New accounting framework for Irish companies
Read our April 2013 financial reporting brief for details on the most significant development in accounting of our generation
Revised proposals on accounting for leases and insurance contracts
Read our July 2013 financial reporting brief for commentary on accounting and regulatory developments during the second quarter of 2013
Financial Reporting Brief - February 2014
This month's article: Pensions – more than an accounting challenge?
Welcome to our financial reporting brief for February, our opportunity to update you on recent developments with our featured article which discusses the challenges of pension accounting and the unsettled conclusions reached.
Pensions – more than an accounting challenge?
Employers, employees, regulators, investors and the public at large - for all, pensions and the accounting for pensions is a challenge always with us.
The accounting community have never spent long without making tweaks to how pensions, and other post-retirement benefits, are accounted for and, on occasion, there are some more significant changes. 2013 reporting by IFRS-adopters requires the implementation of IAS19 (revised) with many changes in reporting requirements, particularly with regard to defined benefit schemes.
One may wonder why is this area of accounting subject to such frequent and significant change? Is there an underlying unrest, an enigmatic conundrum, which leads standard-setters to the conclusion that the best they can achieve is an unsettled conclusion?
Is Pension Accounting appropriate?
This unsettled and unsettling conclusion gives rise to much unrest and confusion amongst those in the industry and both providers and beneficiaries. There have been numerous comments made by senior figures questioning whether accounting standards and requirements in this area are appropriate. A prime example of this is the comment made by the Chairman of the UK National Association of Pension Funds at its 2010 Annual conference – “Current accounting standards have been damaging to defined benefit pension provision, leading many companies to close their schemes...pension funds are long term but today’s accounting standards fail to reflect this”.
Subsequently a report was commissioned from Leeds University Business School which was based on an independent investigation into accounting for pensions. The report was supported by consultation with finance directors, trustees, accountants and actuaries, and highlights a number of key issues, including:
- IAS 19 applies a mixed accounting model with discounted cash flow valuation via a market determined discount rate to estimate pension liabilities, and market prices to value pension assets. The application of this approach has been detrimental to the sustainability of the defined benefit pension scheme as it removes the interaction that occurs between pension assets and pension liabilities and asset/liability cash flows when both are valued using discounted cash flows. Consequently, this has led to greater volatility in comprehensive income and the recognition of substantial and often volatile pension deficits on the balance sheet
- Mandating the use of AA rated yields to discount the present value of pension liabilities has resulted in schemes purchasing greater amounts of financial investments, bonds, which better match pension liabilities, and divesting real asset investments such as equities. As bonds have been consistently shown to have lower long-term returns than equities, any shortfall on scheme funding will, all other things being equal, have to be met from corporate earnings
- Pressure on corporate earnings will inevitably lead to scheme closures or significant adjustments to pension benefits available to scheme members.
In the Leeds University Report, the biggest issue finance directors raised with current pension accounting is the ‘snapshot’ problem arising from the mixed accounting model, as outlined above. A NAPF survey generated the following overall comment from over 70% of respondents ‘the snapshot method of accounting – valuing assets according to today’s market values is inappropriate for long-term products such as pensions and generates too much volatility in the scheme valuation’.
Not all the blame for the demise of defined benefit pension schemes can be placed on the factors above. Successive amounts of regulatory overlay have increased the cost of pension provision and rapid increases in life expectancy have increased the ultimate liability faced by corporate sponsors.
While many factors have contributed to creating the myriad of pension deficit ‘horror stories’ which have been seen in recent years, the IASB and interested participants and observers would no doubt be hopeful that what may be seen as accounting imbalances in periods of turbulence do not lead to over-reaction on the part of providers.
The unsettled ground on which current pension accounting standards are based has given rise to many issues on implementation. Perhaps the most significant is the determination of what is the appropriate discount rate to be used. This has taken on even more significance under IAS 19R, effecting not only the value of scheme obligations but also the net interest charge in arriving at profit or loss.
The International Accounting Standards Boards’ Interpretations Committee grappled with this during 2013, having received a request in November 2012 for guidance on the determination of the rate used to discount post-employment benefit obligations. At its November 2013 meeting, the Committee issued a final rejection notice stating that an entity should take into account the guidance in the relevant paragraphs of IAS 19 in determining what corporate bonds can be considered to be ‘High Quality Corporate Bonds’ (HQCB). The Committee noted that the term ‘high quality’ reflects an absolute concept of credit quality and not a concept of credit quality that is relative to a given population of corporate bonds. It also indicated that an entity’s policy for determining the discount rate should be applied consistently over time.
The European Securities and Markets Authority (ESMA) in its statement of enforcement priorities for 2013, stated that it expects entities to maintain a consistent approach to determining the discount rates, provided that the relevant HQCB market remains deep.
The net interest costs are calculated by applying the discount rate to the defined benefit liability or asset at the beginning of each reporting period. The difference between the actual return on plan assets and the return on assets included in the net interest costs will be included in the statement of other comprehensive income. This will impact on the profit or loss for the year since the benefit of the expectation of higher returns on investments will not be included in earnings.
IAS 19R includes significant additional disclosures to enable users of financial statements to evaluate better the financial effect of scheme assets and liabilities, with a focus on:
- explaining the characteristics of the scheme and the related risks
- identifying and explaining the amounts in the financial statements; and
- describing how defined benefit plans may affect future cash flows.
To meet these objectives, additional disclosures are required in relation to description of risks, impact of changes in demographic and financial assumptions, assets/liabilities matching strategies, expected contributions and the weighted average duration of obligations.
These new disclosures should help to alleviate the concerns of many that disclosures under the previous IAS 19 were of limited value, with the focus on narrative explanation providing more meaningful information for stakeholders.
The IASB has grappled with pension accounting for many years and has continued to make changes with IAS 19(R), not only in the areas outlined above, but also with regard to such areas as termination benefits, short term benefit classification and the elimination of the ‘corridor’ approach, which was not widely used by Irish companies.
The bigger issues arising from the mixed accounting and valuation approach remain with the inevitable consequences as outlined above.
Perhaps another day!!
What’s new - monthly reporting pack
Irish GAAP / GAAS and related developments
- FRC challenges the reporting of companies classifying pension liabilities as equity
- FRC urges IASB to bring back prudence, stewardship and reliability
IFRS and related developments
- IIRC and SASB sign cooperation agreement
- EFRAG launches ‘Short Discussion Series’
- IASB user survey on debt disclosures
- EFRAG draft comment letter on equity method
Regulatory and related developments
- Companies (Miscellaneous Provisions) Act 2013 signed into law
- Central Bank announces new authorisation process for Investment Firms
Deloitte publications and articles
Financial reporting brief
- January 2014 - Quarterly edition of financial reporting brief
- November 2013 – Accounting alert – hedge accounting
- October 2013 – Quarterly edition of financial reporting brief
- July 2013 – Quarterly edition of financial reporting brief
- May 2013 – Accounting alert – leases
- March 2013 - Special edition on the New Irish GAAP (FRS 102)