U.K. Recommendations Could Have Significant Effects on Pension Accounting Worldwide

Recent recommendations by the U.K. Accounting Standards Board (ASB) could have significant effects on pension accounting worldwide if the International Accounting Standards Board (IASB) and U.S. Financial Accounting Standards Board (FASB) follow the same line of reasoning. The ASB’s recommendations would substantially increase the reported pension liabilities that appear on the balance sheet.

The ASB’s recent recommendations stem from a project the group began in 2006 to review the complex subject of accounting for pensions. The recent discussion paper sets out preliminary views on the principles that the ASB would like to see adopted when the major global accounting standard setters, the FASB and IASB, develop future standards.

The ASB discussion paper (available at http://www.frc.org.uk/asb/technical/projects/project0065.html) presents a set of proposals based on principles applied elsewhere in the current accounting literature and calls for a fundamental review of the existing pension accounting rules.

The paper’s preliminary views include:

• Future cash flows should be discounted at a “risk-free” rate rather than the high quality (typically AA-rated) bond yields currently used in the United States.
• For final-pay plans, the obligation should be based on accrued benefit liabilities. There should be no allowance for future pay increases.
• Pension cost should be based on actual return on assets rather than the expected return.
• Changes in pension assets and obligations should be reported in the period in which they arise. The impact of gains and losses should not be spread. However, the factors involved will be included in specific sections of the income statement. So, for example, the actual return on plan assets would be included as a financing cost/credit, separate from operating income.

Implementation of these preliminary views would typically result in a significant increase in the pension liability that appears on a plan sponsor’s balance sheet, particularly for more mature plans. This would be especially true in the current climate, where the difference between AA-rated corporate bond yields and those on government bonds/swaps has increased dramatically. Based on the current interest rate environment, Watson Wyatt estimates that this change alone would add approximately 15 percent to 20 percent to reported pension obligations for typical defined benefit plans, adding in aggregate about $250 billion for FORTUNE 1000 companies.

In addition, while the annual pension cost would no longer spread costs associated with actuarial gains and losses (and likely plan amendments), the current cost components would be segregated into different sections of the income statement. This represents a very important change over the current rules. Segregation allows the reader to clearly identify:

• The portion of the pension cost that represents deferred compensation as an “operating cost.”
• The portion of the cost that results from financing activities, such as actual asset returns and the effect of discount rate changes. This would be included in “financing cost.”
• The portion of the cost that results from actual plan experience being different than assumed as an “other financial performance cost.”

The portion attributable to operating cost will be very stable (more so than the current definition of pension cost), while the financing cost and other financial performance cost will be quite volatile. However, equity analysts will focus primarily on operating costs, operating income and operating earnings per share. So while the total pension cost may be more volatile, the volatility will be separated in a manner that is more useful to financial analysts and results in more stable operating costs.

Pension accounting is currently high on the agenda of the IASB and FASB with the IASB due to publish a discussion paper on its Phase I review shortly. The ASB project, however, looks further ahead than this to Phase II of the FASB and IASB reviews. It is in these reviews that the accounting bodies are expected to make the most far-reaching changes to the way pensions and other benefits are included on financial statements.

About the UK’s ASB

The ASB in the UK is an operating body of the Financial Reporting Council, the UK’s independent regulator responsible for promoting confidence in corporate reporting and governance. The ASB issues accounting standards, like the FASB in the U.S., that are recognized for this purpose under UK law.

The ASB also collaborates with accounting standard setters from other countries and the IASB in order to influence the development of international standards and to ensure that its standards are developed with due regard to international developments.