The conclusions of a research project, led by the ASB, into pensions accounting are published as a discussion paper this month. ASB Director of Research Andrew Lennard describes the importance of this work and the main issues arising.

Pensions continue to attract controversy, which is unsurprising given their economic significance and the complexity of pension liabilities. Decades often pass between the right to a pension first arising and the final payment. The amount and timing of the payments is subject to a host of uncertainties. Some of the controversy surrounds how pensions are reported in financial statements. Whilst standardsetters continue to buttress their existing standards by addressing problems as they crop up, it is widely accepted that a fundamental review is necessary.

The Discussion Paper ‘The Financial Reporting of Pensions’, published in January, is a first step towards just such a review. It seeks to establish principles for future standards, rather than simply attempting to make marginal changes to current practice. A common theme is that the principles that are applied elsewhere in accounting would improve financial reporting if they were applied to pensions.

The ASB led the development of the paper, assisted by its Pensions Advisory Panel which was formed for that purpose. The paper is being published as part of the Proactive Accounting Activities in Europe (PAAinE) initiative, which seeks to provide a European input to financial reporting developments, from a partnership of standard-setters and EFRAG. The views expressed in the paper are the preliminary views of the ASB: other bodies associated with the paper have not taken a view on them. Here it is possible to mention only some of the more radical proposals covered in the paper.

Present accounting standards draw a sharp distinction between defined benefit plans (including final salary plans) and defined contributions plans, and contain separate requirements for these two classes. This can be troublesome, for example, in connection with hybrid plans. The paper does not rely on such a distinction, but proposes that the same principles should be applied to plans of all types.

A particularly difficult issue is whether, as required by present accounting standards, the liability should include the effect of future salary increases. The paper tries to explore the arguments from both points of view, as opinions are strongly held on both sides. It notes, however, that a majority of ASB members believe that the benefits that the employer is currently committed to provide are based on current salaries. An implication of this is that, when a salary increase is awarded, an expense will arise reflecting the increase in the value of pensions that have already been earned.

In many cases a pension liability will be due not from the employer directly, but rather from a plan. In such cases it will often be appropriate for the employer to account for its responsibility (if any) to ensure that the plan is able to pay the benefits as they fall due. However, if application of the normal principles for consolidation requires it, an employer should consolidate the pension plan. (This may not often arise in respect of UK plans, inter alia because of the duty of the trustees to act in the interests of beneficiaries and not simply that of the employer.)

Consistent with current standards, it is proposed that assets held to pay pensions should be measured at a current value. Liabilities, it is proposed, should be discounted at a risk free rate, rather than the bond rate used under current standards. All changes in assets and liabilities should be reported in the period in which the change takes place. This means that there would be no 'corridor' within which gains or losses may be unrecognised, nor would any gains and losses be spread to future accounting periods.

Under current accounting standards, the expected return on assets is treated as part of the performance of the period, and the difference between the expected and the actual return is treated as an actuarial gain or loss. In contrast, the paper proposes that the actual return on assets should be reported as income. The expected return would, however continue to be disclosed.

The paper addresses financial reporting by pension plans as well as by employers. It notes that the current international standard—IAS 26—contains significant weaknesses and suggests improvements, including that the balance sheet of a pension plan should include the liability to pay benefits in the future, calculated using the same principles as for an employer.

Comments on the paper, which can be downloaded from the website at: http://www.frc.org.uk/asb/technical/projects/project0065.html, are requested by 14 July 2008, and a report will then be published setting out the conclusions of a reconsideration of the proposals in the light of the comments received. This report will provide input to the IASB and the FASB for the long-term review of pensions, to which both boards are committed.