The solutions manual for advanced financial accounting_6 potx

The tasks that have to be performed are: ● determine the amount that must be paid into the pension fund each year in order to allow it to pay the promised pensions, this is sometimes cal

(c) Explain briefly any circumstances in which a lessor and a lessee might classify a

partic-ular lease differently, i.e the lessee might classify a lease as an operating lease whilst

the lessor classifies the same lease as a finance lease or vice versa (3 marks)

(d) Explain briefly any circumstances in which the requirements of SSAP 21 with regard to

accounting for operating leases by lessees might result in charges to the profit and loss

account different from the amounts payable for the period under the terms of a lease.

(3 marks)

(e) Draft a concise accounting policy in respect of ‘Leasing’ (as a lessee only) suitable for

inclusion in the published accounts of Pilgrim plc and comment on the key aspects of

your policy to aid your managing director’s understanding (4 marks)

(f) List the other disclosures Pilgrim plc is required to give in its published accounts in

respect of its financial transactions as a lessee (3 marks)

Note: Ignore taxation.

9.9 Flow Ltd prepares financial statements to 31 March each year On 1 April 1998, Flow Ltd

sold a freehold property to another company, River plc Flow Ltd had purchased the

prop-erty for £500 000 on 1 April 1988 and had charged total depreciation of £60 000 on the

property for the period 1 April 1988 to 31 March 1998

River plc paid £850 000 for the property on 1 April 1998, at which date its true market

value was £550 000

From 1 April 1998 the property was leased back by Flow Ltd on a ten-year operating

lease for annual rentals (payable in arrears) of £100 000 A normal annual rental for such a

property would have been £50 000

River plc is a financial institution which, on 1 April 1998, charged interest of 10.56% per

annum on ten-year fixed rate loans

Requirements

(a) Explain what is meant by the terms ‘finance lease’ and ‘operating lease’ and how

oper-ating leases should be accounted for in the financial statements of lessee companies.

(7 marks)

(b) Show the journal entries which Flow Ltd will make to record:

● its sale of the property to River plc on 1 April 1998,

● the payment of the first rental to River plc on 31 March 1999

Justify your answer with reference to appropriate Accounting Standards. (13 marks)

9.10 Leese, a public limited company and a subsidiary of an American holding company

oper-ates its business in the services sector It currently uses operating leases to partly finance its

usage of land and buildings and motor vehicles The following abbreviated financial

infor-mation was produced as at 30 November 2000:

Profit and Loss Account for the year ending 30 November 2000

£m

––––

Profit on ordinary activities before taxation 88

Taxation on profit on ordinary activities (30)

––––

Profit on ordinary activities after taxation 58

––––

Balance Sheet as at 30 November 2000

Creditors: amounts falling due after more than one year(interest free loan from holding company) (50)

––––

320––––

––––

320 ––––

Total future minimum operating

The company is concerned about the potential impact of bringing operating leases onto thebalance sheet on its profitability and its key financial ratios The directors have heard thatthe Accounting Standards Board (ASB) is moving towards this stance and wishes to seekadvice on the implications for the company

For the purpose of determining the impact of the ASB’s proposal, the directors havedecided to value current year and future operating lease rentals at their present value.The appropriate interest rate for discounting cash flows to present value is 5% and thecurrent average remaining lease life for operating lease rentals after 30 November 2003 isdeemed to be 10 years

Depreciation on land and buildings is 5% per annum and on motor vehicles is 25% perannum with a full year’s charge in the year of acquisition The rate of corporation tax is 30%and depreciation rates equate to those of capital allowances Assume that the operating leaseagreements commenced on 30 November 2000

Required (a) Discuss the reasons why accounting standard setters are proposing to bring operating

(b) (i) Show the effect on the Profit and Loss Account for the year ending 30 November

2000 and the Balance Sheet as at 30 November 2000 of Leese capitalising its

(ii) Discuss the specific impact on key performance ratios as well as the general ness impact of Leese capitalising its operating leases. (8 marks)

busi-ACCA, Financial Reporting Environment (UK Stream), December 2000 (25 marks)

9.11 Accounting for leases has been a problematical issue for some years In 1984, SSAP 21, –

Leases and hire purchase contracts was issued This Accounting Standard requires that lessee

companies capitalise leased assets in certain circumstances The Standard classifies leases as

either finance leases or operating leases, depending on the terms of the lease In December

1999, the Accounting Standards Board (ASB) published a Discussion Paper – Leases:

Implementation of a New Approach.

Under the recommended approach, at the beginning of a lease the lessee would

recog-nise an asset and a liability equivalent to the fair value of the rights and obligations that are

conveyed by the lease (usually the present value of the minimum payments required by the

lease); thereafter, the accounting for the leased asset and liability would follow the normal

requirements for accounting for fixed assets and debt

Expo plc prepares financial statements to 30 September each year On 1 October 2001,

Expo plc leased a fleet of cars for its sales force There were 50 identical cars in the fleet

Relevant details for each car are as follows:

● Fair value on 1 October 2001 was £10 000

● Lease term is 2 years

● Estimated residual value of car on 30 September 2003 is £3000

● Lease rentals are £9000 in total – a payment of £4000 on 1 October 2001 plus two

pay-ments of £2500 on 30 September 2002 and 30 September 2003

● The payments of £2500 increase by £1 for every mile travelled in excess of an agreed

annual maximum of 50 000 miles per car

● The lessor is responsible for repair and maintenance of the fleet

Required

(a) Explain the factors that led to the issue of the Discussion Paper in 1999. (6 marks)

(b) Demonstrate the effect of the leasing arrangement on the profit and loss account of

Expo plc for the year ended 30 September 2002 and its balance sheet at 30 September

2002,

● assuming Expo plc follows the proposals outlined in the Discussion Paper.

(7 marks)

Note: The discount rate to be used where relevant is 10% In requirement (b), you

should explain exactly where in the profit and loss account and balance sheet the

relevant amounts will be reported.

CIMA, Financial Reporting – UK Accounting Standards, November 2002 (20 marks)

The provision of occupational pension schemes for employees is now common practice in the UK and in many other countries Expenditure on pensions can be extremely significant, adding 20 per cent, or even more, to the costs of employees’ remuneration.

Prior to the issue of SSAP 24 Accounting for Pension Costs, in 1988, the treatment of

pension costs in financial statements was subject to very little regulation through either statute law or professional guidance The result was that, in general, the financial state- ments failed to disclose a realistic figure for the costs of employing staff in that they did not indicate the actual costs of the pension and, accordingly, balance sheets often failed to dis- close the liability that the company faced in discharging its obligations SSAP 24 was a major step forward in bringing some degree of order to what had been a very disorganised field of accounting activity.

Despite, or possibly in part because of, the pioneering nature of SSAP 24, many mentators believed that it suffered from a number of conceptual weaknesses and allowed reporting entities too much scope However it took a long time to bring forward an improved standard It was only after many years’ deliberation that the ASB published FRED 20

com-Retirement Benefits, in 1999, and it was not until November 2000 that the resulting

stan-dard, FRS 17 was published That is not the end of the story because, for reasons we will explore in this chapter, FRS 17 has proved to be extremely controversial and the ASB has now decided that it will not be implemented in full until 2005 We will therefore need to deal

in some detail with both standards in this chapter

Thus in this chapter we will cover:

● SSAP 24 Accounting for Pension Costs (1988)

● FRS 17 Retirement Benefits (2000)

● IAS 19 (revised) Employee Benefits (revised 2000)

● FRED (unnumbered) Amendment to FRS 17 (2002)

Introduction

We think it would be helpful if we started by describing the main types of pension schemesthat are to be found and, at the same time, explaining some of the terms which have to beunderstood if the reader is to make sense of the rest of the chapter

1 Funded or unfunded: In the case of the funded scheme, contributions are paid into a

sep-arate fund that is usually administered by trustees who invest the contributions and meetthe pension commitments The contributions are invested in a portfolio of propertyand/or securities either directly or indirectly by the purchase of insurance policies Inunfunded schemes, contributions are not placed in a separate fund but are reinvested in

Pension costs

10

the employer’s business and pensions are subsequently paid on a ‘pay-as-you-go’ basis.

An unfunded pension scheme is obviously the more risky from the point of view of the

employees and the vast majority of pension schemes in the UK are funded

2 Defined benefits and defined contribution scheme: In defined contribution schemes, the

contributions are determined and the employees receive pensions on the basis of

what-ever amounts are available from those contributions and the returns earned from their

investment The risks in such a scheme fall entirely upon the shoulders of the employees

Such a scheme poses few problems for the accountant The amount to be charged as the

cost of providing pensions is clearly determinable as the amount payable to the scheme by

the employer in respect of a particular year

Under a defined benefit scheme the retirement benefits are determined, sometimes on

the basis of average salary over the employee’s period of service, but more often on the

basis of salary in the final year or years before retirement For such a scheme the cost of

pensions in a particular year is, as we shall see, much more difficult to determine It

depends not only upon the contribution payable in respect of a year but also upon the

pensions that will be paid in the future The pensions payable depend on such factors as

the future rate of increase in wages and salaries, the number of staff leaving the scheme

before retirement and the life expectancy of pensioners and, where relevant, their

depen-dants In addition, the cost in the year of providing future pensions depends upon the rate

of return to be earned on contributions and reinvested receipts It is the need to take a

very long-term view in the face of great uncertainties that makes accounting for defined

benefit schemes such an interesting and difficult problem for the accountant

Fortunately for many employees, but perhaps unfortunately for accountants, most UK

pension schemes, certainly those of major employers, have been of the defined benefit

variety However, in recent years, a large number of major employers have closed down

their defined benefits schemes to new employees and replaced them with defined

contri-bution schemes

3 Contributory or non-contributory : Some schemes are contributory, where the employees

and the employer share the cost, while others are non-contributory, where the whole cost

falls on the employer

The issues

We will in this chapter concentrate on funded schemes where the assets are held by the

trustees of the pension fund on whom falls the liability of paying the actual pension Pension

schemes are not normally subsidiaries, or quasi-subsidiaries, and it is not, therefore,

appro-priate to consolidate the scheme into the employer’s financial statements However, a

pension scheme can give rise to assets and liabilities of the employer but only to the extent to

which the employer is entitled to benefit from any surplus or has a legal or constructive

obligation to make good any deficit

The tasks that have to be performed are:

● determine the amount that must be paid into the pension fund each year in order to allow

it to pay the promised pensions, this is sometimes called the regular contribution;

● measure the assets and liabilities of the fund;

● decide how any difference between the assets and liabilities should be reflected in the

financial statements

Pensions involve, by their nature, long-term issues including such things as life expectancy.Thus actuaries play a key part in assessing the regular contribution and in valuing the liabil-ities, although their role in valuing assets will be of less significance when the provisions ofFRS 17 are applied in full.

We will illustrate the issues involved and the approach that might be taken by the actuary

by describing a very simple scheme involving only one employee

Let us suppose that at the inception of the scheme the sole employee, Mac, is aged 41 and

is due to retire in 24 years’ time at 65 It is currently estimated that his life expectancy on hisdate of retirement will be 15 years

The actuarial calculations might proceed as follows:

Assume that Mac’s salary will increase by 6% per year Hence, salary on retirement = £20 000 (1.06) 24 ≈ £81 000.

If, on retirement, a pension of half final salary is payable, the fund will need to be sufficient

to pay £40 500 per annum for 15 years Assuming, for simplicity, that the retirement pensionwill be paid at the end of each year and that it is expected that the assets in the fund will earn

8 per cent per annum for the period following retirement, the capital value of the fund atretirement age will need to be £346 660.1

If we assume that, in the period until retirement, the annual return on investments is only

7 per cent, then 13 per cent of the staff member’s salary will need to be paid into the fund.2

Actuarial gains and losses

Now let us see how things can go wrong, or to be more precise, how things might change.Few, if any, pension funds put all their investments in fixed-interest securities and so thereturn earned will probably not be 7 per cent If the assets in, say, five years are worth morethan the actuary had expected, how should that gain be treated? Should the surplus be cred-ited to the profit and loss account immediately or over some future period? A differentquestion is whether the difference between the expected and actual value of the assets should

be returned to the employer immediately or used to reduce the future regular payments.There may also be changes in the actuarial assumptions Actuarial science is based onaverages and people are, on average, living longer Thus, suppose that five years into thescheme, the actuary revises his estimate of Mac’s life expectancy and now expects that he willlive for 18 years after retirement rather than 15 The fund will not be sufficient to pay theexpected required pension, so what should be done? Should the extra cost be charged to thecurrent profit and loss account immediately or spread over some future period? A different

1On the date of retirement the required balance on the fund x is given by:

question concerns whether the employer should immediately pay the extra required or

simply increase the regular payments to reflect the new assumption

The above are simple examples of what are termed actuarial gains and losses and as we

shall see SSAP 24 and FRS 17 take very different lines as to how they should be treated

Valuation of pension fund assets and liabilities

There are basically two ways of measuring pension fund assets: the actuarial approach (the

basis underlying SSAP 24) and the market approach which is the one most commonly used in

countries other than the United Kingdom and is the method specified in both FRS 17 and

IAS 19 Employee Benefits (revised 1998)

The actuarial approach measures both the obligations of the fund and the assets of the

fund by reference to the present values of the expected cash flows In contrast, the market

approach, as the name implies, values the assets by reference to their current market values

while, in theory at least, the liabilities would be measured by the price that would have to be

paid to purchase appropriate deferred annuities These two methods are obviously not

unconnected; for example, a change in the market’s view as to long-term interest rates will

affect the actuary’s calculations of present values, the current value of investments and, in

particular, the market value of deferred annuities But in the short term, there may be

con-siderable variations due to the short-term market fluctuations

As we shall see, those who would advocate a market approach recognise that it is rarely

possible to identify market values against which the obligations of the pension fund can be

measured Thus it is accepted that the fund’s liability will have to be based on the present

value of the expected pension payments but that still leaves open the choice of interest rate

Traditionally, the actuarial approach discounted the future pension payments at the same

rate as that used to estimate the return on assets An alternative approach, which is more in

tune with the market approach, is to use a rate of interest that reflects the time value of

money plus a risk premium relating not to the risks associated with the returns on the assets

but to the risk that the employer will not be able to meet its obligations, see p 262

SSAP 24 and FRS 17– the differences in outline

We will look at the differences between SSAP 24 and FRS 17 in more depth after we have

properly introduced the two standards but readers will find it helpful, before examining

SSAP 24, to be aware of the major differences between the two approaches

SSAP 24 focuses on the profit and loss account and is primarily concerned with matching

revenue and expenses even if this results in some rather unsatisfactory estimates of assets and

liabilities Its stated objective is to require ‘the employer to recognise the cost of providing

pensions on a systematic and rational basis over the period during which he benefits from

the employees’ services’.3No mention here of the reporting of assets and liabilities

In contrast, FRS 17 takes a much more ‘balance sheet approach’ and seeks to ensure that

the fair values of the pension fund’s assets and liabilities are the bases for determining

whether the employer has an obligation to the fund or the fund has an obligation to the

employer Specifically the objectives of FRS 17 are to ensure that:

3 SSAP 24, Para 16.

a financial statements reflect at fair value the assets and liabilities arising from an employer’s retirement benefit obligations and any related funding;

b the operating costs of providing retirement benefits to employees are recognised in the accounting period(s) in which the benefits are earned by the employees, and the related finance costs and any other changes in value of the assets and liabilities are recognised in the accounting periods in which they arise; and

c the financial statements contain adequate disclosure of the cost of providing retirement benefits and the related gains, losses, assets and liabilities 4

The main consequences of the very different approaches taken by FRS 17 and SSAP 24 are:

● SSAP 24 allows certain types of differences, called experience differences, to be written offover the remaining service life of the current employees while FRS 17 calls for immediaterecognition in the financial statements

● SSAP 24 is based on the actuarial method of valuation, for both pension fund assets andliabilities, while FRS 17 is firmly rooted in the market approach

● FRS 17 is much more prescriptive about the methods that should be used

In addition, in line with the principle that users should be provided with more ‘narrative’information that would enable them more easily to appreciate the information provided inthe financial statements, the disclosure requirements of FRS 17 are more extensive than thenot inconsiderable requirements of SSAP 24

SSAP 24 Accounting for Pension Costs

The accounting principles underlying SSAP 24

Prior to the adoption of SSAP 24 many companies simply showed their contribution to thepension scheme as the pension cost for the period The contribution may have been affected

by factors other than those relating solely to the needs of the fund Employers might, forexample, increase the contribution for a year or for a limited period, with a view to reducingcontributions in the future Conversely, employers have in periods of financial stringencyreduced their contributions Such actions may have been effective in achieving the desiredability to manipulate the levels of reported profit, but they did little to help users of financialstatements assess the total costs of employment for the period

The accounting objective set by SSAP 24 was to require employing companies to nise the cost of providing pensions on a systematic and rational basis over the period inwhich they benefit from the services of their employees and to recognise that, in manycases, this cost may well not be equal to the contribution made to the pension scheme inany period.5

recog-Thus, in a very simple world, the actuary’s task is to estimate what proportion of able pay would have to be paid into the scheme each year to pay for the pensions, and thewhole of this (in the case of a non-contributory scheme) or a part of this (in a contributoryscheme) would represent the cost to the employer This cost can be regarded as the regularpension cost

pension-4 FRS 17, Para 1.

5 Since tax relief is based on the contributions paid to the scheme the difference has deferred tax implications See Chapter 12.

But we do not live in such a state of simplicity and both the world and employers change

their minds The world changes its mind through altered interest rates, changes in the level

of earnings and by allowing people to die other than when predicted by the actuary

Employers can also change their minds (or have their minds changed for them) and vary the

conditions under which pensions are paid

Thus, there will be variations to the regular cost and a large part of SSAP 24 is devoted to

discussing how to account for these variations Variations from the regular cost may be due

to the following:

(a) the results of the world not being as the actuary expected it to be when he or she last

worked out the regular cost – experience surpluses or deficiencies;

(b) changes in actuarial assumptions and methods and retroactive changes in benefits or

conditions of membership;

(c) discretionary pensions increases

Bases of the actuarial methods

In general SSAP 24 does not specify how the actuary should determine the actuarial value of

pension fund assets and liabilities Much is left for the actuary to decide:

The selection of the actuarial method and assumptions to be used in assessing the pension

cost of a defined benefit scheme is a matter of judgement for the actuary in consultation with

his client, taking account of the circumstances of the specific company and its work force.

(Para.18)

It would perhaps not be too great an exaggeration to say that, as far as SSAP 24 is concerned,

it is a matter of ‘anything actuarial goes’ FRS 17 is far more prescriptive and it will be

con-venient to defer our discussion of some of the main actuarial methods used to that section of

the chapter in which we discuss FRS 17 in more detail

Experience surpluses or deficiencies

In deciding whether the fund is in balance, that is whether it has sufficient assets to pay the

required pensions given all the necessary assumptions about salary increases, rates of return

and the like, the pension fund’s assets are compared with its liabilities Part of any difference

may be due to changes in policy and assumptions about the future; these will be dealt with

in the reassessment of the regular costs but, as noted above, part of the difference will, in

all likelihood, be because some of the assumptions made at the last review proved to be

incorrect, for example the rate of wage and salary increases might have been under- or

over-estimated This part of the difference is known as experience surpluses or deficiencies, which

are defined in SSAP 24 as follows:

An experience surplus or deficiency is that part of the excess or deficiency of the actuarial

value of the assets over the actuarial value of the liabilities, on the basis of the valuation

method used, which arises because events have not coincided with the actuarial

assump-tions made for the last valuation (Para 63)

The definition refers, not to the market value of the assets, but to their ‘actuarial value’,

which is a value based on assumptions about future cash flows and interest rates and which

may well, from time to time, differ significantly from the current market value As we

explained earlier the use of actuarial rather than market values was a controversial issue andFRS 17 takes a very different approach.

But at this stage we will concentrate on the treatment of experience surpluses and ciencies Should they be credited (or charged) to the past, the current year or the future?SSAP 24 specifies that, with certain exceptions to which we will refer later, material ex-perience deficiencies, and surpluses, should be dealt with by adjusting current and futurecosts and not by immediately expensing (or crediting) the amount In accordance with themain accounting objective of SSAP 24, the normal period over which the effect of the defi-ciency or surplus should be spread is the expected remaining service life of the currentemployees in the scheme after making suitable allowances for future withdrawals, or theaverage remaining service lives of the current membership

defi-There are three exceptions to the general rule:

(a) Where there is a significant reduction in the number of employees covered by thescheme (see below)

(b) Where prudence requires a material deficiency to be made up over a shorter period Thisexception is strictly limited to cases where a significant additional payment has to bepaid into the scheme arising from a major transaction or event outside the actuarialassumptions and normal running of the scheme; a possible example is the consequence

of a major mismanagement of the assets of the pension scheme The standard does notspecify the period over which the additional charge should be spread; it merely allows ashorter period than would otherwise be required

(c) Where a refund is made to employers subject to deduction of tax within the provisions

of the Finance Act 1986, or similar legislation In such cases the employer may (notmust) depart from the normal spreading rule and recognise the refund in the period inwhich it occurs

The exception arising from a significant reduction of employees merits further comment.There have been many instances in recent years where reorganisation schemes have resulted

in significant redundancies These have often led to large surpluses in the pension funds,with the result that future contributions are reduced or eliminated for a period (a ‘contribu-tion holiday’), or contributions are refunded

In such instances, the benefit should not be spread over the lives of the remaining workforce but instead recognised in the periods in which the benefits are received They should,

in general, not be anticipated in the sense of taking credit immediately the facts are known,but should be recognised on a year-by-year basis But to this rule there is an exception,where the redundancies are related to a sale or termination of an operation, for in such a

case FRS 3 Reporting Financial Performance must be followed (SSAP 24, which of course

predates FRS 3, refers to SSAP 6 in this context.) It may not be appropriate to defer tion of a pension cost or credit, because FRS 3 requires that provisions relating to the sale ortermination of an operation be made after taking into account future profits of the operation

recogni-or on the disposal of the assets

Changes in actuarial assumptions and methods and retroactive changes to the scheme

The effect of changes in the assumptions and methods used by the actuary should be treated

in the same way as experience deficits and surpluses – they should be spread over the period

of the expected remaining service lives of the current employees

The same rule should be applied if there are retroactive changes in benefits and

member-ship Such changes, often called past service costs, may give improved benefits, e.g

increasing the proportion of final salary which will be paid as pension, or give employees

credit for periods of service before they joined the scheme

In some cases a surplus on a pension fund may be used to improve benefits and if, as a result,

a provision that the company had made in its own accounts is no longer necessary, that

provi-sion should be released over the estimated remaining service life of the current employees

Discretionary pension increases

A pension scheme might allow for pension increases within its rules, in which case they will be

taken into account in the actuarial calculations, as should any increases required by legislation

Other increases are discretionary on the part of the employer, whether paid direct or

through the pension scheme If such increases are granted on a regular basis, SSAP 24 states

that the preferred treatment is to allow for them in the actuarial calculations If this is not

done, the full capital value of the increase should be provided in the year in which it is

granted, not in the years in which it is paid, to the extent to which the increase is not covered

by the surplus on the fund

The same procedure should be followed in the case of an ex gratia pension granted to an

employee on retirement, such as a long-serving member of staff who for some reason has not

been a member of the scheme Thus, for example, if it is estimated that the amount which would

need to be invested to produce the desired pension at the estimated rates of interest is £400 000

then that amount should be charged to the profit and loss account in the year of retirement

A non-recurring increase, which is granted for one period only with no expectation of

repetition, should be charged to the period in which it is paid to the extent that it is not

cov-ered by a surplus

The following example serves as a summary of the above and illustrates the variations

between the contributions made to the scheme and the costs of pensions charged to the

profit and loss account

Slick Limited is a small company that established a non-contributory defined benefit funded

scheme in 20X1 Its year end is 31 December.

For arithmetical simplicity we will assume that the annual pensionable salary bill was

£1 000 000 before the reorganisation referred to in paragraph C below and £600 000 thereafter.

(A) On the inception of the fund in 20X1 the actuary estimated that a contribution rate of 20 per

cent on pensionable salaries would be required.

20X1–20X3

The charge to the profit and loss account will equal the contribution paid to the fund in each

year, that is 20 per cent of £1 000 000 = £200 000.

(B) At the first triennial actuarial valuation in 20X4 the regular cost was estimated to be 21 per

cent There was at that stage an experience deficit of £75 000 which was paid into the fund

by the employer in 20X4 The average remaining service life of the employees at that date

was 15 years.

Example 10.1

The position for each of the years 20X4–20X6 will be as follows:

The surplus resulting from redundancies was estimated to be £200 000, which is to be recouped by a reduction of £50 000 in the contributions otherwise payable for each of the four years 20X7–20Y0 We shall assume that this event constitutes a ‘sale or termination’ of

an operation as defined in FRS 3.

In addition there was an experience surplus of £56 000 arising from events other than the reorganisation The remaining average service life of the employees was 14 years.

The regular cost is estimated to be 18 per cent of £600 000 and the experience surplus of

£56 000 is to be deducted in arriving at the 20X8 (not 20X7) payment.

For each of the years 20X7–20X9 the accounting treatment will be as follows:

Charge to profit and loss account

in respect of regular cost and experience deficit/surplus.

Credit to profit and loss account

in respect of surplus on termination 200 000

Amount paid to fund

––––––––– –––––––––

Charge to profit and loss account – as above 109 000

Amount paid to fund – as above 58 000

less Experience surplus 56 000 2 000

––––––––– –––––––––

Charge to profit and loss account – as above 109 000

–––––––– –––––––––

The above may be summarised as follows:

Profit & loss Cash Balance account expense payment prepayment at

The prepayment at 31 December 20X9 may be analysed as follows:

––––––––

51 000 ––––––––

Note: The deferred tax implications have been ignored.

We have now completed our main discussion of the accounting principles underlyingSSAP 24, but we will deal with a number of related issues before turning to disclosure

Related issues

The effect of discounting

SSAP 24 points out that financial statements normally show items at their face value withoutdiscounting, but by their very nature actuarial assumptions do make allowances for interest sothat future cash flows are discounted to their present values The statement points out that thequestion of whether items should be discounted in financial statements is a general one and onthis general issue SSAP 24 should not be regarded as establishing standard practice

In the special case of unfunded schemes the question of discounting cannot be avoided Theannual charge for pensions in any unfunded scheme is made up of two elements: the charge forthe year (which is equivalent to the contribution to a funded scheme) plus interest on theunfunded liability In an unfunded scheme the assets to support the pension are retainedwithin the business and the latter element represents the return on those investments

We will return to this topic when discussing FRS 17

Group schemes

It is common for a number of companies in a group to use a single group scheme in which it

is accepted that a common contribution rate can be used, even if when calculated company

by company different rates would emerge The standard allows this practice to continue andfor lesser disclosure in the case of subsidiary companies, although full details have to be pro-vided in the financial statements of the holding company

Foreign schemes

In principle, all pension costs should be accounted for in accordance with the standard andhence consolidation adjustments may be required in the case of overseas subsidiaries.However, where countries overseas have very different pension laws or where the cost ofmaking the necessary actuarial calculations is excessive, the contributions to the relevantoverseas scheme may be treated as the costs for the period

11 ––

14

9 ––

15

Scope

The standard is not restricted to instances where employers have a legal or contractual

com-mitment to pay pensions; it also covers cases where the employers implicitly, through their

actions, provide or contribute to employees’ pensions

Disclosure requirements

The main accounting principle is fairly straightforward Estimate the regular cost and,

sub-ject to certain exceptions, spread the cost or benefit from variations over the remaining

service lives of the current employees

Given the uncertain nature of the estimates that are involved and the length of the time

period over which they have to be made, it is not surprising that the standard requires

exten-sive disclosure of surpluses or deficiencies in respect of defined benefit schemes, just

stopping short of asking for the colour of the actuary’s eyes

It would not be helpful to repeat the requirements here but they can be summarised as

follows:

(a) nature of the scheme;

(b) accounting and funding policies;

(c) date of last actuarial review and status of the actuary; i.e whether or not an officer of the

company;

(d) the pension cost for the period, together with an explanation of significant changes

com-pared with the previous period, and any provisions or prepayments included in the

balance sheet;

(e) the amount of any deficiency and action, if any, being taken in consequence;

(f) details of the last formal valuation or review of the scheme including:

(i) actuarial method used and main actuarial assumptions;

(ii) market value of the assets;

(iii) level of funding expressed in percentage terms of the benefits accrued by members

and comments on any material surpluses or deficiency so revealed;

(g) details of any commitments to make additional payments and the effect of any material

changes in the company’s pension arrangements

An appendix to the standard provides some useful hypothetical examples of what might be

disclosed by different types of companies but, a little surprisingly, does not provide an

ex-ample of an unfunded scheme

From SSAP 24 to FRS 17

The introduction of SSAP 24 in 1988 resulted in some reduction in the range of methods

used for accounting for pension costs but, given the pioneering aspects of the standard, there

was a need for a reasonably early review of the lessons learnt from its implementation The

review did not, however, come quickly, for the first of the two discussion papers relating to

review, Pension costs in the employer’s financial statements, was not published until 1995 The

second paper, Aspects of accounting for pension costs, emerged in 1998 and this was followed

by FRED 20 Retirement Benefits, issued in October 1999 The whole process culminated in

the promulgation of FRS 17 Retirement Benefits in November 2000.

SSAP 24 had, even when it was issued, an old-fashioned air about it While it was, in someways, a radical document in that it attempted to bring some order to an important aspect offinancial reporting that had previously been largely unregulated, it was also backward look-ing in that it did not seek to ensure that an entity’s assets and liabilities were properlyrecorded Examples of this include the provision that pension funds assets should be valued

at the actuarial rather than their market value and that actuarial surpluses and deficitsshould be recognised over time rather than immediately

There has over the period since 1988, and in particular since 1995, been a move towardsthe view that users of financial statements are generally better served if supplied with infor-mation about the fair values of assets and liabilities

The 1995 discussion paper set out the two alternative methods of asset valuation but theresponse was overwhelmingly in favour of the actuarial method, the main reasons being thevolatility of market values and the impossibility of estimating the market values of the pen-sion liability A majority of the members of the ASB agreed with this consensus but, at thesame time, the Board recognised that there is no prospect of other countries adopting theactuarial approach and hence, as part of the move to international convergence, the 1998paper proposed the acceptance of the market value approach This proposal was accepted bythe majority of the respondents to that paper.6 While this seems to indicate a significantchange of opinion over the three-year period, there are still considerable concerns about thegreater volatility introduced by the use of the market approach

● Should account be taken of salary increases to which the employer is not yet committed?

● At what rate should the liabilities be discounted?

Should account be taken of the time value of money in determining the current service charge?

The annual cost of providing a pound of pension for an employee in her twenties is less than that

of a counterpart in her fifties because a greater return will be earned on the assets transferred tothe pension fund Should this be recognised in determining the current service charge?

Two types of actuarial methods are mentioned in SSAP 24:

● accrued benefits methods;

● prospective benefits methods

These differ in their treatment of the time value of money

6 FRS 17, Appendix IV, Para 6.

Under an accrued benefits method, each period is allocated its share of the eventual

undiscounted cost of the pension The share of each period is then discounted and this

pro-duces a lower cost the further each period is away from the date of retirement This results in

a higher cost towards the end of an employee’s service life than at the beginning because the

effect of discounting the cost lessens as the employee approaches retirement

Under a prospective benefits method, the total cost including all the interest that will

accrue is spread evenly over the employee’s service life

The ASB believes the financial statements should reflect the fact that the cost of providing

a defined benefit pension increases the closer the employee gets to retirement and therefore

requires the use of an accrued benefits method.7We shall illustrate the application of an

accrued benefit method in Example 10.2

Should account be taken of salary increases to which the

employer is not yet committed?

In terms of calculating the retirements benefits to which an employee is due, account should

be taken of estimated salary increases to which the employer is not yet committed In

deter-mining the percentage of salary that needs to be set aside to provide for these benefits,

however, future salary increases should not be taken into account Let us look at each in turn

Likely benefits

The standard requires the defined benefit liability to be the best estimate of the present value

of the amount that will actually be paid out.8 Thus, for defined benefit schemes based on

final salaries the liability should be based on the expected final salary, not the current salary

The Board accepts that there might be an argument, based on FRS 12 Provisions, Contingent

Liabilities and Contingent Assets, that because the employer has some control over the future

increases in salary it does not have a present obligation relating to those increases This

argu-ment is rejected because the Board believes that there is a present commitargu-ment to pay a

pension based on final salary, and that this liability should be reflected in the financial

state-ments It also points out that the use of expected final salaries is consistent with IAS 19

(revised) as well as with the US FAS 87

Basis for the contributions

The approach adopted by FRS 17 is inconsistent, although, in determining the percentage

of the salary that needs to be set aside to allow for the payment of the expected benefits, only

the salaries expected to be paid in the following year are taken into account, as the method

specified in FRS 17 is the projected unit method.9With this method the standard rate of

con-tribution, the regular cost, is calculated by dividing the present value of the benefits expected

to accrue in the year after the valuation (which will take into account the projected final

earnings of employees) by the present value of the projected earnings of the employees in

7 FRS 17, Appendix IV, Para 11 In the case of a mature pension scheme where the average age of the employees is

reasonably constant the two methods will yield pretty much the same result.

8 FRS 17, Appendix IV, Para 12.

9 FRS 17, Para 20.

that year.10There is an alternative actuarial approach known as the attained age method

where the contribution rate is calculated by dividing the present value of the benefits whichwill accrue to the members of the scheme after the date of the valuation, as with the pro-

jected unit method, by the present value of the total projected earnings of the members of

At what rate should the liabilities be discounted?

In the past, actuaries discounted liabilities in a defined pension scheme by using the mated expected rate of return on the scheme’s assets While this approach does not seemunreasonable the Board take the view that a more realistic approach would be to use a dis-count rate that reflects the time value of money and the risk associated with the liability.11The point that employers could, if experiencing financial difficulties, mitigate their position

esti-by granting less than expected salary increases is made to support the view that the risk mium should be small While the Board recognises that the risk premium will differ betweenschemes it requires, for the sake of both objectivity and international convergence, the use of

pre-a stpre-andpre-ard interest rpre-ate: the rpre-ate of return on pre-a high qupre-ality corporpre-ate bond, i.e one rpre-ated pre-at

AA or equivalent status

Frequency of actuarial valuations

Full actuarial valuations should be undertaken by a professionally qualified actuary at leastevery three years but the actuary should review the most recent valuations at each balancesheet date and update them in the light of current conditions (Para 35)

FRS 17 and the recognition of the costs of retirement benefits schemes

The nature of the costs

As we described earlier one of the major differences between SSAP 24 and FRS 17 is that theformer requires certain differences to be written off over a period of time while the latterrequires instant write-off, while believing that it is important to distinguish between thoseitems that should appear in the profit and loss account and those whose place is in the state-ment of total recognised gains and losses We will discuss the ASB’s rationale for theapproach taken by FRS 17 in a later section of the chapter dealing with the reaction toFRS 17 but we will first outline the relevant provisions of the standard

10 The reason why the calculation is based on the figures for the following year rather than the current year is that the method was developed by actuaries to determine the regular cost for the future period.

11 FRS 17, Appendix IV, Para 21.