The European Commission is on the cusp of endorsing the revised International Accounting Standard (IAS 19) for use by Europe-listed companies, but the effects on many companies’ financial statements remain uncertain, according to Mercer.
The revisions to IAS 19 are intended to make the treatment of pension risk on a company’s balance sheet more transparent to investors, in the financial statements, by requiring immediate recognition of any under- (or over-) funded liabilities, and in the disclosures. Companies with DB pension plans that impose relatively large liabilities on their balance sheets, and that have relatively high exposure to risk-seeking assets, may find that stakeholders give greater scrutiny to their financial statements as they seek to understand what steps are being taken to mitigate the potentially volatile effect.
“Amongst other things, the revised IAS 19 requires companies to disclose more information about their pension plan risks and liabilities,” said Dr. Deborah Cooper, partner at Mercer in London. “This will give investors more insight into the pension risk that a company carries. All else being equal, where the risks are material, investors are likely to prefer those companies that can identify stronger governance and internal controls.”
Cooper says this increased scrutiny may well prompt a widespread review of the risk management procedures applied to DB plans.
In Canada, where The Canadian Accounting Standards Board has already adopted amended IAS 19, the industry is already paying attention to the new standard’s impact on organizations.
“Publicly traded companies in Canada, as well as private enterprises that have adopted IFRS, will need to transition to amended IAS 19,” said Lorraine Gignac, principal at Mercer in Toronto. “The combination of amended IAS 19 and Basel III will have a significant impact on Canadian financial institutions.”
While most U.S. companies are focused on US GAAP rather than IFRS, the changes in IAS 19 could have a secondary effect on American companies.
“The ability under IAS 19 to exclude actuarial gains and losses from the company’s annual net income is an advantage in the capital markets that some U.S. companies have already started trying to match by combining immediate gain and loss recognition with no-GAAP reporting,“ said Jim Verlautz, a principal with Mercer in Minneapolis. “In addition, FASB [the Financial Accounting Standards Board] has announced that they have felt pressure from the investment community to change U.S. pension accounting and that adoption of rules similar to the new IAS 19 is one option to be considered.”
Mercer considers that removing the expected return on assets is likely to make companies focus more on their choice of discount rate. The discount rate prescribed by IAS 19 is driven by yields on high quality corporate bonds, but in most European countries the market for these has come under considerable pressure recently due to the sovereign debt crises.
“We expect companies to be more careful about how they choose to value their pension liabilities, now that the effect of the discount rate will hit balance sheets immediately and also affect the bottom line,” explained Cooper. “The market for ‘high quality’ bonds is not that deep, and a significant proportion of those bonds are issued by companies operating in the financials sector, so the market is likely to be distorted by the euro crisis. Simply selecting a yield from a bond index might result in a company disclosing a worse position than is intended under accounting standards.”
Mercer has also pointed out that the revised standard makes apparently small technical changes that could have material, but country-specific, effects on companies’ reported earnings. For example, the required treatment of risk-sharing approaches, such as those in the Netherlands and Switzerland, seems to vary according to whether the risk is shared via reduced benefits or increased contributions.