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Saturday, 20th April 2024 |
| FRS 17 and its impact on the bottom line |
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| Pension costs disclosures under FRS17 will no longer form part of the notes to companies’ financial statements for years commencing on or after 1 January 2005, but will directly impact the bottom line. Kathy Murphy discusses the impact of the reporting requirements on company’s finances. |
The FRS 17 standard requires a move to fair value accounting for pension costs reflecting international trends. It reduces flexibility in choosing assumptions and methods used to cost pension benefits and in this way attempts to improve comparability of reported costs between companies.
There has been much publicity about the issues FRS17 raises for companies with defined benefit pension plans:
• Volatility is one of the biggest headaches for financial directors. Just what is the size of the pension fund relative to that of the company? The asset or liability on the balance sheet directly impacts what a company is worth and recognising a large deficit on the balance sheet may reduce distributable reserves below the level required to cover an intended dividend payment.
• How important is a stable operating profit for the company. This is a key measure for analysts but redundancies or granting benefit improvements in the course of the year will have a significant effect on this figure over the previous year’s reported amount.
• Provision of continuing finance may be conditional upon meeting various financial covenants which may include the attainment of certain ratios e.g. debt to current/ total assets, interest cover and total net assets levels. FRS17 will impact these rations so it may be necessary to review existing covenants and revise or amend these as appropriate.
Likewise bonuses or incentive plans for employees are typically linked to the financial performance of the business and these may be impacted. Their design should be reviewed to ensure payouts are not spuriously inflated or reduced.
Arguably FRS17 is just making the financial risks and costs of defined benefit pensions more explicit. Is it a backward step if analysts and investors are increasingly wary of pension liabilities when assessing potential investment opportunities? So often pensions’ issues take a back seat in mergers and acquisitions, only to cause problems after the deal is done.
Forewarned is forearmed
Although assumptions must be set on the advice of an actuary, it is ultimately the responsibility of the company to determine the assumptions used when calculating the accounting costs. Active engagement with your advisers to gain an understanding of how the assumptions are derived and an appreciation for the sensitivity and impact of those assumptions on the amounts disclosed can aid financial directors in managing the impact of reported pension costs on the bottom line.
Yes, FRS17 is prescriptive, but there may be a range of appropriate assumptions that can be adopted (within the constraints of consistency and objectivity from year to year) depending on the circumstances of your particular plan. Hewitt has certainly had a lot of discussion with companies on the appropriateness of assumptions and their impact on the financials that are important to them. No one size fits all.
For example the discount rate must be set with reference to the yield on a high quality corporate bond of equivalent currency and term to the liabilities. High quality corporate bonds are those rated AA or higher. Emerging practice is to use the yield on an appropriate index of bonds. The standard however would allow adjustments to be made to yields on typical indices to extrapolate along the yield curve to more closely align the duration of bonds and the term of the liabilities. Auditors are allowing companies to use the upper quartile yield in an appropriate index; or particular high yielding bonds but it should be noted:
• Auditors will want to see an objective and consistent process for setting assumptions from year to year (and/or good reason for changing approach the following year);
• A particular approach taken one year may not be beneficial next year e.g. extrapolating along a rising yield curve which may be downward sloping the following year; and
• Particular bonds used to reference yields may not exist the following year.
• Salary increases are company specific and companies should ensure that an assumption appropriate to their circumstances has been made. This assumption is usually set with reference to the inflation assumption – this again could fall within a range which materially impacts the value of the pension liabilities and the reported balance sheet position.
Investment policy is one avenue being used by some companies to control volatility on the balance sheet. However it should be remembered that the pension scheme Trustees are ultimately responsible for the investment of the plan assets and their investment objectives and priorities may differ from those of the employer. Consultation with trustees is therefore important not only on this issue but also where the balance of power is in their favour in granting benefit improvements or exercising discretionary powers which could significantly increase pension costs.
Changes to the underlying pension arrangement may be another way to control the impact and the cost. However this may not always be possible (or even on the company agenda) if broader remuneration and human resource strategies are to succeed.
And if companies think they are just getting to grips with FRS17 – what about international financial reporting standards (IFRS) and IAS19? What will companies be implementing - FRS17 or IAS19? Recent EU regulations require all EU listed companies to apply IFRS to their consolidated accounts for financial years commencing on or after 1 January 2005.
For individual company accounts, unlisted groups or groups listed outside EU there is the option to apply local accounting standards (i.e. FRS17) or IFRS. Companies with the choice may adopt IFRS to avoid producing two sets of disclosures.
IAS19 means more decisions for directors at the time of implementation and on the approach to be taken in the future in recognising gains and losses and with the emergence of a greater appetite for consistent standards globally it seems the sands will continue to shift for a while to come.
At the end of the day materiality is what counts – it could be different for the balance sheet, the profit and loss account and the statement of recognised gains and losses. What’s important for you? |
Kathy Murphy is actuarial director at Hewitt.
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| Article appeared in the November 2005 issue.
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