Home > News > 2000 > January 2000 > FRED 20 : Accounting For Retirement Benefits
FRED 20 : Accounting For Retirement Benefits
Jon Bridger presents Barnett Waddingham's summary and comments on Financial Reporting Exposure Draft (FRED) 20 which sets out proposals for the treatment of pensions and other forms of retirement benefits in a company's accounts.
- Introduction
- Financial Reporting Exposure Draft (FRED) 20 sets out proposals for the treatment of pensions and other forms of retirement benefits in a company's accounts.
- The main features of FRED 20 are summarised below:
- Valuation of assets and liabilities;
- Recognition in the financial statements;
- Transitional Arrangements;
- Subsidiaries;
- Frequency of calculations;
- Timescales.
In each case Barnett Waddingham's initial comments on these proposals are shown in bold-italics.
- Broadly speaking FRED 20 proposes that the assets and liabilities of the pension scheme should be valued by reference to current market conditions. This is consistent with the approach adopted under FAS87 (the US accounting standard) and IAS19 (the International accounting standard).
- In terms of recognition in the financial statements, the profit and loss account will show the ongoing service cost, market fluctuations will be recorded in the statement of total recognised gains and losses while the balance sheet will show the surplus or deficit in the scheme to the extent that the employer expects to benefit or suffer from it.
- Valuation of assets and liabilities
- Assets are taken at market value.
- Liabilities are valued using a discount rate based on the return available on AA corporate bonds at the balance sheet date.
This is a major change from SSAP24 which required the assets and liabilities of a pension scheme to be valued on the basis of long-term assumptions. However the Accounting Standards Board (ASB) are concerned that smoothed figures are more difficult to interpret and so their preference is for an approach based on market values.
The UK corporate bond market is reasonably limited and so an element of subjective judgement will be required in order to choose the appropriate discount rate. Even in the US where the corporate bond market is much more developed, there is considerable variation in the level of the discount rate used for FAS87 purposes. It will be important to remember that just a 1/4 % p.a. change in the discount rate could have a significant effect on the value of the liabilities and hence the reported pension costs.
The difference between the value of the assets and the value of the liabilities is likely to be very volatile using this method especially for those schemes with significant levels of equity investment.
- All other financial assumptions should also reflect market conditions at the balance sheet date.
- All actuarial assumptions should be the actuary's "best estimate" and be mutually compatible.
Under FAS87 and IAS19 the choice of assumptions rests primarily with the Company but FRED 20 implies that the choice of assumptions rests solely with the actuary. However we would normally expect to discuss the assumptions with the Company before completing our calculations.
- FRED 20 also proposes that discretionary pension increases "awarded under an established practice that creates among the employees a valid expectation of receiving them" should be included in the actuarial assumptions.
We expect this rather imprecise wording will lead to some interesting discussions as to whether discretionary pension increases should be included in the actuarial assumptions or not.
- The expected rate of return on assets which forms part of the calculation of the pension cost in future years is based on the pension scheme's current investment strategy. FRED 20 requires the expected rate of return to be separately disclosed for each main asset class, namely; domestic bonds, domestic equities, overseas investments and other investments. The expected rate of return on these asset classes should be based on the actuary's long-term expectations.
The ASB acknowledges that the expected rate of return on equities is a difficult figure to assess which means that there is likely to be a wide variation in the choice of this particular assumption.
Recognition in the financial statements
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Profit And Loss Account
- The profit and loss account will include the following items:
- current service cost;
- any past service costs;
- gains and losses on any settlements and curtailments;
- The current service cost is the cost to the Employer of benefits arising in the future.
- The current service cost will be calculated using the "Projected Unit Method".
This is the cost of benefits arising in the year following the valuation date after allowing for projected earnings up to retirement.
- The past service cost refers to the cost of any benefit improvements.
- FRED 20 proposes that any past service costs should be recognised in the profit and loss account over the period in which the increase in benefit vests.
Therefore the total capital cost of an immediate improvement to benefits should be recognised immediately in the profit and loss account.
- Similarly FRED 20 proposes that any gains or losses arising from settlements and curtailments not allowed for in the actuarial assumptions should be recognised immediately in the profit and loss account.
Examples of settlements and curtailments include a bulk transfer or a major redundancy exercise.
- In addition to the above the interest cost and the expected return on assets should be included as a net financial item adjacent to interest in the profit and loss account.
The interest cost is calculated as the value of the liabilities multiplied by the discount rate while the expected return on assets is calculated as the value of the assets multiplied by the expected rate of return on assets.
Given that any past service costs or settlements and curtailments are unusual events the ASB hopes that the pension costs shown in the profit and loss account will be reasonably stable from year to year.
However we believe that the net effect of the interest cost and the expected return on assets could still be a volatile item especially for mature pension schemes where the current service cost is a very small proportion of the total size of the fund.
- Statement of Total Recognised Gains and Losses (STRGL) FRED 20 proposes that any actuarial gains or losses arising during the year are recognised immediately in the statement of total recognised gains and losses (STRGL).
- The STRGL is intended to show those gains and losses which are incidental to the main operating business of the Employer. Examples of such items include revaluation of fixed assets and exchange rate gains and losses on overseas investments. These items are deemed to be incidental to the Company's main activities and are therefore not appropriate for disclosure in the profit and loss account.
This approach is significantly different to SSAP24, FAS87 and IAS19 where actuarial gains and losses are spread forward over a number of years and recognised though the profit and loss account.
Although the amounts of these gains and losses will be very volatile from year to year the ASB believes that "users of accounts are sufficiently sophisticated to view them in their proper context."
- The actuarial gains and losses shown in the STRGL will not be recycled through the profit and loss account (this was considered as a possibility in earlier consultation papers).
Balance Sheet
- FRED 20 proposes that the total surplus or deficit in the pension scheme should be recognised in the balance sheet to the extent that this surplus or deficit is recoverable to or from the Employer.
- A surplus could be recovered through reduced contributions or a refund of surplus. The amount that can be recovered through reduced contributions is based on the total saving in future contributions for existing employees.
The total surplus or deficit in the pension scheme represents the difference between the market value of the assets and the value of the liabilities based on the proposed assumptions. The surplus or deficit and hence the amount recognised in the balance sheet is likely to be very volatile especially for those schemes which invest in equities.
- FRED 20 also proposes that the recognised surplus or deficit should be presented separately on the face of the balance sheet after other net assets.
- Transitional arrangements
- The new accounting standard will apply to all accounting periods beginning on or after a date yet to be specified by the Accounting Standards Board.
- However FRED 20 proposes that any gains or losses arising on the initial application of the new standard should be dealt with as prior period adjustments.
- Subsidiaries
- Where possible subsidiaries will account for defined benefit scheme in accordance with the proposed accounting standard.
- However, FRED 20 recognises that many group schemes are run on a basis that does not enable individual companies within the group to identify their share of the underlying assets and liabilities.
- In these circumstances the individual companies within the group will account for the scheme as a defined contribution scheme subject to additional disclosure requirements.
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- Frequency of calculations
- FRED 20 proposes that the actuary should review the most recent formal actuarial valuation and update it to reflect current conditions at the balance sheet date.
We would expect to discuss with the Company the extent to which a formal valuation or approximate calculations are required at the balance sheet date.
- Timescales
- Comments on the exposure draft are invited by 5 February 2000 and so we can expect the new standard to be published some time next year.
- However the effective date for implementation of the new standard is not yet known.
For further information, please contact Jon Bridger at the Cheltenham office.
Jon Bridger, January 2000.