The issue of accounting for pensions has always been fraught for standard-setters who by necessity concentrate their efforts on the needs of investors who are, after all, generally considered to be the primary users of financial statements. The aim is always to try and create greater transparency and ease of comparability. But changes to pensions accounting are thought to have a wider effect due to their perceived influence on corporate and pension fund strategy. And understandably, there will always be a reaction that concentrates on the financial consequences rather than the intentions of those proposed changes.
For the standard-setters the aim is simply to clarify matters. That does not mean that they are insensitive to the effects of change, but this sensitivity has to come second to the ultimate goal of helping investors understand the true financial position, including pensions obligations, of the companies they are investing in. In some cases these obligations are greater than the market capitalisation of the entity itself, which further underscores the importance of full and accurate disclosure.
This is the context in which the International Accounting Standards Board’s proposed amendments to IAS 19 in accounting for defined benefit (DB) plans should be seen.
The guiding spirit has been to make it easier for users of financial statements to understand how DB plans affect a company’s financial position, financial performance and cash flows. IAS 19 has been in need of an overhaul since the IASB inherited it from its predecessor body. The deferred recognition of gains and losses made it difficult to understand the amounts relating to DB plans in financial statements. Companies could choose different options for recognising and presenting gains and losses, making comparability difficult. The resulting disclosures are voluminous but often failed to capture the key issue of risk.
The IASB believes the main way to improve transparency and comparability is by removing what is known as the ‘corridor’ method; in essence, to account immediately for all the estimated changes in the costs of providing benefits and all changes in the value of plan assets. The corridor method is confusing; it produces meaningless balance sheet figures and provides income statement charges and credits that have little to do with the current period.
For many people the upside was that it effectively smoothed the figures. While the attraction of this approach is obvious, IASB believes it only serves to obscure what is actually happening.
The next issue is that of the recognition of net interest and not recognising the expected return on pension assets. When the IASB published its discussion paper back in 2008, a number of alternatives were presented - but there was no overwhelming support for any one approach.
There was much criticism of the current expected return on ‘plan assets’ approach, with gains being booked for assumed returns even if they did not materialise. Some suggested using ‘actual returns’. But many argued that such an approach would be confusing and not give a useful presentation of performance. So, what IASB is proposing is to create an interest income and expense amount that is linked to the funded status of the scheme, and which would reflect the unwinding of the present value calculation inherent in the reported net surplus or deficit. This should improve the visibility of the different types of gains and losses arising from DB plans. Companies would present ‘service cost’ in profit and loss, ‘finance cost’ as part of finance costs in the profit and loss, and ‘re-measurements’ in other comprehensive income.
The proposals should also make clear the risks and rewards. Pension schemes create costs in the value of benefits provided and the accretion of liabilities. They also create potential rewards in the sense of gains from investing pension fund assets. But there are also significant risks. Some risks can arise from the uncertain cash payments to employees, which depend on issues like life expectancy, salary growth, etc.
Other risks relate to investment strategy. If liabilities are not funded by assets that produce matching cash flows, then investment risk arises. Companies may well be willing to accept such risk considering the potential benefits of reducing cash payments to the scheme. But it is important that risks and rewards are reported clearly.
The current approach does not achieve this. The risk is largely hidden through the use of the various smoothing techniques - notably the corridor method - and the use of expected asset return. But reward for accepting a risk in the funding strategy is included in the profit and loss through the expected return. So more risk, through a higher equity weighting, for example, gives a higher profit, which is very visible, but it also creates a higher risk, which is partly hidden. The revised approach in IASB’s exposure draft ensures that risk and reward are both put in the same place - other comprehensive income.
So will the proposals in the exposure draft result in higher pension costs? It does not change the fundamental measurement basis for assets or liabilities, therefore, and for those using the current ‘other comprehensive income’ approach the overall expense should not materially change. What will change though is the amount of this overall cost reported in the profit and loss versus other comprehensive income.
For companies with high-expected asset returns the proposals will likely result in an increase in the expense reported in profit and loss, but a reduction in the expense (or increase in the gain) reported in other comprehensive income. For companies using the corridor method the overall cost may change depending on the current allocations of past gains and losses.
Conscientious and painstaking though the efforts of standard-setters are, there will always be a reaction to any change in the rules, which relates more to the financial impacts of the changes than to efforts to bring about greater clarity in financial reporting.
IASB is aware of the importance of these issues. But it is precisely because of their importance that we need to reflect the realities of pensions schemes in as faithful and unbiased manner as possible.
At present the changes outlined above are merely proposals; the final standard will be developed only after extensive consultation. We encourage all interested parties to provide us with comments.