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Radical change to pensions accounting loom for finance directors in FRED20 Back  
Accounting for the cost of defined benefit pension schemes will mean that balance sheets will be more volatile, writes Philip Shier, but actuarial judgement will still be required in the critical area of the choice of expected return.
In November 1999, the Accounting Standards Board (ASB) produced its long awaited Financial Reporting Exposure Draft on accounting for retirement benefits in company accounts (FRED20). This is radically different from the existing standard, SSAP24 and will lead to much greater volatility in companies’ balance sheets and, to a lesser extent, in their profit and loss accounts. The consultation period for the exposure draft has now ended, and the ASB is considering the comments received. The expectation is that a new standard will be issued later this year. The standard will apply to companies registered in the UK or in the Republic of Ireland apart from companies which use the Financial Reporting Standard for Smaller Companies who will be exempt. The standard will cover all retirement benefits, including for example post retirement medical plans, but in this article I concentrate on the cost of defined benefit pension schemes.

More prescriptive approach

Under SSAP24, there is flexibility to choose the actuarial valuation method and assumptions used to quantify pension costs, and the disclosures required are not tightly prescribed. Furthermore, the extent to which smoothing and spreading of costs is permitted under SSAP24 makes it difficult, if not impossible, to identify the true cost of pensions being provided by the company for its employees. FRED20 addresses these issues by setting out a more prescriptive approach to calculation of pension costs, requiring more detailed disclosure and, most controversially, requiring immediate recognition of gains and losses and the cost of any improvements to benefits. FRED 20 is also more consistent with international standards following the recent revision of the International Accounting Standard IAS19.

The ASB identifies the two key principles of FRED20 to be
• Measurement of scheme assets and liabilities at fair value; and
• Immediate recognition of gains and losses but in the Statement of Recognised Gains and Losses (‘STRGL’) rather than in the profit & loss account (‘P&L’).
The main changes proposed in FRED20 are set out in the accompanying box.

FRED20 in practice

The responses received by the ASB to the consultation process may lead to some changes before the new standard is adopted. However, it is unlikely that there will be any significant change in the thrust of the proposals, and it is clear that the new standard will lead to significantly increased volatility, particularly in the balance sheet and STRGL.

This is because FRED20 requires the use of market values in valuing assets, and market yields for valuing liabilities, rather than the smoothed approach used under SSAP24. Furthermore, the difference between assets and liabilities (surplus or deficit) will be shown in full in the balance sheet as at the end of the accounting period rather than being amortised over a long period. Although it is proposed that the pension asset or deficit be separately identified in the balance sheet so that analysts and shareholders can understand the impact of the pension scheme on the company balance sheet, it remains to be seen how well this will be understood in practice.

Under FRED20, the pension scheme surplus is recognised in the balance sheet as a company asset, though the amount is restricted to that “recoverable by the company” which is defined as the present value of an indefinite contribution holiday or any agreed refund to the employer.

Accordingly, if the company wishes to grant an improvement to accrued benefits (e.g. a discretionary increase to pensions in payment for which no advance provision has been made), the full capital cost of this improvement will be shown as a cost in the P&L account in the year in which it is granted, unless part or all of the cost can be covered by surplus which is not recoverable by the company. This emphasises the fact that an improvement to the benefits granted under a pension scheme is an additional cost to the company, notwithstanding the fact that there may be sufficient surplus in the pension scheme to meet the additional liability. It is possible that this requirement will lead to a reduction in the incidence of discretionary benefit improvements.

The Society of Actuaries in Ireland in its submission to the ASB has suggested an alternative approach of recognising the cost of benefit improvements (to the extent that they are covered by experience surplus) in the STRGL for consistency with the recognition of surplus.

Expected rate of return

FRED20 adopts a prescriptive approach to the determination of pension liabilities However, the choice of the expected rate of return, a key determinant of the P&L cost, remains a matter for actuarial judgement. If the actuary takes an optimistic view of future returns, the P&L charge will be reduced, and any resulting experience loss will flow through the STRGL, rather than the P&L account. The finance director may, therefore, wish the actuary to take an optimistic view. Since the rate of return assumed must be disclosed, a reader of the accounts can form his or her own view of the extent to which an over-optimistic view was taken.

If the new accounting standard follows FRED20, there will be substantially greater transparency in the disclosure of defined benefit pension costs in company accounts, and increased volatility, particularly in the balance sheet. Analysts will be able to form a more accurate view of a company's ongoing pension costs provided that they focus on the relevant figures, rather than the (possibly large) pension items in the balance sheet and the STRGL. Discretionary benefit improvements may be less frequent. There may also be an acceleration of the trend to defined contribution pension schemes to ensure stability in pension costs in company accounts.

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