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.
Example of the previous accounting treatment for defined benefit
The actuarial valuation of the defined benefit pension scheme
of Big Brother Company showed an experience deficit of £/$30,
that is to say the actuary had valued the pension fund assets
at £/$30 less than the pension fund liabilities, such a
difference arising because previous actuarial estimates in the
light of experience turned out to be incorrect.
The actuary suggested the deficit should be eliminated by making
additional cash payments of £/$12 now, £/$8 in one
year’s time and £/$10 in two years’ time.
The regular pension cost is £/$10 and the average remaining
service lives of the employees is 15 years (discounting is ignored).
Illustrate how prior to the introduction of the new standards
Big Brother Company would account for its pension costs.
Solution to Big Brother Company
Profit and loss account
The annual profit and loss charge for pensions will be:
|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.
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:
||Total cash paid
|4 - 15
||10 per year
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.
||Cash paid minus the expense plus
the balance bought forward
||Prepaid asset on the balance sheet
(a cumulative figure)
||(22 – 12)
||(18 – 12) + 10
||(20 – 12) + 16
||(10 – 12) + 24
||(10 – 12) + 22
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
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
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!
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
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
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
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
Full actuarial valuations should be obtained at intervals not exceeding
three years and should be updated at each balance sheet date (see Table
| Table 1: Recognising the changes in the defined benefit pension
fund assets and liabilities in the profit and loss account
|The current service cost
||This is the increase in the actuarial liability expected
to arise from employee service in the current period.
||Profit and loss account expense within the appropriate heading
i.e. wherever the salaries would be allocated.
|The interest cost
||The interest code is the unwinding of the pension scheme's
liability i.e. the expected increase in the scheme's liabilities
because the benefits are one period closer to settlement.
||Profit and loss account item adjacent to interest.
|The expected return on assets
||The expected return is the expected increase in the market
value of the scheme's assets.
||Profit and loss account item (shown as a net figure within
the interest cost) adjacent to interest.
|*Past service costs (if any)
||These are increases in the actuarial liability related to
employees' service in prior period but arising in the current
period as a result of the introduction of, or improvement
to retirement benefits.
||Recognised immediately in the profit and loss account.
|*Settlements and curtailments (if any)
||These arise when employees are made redundant or are transferred
out of the scheme.
||Recognised immediately in the profit and loss account.
|*These are non-periodic costs and this fact
needs to be disclosed in the notes to the accounts
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
|Market value of pension
To advise the company the actuary has made the following assumptions:
|Expected return on plan assets
|Discount rate used to determine pension fund liabilities
|Current service cost
|Contributions to the Pension Fund of
|Benefits paid out amounted to
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
|Pension Fund Liabilities
|Net Pension Liability
Profit and loss account extract
Then let us prepare the extracts from the profit and loss account:
|Current service cost*
(12% x 1,000)
|Expected return on the assets**
(8% x 1,000)
* 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
||Pension Fund Assets
|Pension Fund Liabilities
|Current service cost
|Contributions to the pension fund
|Benefits paid out
|Surplus (balancing figure)
|Deficit (balancing figure)
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
|Actual return less the expected return on the pension scheme assets
This will give rise to a separate pension reserve with a DR bal (negative)
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
|Pension Fund Liabilities
|Net Pension Liability
|Plus the net actuarial deficit
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.
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
Sir David Tweedie’s comments on the introduction of FRS 17 ‘Retirement
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’
Tom Clendon FCCA is a senior lecturer at FTC in London & Singapore.
- 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).