In anticipation of the International Accounting Standards Board's latest exposure draft, Sebastian Cheek investigates the impact it will have on the pensions industry
Accountants, investment consultants, employers and pension schemes alike are waiting for the latest exposure draft on pensions accounting set out by the International Accounting Standards Board (IASB). The industry was originally promised this would be available at the end of last year but the IASB has deemed it necessary to do some finer tuning and it is now expected by the end of March.
The exposure draft will contain proposed changes to how pensions are reflected in company accounts under international accounting standard 19 (IAS19). At present companies can somewhat controversially choose when they recognise actuarial gains and losses in their accounts and can use ‘expected returns’ on assets rather than ‘actual returns’.
To this end, some companies have chosen to defer recognition of gains and losses enabling them to spread out the returns over a period of time so what is on their balance sheet does not necessarily equate to whether the scheme is in surplus or deficit.
The problem with expected return is that it is ‘expected’ – just because you expect something to happen it doesn’t mean it will
Perhaps understandably, the IASB is not a fan of this practice and is clamping down on immediate recognition in pension scheme accounting. Under the revised IAS19 all companies will have to immediately recognise gains and losses on their balance sheet in the period in which they occur. The option to defer them will no longer exist.
According to IASB senior project manager Ann McGeachin, under the current standard a company could in fact have a deficit in its pension plan but show full funding on its balance sheet because it has not immediately recognised its losses.
“There is no way we can expect people to understand this,” McGeachin added. “The point about immediate recognition is if you have a surplus you have an asset in your balance sheet and if you have a deficit you have a liability. It makes it much easier to follow.”
PricewaterhouseCoopers pensions partner Brian Peters agreed this equates to a “lack of comparability” between companies. “The problem with expected return is that it is ‘expected’ – just because you expect something to happen it doesn’t mean it will,” he said.
There is also an added unpredictability with this approach, as independent consultant Simon Banks acknowledged. “Expected return is subjective because return on equities is unpredictable. Two similar companies could be using quite different expected return assumptions and that could result in very different impacts on their profit and loss.”
About 80% of UK companies already recognise their gains and losses immediately but there are some large listed companies that do not. In fact, according to a report issued by Lane Clark & Peacock in August, Accounting for Pensions 2009, the corridor mechanism used by some companies to smooth out the pension amount recognised on the balance sheet is still in use by nine FTSE100 companies. Outside the UK it is more common for companies to defer recognition.
Profit and loss
The IASB is also calling for the interest on the surplus for the deficit to be recognised in profit and loss (P&L) and other items which come under actuarial gains and losses, such as re-measurements of the pension plan’s assets and liabilities, to be recognised under other comprehensive income (OCI).
Also, rather than look to the expected return on assets, a company will calculate interest using the discount rate in IAS19 on the net of the plan assets and liabilities. This, said the IASB, has the effect of replacing the expected rate of return with an amount calculated using the discount rates under IAS19.
This is a “more objective way of doing it,” said McGeachin, as sometimes expected rates of return have not happened.
PwC’s Peters said: “The P&L charge will be the interest on the deficit, which means most companies will have a higher pension cost and a reduction in their profit. It will increase the cost of pensions as measured in the P&L account.”
However, McGeachin believes users will be “generally supportive” of the measures as it gives a much more comparable and objective way of calculating this figure. “There has been a lot of abuse in the past of expected return and many people think it is discredited now,” she said.
One issue the IASB’s proposal of using immediate recognition throws up is that of the impact of volatility on asset values. Last year, most companies who held equities might have assumed they would return 7% or 8% during the year, but in practice returns in 2008 were negative and in 2009 were largely positive so the expected number does not relate to the reality of what is happening.
Banks observed there is typically a net credit because the expected return from the assets (predominantly in equities) is expected to be higher than the interest cost – which is based on bond yields – even when in deficit.
Hewitt Associates pension consultant Simon Robinson said using the ‘actual return’ on assets would make profits much more volatile. “If the actual return goes through the P&L you could suddenly get massive boosts to profits because companies have had 50% returns on pension portfolios in one year, followed by a massive hit in the next year if markets then fall,” he said.
Lane Clark & Peacock partner Colin Haines said the proposals will not fundamentally change the underlying value of the liabilities or the assets used for accounting purposes. “What it means is that the pension cost in profit and loss will be calculated differently and companies that still use the corridor will see changes to their balance sheet,” he said.
However, Haines observed one of the challenges for companies will be to carefully communicate the changes to their shareholders. “The changes in the way that company profits are calculated could impact some of the key business metrics used by analysts and investors to evaluate companies,” he said.
The IASB has made clear its intention of one day reaching an all-encompassing global accounting standard, and another issue being touted on the global accounting stage is convergence of standards with the US.
However, McGeachin said, despite a joint project on financial statement presentation in place, the IASB and US Generally Accepted Accounting Principles (GAAP) were not going to completely converge on pensions anytime soon. “Because we come from different starting points on the presentation and use of OCI, generally we are not going to end with the same answer,” she said.
Indeed, if the length of time it has taken for the changes to IAS19 to come into force is anything to go by then McGeachin is probably right to play down the likelihood of convergence happening in the near future.
As with all reforms, the IASB’s proposals to IAS19 are unlikely to sit well with all parties concerned, even though the general consensus is it will improve the transparency and comparability of accounts, making them less prone to subjective judgment and put an end to massaging by corporates to present themselves how they want.
All will hopefully become clear in March, when the exposure draft on disclosure is expected to be released. Following this, the IASB said it is expecting to publish the final amended standard in 2011 and it would be effective from January 1, 2013 at which point it will be mandatory. It also suggested it would allow early adoption of the standard for those who want to use it before 2013.
Bonds and liabilities
The IASB has also proposed changing the way schemes account for their liabilities by eliminating a risk free discount rate. Critics of the move have said changing the discount rate would fundamentally affect the value companies place on liabilities for accounting purposes, which would lower discount rates and significantly push up accounting liabilities. As a result, balance sheet deficits would go up as well and that could knock on to shareholder equity.
In August last year, the IASB issued a draft in relation to its proposal to eliminate the use of government bonds to determine discount rates.
IASB senior project manager Ann McGeachin said: “At the moment you use a high quality corporate bond rate if there is a deep market in your jurisdiction and if there is not a deep market you use a government bond rate. The difference between those rates was very wide at times which left some people in a jurisdiction without a deep market feeling disadvantaged as they were having to use a much lower discount rate.
“It seemed to make sense to have a consistent rate people should aim for. But when we got the responses back from the draft many people in jurisdictions without a deep market preferred to use a government bond rate because they could observe it easily and did not have the subjectivity and complexity of trying to estimate what a high quality corporate bond rate might be.
“So the board dropped those proposals and said it was not going to make any changes. We are leaving it as it is at the moment. We know we need to look at it and will do so as part of a fundamental review of pension liabilities but not at this stage. At the moment we are focusing on getting transparency in the numbers with the proposals for immediate recognition.”
Lane Clark & Peacock senior consultant Tim Marklew said using a “risk free” discount rate rather than a discount rate based on corporate bonds “would be a big step change for companies and could push up typical pension accounting liabilities in major countries by 15% to 30% in current conditions”.
Independent consultant Simon Banks added: “The choice of discount rate is largely prescribed and quite narrow, while the choice of expected rate of return is still pretty subjective. However, the expected rate of return on assets is likely to exceed the discount rate for most schemes, so even a scheme in deficit could be making a positive contribution to P&L under the current version of IAS19, if the difference in rates is big enough.”
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