In its quest for greater clarity, transparency and comparability of accounting information the London-based International Accounting Standards Board (IASB) tentatively decided some years ago to amend IAS 19 – the accounting standard applicable to employers accounting for employee benefits – by bringing it in line with the equivalent standard issued by the British Accounting Standards Board (ASB), FRS 17. However, the IASB had made this step conditional on a more far-reaching project being completed. Initially foreseen to be completed in 2004, the process for amending IAS 19 has now not only slowed down significantly but has been amended in direction too.
This is good news for those preparing financial statements since the principles currently embedded in both IAS 19 and its US-equivalent, FAS 87, appear to remain unchanged for the next few years at least.
Story so far
In September of 2003 the IASB was still hoping to issue an Exposure Draft in the fourth quarter of 2003 or first quarter of 2004 with far reaching consequences: the form and content of the profit and loss (or income) standard into a comprehensive income statement was to be overhauled in its very substance. The issuance of the final standard was planned for 2004, in time for the sweeping application in the EU of its suite of standards, the International Financial Reporting Standards (IFRS) in 2005. However, as so often happens in real life, things did not unfold totally in accordance with the plan. It appears now that the project has been deferred to 2005, possibly even 2006.
What was the issue? The adoption of the Comprehensive Income Statement would have meant that a company’s pension plan’s assets and liabilities would not only have to be measured at fair value (as is the case today already), but the amounts would also have to be recognised in the balance sheet. This treatment is referred to in technical accounting jargon as ‘immediate recognition’ in contrast to the current method of ‘deferred recognition’, which allows some time before recognising these amounts in the balance sheet. Immediate recognition would have led to significant volatility (also referred to as ‘roller-coaster effects’) in the company’s shareholder funds and the period’s income. In my opinion, the recognition of a pension plan’s assets and liabilities at the market value determined at any point in time on the face of the balance sheet is inappropriate. This is because fair values for amounts due over several decades can be subject to significant swings from one balance sheet date to the next, without the payment changing significantly. The effect of accounting for pensions in this way would have the same effect on shareholder value as a roller-coaster on the stomach of a faint-hearted reveller.
As already mentioned, the IASB had tentatively decided some years ago, that it wished to carry the principle of immediate recognition into IAS 19. However, it also decided that this was only to occur after issuance of a standard introducing the Comprehensive Income Statement. Since this has now been deferred for various reasons, possibly in particular to the intransigence of the US Accounting Standards Board, FASB, and apparently for several years, the IASB decided in its meeting of mid-December 2003 to implement a ‘small solution’ to IAS 19 by 2005 instead.
What will IAS 19 look like?
This “small solution” is expected to contain two amendments. First, preparers will be given the choice of applying immediate or deferred recognition. Immediate recognition will be effected along similar lines to the treatment under FRS 17, ie, IAS 19 will allow preparers to pass unexpected movements in the assets and liabilities not through the income statement itself, but rather through a “shadow” – or “other comprehensive” – income statement. Second, the current disclosure regulations of IAS 19 will be amended to come closer into line with those issued by the FASB in December of last year.
IASB’s reasoning
Does this mean that the IASB has come around to accepting deferred recognition in principle? By all accounts, and regretfully, this cannot be assumed for the majority of the board members, at this time at least.
What are the main reasons underpinning the majority opinion on the board of immediate recognition? My understanding is that there are three main reasons: First, IAS 19 is apparently incompatible with IAS 1, the standard governing the presentation of financial statements. Second, the principle of deferred recognition contained in IAS 19 and its US counterpart FAS 87 are considered, in particular by the IASB chairman, Sir David Tweedie, as being “arbitrary” as well as permitting preparers to “fudge” results. Third, the relevant British standard on employee benefits, FRS 17, is considered as best in class amongst standards existing in the world today.
Some serious objections should be levelled against these arguments. When the current version of IAS 19 was passed in 1998 it was considered at the time by the board to be in line both with IAS 1 and with the then internationally accepted US accounting standard, FAS 87. In view of the long-term nature of pension contracts and the long established treatment of accruing pension cost according to the principle of deferred recognition, preparers have some right to expect continuity. A sudden change in direction, as that envisaged by the board on such a fundamental issue, can only be considered as a breach in confidence.
As to the second reason of classifying the current methodology as arbitrary and tantamount to fudging, this can only be objected to with vehemence. The so-called 10% corridor method is – and I would expect most to agree with me on this – certainly worthy of improvement and correction. But it is by no stretch of the imagination arbitrary or tantamount to fudging. To discard a method practised for decades and replace it with a completely different approach in order to win the acceptance of users is adventurous to say the least. Furthermore, the user is not provided with any additional information than that which is currently already available under the current version of IAS 19. This has been recognised by the FASB in its decision of December of 2003, in which the disclosure requirements for defined benefit plans was expanded and enhanced.
The third argument, that of FRS 17 representing the best in class, is curious indeed. After the wholesale closure and wind-ups of pension funds in the UK as well as the significant sell-off of equity portfolios (sometimes against better judgement), this seems an astonishing point of view, even if these measures were probably taken by British employers not only due to FRS 17 but nevertheless effected in the wake of its issuance. I would at least strongly contest the opinion elevating FRS 17 as a model for the world to follow.
It is common knowledge that quantifying the fair value of long-term liabilities and the corresponding assets is difficult. I doubt whether it is really in the interests of the preparers, the financial markets and the beneficiaries of defined benefit plans to give preference to being “exactly wrong” rather than “approximately correct”. Apart from having been tried and tested in practice, deferred recognition together with all due disclosures also has a theoretical justification.
Unhelpful and frustrating too is the point now often repeated by some members of the IASB, that the issue at stake is a minor one, which should not cloud the view of the big picture. This line of reasoning was most recently given by the chairman of the IASB when presenting and defending the new versions of IAS 32 and 39, when the concern expressed was referred to as “banking-specific details”.
So what now?
In my opinion, preparers can be advised to do the following. First, they need to grasp the possible repercussions that the planned amendments will have on their financial statements. Since it is well known that amending employee benefit and pension arrangements in particular is a time-consuming exercise, the recent decision by the IASB to retain the principle of deferred recognition for the time being should give employers sufficient opportunity to study the relevant aspects. Second, a co-ordinated national and international action is necessary by those responsible for corporate finance to articulate concerns and attempt to influence the IASB.
Thankfully the recent developments at the IASB have given employers some time to react. This time should be used effectively.
Alf Gohdes is managing director of Buck Heissmann International in Wiesbaden