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The Actuary The magazine of the Institute & Faculty of Actuaries

Accounting for pension costs

FRED20 is the exposure draft of a revised standard to govern how companies account for the costs of providing pensions to their employees. It affects plans providing defined benefit pensions and other post-employment benefits, eg post-retirement medical cover.
SSAP24, the current standard for accounting for pension costs, has been criticised because:
u it gives actuaries freedom to decide on the actuarial assumptions, so the figures shown in accounts are not comparable between companies;
u the standard of disclosure has been poor, so it is virtually impossible to interpret the accounting treatment of pensions; and
u it is difficult to relate the balance sheet entries to what is actually happening to the pension plan.
At the same time, the Accounting Standards Board has been pursuing a crusade for ‘reality’. It believes that ‘reality’ is defined by market valuations and that changes in a company’s position in relation to market values should be reflected in its financial statements. Pensions have been the first target of this philosophy.

FRED20 looks very much like the US Standard, FAS87, and the new International Standard, IAS19 (revised 1998), except for the way in which actuarial gains and losses are treated. The main proposals are as follows.
The profit and loss charge will be: the service cost plus interest cost less expected return on assets plus any special items.
The service cost is the discounted cost of a year’s benefit accrual, using the projected unit actuarial method and allowing for salary projection. The interest cost is one year’s interest on the accrued pension liabilities. The return on assets is one year’s expected return on the plan assets. Special items include the cost of any benefit improvements, and gains or losses resulting from major plan reconstructions.
The balance sheet prepayment (or provision) will in principle be the plan surplus (or deficit), with some exceptions, eg if an employer cannot fully recover value from a surplus.
It is intended that gains and losses due to differences between assumptions and actual experience will be reflected on the balance sheet not by charging them through the profit and loss account, but by showing them in the statement of recognised gains and losses (STRGL). Gains and losses never go through the profit and loss account. This is the key difference compared with FAS87 and IAS19.
Plan assets are to be taken at market value (in contrast with the smoothed ‘actuarial’ values under SSAP24). Liabilities are to be assessed using a ‘market’ rate of interest, which has been interpreted as the yield on long-term corporate bonds. Other actuarial assumptions are to be best estimates. Far more detailed disclosures will be required, and year-to-year reconciliations will need to be shown. This will give analysts a clearer picture of the company’s pension position.

FRED20 pension accounting will look very different from SSAP24 accounting.
u We expect volatility in the balance sheet, as investment fluctuations will lead to volatility in plan surpluses (and deficits). We also expect some volatility in the overall profit and loss charge, but this will be moderated by the counterbalancing of interest costs and expected returns on assets.
u Showing pension surpluses (and deficits) on the balance sheet will be an issue for many companies. The principle of showing large and volatile assets on a company balance sheet, when the company may well not have full control of those assets, is questioned by many. Also, there are concerns that pension assets or liabilities may affect dividend payments.
u FRED20 will lead to relevant balance sheet items, in the sense that the balance sheet figure will often be equal to the pension plan surplus or deficit. However, some believe that it is inappropriate that experience gains and losses should never be reflected through the profit and loss account.
u The expected return on assets will substantially exceed the interest cost, and this may well mean lower pension charges to the profit and loss account than in the past. However, this may not be immediately obvious, since the pension cost is to be split between the operating and financing parts of the profit and loss account. Companies may wish to carry out modelling exercises to help them assess their own position.
u The full cost of benefit improvements will normally be shown in the profit and loss account in the year that they are granted. This contrasts with SSAP24, when the cost of improvements was normally spread over 10 to15 years. There may be fewer benefit improvements in future as a consequence.
u Some view FRED20 as another example of new difficulties for defined benefit plans, and one more factor that encourages the fashion for closing defined benefit plans and offering employees defined contribution plans, which have a less volatile impact on the company’s finances.

The future of FRED20
Until recently it was expected that FRED20 would become a financial reporting standard some time in the year 2000, quite likely without major changes. However, FRED20 has proved very controversial. There is considerable discomfort at the prospect of pension surpluses and deficits being shown on company balance sheets. One view is that it would be better simply to account for cash, and give a FRED20-style disclosure so that the pension position could be seen, without introducing volatility into the financial statements. However, the Accounting Standards Board has said this would be unsatisfactory.
The adverse reaction may partly be a result of pensions being the first target of the ‘reality’ crusade. Not all finance directors and accounts preparers have signed up for the crusade. Nonetheless, the ASB appears to have over-ruled the major objections and it is now expected that FRED20 will be implemented, substantially unchanged for accounting years ending after 23 June 2003, with some disclosure in the two preceding years.