The Accounting Standards Board (ASB) have published for public comment an exposure draft (FRED 20) of a new accounting standard on the treatment of pensions and other retirement benefits in the employer's accounts. The proposed accounting standard would replace the existing standard, SSAP 24 'Accounting for pension costs'. The requirements for defined contribution (money purchase) schemes would remain unchanged but significant changes are proposed to the treatment of defined benefit schemes (schemes where the employees are promised a specific benefit regardless of the investment performance of the scheme).
At present, under SSAP 24, the assets and liabilities in a defined benefit pension scheme are valued on an actuarial basis. The objective is to arrive at a regular pension cost each year that is a substantially level percentage of the pensionable payroll. Any variations from the regular cost are spread forward and recognised gradually over the average remaining service lives of the employees.
SSAP 24 has come under pressure over the last few years. It is criticised in the UK for the number of different valuation methods and ways of accounting for the resulting gains and losses that it allows, its poor disclosure requirements and the lack of transparency in the figures it produces. It is also inconsistent with international standards on the subject.
The FRED proposes a move away from the use of actuarial values for assets in a pension scheme to a market value based approach. This is consistent with practice internationally. It is also in line with the increasing use of market values by the actuarial profession in the UK.
The use of market values at the balance sheet date introduces volatility into the measurement of the surplus or deficit in the pension scheme. This was ignored in the actuarial values used under SSAP 24. Internationally this volatility is dealt with by averaging the market values over a number of years and/or spreading the gains and losses forward in the accounts over the service lives of the employees. The problems with this approach are that it gives rise, first, to figures in the balance sheet that do not represent the current surplus or deficit in the scheme and, secondly, to charges in the profit and loss account that are contaminated by gains and losses that occurred up to fifteen years previously.
The ASB has developed an alternative approach to cope with the volatility. The profit and loss account shows the relatively stable ongoing service cost, interest cost and expected return on assets measured on a basis consistent with international standards. The effects of the fluctuations in market values, on the other hand, are not part of the operating results of the business and are treated in the same way as revaluations of fixed assets, ie are recognised immediately in the second performance statement, the statement of total recognised gains and losses. This has two advantages over the international approach: (i) the balance sheet shows the deficit or recoverable surplus in the scheme and (ii) the total profit and loss charge is more stable than it would be if the market value fluctuations were spread forward.
Introducing FRED 20, Sir David Tweedie, ASB Chairman, commented:
"SSAP 24 has lost all credibility. We are replacing it with an approach that is consistent with international standards in the measurement of the pension scheme surplus or deficit and takes a step forward on immediate recognition. This is what I suspect IASC would have liked to do if it had had longer to develop its standard. The result of the proposals will be pension figures in accounts that do not disguise the significant yet uncertain influences that a pension scheme may have on a company. For the first time a company's pension surplus or deficit will be shown on the balance sheet rather than being represented by a number bearing no relation to reality and which is difficult, if not impossible, for the analyst to unpick as a starting point for any serious evaluation of the financial position. No-one pretends that final pay pensions are easy to represent in accounts. But understanding is not eased by locking all the numbers in a black box and then losing the key."
Comments on the FRED are invited by 5 February 2000.
The importance of this proposed change to all those involved in running or advising on defined benefit scheme cannot be overestimated. That the treatment of money purchase schemes continues unchanged is perhaps another reason for preferring these schemes being considerably easier to deal with from an accounting standpoint.
Despite the accounting changes that may arise however, it is worth noting that tax relief is still only available for allowable contributions made through the accounting period and not for any profit and loss / balance sheet adjustment. It is important to remember however, that alignment of accounting principles with tax principles continues on many other fronts including the deductibility (or not) of contributions to employee share ownership schemes where the shares remain subject to the trust.