Balance Sheet Recognition of Pension Liabilities Under International Accounting Standards (IAS)
International Accounting Standard 19 (IAS 19) allows certain gains and losses due to changes in the pension plan or market returns to b smoothed over several years rather than recognized at once. As a result, the balance sheet generally does not reflect the full net asset or liability. Prior to the adoption of SFAS 158 US rules were similar. In some cases, such as after the Internet bubble burst, many plans were being shown on balance sheets as having net assets (due to past market returns being smoothed in) when the actual funded status was a net liability.
As an example of the effect smoothing can have, consider note 35 to the consolidated financial statements of Lloyds TSB Group PLC 20-F filing:
The present value of funded obligations is the amount Lloyds would have to pay today in order to satisfy its future pension obligations (assuming the actuarial assumptions involved are correct.) This amount changed relatively little between 2005 and 2006 – an increase of 58 million or less than one third of one percent.
The fair value of scheme assets is the amount Lloyds has in the fund to cover the future obligations. This amount increased by 1.25 billion, or nearly 9%.
Below that is the difference between the two amounts, or the funded status. In each of the two years, Lloyds had less in the fund than would be needed to satisfy the future obligation. In other words, the plan is underfunded. However, the small rise in liabilities compared to assets significantly reduced the funding gap in 2006.
The next line shows how much of the net liability has not yet been recognized due to permissible accounting smoothing. In 2005 there were 485 million of unrecognized losses. In 2006 this shifted to an unrecognized 263 million gain.
So, in 2005 Lloyds had an unfunded position (economic value) of 3.3 billion. Some of this was not recognized on the balance sheet, however, which showed the liability as being just $2.8 billion – 485 million less than the economic liability.
In 2006, the unfunded position had fallen dramatically to just 2.1 billion. However, the smoothing was now ignoring some gains and the balance sheet liability was shown as being 2.4 billion – 263 million more than the economic liability.
Investors might want to replace the balance sheet figures with the economic status in order to get a more current picture of the true assets and liabilities. This would also be useful when comparing the balance sheets of a firm that uses IAS with one that reports under U.S. GAAP. Since passage of SFAS 158, U.S. firms are now recording the full economic liability (net funded status) on the balance sheet.
For more information, see all articles on: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
