Fair value accounting not so fair, says report

FAIR value accounting (FVA) practices are being manipulated by company directors, auditors and actuaries to hide bad news and disguise pension liabilities, according to a Leeds University Business School report.

The study – Fair Value Accounting and Managerial Discretion – argues that since FVA was introduced in 2001 financial accounts have become opaque and misleading.

It questions the suitability of FVA for accounting pensions after finding that variation in the underlying assumptions for pension schemes was “considerable”.

It found that different assumptions were determined by a range of firm and pension scheme characteristics with the most favourable assumptions adopted for the most risky pension schemes.

Management adopt different assumptions in response to the solvency of the pension scheme. Where scheme solvency is high, management choose to use higher discount rates and apply less conservative methods of estimating the pension liability.

Conversely, where schemes have large deficits relative to the firm, managers choose to derive a larger amount of financial income from the assets in the pension scheme.

The authors also criticised the fact that assumptions presented in the financial accounts cannot be attributed to either the auditor of the actuary of the firm.

Professor David Hillier, one of the author’s of the study and head of the business school’s accounting and finance division, said that managers displayed considerable variation in conservatism when implementing FVA as determined by pension scheme characteristics, such as asset allocation and pension solvency.

“As a result, there is an inconsistency in reporting across companies bringing into question the efficacy of fair value accounting for assessing corporate risk,” he added.

Prof Hillier said that proponents of fair value accounting argue that historical cost obscures the true underlying economic position of the firm, while cynics believe that the transitory nature of fair value injects unnecessary volatility in financial reports.

He continued: “It is clear from our study that there are different objectives for management depending on the solvency of the pension scheme.

“Companies with the greatest level of funding have the highest discount rates and discount rate spread assumptions.

“We also found that firms with large pension scheme deficits relative to the size of the firm will tend to choose a higher equity return and equity spread assumption. In this case, management appear to choose assumptions that maximise the level of financial income that can be derived from pension scheme assets.”

As part of the study the team from the Leeds University Business School assumed that a firm has a pension liability of £1bn. After one year’s accrual of benefits, the pension liability that is owed by the firm is likely to have increased due to an increase in employee wages. Assume that the future value of this payment is £100m.

To calculate the increase in the present value of the pension liability, the £100m in new benefits will have to be discounted back to today. If the management of the firm choose to apply a higher discount rate, the increase in the present value of the liability will be less. Consequently, the change in the liability from one year to the next will be underestimated in the annual report.

From this, if we assume a pension liability of £500m and an increase in the discount rate 5% to 5.5% then the 0.5% change in the discount rate has therefore reduced the pension liability by 12%.

Firms also have considerable scope to manipulate the pension assets for crediting the profit and loss account under other financial income. Leeds University Business School identified company pension which was 100% invested in equity with a liability of £100m and assets of £80m, thus having a £20m deficit. Further, the discount rate is assumed to be 5% and the expected return on equity 10%.

From one year’s unwinding of the scheme, the interest cost will be £5m (5% discount rate multiplied by the pension liability).

The expected return on plan assets in the same year will be £8m (from the 10% return on plan assets). In reconciling this to the profit and loss statement, there would be an interest charge of £5m and a financial income credit of £8m. The profit and loss will therefore be credited with a net income of £3m.