows:

Post-employment benefits
"Post-employment benefits are employee benefits (other than termination benefits) which are payable after the completion of employment."

Termination benefits
"Termination benefits are employee benefits payable as a result of either:

Sometimes the distinction between post-employment benefits and termination benefits is judgemental (see the analysis below of the compensation payable under (5)). Both types of benefits are payable when the employment relationship ceases. Post-employment benefits are paid for the past services of the employee. Subject to vesting requirements, the employee is entitled to receive the benefits regardless of the reason for his/her departure (HKAS/IAS 19.136). On the other hand, termination benefits are payable arising from a decision to cease the employment relationship. The employer can avoid the payment if it does not decide to terminate the employment relationship.

In our view, the compensation payable under (2), (3), (4) and (6) are termination benefits under HKAS and IAS 19. Under these circumstances, it is the employer's decision (voluntary or not) to terminate the employment relationship. These meet condition (a) of the definition of termination benefits (see above).

Under situation (1), it is the employee's decision to rescind the employment contract. Because of the contraventions as set in Article 38 of the Law, the employer is legally committed to compensate an employee if the employee chooses to be compensated instead of continuing the employment relationship. In our view, there is no difference of substance from condition (b) of the definition of termination benefits. 

The determination of compensation payable under (5) is less straightforward as compared with the other situations. Our interpretation of Article 44 item 1 of the Law is that if the entity offers the employee the same contract terms as the current one, it can avoid the compensation. Effectively, we would see that the Law has changed a fixed-term contract into an open-ended one. No compensation obligation would arise on the condition that the entity offers the employee the same or even better contract terms. If the entity offers new contract terms worse than those under the current contract, we would regard this as, in substance, a voluntary redundancy offer. The compensation payable would therefore be treated as termination benefits for accounting purpose.

Recognition of termination benefits
An entity should recognise termination benefits as a liability and expense when and only when, the entity is demonstrably committed to either:

In making a judgement as to when to recognise termination benefits, due care should be paid to the accounting meaning of "demonstrably committed to" and the interpretation of the Law.

Under HKAS/IAS 19, an entity is demonstrably committed to a termination when, and only when, the entity has a detailed formal plan for the termination and is without realistic possibility of withdrawal. The detailed plan should include, as a minimum:

  
In any case, an entity should recognise termination benefits either when it is demonstrably committed to a termination or when it is legally obligated, whichever is the earlier.

In some cases, the judgement is straightforward and the entity is demonstrably committed to a termination in the accounting sense at the same time as the entity has the legal obligation. For example under (2), the employer should recognise the termination benefits when mutual agreement with the employee is reached. In other cases such as the mass lay-off under Article 44 of the Law, the entity may be demonstrably committed to a termination under HKAS/IAS 19 before or after its obligation under Article 44 of the Law is established. 

Entities should note that the legal interpretation of facts is critical in assessing if there is any obligation to be recognised and if so, at what point it should be recognised. Legal advice should be obtained if there is any doubt. One example is the failure to renew fixed term contracts under item 1 of Article 44. If an entity offers an employee a contract with terms different from those of the current one and the employee decides not to accept the new contract, the Law requires the entity to compensate the employee if the new contract terms are worse than the current contract. Whether a contract of different terms is better or worse than the current contract could be judgemental and subjective. 

Measuring compensation
Article 47 of the Law contains the rules on measuring the amount of compensation. Where the compensation is due for settlement in more than 12 months from the balance sheet date, HKAS/IAS 19 requires the entity to discount the amount at a rate that reflects the market yields on the balance sheet on high quality corporate bonds or government bonds, as appropriate.

Fanny Hsiang Professional Practice fanny.hsiang@gthk.com.hk