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«ASSUMING THE WORST: THE SHIFTING SANDS OF PENSION ACCOUNTING Alistair BYRNE Towers Watson Actuarial Consulting, London, United Kingdom Iain CLACHER1 ...»

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Accounting and Management Information Systems

Vol. 12, No. 2, pp. 190 –212, 2013



Alistair BYRNE

Towers Watson Actuarial Consulting, London, United Kingdom


University of Leeds, United Kingdom


University of Strathclyde, United Kingdom


University of Queensland Business School, Australia


Accounting for defined benefit pension plans is complex, and given the magnitude of many of these schemes relative to their corporate sponsor, understanding whether pension disclosures are value relevant is key to improving the quality of financial reports. The application of fair value accounting for pensions allows for a high level of managerial discretion with respect to ex ante accounting choices.

Utilizing a sample of firms that apply FRS-17, we examine the main determinants of the assumptions managers use to arrive at pension scheme valuations. We find significant differences in the stated assumptions across companies, auditors and actuaries. Further, managers display considerable variation in conservatism when implementing fair value accounting, and this variation is related to scheme-specific characteristics, such as asset allocation and pension plan solvency. Crucially, pension disclosures are found to be value relevant, therefore, managers are able to present pension disclosures in a more favorable light, and this is reflected in prices. As a result of the observed inconsistency in reporting across firms, and the value relevance of these disclosures, this brings into question the efficacy of fair value accounting for assessing pension values.

Corresponding author: Leeds University Business School, Maurice Keyworth Building, University of Leeds, Clarendon Road, Leeds, United Kingdom, LS2 9JT Tel:(+44) 113 343 6860;

E-mail address: ic@lubs.leeds.ac.uk Assuming the worst: the shifting sands of pension accounting Pension Accounting Standards; FRS-17 Pensions Valuation;

 Managerial Pension Discretion; Pensions and Fair Value Accounting JEL codes M410; M480; G140


Proponents of fair value accounting argue that historical cost valuation obscures the “true” underlying economic position of the firm, and that fair value provides a better measure of fundamental value. Conversely, critics argue the transitory nature of fair value injects additional volatility into financial reports that are already difficult to assess. For example, prior research indicates that market participants are unable to reach a consensus on information (accruals) presented in annual reports, particularly when it is complex (Sloan, 1996; Hirst, 1998). Similarly, pension accounting under fair value has the potential to remain opaque and problematic for users of financial accounts. There are two main reasons for this; first, pension valuation is complex. Any assessment of the liabilities in a pension scheme requires detailed mortality calculations and forecasts on future macroeconomic conditions. Second, fair value accounting for pensions provides considerable discretion to management. The accounting assumptions used in pension valuation are ultimately decided upon by management. Although there are a number of factors that guide these assumptions. The accounting standard itself sets some parameters for these estimates, and they are arrived at under the guidance of the firm’s actuary, and are monitored and approved by the firm’s auditor. Despite this, they are potentially open to manipulation within broad confidence intervals. For example, if there is a large variation in pension assumptions across firms, fair value accounting fails in one of its key goals ― namely the provision of transparent, consistent and informative financial statements.

In the U.S., SFAS-87 has come under increased criticism and pressure from regulators and industry amid calls for a move towards fair value pension accounting. The CFA Institute stated that the SFAS-87 method of accounting “…imposes a huge and costly burden” on the users of financial accounts. The U.S.

Senate Finance Committee also threatened legislation that would remove the complex smoothing mechanism of actuarial gains and losses under SFAS-87. In 2005, the Securities and Exchange Commission (SEC) concluded that balance sheets are “… often not transparent as to the true funded status of pension plans”1 leading to calls that pension accounting should be reformed by the Financial Accounting Standards Board (FASB). In response, FASB proposed a two-stage process to reform pension accounting, the first part of which was the introduction of FAS-158, which came into effect for fiscal year ends after December 15, 2006.

Vol. 12, No. 2 Accounting and Management Information Systems

Most work on pension accounting is focused on the value and credit relevance of fair value footnote disclosures under SFAS-87. Hann et al. (2007) for example, found that fair value footnote disclosures did not improve the information quality of financial reports and did not allow for an assessment of how management implements fair value when there is a requirement of full recognition in the balance sheet. Although the U.S. has yet to fully adopt a standard that is equivalent to the fair value requirements of IAS-19, the introduction of FAS-158 has moved US standards closer to full fair value pension accounting and there is evidence that the use of aggressive assumptions by management still exist report despite the fact that almost all the fair value disclosures only appear in the footnotes to the accounts (Grant et al., 2007).

Based on the above evidence, and the push for full fair value accounting for pensions in the U.S., we analyze how fair value pension accounting has been implemented in practice based on a sample of FRS-17 disclosures from 2001-2004.

This allows for us to not only analyze whether fair value pension accounting provides information about the value and risk of pension schemes, but to do so under changing economic circumstances e.g. falling equity values and changing bond yields; both of which are crucial in fair value pension accounting.

We make four main contributions to the literature. First, we document the variation in assumptions that management apply when accounting for pensions under fair value. One of the fundamental reasons for adopting fair value is to make the information in financial accounts consistent and representative across firms. If there is significant variation in accounting assumptions across firms, this calls into question the decision usefulness of pension disclosures. Second, we analyze the role and impact of auditors and actuaries on managerial discretion by investigating whether the variation in assumptions across firms can be attributed to either of these external groups. Although audit firms and actuarial firms are likely to have similar technologies, there is scope for different firms to have different ‘house views’ on particular assumptions, and this in turn may influence the choice of the audit or actuarial firm. Conversely, if there is considerable variation in the assumptions used across clients of a particular auditor and/or actuary (i.e. no consistent house view), this suggests that actuaries and auditors adopt the assumption process applied by individual firms.

Third, we consider the determinants of both managerial choice and conservatism in pension accounting and their relation with firm characteristics. Prior research has found strong links between the percentage of pension assets held in equity, the expected return on plan assets and corporate events (Bergstresser et al., 2006). Our final contribution is to analyze the value relevance of the assumptions that are used to arrive at the accounting amounts as well as the fair value disclosures presented in the annual report.

192 Vol. 12, No. 2 Assuming the worst: the shifting sands of pension accounting Briefly, our results are as follows. We document that the difference in underlying pension assumptions across firms is substantial. Essentially, there are basic economic reasons why discount rates and expected rates of return on pensions should be similar across firms, but this is not what we observe. Further, the differences are not related to the identity of the firm’s actuary or auditor, suggesting that different ‘house views’ is not an explanation. We also report that management have different valuation objectives depending on the solvency of the pension scheme. Companies with the greatest level of solvency i.e. the ratio of pension assets to pension liabilities, have the highest discount rates and discount rate spread assumptions. In addition, we find that firms with large pension scheme deficits, relative to the size of the firm, tend to choose higher equity return and spread assumptions. Management appear to choose assumptions that maximize the level of reported financial income that can be derived from pension scheme assets.

Finally, we show that the assumptions underlying the pension calculation impact prices; with pension funding levels, liabilities and assets all affecting share value.

One interpretation is that the external market views both the assets and liabilities of the pension scheme as the assets and liabilities of the firm which is consistent with the corporate view of pensions.

The rest of the paper is set out as follows. Section one provides an overview of FRS-17. In section two, we outline our motivation and develop the hypotheses that are tested in the paper. Section three describes the data and the methodology.

Section four discusses the empirical results and the last section concludes.


1.1. Financial Reporting Standard (FRS) 17 The introduction of FRS-17 fundamentally changed how firms account for defined benefit pensions in the UK. Until 2001, pension accounting was governed by the Statement of Standard Accounting Practice 24 (SSAP-24). This standard, however, was widely criticized as not providing useful or comparable disclosure of the underlying risks of company pension schemes. One of the major criticisms was that the Standard afforded management too much discretion in how they accounted for pensions. After wide consultation, the Accounting Standards Board (ASB) issued FRS-17, which applied to all companies reporting financial statements after June, 2001.

The framework for FRS-17 can be split into two broad categories: methodological and disclosure. Unlike previous standards, which allowed the actuary and/or management to select the actuarial method of liability calculation, 2 FRS-17 specified that liabilities must be calculated using the projected unit method 3 ― an accrued benefits valuation model which takes account of the right to benefits earned by scheme members by allowing for future increases in the level of

Vol. 12, No. 2 Accounting and Management Information Systems

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