Liabilities

The expected cashflows of the pension scheme should be calculated using assumptions which represent a best estimate of the future. These cashflows should then be discounted using yields on high quality corporate bonds of appropriate term and currency. In general the yield on AA-rated bonds is used when accounting for UK schemes.

The liabilities should be measured using the projected unit method - this means that the liabilities should include advance provision for expected future salary increases up to assumed date of leaving, retirement or earlier death.

Non-financial assumptions are often set to be the same as those used for funding valuations. The assumptions used for funding valuation will generally be set to include a margin for "prudence" so there may be scope to adjust these assumptions to reflect a best estimate which produces a lower liability.

Assets

Assets should be taken into account at "fair value" which for quoted investments is normally taken to be the "bid-price" - i.e. the amount that could be realised by cashing in the investments.

Surplus/deficit

The use of  high corporate bonds to determine the rate used to discount the future cashflows means the value of the liabilities will only move in the same way as the value of assets held by the scheme if they are invested in AA corporate bonds at the reporting date. In reality schemes will be invested in a range of assets including equities, property and government bonds. Classes such as equities tend to have market values which are volatile and hence the surplus/deficit calculated under the accounting standards can be volatile from year to year.

Recognition of surplus/deficit

Under FAS158 the difference between assets and liabilities should be recognised in full on the company's balance sheet. Under FRS102 the amount of any surplus should be restricted so that it is no more than the economic benefits that could be realised by the company, either in the form of future refunds or reductions in future contributions. FRS102 allows recognition in more cases than its predecessor FRS17 by including potential future refunds.  The position is more complicated under IAS19, and there is also the potential for recognition of additional liabilities to be required.

IFRIC14 (only applies to companies reporting under IFRS)

If the scheme has a surplus, or a funding plan set under a "minimum funding requirement" (such as the UK Scheme Funding regime laid down in the Pensions Act 2004) that is expected to lead to a future surplus then the company may be required to recognise an additional liability on its balance sheet. This is only an issue if the company does not have an "unconditional" right to benefit from the surplus in the future. The position varies between schemes and often depends on the interpretation of nuances in the wind-up section of the scheme's trust deed and rules. This is one area where a funding plan agreed with the trustees of a scheme can have unintended consequences for the company's balance sheet.

"In 2015, 28 companies decreased returns to shareholders whilst increasing or maintaining DB deficit contributions."

Profit and Loss items

The annual cost of providing pension benefits will not be the same as the cash contributions to the scheme. The cash contributions for funding the scheme will be calculated using funding basis agreed with the trustees.

The elements of pension cost that are recognised through profit and loss can be broadly broken down into three types:

Service cost

Financing cost

One-off costs

The represents the value of benefits accrued by members over the accounting period less any contributions paid by members. As with the balance sheet liabilities it is calculated using the projected unit method so makes advance provision for future salary increases, if the scheme is a final salary arrangement.

Under US GAAP, this is calculated as the difference between the expected return on the assets over the accounting period less the interest on liabilities This calculation makes allowance for cashflows in and out of the scheme over the period.

The calculation is similar under FRS102 and IAS19 except that the expected return on assets is effectively set to be equal to the discount rate.

There is still an option under US GAAP for a smoothed market value to be used in this calculation.

These will arise in three ways:

  • Past service costs from improvements to benefits or granting of discretionary benefits. Under FRS102 and IAS19 the capital cost is normally recognised immediately through the P&L although some spreading may be possible under IAS19 if the benefits do not vest immediately. Under FAS158 past service costs should be amortised through P&L over a pre-determined period.

  • Curtailments which arise when a significant number of the members no longer qualify for benefits under the scheme or only qualify for reduced benefits. Under FRS102 and IAS19 the cost/saving associated with this event is recognised through the P&L. Under FAS158 the amount recognised will depend on whether a gain or loss occurs and whether there are any previously unrecognised past service costs.

  • Settlements occur when the company is relieved of part or all the pension liability. For example, when the benefits are secured with an insurance company through a buy-out. The accounting treatment differs between the standards and may depend on precisely how the transaction is structured. There is also scope under US GAAP for settlements to trigger immediate recycling of gains and losses previously recognised in OCI through profit and loss. When running exercises, such as enhanced transfer values or buy-outs, it is important to consider any consequences for the accounting position.

Actuarial gains and losses

Actuarial gains and losses arise in three ways:

  • differences between expected returns on assets and returns actually achieved
  • differences between actuarial assumptions and the actual experience of the membership over the period. For example more people dying than expected would contribute to a gain here.
  • changes to actuarial assumptions over the period. For example, adoption of new mortality tables would lead to an item here.

The treatment of actuarial gains and losses is different between the three standards.

  • Under FAS158 all actuarial gains and losses should be recognised initially through Other Comprehensive Income but then recycled through the profit and loss account using the corridor method described above
  • Under FRS102 and IAS19, the actuarial gains and losses are recognised in Other Comprehensive Income and do not impact on the profit and loss account.