by Tom Clendon

The accounting by employers for the pension costs of their employees has recently changed following the revision by the International Accounting Standards Committee of IAS 19 (revised 1998) Employee Benefits and the issue in November 2000 by the Accounting Standards Board of the UK of FRS 17 ‘Retirement Benefits’, to supersede SSAP 24 ‘Accounting for Pension Costs’. In this article where there are no differences between them I will refer to IAS 19 (revised 1998) ‘Employee Benefits’ and FRS 17 ‘Retirement Benefits’ collectively as ‘the new standards’. The two new standards are substantially the same and both represent a radical change from past accounting practice. The new standards address the accounting for the payments that the company and/or employer makes to the pension fund and the resulting assets and liabilities that may arise in the company’s financial statements.

Defined contribution schemes (money purchase schemes)
This is a relatively simple type of scheme to account for and under the new accounting standards the accounting treatment has not changed.

Under a defined contribution scheme the employer will contract to pay a certain contribution to an employee’s pension fund, e.g. 5% of the annual salary. The amount the employee will ultimately receive as a pension will depend on the investment performance of the fund assets. The employer has no on-going liability. The cost to be charged in the profit and loss account is just the contributions payable.

We can reflect that this is a sensible, uncontroversial accounting treatment which is in accordance with the matching concept. The cost of providing the pension is clearly being charged during the employee’s working life, which is when they are giving the benefit to their employer. Pensions are deferred remuneration.

Defined benefit schemes (final salary schemes)
For accounting purposes the other type of pension scheme is the defined benefit scheme. These schemes are potentially complicated to operate and to account for. The remainder of the article is concerned with funded defined benefit schemes (a funded scheme is one where the employer actually makes a cash contribution to a separate fund. The vast majority of company pension schemes are funded.)

Under a defined benefit scheme the employer will contract to finance a pension of a certain amount. Whilst the exact terms will vary from scheme to scheme an example of the way a defined benefit can be expressed is 2/3 of the employee’s final salary multiplied by say the number of years service divided by 40 years. Accordingly the higher paid the employee is on retirement and the longer the length of service the greater the employee’s pension entitlement and thus the liability on the pension fund. An actuary will have to advise the employer of the cash contribution required to be made. This is a complicated estimate, as for example, the salary levels when employees retire and future investment returns will be uncertain.

With defined benefit schemes the employer has an opened ended liability to make additional contributions should there be a deficit in the pension fund. A deficit may arise for example if salary levels rise greater than expected or the fund assets under-perform. It will be necessary for the actuary to regularly revalue the pension fund’s assets and liabilities to estimate if it is in deficit (the employer will have to make good the shortfall), or in surplus (the employer can reduce future contributions, take a contributions holiday or even receive a refund).

The previous accounting treatment for defined benefit schemes
The new accounting standards have been introduced to remedy the problems of the previous accounting treatment. It is, therefore, relevant to consider briefly how defined benefit schemes were accounted for prior to the new standards.

The previous accounting treatment was very profit and loss account orientated. It required that the profit and loss charge was calculated first and would basically comprise:

• the regular cost, this is the consistent on-going cost as advised by the actuary normally a percentage of the pensionable payroll which is paid to fund every period; and,
• any variations from regular cost arising from fund surpluses and deficits – the increase or decrease in contributions payable were generally not recognised in the profit and loss account as they occurred but were spread forward over the average remaining service lives of the current employees.

The balance sheet figure was left as a mere balancing figure, being the difference between the amount paid and the amount written off to the profit and loss account.

Solution to Big Brother Company
Profit and loss account
The annual profit and loss charge for pensions will be:

Regular cost	10
Plus a deficit of £/$2 being a deficit of £/$30 spread forward over the 15 years average remaining service lives of employees in the scheme.	2
Total	12

Cash flow statement
The annual cash payments will not be the same as the expense written off to the profit and loss account because in cash terms the deficit is made good in a shorter period. The cash flow statement will include the actual cash payments as follows:

Balance Sheet
Left as a balancing figure, there will be prepayments on the balance sheet. This is because in the first year the cash contribution paid was £/$22 but the profit and loss expense was only £/$12. Prepaid expenses appear as assets on the balance sheet.

Year	Cash paid minus the expense plus the balance bought forward		Prepaid asset on the balance sheet (a cumulative figure)
1	(22 – 12)	=	10
2	(18 – 12) + 10	=	16
3	(20 – 12) + 16	=	24
4	(10 – 12) + 24	=	22
5	(10 – 12) + 22	=	20

Each year thereafter the prepayment will reduce by £/$2, so that in ten years’ time at Year 15 it will be zero.

Problems with the previous accounting treatment for pensions
The main reasons for the introduction of the new standards stem from problems with the previous accounting treatment for defined benefit schemes.

1. Profit and loss approach
The previous accounting treatment for defined benefit schemes was profit and loss account orientated and this is inconsistent with the approach adopted by the conceptual frameworks (the statement of principles for financial reporting and the framework for the preparation and presentation of financial statements) which have a balance sheet orientation. Accordingly, the previous accounting treatment was becoming more out of line with new accounting standards being issued which are based on the conceptual frameworks.

2. Off balance sheet liabilities
The previous accounting treatment for defined benefit schemes resulted in off balance sheet liabilities or assets when the scheme was in deficit or in surplus. Consider, for example, the position of Big Brother Company at the end of the first year. Of the original deficit of £/$30, identified by the actuary, only an additional £/$12 contribution was made, leaving a remaining deficit of £/$18. Big Brother Company has an obligation to make good this deficit i.e. an obligation to transfer economic benefits as a result of past transactions and events. However, under the previous accounting treatment, the balance sheet does not reflect this liability at all indeed, in fact Big Brother Company shows an asset at the end of the first year of £/$10!

3. Flexibility
There were too many options available to the preparers of financial statements, and to the actuary in valuing the pension fund assets and liabilities. This inevitably leads to a reduction in comparability between financial statements, thus reducing the usefulness of the accounts. Let us consider just one example where companies were allowed a choice.

In determining the deficit or surplus on the pension fund, the actuary will have to arrive at a value for the pension fund assets and the pension fund liabilities. If the pension fund assets exceed the liabilities, then the fund is in surplus whereas where the pension fund liabilities exceed the fund assets, then the fund is in deficit. The majority of pension fund assets are typically minority holdings in quoted company shares. There are different ways of valuing such assets. For example, the simplest approach would be to use the market value. This has the advantage of being objective, but it should be noted, takes a short term view of the share’s value, and has the potential for volatility. Another approach would be to value the shares using an actuarial method e.g. the dividend valuation model i.e. the capitalisation of the future dividend stream. This method has the advantage of taking a long term view, but it should be noted is subjective.

Because of the subjectivity of the dividend valuation model there is a possibility that some companies “opinion shop”, e.g. where actuarial advice initially shows a large deficit the company could obtain a second valuation using different methods to achieve a more favourable result.

4. Inadequate disclosures
Previously, the disclosure requirements did not necessarily ensure that the pension costs and the related amounts in the balance sheet were adequately explained to users.

5. International harmonisation
Finally, from a UK perspective, with the revision of IAS 19, (revised 1998) and the US accounting standard FAS 87 which basically adopts the same approach, the UK accounting treatment was increasingly out of line with international accounting practice. There are of course, considerable advantages to the increasing international harmonisation of financial reporting standards.

The objective of the new standards
The objective of the new standards is to ensure that:

• the financial statements reflect at fair value, the assets and liabilities arising from an employer’s retirement benefit obligations and any related funding; and
• the operating costs of providing retirement benefits to employees are recognised in the accounting periods in which the benefits are earned by employees, and the related finance costs are recognised in the accounting periods in which they arise; and
• the financial statements contain adequate disclosure of the costs of providing retirement benefits and the related gains, losses, assets and liabilities.

The requirements of the new standards
The new standards have been developed in accordance with a conceptual framework and follow the balance sheet approach with its emphasis on assets and liabilities which is consistent with other new accounting standards.

Accordingly, when there is a deficit/surplus on a defined benefit scheme a liability/asset is recognised on the balance sheet. A liability is recognised to the extent that the deficit reflects the employer’s obligation. An asset is recognised to the extent that an employer can recover a surplus through reduced contributions and refunds.

The new standards provide firm rules concerning the valuing of pension fund assets and liabilities. Assets should be measured at their fair value. For quoted securities, this means the mid-market value. Liabilities should be measured on an actuarial basis, using the projected unit method. The projected unit method is an accrued benefits valuation method in which the scheme’s liabilities make allowance for projected earnings. The defined benefits scheme liabilities should be discounted at a rate that reflects the time value of money, for example, at a AA corporate bond rate.

Full actuarial valuations should be obtained at intervals not exceeding three years and should be updated at each balance sheet date (see Table 1).

Accounting treatment of experience deficits and surpluses: a major difference between IAS 19 and FRS 17
The only major difference between IAS 19 ‘Employee Benefits’ (revised 1998), and FRS 17 ‘Retirement Benefits’, is over the recognition of actuarial gains and losses. Actuarial gains and losses are changes in actuarial deficits or surpluses that arise because events have not coincided with the actuarial assumptions made for the last valuation (experience gains and losses) or the actuarial assumptions have changed. For example if the actuary forecast that investment returns were going to be say 8% in a year, but in fact the return on investments actually achieved was only 5%, this would give rise to an actuarial deficit.

FRS 17 requires actuarial gains and losses to be recognised immediately they occur, in the statement of total recognised gains and losses i.e. they are taken directly to reserves.

However IASs do not have a statement of total recognised gains and losses. IAS 19 (revised 1998) requires actuarial gains and losses to be recognised in the profit and loss account to the extent that they exceed 10% of the gross assets or gross liabilities in the scheme. Recognition of actuarial gains and losses within the 10% corridor is allowed but not required. Recognition of actuarial gains and losses exceeding the 10% corridor may be spread forward over the expected average remaining working lives of the employees participating in the scheme. The practical effect of this is that where the actuarial gain or surplus is less than the 10% corridor (which is likely unless there have been major fluctuations in the value of shares) they are shown on the balance sheet, netted off against the pension fund assets and liabilities.

Example of the new accounting treatment for defined benefit schemes
Castaway Company operates a defined benefit pension scheme on behalf of its employees. The company operates an annual review of funding in conjunction with their actuaries who have supplied the following information:

	At 31 Dec 2000 £/$	At 31 Dec 2000 £/$
Present value of pension fund obligations	1,000	1,200
Market value of pension fund assets	1,000	1,150

To advise the company the actuary has made the following assumptions:

Expected return on plan assets	8%
Discount rate used to determine pension fund liabilities	12%
Current service cost	£/$100
Contributions to the Pension Fund of	£/$140
Benefits paid out amounted to	£/$95

Required
Illustrate how with the new standards Castaway Company would account its pension costs.

Solution to Castaway Company

Balance sheet extract
First let us prepare the balance sheet extract showing the company’s liability to make good the deficit on the pension fund

	£/$
Pension Fund Assets	1,150
Pension Fund Liabilities	1,200
Net Pension Liability	(50)

Profit and loss account extract
Then let us prepare the extracts from the profit and loss account:

* these are DRs in the P&L, with the double entries as CRs to the pension fund liability i.e. to increase the liability.
** this is a CR in the P&L, with a double entry as a DR to the pension fund assets i.e. to increase the asset.

Now we have to determine the experience deficit and surplus on the fund assets and liabilities. This can be achieved by preparing the following disclosure note to determine the experience surpluses or deficits as balancing figures.

	Pension Fund Assets £/$	Pension Fund Liabilities £/$
Opening balance	1,000	1,000
Interest		120
Current service cost		100
Expected return	80
Contributions to the pension fund	140
Benefits paid out	(95)	(95)
Surplus (balancing figure)	25
Deficit (balancing figure)		75
Closing balance	1,150	1,200

There is a net actuarial deficit of £/$50

FRS 17 requires the net actuarial deficit to be recognised in the statement of total recognised gains and losses.

Extract from the statement of total recognised gains and losses.

	£/$
Experience deficit arising on the scheme liabilities	(75)
Actual return less the expected return on the pension scheme assets	25

This will give rise to a separate pension reserve with a DR bal (negative) of £/$50.

IAS 19 (revised 1998) however requires the net actuarial deficit to be taken to the balance sheet as it falls within the 10% corridor test. The net deficit of £/$50 is well within £/$120 being 10% of £/$1,200 of the gross liabilities in the scheme. As a result the net deficit (a DR) is taken to the balance sheet the extract of which is redrafted as follows.

Extract from the revised balance sheet

	£/$
Pension Fund Assets	1,150
Pension Fund Liabilities	1,200
Net Pension Liability	(50)
Plus the net actuarial deficit	50
	nil

The net deficit is a DR (and hence a plus on the net assets side of the balance sheet) because it represents an unrealised loss.

General comments
I think the new standards are to be welcomed for bringing a greater consistency and transparency into the way that pension costs will be accounted for by companies. One reservation that I have is the use of the fair value/market value approach towards valuing quoted company shares held as assets in pension funds. This does rather assume that a short term approach is being taken towards holding the shares. Pension funds are long term investors, so the dividend valuation model is a better method of reflecting the shares value in these circumstances. A short term approach has therefore been adopted for a long term problem. The reason that the new standards have adopted a market based approach to the valuation of assets is on the grounds of objectivity.

Specifically in respect of FRS 17, there is also the criticism that all figures in the profit and loss account are actually estimates, but the correction to those estimates goes to reserves via the statement of total recognised gains and losses. Thus there is a lack of accountability and an inconsistency with, say, the depreciation of fixed assets. Depreciation is also an estimate recognised as an expense in the profit and loss account, but where it has been underestimated the loss that will arise on disposal is also recognised in the profit and loss account and not “swept under the carpet” in reserves. However, following the recent issue of FRED 22 ‘Revision of FRS 3 Reporting Financial Performance’, it appears to be the intention of the ASB to combine the profit and loss account and the statement of total recognised gains and losses into a single income statement. This new statement of financial performance would then include all recognised gains and losses.

Specifically in respect of IAS 19 (revised 1998), there is also criticism of the accounting treatment of the experience deficits and surpluses arising with defined benefit schemes. The 10% corridor is an arbitrary measure and it is without conceptual justification to take an unrealised gain or loss and to report it next to assets and liabilities on the balance sheet.

Sir David Tweedie’s comments on the introduction of FRS 17 ‘Retirement Benefits’
Sir David Tweedie (who was the Chairman of the ASB when FRS 17 was issued) has gone on record as saying:

“SSAP 24 has lost all credibility. We are replacing it with an approach that is consistent with international standards in the measurement of the pension scheme surplus or deficit and takes a step forward on immediate recognition. This is what I suspect IASC would have liked to do if it had had longer to develop its standard. The result of the proposals will be pension figures in accounts that do not disguise the significant yet uncertain influences that a pension scheme may have on a company.

“For the first time a company’s pension surplus or deficit will be shown on the balance sheet rather than being represented by a number bearing no relation to reality and which is difficult, if not impossible, for the analyst to unpick as a starting point for any serious evaluation of the financial position. No-one pretends that final pay pensions are easy to represent in accounts. But understanding is not eased by locking all the numbers in a black box and then losing the key.”

The ASB has granted a long implementation period for UK companies to adapt to FRS 17 and for the ASB to gauge whether there are any insurmountable difficulties. Because of its complications FRS 17 will not come fully into force until June 2003 (but early adoption is encouraged).

Some companies are said to fear that shareholders will get worried over potential fluctuations in the balance sheet, but Sir David Tweedie has robustly argued: “Is it best to keep shareholders in the dark? An accountant’s job is to show what the figures are. The management’s job is to explain the figures.”
However, in my opinion the examiner expects you to be able prepare the extracts from the accounts and to explain them.

The accounting for pensions is undoubtedly a complex issue but I hope that this article will have helped you.

Summary of the main disclosures for defined benefit schemes required by FRS 17 ‘Retirement Benefits’

• The main assumptions underlying the scheme: including, the inflation assumption, the rate of increase in salaries, the rate of increase for pensions in payment, and the rate used to discount scheme liabilities.
• An analysis of the assets in the scheme into broad classes and the expected rate of return on each class.
• An analysis of the amounts included within operating profit, finance costs, and the statement of total recognised gains and losses.
• A five year history of the difference between the expected and actual return on assets, the experienced gains and losses arising on the scheme liabilities and the total actuarial gain or loss.
• An analysis of the movement in the surplus or deficit, in the scheme over the period and a reconciliation of the surplus/deficit to the balance sheet asset/liability.

Summary of the main requirements of FRS 17 ‘Retirement Benefits’

• Pension scheme assets are measured using market values
• Pension scheme liabilities are measured using a projected unit method and discounted at an AA corporate bond rate
• The pension scheme surplus (to the extent it can be recovered) or deficit is recognised in full on the balance sheet
• The movement in the scheme surplus/deficit is analysed into:
  1. The current service cost and any past service costs; (these are recognised in operating profit)
  2. The interest cost and expected return on assets; (these are recognised as other finance costs)
  3. Actuarial gains and losses (these are recognised in the statement of total recognised gains and losses).