Accounting for pensions – what’s the benefit?

There are some problems in accounting that refuse to go away. Deferred tax, goodwill and the impact of changing prices have been debated for decades, and accounting for pensions is another subject ripe for debate. The IASB issued a discussion paper in March representing new proposals for significant change in this area.   

The discussion paper is not a fundamental review of IAS 19.  Instead it aims to eliminate some of the deferred recognition and smoothing mechanisms currently permitted or required, and to address perceived problems for plans that have features both of defined benefit and defined contribution.

Some would argue that eliminating the deferred recognition options, (particularly the so-called ‘corridor approach’ to recognising actuarial gains and losses) is an overdue and much needed fix. Immediate recognition of actuarial gains and losses is permitted by IAS 19, but only as a relatively recent option. Hence, many companies’ balance sheets drawn up under IFRS include a number that bears little resemblance to the surplus or deficit in the pension plan.

Equally, many would say that recognising an expected rate of return on plan assets in the income statement, irrespective of the actual return, doesn’t reflect reality. Furthermore, if estimates prove to be on the high side, a company may reflect the bad news directly in equity instead of the income statement .

Having concluded that smoothing tools are not appropriate, the discussion paper then addresses where to recognise the resulting, potentially highly volatile and large, pension expense. A common feature of the proposed alternatives is that more components of pension expense, including some of the experience gains and losses and changes to assumptions that may currently be recognised directly in equity, would be reflected in the income statement.   This could increase or decrease profit or loss, and would depend largely on how good actuaries’ predictions were .

Finally, the IASB proposes a radical new approach to plans that have features both of defined benefit and defined contribution, which it calls ‘contribution based plans’. An example of such a plan, common in the US, is a plan in which benefits are based on contributions plus the yield on treasury bills. This has proved to be a particularly troublesome topic for the IASB. The IFRIC published a draft interpretation, ‘Employee benefit plans with a promised return on contributions or notional contributions’, almost four years ago, but it has never been finalised and practice remains mixed. The discussion paper proposes fair value measurement for these plans’ obligations. If this means exit price, it might be equivalent to the cost of buying an annuity from an insurance company, which could be considerably higher than the amount at which these liabilities are typically measured.

The discussion paper doesn’t address measurement of defined benefit plans, which is intended to be discussed in a ‘phase 2’ of the project. A discussion paper issued in January by the EFRAG and certain European standard setters as part of the Pro-active Accounting Activities in Europe (PAAinE) initiative has suggested that pension obligations should be measured using a risk free rate rather than the corporate bond rates used currently. Some actuaries estimate that this change could add as much as 25 per cent to pension plan liabilities and significantly increase reported deficits. But if the fair value model proposed by the IASB for contribution based plans was to be applied instead, the impact could be even greater.

This is only the first tentative step towards a new accounting standard. So what will come next? Some concerns are already being expressed about proposals for measuring contribution based plans. The IASB and FASB’s joint board meeting in April discussed whether the scope of the project might be reduced or longer-term changes put on hold - given the burden of other projects. Undoubtedly, this could be a very long journey, but those who want to influence the debate will need to get involved now. I would be very interested in your views, either by commenting below or by email.