Eighteen months ago employee benefits accounting was considered a fairly dull subject, of little interest to anyone not directly involved in annual reporting activity. In recent months employee benefits accounting has received huge media interest and all stakeholders are now paying attention. What catapulted employee benefits accounting to the top of finance directors/human resource professionals’ agendas and what should multinationals do now?
In the UK, the increased attention is probably down to a number of high-profile companies closing their defined benefit (DB) plans, with this decision being blamed on the new UK retirement benefits accounting standard, FRS 17. In reality, FRS 17 has not changed the costs associated with running a DB plan. Instead, unlike its predecessor SSAP 24, it has increased the transparency of those costs and introduced a consistent approach for valuing pension liabilities and assets for all companies.
The introduction of IAS with effect from 2005 for all listed European Union companies will have an impact on how companies that have not previously applied a market-based accounting standard, such as IAS 19, report their benefits costs and liabilities.
The new accounting standards are delivering better information into the public domain, giving investment analysts and rating agencies better and more consistent data about benefits costs and liabilities. They will now include these costs in their company valuations and have already written reports commenting on these costs for particular companies.
In the US, the new interest can be partly explained by the increased focus on company financial statements in the wake of Enron, WorldCom and other high-profile corporate events.
Even before those events some stakeholders were paying more attention to employee benefits accounting. For example, the US regulator, the Securities and Exchange Commission (SEC), was increasing its scrutiny of the financial assumptions used by companies to prepare its benefits accounting disclosures under FAS 132. For example, the SEC is particularly concerned about the high expected rates of return on plan assets and the low levels of assumed future increased in medical costs used by some companies in calculating their annual pension cost. Using high expected asset return or low medical cost increase assumptions results in a lower cost being charged through the income statement. Analysts and the press are drawing adverse attention to companies that use overly optimistic assumptions to increase their profits.
As a result of these events auditors are growing increasingly nervous about how employee benefits accounting is carried out, from both process and compliance perspectives. They will be checking everything in greater detail going forward.
The Sarbanes–Oxley Act in the US is another response to recent events. This will mean that CEOs and CFOs will need to certify the integrity of their organisations’ financial statements. In doing so, they will be responsible for ensuring that no material facts or transactions have been omitted and that the statements fairly and honestly present the company’s financial condition and results. The penalties for non-compliance are high – companies can be delisted and the CEO/CFO can be fined. As a result, CEOs and CFOs will be paying more attention to employee benefits accounting.
So what should companies be doing to address these issues? They should be targeting four key areas:
q Efficient and effective year-end processes Companies will need to invest time and effort in setting up processes that will deliver results in a timely and accurate way to meet the year-end reporting deadlines.
Having a robust approach to setting actuarial assumptions is critical because auditors, regulators and investment analysts are placing the appropriateness of these assumptions under greater scrutiny. Companies are spending a great deal more time on selecting the assumptions and making sure that they can respond to questions raised by stakeholders.
For multinationals, having a sound methodology for choosing the plans to include and exclude from the year-end reporting cycle is also critical. In the past it was possible to include the bare minimum but, for US-registered companies, the CEO and CFO are going to want to ensure that the costs and liabilities associated with plans excluded from the process do not have a material impact on the financial statements. Some multinationals have made a decision to value all DB plans under the appropriate market-based accounting standard for this coming year-end and will use the results to determine which plans to include in the year-end process going forward. Despite the time involved initially in carrying out this work, in the end it will make it easier to prove that all material plans are covered.
There are a number of obstacles impeding an organisation’s ability to meet the tight timeframes set for providing final figures for year-end reporting. The requirement to use year-end asset values and discount rates set based on year-end conditions means it is not possible to finalise results prior to the end of the fiscal year. Multinationals face the challenge of having to gather complex information from a number of countries for many plans. It can be a logistical nightmare to gather and check the information provided and still meet the deadlines.
Multinationals are using a variety of techniques to ensure that the process works well. Web-based technology can be used successfully to ensure that those involved in the process around the world know what to do and when. Active project management and planning are the only ways to make sure that quality results are reported.
q Understanding costs and liabilities Companies that do not have a methodology in place to allow them to see how their benefits costs and liabilities may be affected by investment markets will be hit by surprises year after year. Companies that have adopted this wait-and-see approach over the past two years will have received only bad news.
In the past, asset liability modelling has been used primarily to determine the best-fit asset allocation, given the plan’s particular circumstances. Companies are recognising the value of using both ‘what-if’ scenario testing and stochastic modelling to help understand their accounting costs and how benefit design, funding and investment decisions impact on these costs. Multinationals should look at their global exposures to understand the potential volatility of their benefit costs from year to year and use this information to better manage their plans within risk parameters that are in line with company’s objectives.
Our clients are beginning to look more closely at their annual budgeting process. Where, in the past, it might have been acceptable to use last year’s numbers, this is no longer the case. Companies that want a good understanding of their short-term costs are carrying out more sophisticated calculations to determine a better quality budget figure. These might take into account actual investment returns to date and incorporate changes to assumptions based on up-to-date market conditions.
Finally, it is important for companies to fully understand the impact of transitioning to a new employee benefit accounting standard, for example, IAS 19 or FRS 17. While there will be an ultimate deadline by which full implementation is required, projections should be prepared as soon as possible to help determine the best time for full implementation.
q Communication with stakeholders The increased publicity about benefits costs and liabilities means that companies can expect to be asked more questions by auditors, regulators, investment analysts and the media. People responsible for responding to these questions will need to have a good understanding of the factors that influence the costs and liabilities as well as a good understanding of the accounting standards that are being applied. Giving these groups incorrect information could result in negative coverage from the press or investment analysts or lower credit ratings. For CEOs and CFOs responsible for multinationals this may well involve a steep learning curve.
q Governance Some companies have established committees to oversee, from a governance perspective, the management of employee benefit programmes. The committees will comprise members from treasury, financial controllers and human resources. Given the requirement for CEOs and CFOs to take personal responsibility for the financial statements under the Sarbanes–Oxley legislation it would not be a surprise to see more of these people becoming more involved in committees. Some companies are instigating governance reviews to make sure that the decision-making processes for employee benefits are robust so the CEO and CFO will feel comfortable signing off the financial statements.
Looking forward, there is no reason to expect that the publicity surrounding employee benefits accounting will suddenly disappear. Stock markets remain volatile, employee benefit costs are continuing to rise and new accounting standards are on the way.
The IASB’s pensions convergence project, which is expected to run into next year, is looking at how the various employee benefits accounting standards around the world can be made to converge. This review could result in the volatile aspects of the UK standard, FRS 17, being introduced into the International Accounting Standard. This would mean changes to accounting processes and increased volatility in some of the financial statements.
Poor investment returns so far this year do not bode well for year-end results. Unless markets rebound, companies can expect their pension costs for 2003 to be significantly higher than for 2002. It goes without saying that the press will focus on the high-profile cases.
Companies should take action to understand the factors that influence their costs and liabilities. With this knowledge they will be in a position to take action to address any issues identified. They can also take action to make sure they can respond when required to their stakeholders, safe in the knowledge that they have established robust processes for delivering results.
Christine Farmer is a senior consultant at Towers Perrin in London