A Time Bomb Lurking Beneath the Veneer

By Charles Hattingh CA(SA) Chartered Financial Analyst

When AC116 was being discussed in the various APC committees it became apparent that the standards developed overseas would not be applicable to circumstances in RSA. An attempt was made to modify the statement to make it applicable to local conditions but those in power decided that we should not tamper with the statement as we wanted to be seen to be in full compliance with International Accounting Standards. The purpose of this month’s contribution is to expose the true situation and the possible impact it could have on the financial wellbeing of companies.

Financial theory requires one to discount pension fund liabilities at the market return on investments with the closest characteristics to those liabilities. This is why AC116 requires the use of interest rates on low risk bonds to discount post-retirement benefit obligations. Actuaries, on the other hand, argue that pension fund obligations should be discounted at the return expected from the assets in the fund.

The actuaries and the accountants have been at loggerheads on this issue for years. Accountants, being who they are, prefer to use bond rates because bond rates should always be lower than equity returns due to the risk element in equities. Using bond rates gives one a more conservative (remember the old prudence concept?) answer. According to the accountants, the actuaries are understating pension fund obligations.

Actuaries, on the other hand, argue that the assets are invested to fund the benefit payments when they fall due. Practically one needs to project whether there will be enough assets at the end of the day to fund the payments. This is financial reality, not financial theory.

In RSA the returns expected on fund assets are way below government bond interest rates. So in RSA it is the accountants who are understating pension fund obligations, and not the actuaries. A typical return on pension fund assets with a spread between equities and bonds after tax and after expenses is between 6% and 9% (I have seen both projections used by actuaries in RSA). Financial theory works in the US and in the UK because interest on pension fund assets is not taxed, although the situation in the UK could be changing soon. And financial theory, for some reason or other, forgot that the return on pension fund assets is after audit fees, actuarial fees, asset manager fees, trustee fees, accounting fees, brokerage fees, etc.

The law in RSA requires that companies providing post-retirement defined benefits to employees must set aside assets in a separate entity to fund these obligations. Actuaries are appointed in terms of the law to determine the amount of the obligation. An actuary may use 7% to discount the obligation for regulatory purposes. The accountant, on the other hand could use 12% to determine the obligation. With a little knowledge of time value of money, you will realise that the accountant will grossly understate the true obligation. I have seen large companies in RSA using discount rates as high as 15% p.a. with the express purpose of understating the obligations.

While restudying the GAAP statements during my December break it struck me that we may all have been missing an important principle. So as not to give you, dear reader, a heart attack, I will break the news gently:

  1. A liability is a present obligation arising from a past event the settlement of which is expected to result in an outflow of resources.
  2. A provision is a liability of uncertain timing or amount.
  3. An obligating event is a legal or constructive obligation that results in an enterprise having no realistic alternative to settling the obligation.
  4. An onerous contract is one in which the unavoidable costs of meeting the obligations under the contract exceed the expected economic benefits to be received under it.

Are you starting to catch my drift? The law requires that a company providing defined post-retirement benefits for employees must set aside assets in a fund. If the assets in the fund are not capable of providing a return sufficient to meet the obligations, the company is faced with an onerous contract. AC 130 requires a provision to be made for onerous contracts.

I know that AC130 specifically states that it does not apply to provisions covered by another statement of GAAP. AC116 deals with the measurement of the pension fund asset or pension fund obligation using financial theory. The statement is based on the premise that the return expected from the fund assets will exceed the discount rate used to value the liability. There is no standard in AC116 requiring an entity to provide for the onerous nature of the contract between the entity, the government and the entity’s employees. I do not believe that a company can hide behind AC116 to avoid telling the truth about the real pension fund obligation while AC130 is in force. What do you think?

Dear Uncle Charlie,

I was reading in the September 2002 Accountancy journal that the UK profession has decided to postpone the implementation of the statement on retirement benefits (FRS 17). With the recent fall in equity market prices, reductions in interest rates, the proposed tax treatment of fund assets and changes in final pension fund schemes, the new statement will expose the truth about pension fund liabilities. This could have a negative impact on balance sheets of companies in the UK. Is the postponement of this statement not equivalent to legislating deceit?

Just pondering.

Dear Just Pondering,

I was just wondering what the investing public thinks? This fudging and dodging must stop. We need to embrace a new ethic. How about “Accountants can be trusted to tell it like it is”?

I get the distinct impression that the IASB is setting the standard in this new ethic – witness their bold move on accounting for share based payments. I am confident that in the very near future we will have recaptured the high ground that we once occupied.

Thank you for speaking out – we need more people like you to challenge actions such as these.

Uncle Charlie