International Pension Funds and their Advisers
Articles
Accounting For Pension Costs
Ian Sykes
Director, KPMG
EU regulations require that the consolidated financial statements of companies publicly quoted within the EU are prepared in accordance with International Financial Reporting Standards for accounting periods beginning on or after 1 January 2005. Certain other non-EU countries, such as Australia, are also adopting IFRS from 2005. Yet more countries, such as Norway, Switzerland, Canada, China and Russia, are considering whether to adopt IFRS.
International Accounting Standard (IAS) 19 provides the framework for accounting for pension plan liabilities, or more precisely employee benefit arrangements. IAS 19 covers all benefit arrangements provided to employees, both short- and long-term and pre- and post-retirement with one exception: share-based payments, or stock options, which are covered by IFRS 2.
As would be expected, accounting for defined contribution plans is straightforward with the cost equal to contributions due for service during the accounting period. Accounting for defined benefit plans is more complicated as there is considerable uncertainty over the eventual cost to the company.
IAS 19 has much in common with the other principal pensions accounting standards, namely FAS 87 in the US and FRS 17 in the UK. In particular, assets and liabilities are measured at their fair value. For assets, this generally means market value and, for liabilities, this means discounting expected future payments by considering the return on high-quality corporate bonds.
This is a significant change for many countries. As examples,
- Italy historically accounted for its Trattamento di Fine Rapporto (TFR) termination indemnities by simply book reserving the total liability if all employees were to leave service immediately – simple but effective.
- Defined benefit schemes are very rare in Denmark so a simple cash approach has been used.
- The UK’s historic standard, SSAP 24, closely followed the approach used to externally pre-fund defined benefit pension schemes and typically made allowance in advance for expected equity out-performance. SSAP 24 has now been superseded by FRS 17.
IAS 19’s key difference from FAS 87 and FRS 17 is that the amount recognised on the balance sheet can differ significantly from the deficit in the pension fund. FRS 17 requires the deficit to be recognised in full and FAS 87 requires, as a minimum, that the deficit on a “discontinuance” basis is recognised. IAS 19 allows any gains and losses to be spread with no minimum balance sheet recognition requirement, although an FRS 17 style immediate recognition option was introduced in December 2004.
Initial adoption
Companies adopting IFRS have a number of decisions and investigations to make. Firstly, do they adopt IFRS for all companies within the group or just for listed entities, i.e. non-listed UK companies, including subsidiaries of listed companies, are able to retain UK Generally Accepted Accounting Principles (GAAP). This may have implications for pension accounting as the treatment of group-wide arrangements may differ between IAS 19 and local standards.
Secondly, IAS 19 may cover a greater number of arrangements than the current accounting standard, particularly if the current standard only covers pensions. Some of these additional arrangements may be immaterial but companies should obtain a complete benefit inventory to test this.
Thirdly, the default position for adoption of IAS 19 is to calculate the position as if IAS 19 had always applied. This is likely to be an onerous task as many years of historic information may be required and there may have been significant corporate transaction activity during that period. Recognising this, as an option the International Accounting Standards Board (IASB) has allowed an exemption under IFRS 1 (“First Time Adoption of IFRSs”) so that companies may recognise cumulative gains and losses, better known as surpluses or deficits, at the “date of transition”. The date of transition is the beginning of the comparative period, or 1 January 2004 for companies with a 31 December year-end.
Most companies appear to be choosing immediate recognition, most likely due to the potentially enormous work involved in retrospective adoption. But a number of companies are looking at the retrospective option, and it can make a staggering difference. A significant liability resulting from recent investment losses can be replaced by an asset if retrospection is applied.
Fourthly, what approach is used to recognise gains and losses going forward? Companies can choose to recognise gains and losses immediately and directly to equity via the Statement of Recognised gains and Losses (SORIE), or use the “10% corridor” to recognise actuarial gains and losses as for FAS 87. The 10% corridor ignores gains and losses up to 10% of the greater of the assets and liabilities and spreads recognition of the excess over the expected working lifetime of current employee members. This decision should be carefully considered as it will be difficult, or impossible, to revisit at a later date.
Group-wide arrangements
Within a corporate structure, recognising potentially large and volatile pension fund deficits may restrict payments up the group structure, for example dividend payments. IAS 19 allows, under certain circumstances, companies which participate in group-wide arrangements to account for the pension arrangement as if it were a defined contribution arrangement. This avoids the restriction on dividend payments within groups. Broadly, if the company does not have a policy for allocating any deficit to individual companies within the group, the sponsoring employer treats the pension fund as if it was solely responsible for the deficit and discloses fully under the requirements of IAS 19.
However, companies should bear in mind that there may be restrictions which override this “get-out clause”. In the UK, for example, company directors should consider the full deficit within a pension scheme when deciding on dividend distributions, not just the deficit recognised.
Anticipated market reactions
IAS 19 has been generally well received. Indeed, it is interesting that many UK companies are looking at adopting IAS 19 using the SORIE route, rather than spreading through the P&L, thus accepting the potential balance sheet volatility.
The underlying principles of IAS 19, i.e. fair value of assets and liabilities, are widely accepted as the standard pricing metric in corporate transactions. This acceptance is likely to increase further as the standard is fully implemented.
IAS 19 is also likely to affect pension funds’ investment strategies. Where companies invest heavily in equities, the sponsoring employer may increase holdings of corporate bonds to reduce balance sheet volatility. Although this has the unfortunate effect of reducing profits because of a serious flaw in all of the current pension standards – see below.
This additional visibility and, in many cases, increased cost of benefit arrangements under IAS 19 may cause companies to revisit benefits provided, typically with a view to cost reduction.
Other employee benefit arrangements
As mentioned earlier, IAS 19 covers all employee benefit arrangements, not just post-employment benefits arrangements.
Short-term benefit arrangements include wages, salaries, social security contributions, paid annual leave and paid sick leave, profit-sharing and bonuses, and non-monetary benefits such as medical care and cars for current employees. IAS 19 accepts that accounting for such benefits is generally straightforward and the cost of these benefits are recognised as the amount paid or due to be paid for service during that period.
Other long-term employee benefits include long-service leave, jubilee payments, long-term disability benefits and other arrangements where the payment is made more than twelve months after the end of the accounting period. There is typically less uncertainty over the measurement of these arrangements so, although the underlying asset and liability valuation is the same as for pension funds, all gains and losses are recognised immediately through the profit and loss account.
Problems with the standards
IAS 19 is a huge improvement over most current pensions accounting standards and brings consistency of measurement between territories. However, there are a number of areas where the standard is less than logical – below are a few examples, some undoubtedly controversial.
Discount rate assumption
IAS 19 requires that you should value the accrued benefits as if they were AA rated corporate bonds.
There are two problems with this. Firstly, if you are valuing a promise, you should use a risk free rate of interest – a gilt rate – not a rate which reflects the small but real possibility of default. After all, if you prepared the accounts consistently on this basis, there would be nothing to do – a company would be worth exactly what its capital was worth.
Secondly, AA is not a tightly defined term – there is a range of AA bond yields at most durations - in the UK, this range is currently around 0.5% - and when you apply this over the term of typical pension liabilities this gives you an enormous range. For example, at 31 December 2004, KPMG’s normal range for IAS 19 discount rates was 5.0% - 5.5%. The extremes of this range could increase liabilities for a typical UK scheme by more than 5% compared to the middle of the range.
Inflation assumption
Guidance on how to set the inflation assumption is unclear and there are at least two different approaches used, which can lead to answers differing by up to 0.5%, leading to similar spreads of liability valuations as for discount rates.
KPMG’s experience shows that companies are using quite a range of assumptions, leading to a large range of liability valuations. A significantly under funded scheme on the median basis could show a surplus on one of the more aggressive bases!
Expected return on assets
In the early 2000s, many companies would have recorded a significant credit to the profit and loss account based on expected returns yet were actually making significant losses. It might be more sensible if actual returns, which are known at the year end, were used instead.
Disclosures
Although generally comprehensive, a major omission from disclosures is the demographic assumption set, in particular the life expectancies used. Again using the UK as an example, the most up to date mortality tables can easily add 10% to the liabilities compared to assumptions that many companies are still using – it’s a key assumption and it ought to be disclosed to give readers of the accounts a complete picture.
Summary
Both IAS 19 and IFRS 2 will make employee benefit arrangements much more visible, both to management and shareholders, than was historically the case. For many companies, the impact on its accounts may be a significant increase to costs. Companies that have not yet analysed the impact should do so immediately.
