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British Airways is the latest major company to announce the closure of its final salary pension scheme to new members, blaming the controversial Financial Reporting Standard (FRS) 17 accounting standard. In April, the chairman of fellow FTSE 100 company Dixons bitterly attacked FRS 17 as the company announced its decision to stop its scheme. So why is this accounting standard unpopular, and is it likely to survive?
FRS 17 was issued by the Accounting Standards Board (ASB) on 30 November 2000. It sets out the new accounting treatment for pension schemes. Transitional provisions are in force, but the ASB has encouraged companies to adopt FRS 17 early. It will be in full force for accounting periods ending on or after June 2003.
FRS 17 requires companies to give immediate recognition in their accounts to fluctuations in the value of assets and liabilities in their final salary or defined benefit schemes. Under FRS 17, private sector pension scheme assets are measured using market values, while pension scheme liabilities are measured using a projected unit method and discounted at an AA-rated corporate bond rate. The resulting scheme surplus or deficit is recognised in full on the balance sheet. This also means that the cost of benefit improvements will be recognised immediately in the profit and loss account.
FRS 17 is a major change from the previous pensions accounting standard, Statement of Standard Accounting Practice (SSAP) 24. This was criticised for its lack of transparency and poor disclosure requirements. SSAP 24 uses actuarial values for assets in a pension scheme, but this is inconsistent with international practice. The objective of SSAP 24 was to arrive at a regular pension cost each year that was smoothed and stable. Any variations from the regular cost were spread forward and recognised gradually over a number of years. The perceived problem with this practice is that it produces figures on the balance sheet that do not represent the current surplus or deficit in the pension scheme. It also gives rise to charges in the profit and loss account that are affected by gains and losses that have been accumulated over previous years.
In contrast, FRS 17 uses a market-based approach. Its objective is to provide the shareholders and management of a company with a clearer view of the financial risks involved in operating a pension scheme. However, the use of market values introduces volatility into the measurement of the pension scheme surplus or deficit. Any fall in equity value will have a far more dramatic and immediate effect on the reported figures. The ASB has attempted to mitigate the problem of volatility by requiring that the profit and loss account shows the relatively stable continuing service cost, interest cost and expected return on assets. The effect of fluctuations in market values will not be part of the operating results of the business, but will be treated in the same way as a revaluation of fixed assets, appearing in the statement of total recognised gains and losses. However, erratic fluctuations are still likely to occur.
FRS 17 makes the risks associated with pension schemes more apparent. This is a serious issue considering that the pension scheme may be larger than the capitalisation of the operating company. There is more pressure on companies operating final salary schemes to move away from more volatile equities and into lower risk bonds, but such shifts could lead to lower credit ratings and higher cost of debt for the sponsoring companies. Future earnings or dividends of companies could also be affected as the liquidity of the company could be reduced.
There is a real danger that FRS 17 overstates pensions liability. It has been estimated that around half of the FTSE 100 companies will show pension fund liabilities under FRS 17. In the accounts of one particular company, FRS 17 would have shown a surplus of £3bn for 1997, which became a deficit the following year. Under SSAP 24, no surplus showed up at all.
The Coats Viyella Pension Scheme provides another example of volatility. The scheme had a surplus of £85.4m last year, but following the full implementation of FRS 17 this year, it now has a deficit of £2.2m. As a result, the company's pre-tax profits have been reduced by 18 per cent.
There has been a great deal of press coverage on FRS 17 lately, for the most part linking it to closures of final salary schemes. The Government has challenged the ASB but the ASB has refused to back down. At the May National Association of Pension Funds Annual Conference in Brighton, ASB chairman Mary Keegan criticised schemes for failing to react more quickly to FRS 17 and blamed the state of the market for the unwelcome side effects. One contentious issue is that FRS 17 goes beyond some of the requirements of US and international accounting standards, but the ASB has argued that international standards will ultimately be brought into line. It is questionable whether this is correct, as the EU is planning to require reporting under the International Standard by 2005. Ultimately, FRS 17 is here to stay, at least for the foreseeable future. As far as final salary schemes are concerned - which are already under pressure from forces such as the minimum funding requirement, poor performance and increased mortality - it could well be the straw that breaks the camel's back.
Lesley Browning is a pensions partner at Norton Rose