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Fasshauer, Glaum and Street, 2008

Executive summary

While for several years a significant number of European companies have prepared consolidated financial statements using International Financial Reporting Standards (IFRS), 2005 represented the first year of IFRS adoption by thousands of additional European listed companies. For many of the latter, adoption of IFRS significantly changed the way they account for pension plans, especially defined-benefit plans. Our study provides an in-depth analysis and evaluation of the defined-benefit pension plan disclosures provided in 2005 by companies constituting the premier segments of 20 European stock exchanges. Most importantly, our study identifies the method companies select under International Accounting Standard (IAS) 19 for the recognition of actuarial gains and losses, provides insight into factors affecting the policy choice between the three methods allowed under IAS 19 for the recognition of actuarial gains and losses, and assesses the impact on profit and loss (P&L) and the balance sheet of using the new IAS 19 full recognition option, in contrast to the traditional corridor approach.

The new IAS 19 option

Following the 2004 amendment of IAS 19 ‘Employee Benefits’, companies with defined-benefit pension plans may choose one of three methods to account for the recognition of actuarial gains and losses. A primary objective of our research is thus to determine the method selected in 2005 by European blue chip companies:

• full recognition through the Statement of Recognised Income and Expense (SORIE) (ie through shareholders’ equity)
• full recognition through Profit & Loss (P&L), or
• the ‘standard’ corridor approach.

During its development, FRS 17 spurred tremendous opposition owing to the standard’s potential, inter alia, both to increase reported pension liabilities and to decrease shareholders’ equity, significantly. Sometime thereafter, the US Financial Accounting Standards Board (FASB) faced similar opposition when mandating a movement from the corridor approach to the full recognition of actuarial gains and losses in Statement of Financial Accounting Standard (SFAS) 158 (FASB 2006b).

Therefore, expectations may have been that few European companies would voluntarily adopt full recognition of actuarial gains and losses under the new IAS 19 option.

On the other hand, companies face pressure from regulators, politicians, and the press, to incorporate more transparency into pension accounting, and this may influence decision making on pension accounting policies. For example, financial analysts have a strong preference for immediate recognition (Credit Suisse First Boston 2005; JP Morgan 2006). According to a Shuttleworth actuary: ‘Make no mistake these FRS 17 deficits are real – they represent the company’s probable future contributions and no amount of clever smoothing can cover this up’ (Dovovan 2003).

Furthermore, the International Accounting Standards Board (IASB) currently has a project on its agenda to converge with the US’s SFAS 158. In light of the views expressed in the IASB’s March 2008 Discussion Paper Preliminary Views on Amendments to IAS 19 Employee Benefits, some IFRS companies may well view mandatory immediate recognition as the unavoidable next wave of pension accounting and may choose to be among those companies voluntarily embracing transparency prior to its being mandated.

Sample selection and descriptive statistics

Our sample selection began with the 549 companies constituting Europe’s 20 premier stock market indices in the year 2005. Some companies were deleted for various reasons, including being cross-listed, using US GAAP, and not providing an English language annual report. Of the remaining 481 companies, 265 had material defined-benefit pension plans (defined as having a Defined-benefit Obligation (DBO) representing 2% or more of total assets) that additionally provided the required pension disclosures needed for our study. Based on total assets, the mean/median size of our final sample companies is €36,937.0/€9,292.0 million. Excluding companies in the finance industry, mean/median total revenues is €14,307.1/€6,734.3 million.

Based on the mean/median, sample companies have on average underfunded pension plans, (ie the DBO exceeds the fair value of plan assets); the mean/median funding deficit is €913.9/€247.8 million. For companies with underfunded defined-benefit pension plans, the deficit represents 17%/9% (mean/median) of total shareholders’ equity. Sub-dividing companies with underfunded plans into those using the corridor approach versus those using full recognition, the corresponding numbers are 16%/9% and 19%/10%, respectively.

The ratio of underfunding to total shareholders’ equity is highest for German (37%), UK (22%), Belgian (21%), and Portuguese (20%) companies. The underfunding ratio is lowest for companies based in Switzerland (9%), Luxembourg (8%), Italy (7%), Denmark (7%), and Finland (7%).

Before turning to the primary focus of our study and discussing what IAS 19 methods companies select for the recognition of actuarial gains and losses, and the impact on P&L and the balance sheet of using the new IAS 19 full recognition option, we present our findings regarding the assumptions used by sample companies to measure defined-benefit obligations. We also consider a few best-practice disclosures.

Conclusion and recommendations

The IASB acknowledges that is undesirable to allow different choices for the recognition of actuarial gains and losses. Our findings strongly support the Board’s position by providing evidence that the financial statement impact of using different methods for the recognition of actuarial gains and losses is frequently material, particularly from a balance sheet perspective. For companies with material defined-benefit pension plans, our findings clearly reveal a lack of financial statement comparability, which stems from the flexibility allowed under IAS 19. Specifically, our findings highlight that IAS 19 enables some European companies to achieve material amounts of off-balance sheet financing by using the corridor approach. Sample companies using the corridor are overstating equity by 3.43% on average and understating recognised net pension liability on average by 41.02%.

On a more positive note, we find that the new IAS 19 option, which is based on FRS 17, is widely accepted not only in the UK and Ireland, but also in countries with high unfunded pension obligations (eg Germany).

We encourage the IASB to move forward with the proposal set forth in the Board’s recently issued discussion paper to eliminate the corridor approach and require full recognition of actuarial gains and losses. This would make the IASB standard more consistent with SFAS 158, thereby enhancing international comparability. Otherwise, many European companies will continue to use the corridor approach to achieve off-balance sheet presentation of large parts of their pension liabilities.

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