UK: IFRIC 14 And All That

Last Updated: 12 November 2007
Article by François Barker

Article by Bob Hunt and Francois Barker

New and complex accounting guidance (IFRIC14) will have a significant impact on the way pension scheme surpluses are accounted for in company accounts. In addition, a deficit on a prudent scheme funding target may have to be recognised on the company’s balance sheet.

Corporates will therefore need to join up their thinking on scheme specific funding and pension scheme accounting under IAS19 to avoid weakening their balance sheet.

So What Is IFRIC14?

IFRIC 14 was issued by the Interpretations Committee (IFRIC) of the International Accounting Standards Board (IASB) on 4 July 2007, with a further announcement on 23 August 2007. This guidance clarifies the circumstances and the extent to which a company can recognise a pension scheme surplus as an asset on its balance sheet.

IFRIC 14 applies to companies which report pensions under IAS19. Essentially, this means any public company which (a) is listed on an EU stock exchange; or (b) has elected to report (as many do) under international, rather than domestic, financial reporting standards.

So What Is The Problem?

The existing international pension accounting standard, IAS19, already limits the amount of pension surplus that can be included as an asset on a company’s balance sheet. This is restricted to the surplus that can be returned to the company by way of refunds or reductions in future contributions. According to IFRIC14, in order for a surplus to be included as an asset, a company must either have an "unconditional right" to the refund or "sufficient scope to reduce future contributions".

The "unconditional right" to a surplus will naturally depend on the wording in the pension scheme’s rules. Where companies do not have an unconditional right to a surplus, they may need to hold an additional provision on the balance sheet.

A problem will also arise where the company has agreed to a funding target in excess of IAS 19, for example under the scheme specific funding régime. In effect, where trustees have set a statutory funding objective in excess of IAS 19, they could directly damage the sponsoring company’s balance sheet.

What Do Companies Need To Do?

IFRIC14 is guidance that applies to defined benefit pension arrangements for financial reporting periods beginning on or after 1 January 2008 (although companies must also disclose the impact of IFRIC14 would have had in 2007).

The company’s auditor must form a view – taking account of IFRIC14 – of how the defined benefit pension scheme should be reflected in its accounts. To form this view, the auditor will, amongst other things, need answers to several key legal questions – particularly about the extent to which the corporate is likely to be able to recover any "overfunding" in the pension scheme. In essence, the more easily the auditor can reach the view that the corporate will be able to recover any excess funding in the scheme, the more likely it is that this will enable the company to recognise surplus.

What Legal Questions Does IFRIC14 Raise?

The legal analysis will focus on any rights the company has, under the rules of the scheme in question and/or prevailing legislation, to recover any overfunding via:

  • a refund of surplus during the life of the scheme, or when it winds up
  • a reduction in future contribution levels. Neither of these questions will necessarily be straightforward to answer.

IFRIC14 requires any right to a surplus refund to be "unconditional" – which will require a close analysis of the scheme rules, and particularly the wind up provisions. Where these rules favour the trustees, the corporate sponsor may well want to propose to the trustees that they be changed in the employer’s favour (and the trustees will doubtless negotiate for mitigation in return).

Where the wind up rules are favourable to the corporate sponsor, there may - in extreme cases - still be arguments about whether the trustees’ ultimate control over the scheme’s investment strategy and actuarial assumptions prevents the company from having any "unconditional" right to a refund of surplus. We think that these arguments will only surface in those rare cases where the trustees hold all the key powers under the scheme rules, and there has been a breakdown in the trustees’ relationship with the sponsoring corporate. In many cases, these arguments will tend to ignore the legal responsibilities owed by trustees to the sponsor of their scheme.

The right to reduce future contribution levels does not have to be "unconditional" in the same way. However, a sponsoring company will still need to show that it has sufficient control over the level of employer contributions paid into the scheme. Again, this may be open to question under the scheme specific funding regime.

So Where Do We Go From Here?

The key point is that corporate sponsors of defined benefit arrangements need to understand the potential effects of IFRIC14 when going through scheme specific funding negotiations with trustees. Without this, concluding funding negotiations could leave a corporate sponsor having to recognise a weaker balance sheet position.

Corporate sponsors should negotiate with the trustees of their scheme to use alternative funding methods. These could include contingent assets, the use of escrow accounts, and providing security (such as a parent company guarantee or charge over assets) as an alternative to cash funding. Corporate sponsors need to engage with trustees early in the funding process to achieve a more favourable outcome.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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