technical release Practical Points for Auditors in Connection with the Implementation of FRS 17 'Retirement Benefits' - Defined Benefit Schemes (this guidance issued Febuary 2002) 1 AUDIT 1/02 This guidance does not constitute an auditing standard. Professional judgement should be used in applying it. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this guidance can be accepted by the Institute.
The Auditing Practices Board issued Practice Note 22 1 (PN 22) in November 2001 on 'The Auditors' Consideration of FRS 17 'Retirement Benefits' - Defined Benefit Schemes'. PN 22 provides guidance for auditors when auditing entities with defined benefit schemes following the introduction of Financial Reporting Standard 17 (FRS 17) 'Retirement Benefits'. This guidance is being issued by the Institute's Audit and Assurance Faculty to supplement PN 22 in certain areas and to assist auditors in dealing with specific practical audit issues that they may encounter. Whilst the FRS only comes fully into effect for periods ending on or after 22 June 2003 2, certain disclosures are required for all periods ending on or after 22 June 2001 3. This guidance provides illustrative practical help for dealing with situations arising from the minimum disclosures required in the first transitional year of the implementation of FRS 17. It is not intended to be comprehensive or to deal with all situations that might be encountered, i.e. it is supplementary to and not a substitute for PN 22, which should be regarded as the primary source of guidance for auditors. Approach to the audit and any problems encountered As emphasised in PN 22, it is the responsibility of the directors to obtain all of the information necessary to make the disclosures required by FRS 17. Auditors might use the attached Appendix, which lists planning points, and the process and specific tasks expected of directors, to identify, at as early a stage as possible, any difficulties that there might be. Where issues are identified early, it may be possible to suggest ways to assist the company to rectify the situation, without the company's reporting timetable being affected. In practice, whilst every effort should be made to ensure that a full and proper process is in place, there will be a need for auditors to exercise judgement regarding the materiality of the issues involved. The five sections below highlight particular scenarios that auditors might encounter and suggest possible approaches: 1. Information required for FRS 17 disclosure not available It is possible that auditors will encounter situations where they are informed that the company has not obtained, and will not be able to obtain, the information that is needed to make the disclosures required by FRS 17 in the first year of its operation. Exceptionally, this could be because of a reluctance to implement any part of FRS 17 before the FRS comes fully into effect or because of a concern that the costs that would be incurred, e.g. for the actuarial valuation information, would outweigh benefits from providing the disclosure. More commonly, this situation might arise where the company has not requested and therefore has not obtained the necessary information on time from the actuaries or insurers or pension scheme fund managers. It is therefore important for directors to make sure the necessary requests are sent out on a timely basis. In practice where this situation is encountered by auditors, it would be useful to discuss with the directors whether there are ways of overcoming the difficulty. It is very unlikely that the difficulty would be truly insurmountable. For example, if the company's or pension scheme actuaries are unable to respond to a request for information at short notice other actuaries might be used to obtain the necessary information. It is quite likely that the company will not have fully appreciated the consequences of not making the disclosure and the auditors should therefore explain what the consequences might be. If in respect of a scheme material to the company's financial statements the disclosures required by FRS 17 are still not made, auditors consider qualifying their opinion on the grounds of disagreement (also see section on distributable profits on page 5). 1 PN 22 is available (price 4.00, post free) from ABG Professional Information (telephone 020 7920 8991). 2 For entities applying the FRSSE, 22 June 2004. 3 Entities applying the FRSSE are exempt until 22 June 2002. 1
2. Failing in the process for providing and obtaining information There is the possibility that a failing in the process for the company to provide relevant information on a timely basis to the reporting actuaries could, unless it is improved, give rise to a limitation of scope qualification of opinion. The consequences of a failing in the process include: a) a large range (see section 3b), which covers the possible impact of this on the audit report); or b) failure to take account of major changes. The best way of overcoming b) above is to consider before the year end (or as soon as possible thereafter) whether the process enables the actuaries to take account of all major changes since the latest full actuarial valuation was carried out, which would, according to the latest actuarial guidance, include: salary growth or pension increases which are materially different from those assumed; settlements, curtailments (including redundancies) and other material scheme changes; and other material events including benefit improvements, bulk transfers or constructive obligations. In many instances the actuaries performing the FRS 17 valuations will be the scheme actuaries and the trustees will have formally agreed to inform them of any events expected to have a significant impact on the funding of the scheme. This does not however, remove the obligation from the directors to ensure that the actuaries are informed of all relevant information. 3. Response to ranges around a "best estimate" of a scheme surplus or deficit FRS 17 requires disclosures about retirement benefits, including the surplus or deficit, to be based on "best estimates". Actuarial calculations involve a number of assumptions about events and circumstances in the future. Some of these assumptions are normal and relate to external factors, such as rates of return on investments and interest rates. However, others will be scheme specific and relate to internal matters, such as rates of salary increase, and rates at which staff join, leave or retire from the scheme. In practice the result of actuarial calculations may be affected by uncertainties that mean that a best estimate will lie within a range of possible values. These uncertainties may arise because: different sets of actuarial assumptions could be adopted; the company's process is inadequate, e.g. there are concerns about the reliability of information on internal matters; or events have occurred whose impact on the actuarial liability cannot be determined with certainty. As explained below the auditors' response to uncertainty depends on its source and materiality. It is therefore likely to be important for auditors who are presented with a range for a scheme surplus/deficit to be able to distinguish between the effects of the different possible causes. This is likely to require close liaison between the auditors, the directors and the actuaries. Where the figures in the quoted range are not material, the existence of the range will not (in isolation) impact on the auditors' ability to express an opinion on the financial statements, nor will there be a need for specific disclosure in the financial statements of the range or the factors affecting its size. However, where the figures in the range are large, the following problems may arise: a) Large range arising from "flexing" normal actuarial assumptions In practice, actuaries who are engaged to carry out actuarial calculations will suggest a set of self-consistent assumptions, in consultation with their client, but to demonstrate the sensitivity of the results to changes in key assumptions the actuaries may re-run the calculations using different sets of assumptions and provide their client with a range of assessments of the scheme surplus or deficit. The directors have to be satisfied, after taking advice, which assumptions are most appropriate. Where the range of reasonable monetary amounts is so large that the use of a different amount from within that range could materially affect the view shown by the entity's financial statements, directors should consider whether FRS 18 'Accounting Policies' requires disclosures to be made in the financial statements of the estimation techniques adopted, including details of those underlying assumptions to which the monetary amount is particularly sensitive. The disclosure of key assumptions is also required by FRS 17. At least in relation to the first year of the FRS 17 disclosures, under the transitional provisions, where appropriate disclosures are included in the notes to the financial statements the financial effects of applying alternative sets of actuarial assumptions will not normally require a modification to the audit report, even if potentially large. 2
b) Large range arising from inadequacy in the company's process As described in section 2 above, the company should set up an adequate process for providing the necessary information to the actuaries on a timely basis. In contrast to a full actuarial valuation, when actuaries are requested to carry out a more limited exercise to update a previous full valuation as permitted by paragraph 35 of FRS 17, they may need to make assumptions about the following: the manner and extent to which the membership data has changed in the intervening period, for example because they have been provided by the employer with summarised, rather than detailed, current information; and the impact of significant business events that occurred after the latest full actuarial valuation. As a result of such factors, the actuaries may express their "best estimate" arising from the calculations as a point in a range of values that typically will be affected by the actuaries' degree of confidence about the matter. Where the figures in the quoted range are material to the financial statements the auditors consider taking the following steps: by discussion with the actuaries, establish which factor or factors have the greatest impact on the size of the range and whether there is scope within the employer's reporting timetable for the employer to provide data that is more up to date or more finely analysed. where the range is not capable of being reduced below the auditors' assessment of materiality, consider whether the range primarily arises from: - constraints in relation to the quality of the information which is supplied for the purposes of the updated valuation; or - events or circumstances between the last full valuation and the balance sheet date which give rise to changes in scheme liabilities that cannot be calculated precisely because their effect on the scheme is inherently uncertain - see c) below. In the case of a constraint in relation to the quality of the information supplied to the actuaries, the range may mask a lack of good process for deriving the FRS 17 disclosures and represents a limitation of the evidence available to the auditors to support the FRS 17 disclosures in the accounts. The auditors therefore consider issuing a report which is qualified on the grounds of a limitation of the scope of the evidence available to them in respect of the disclosures made about retirement benefits. c) Large range arising from an unusual event Examples of unusual events are as follows: a voluntary redundancy programme where the characteristics of the staff who will be made redundant in due course will not be known at the date of approval of the employer's financial statements and, as a result, the actuaries are unable to be certain about the effects of the redundancy programme on the future benefit liabilities of the scheme. the outcome of a recent court case or other change in the law whose possible impact on the scheme could be fundamental, but cannot be established with certainty as at the date of approval of the employer's financial statements. Where factors such as those above result in a large range of possible figures around the best estimate, the auditors respond by checking that the notes to the financial statements contain sufficient disclosures about the assumptions. Where they do, there will normally be no impact on the report issued by the auditors. In very exceptional circumstances, where the uncertainty caused by the range is unusually great because of the unusual event(s), auditors might consider its effect on the meaningfulness of the "best estimates" disclosed under FRS 17. In these circumstances, auditors consider including a fundamental uncertainty, explanatory paragraph in the audit report. 3
4. Group schemes treated as defined contribution schemes Group schemes are a type of multi-employer 4 scheme and companies may seek to claim the exemption given in FRS 17 to account for the scheme as if it were a defined contribution scheme. It should be noted that FRS 17 does require the use of defined benefit accounting for group schemes where it is structurally possible. The type of evidence that may suggest to the auditors that defined benefit accounting is possible includes the following: different contribution rates apply to different group companies; substantially all of the contributions to the scheme relate to one group company (indicating that that group company can apply defined benefit accounting, whereas the other group companies may be permitted to apply defined contribution accounting); most of the assets and liabilities can be related to active members who can be identified with individual group companies; a group scheme that is unfunded with no assets; and the scheme's trust deed and rules specify what would happen on the sale of a group company, e.g. the basis for calculating a share of fund. It should also be noted that the method adopted historically under SSAP 24 could in some circumstances be relevant to determining whether an allocation of assets and liabilities can be made for the purposes of FRS 17. Paragraph 39 of Practice Note 22 states that where the multi-employer exemption is being claimed, auditors make enquiries of the directors regarding the basis for their conclusion that the entity's share of the scheme assets and liabilities cannot be identified. The auditors also consider any relevant professional advice (for example, actuarial or legal advice) that the directors may have obtained on this issue. It would be useful for auditors to document the rationale for the conclusion reached by the directors and the audit evidence that has enabled the auditors to concur with the treatment in the accounts. 5. Issues arising from overseas schemes FRS 17 applies to all types of benefits that an employer is committed to providing after employees have completed their service, whether the commitment is statutory, contractual or implicit in the employer's actions. Paragraph 4 makes it clear that FRS 17 applies to retirement benefits arising overseas, not just those in the UK and the Republic of Ireland. Unlike SSAP 24, there is no concession to multinational groups in respect of overseas schemes that have been accounted for under a different accounting standard. Although in principle SSAP 24 required that adjustments should be made to account for the costs of foreign schemes in accordance with the UK standard, it recognised that in some situations it may be impractical and costly to obtain the necessary actuarial information. In such circumstances, compliance was encouraged but was not mandatory provided disclosure was made. Under FRS 17, however, all schemes, subject to materiality considerations, must be accounted for consistently in compliance with FRS 17 and so adjustments are required, where necessary, to convert retirement benefits accounting from local GAAP to a measurement and recognition basis that complies with the FRS. This requirement introduces several issues that must be considered by preparers and auditors of group accounts. These include: how the principles of FRS 17 apply to schemes in the group's overseas locations: this may not be a straightforward question. For example, in certain countries, pension schemes are run by the state whilst in others there may be difficulty in identifying scheme assets; whether the year end reporting timetable includes sufficient time to obtain the necessary information; whether accounts staff in overseas locations are familiar with the measurement and recognition requirements of FRS 17; whether it is possible to communicate with overseas actuaries so as to check that assumptions and valuation bases are appropriate; and whether there are material schemes within overseas (or UK) joint ventures and associates. 4 See paragraphs 8-12 of FRS 17. 4
Other issues Preliminary announcements In the case of listed companies auditors need to give consent to the issue of the preliminary announcement. Where FRS 17 issues arise and there is the potential for a qualified or modified audit report, consideration will need to be given to the content of preliminary announcements. In these situations auditors refer to the Auditing Practices Board's Bulletin 1998/7 'The auditors' association with preliminary announcements'. Consideration of going concern FRS 17 will not, of itself, impact on the cash flows of a sponsoring company into a defined benefit scheme. The contributions required by an employer will be arrived at through negotiations with trustees or through statutory requirements (or both), either of which may involve measuring surpluses or deficits on a different basis to that required by FRS 17. Given this, it may seem unlikely that the introduction of FRS 17 in itself would have any particular impact on the appropriateness, or otherwise, of the going concern concept. However, the disclosure (and, in due course, accounting) requirements of the new standard will certainly focus attention on the health of company pension schemes. This in turn may influence the stance taken by various parties with whom sponsoring companies transact. When considering the appropriateness of the going concern concept, directors consider whether an FRS 17 deficit, either on or off balance sheet, will prejudice the ability of the employer to raise or renew necessary finance (either because of expectations of a cash drain, doubts about the ability of the employer to maintain dividend payments or otherwise). The directors will also need to consider the impact of deficits on existing borrowing arrangements. Where there is a substantial deficit on the FRS 17 valuation basis, auditors make enquiries as to whether there is a problem on a funding basis. In such circumstances, further consideration is given to the appropriateness of the going concern basis and auditors follow SAS 130 'The going concern basis in financial statements'. Distributable profits Whether or not it is lawful to make dividend distributions depends both on statute and common law. FRS 17 transitional disclosures are not relevant to the determination of dividend distributions under the Companies Act, nor are they directly relevant to the common law position. However, in the latter case, where there is a substantial FRS 17 pensions deficit, the auditors make enquiries as to how the directors have satisfied themselves concerning whether, under the relevant funding basis, the pension scheme obligations of the employer company could create solvency problems for the company and whether there are any implications arising from loan covenant conditions. If the auditors qualify their report due to matters regarding FRS 17 transitional disclosures, this is not, in itself, grounds for indicating in any Section 271(4) statement that the matter is material for the purpose of determining whether the proposed dividend contravenes Sections 263 to 265 of the Companies Act. Further guidance on FRS 17 transitional disclosures and distributions by companies will be given in a Technical Release to be issued shortly. Post balance sheet events Where significant events occur after the balance sheet date e.g. constructive obligations arising from the announcement of a major redundancy programme just after the year end, they should be dealt with in accordance with SSAP 17 'Accounting for post balance sheet events'. Faculty monitoring of the progress of implementing FRS 17 The Institute's Audit and Assurance Faculty will continue to monitor the situation and communicate with members as appropriate. Should you encounter situations of likely interest, please contact Chris Cantwell at the Faculty, email chris.cantwell@icaew.co.uk 5
APPENDIX: Company processes for gathering FRS 17 disclosure information Implementing FRS 17 requires the practical application of a disciplined process. Companies need to focus on the key issues that will enable them to deliver reliable disclosures. The following is designed to help audit teams assess company processes. It does not deal with the practicalities such as arranging for permission from the trustees for company auditors to contact scheme administrators, bankers or managers; these and other practicalities can only be addressed by auditors once they understand the company's process. The process for first year implementation of FRS 17 is analysed below into five sub-processes. Asking whether directors have taken all the steps included in the five sub-processes will help identify: client steps to prepare for the drafting of the relevant disclosures; urgent client action points and potential improvements in the company's process; specific risks of financial statement error to be addressed by audit work 5 ; and issues relating to potential limitations of audit scope or disagreement that might impact the auditors' report. (1) To identify and aggregate schemes, directors should: (a) identify defined benefit schemes, excluding relevant multi-employer schemes but including overseas, medical benefit and unfunded schemes; (b) understand the reasons for any change from the schemes covered by SSAP 24 'Accounting for pension costs'; (c) appropriately aggregate schemes with similar attributes for disclosure purposes; and (d) decide which schemes are immaterial and do not require further consideration, and be able to explain the basis for that determination. (2) To measure and analyse scheme assets, directors should: (a) identify the types of assets held within material identified schemes; (b) find out what information is already available (e.g. from scheme accounts and from trustees, administrators, investment managers and custodians); (c) consider whether existing information reports assets at values appropriate for FRS 17, for example insurance policies that secure particular members' benefits and which for the purpose of reporting by the pension scheme will have been left out of the accounts; and (d) consider how and on what timescale the information in the scheme accounts will be updated to the end of the year. (3) To determine asset assumptions, directors should: (a) appreciate the significance of the new concept of expected rates of return; (b) identify all asset categories for which rates will be required; (c) agree respective responsibilities of the company and the actuaries; (d) seek advice as to likely ranges of normal rates; and (e) consider the impact of expected rates on future profit and loss account charges. (4) To report liabilities and related assumptions, directors should: (a) consider what information is already available, such as the most recent funding or SSAP 24 valuation of the liabilities; (b) satisfy themselves that appropriately qualified actuaries are in place for each scheme or group of schemes; 5 Examples of risks of material misstatement in relation to FRS 17 are provided in Appendix 2 of the Auditing Practices Board's Practice Note 22. 6
(c) see whether the actuaries need to change the valuation method and/or discount rate to comply with FRS 17; (d) consider how the most recent valuation of liabilities will be updated for significant business events other than normal service costs and pension payments; (e) identify when, how and from whom information for any updates will be sourced; and (f) review a summary of the assumptions that are likely to be disclosed. (5) To summarise and finalise disclosures, directors should: (a) identify sources of contribution rates (e.g. last year's and next year's contribution schedules for UK defined benefit schemes); (b) consider the need to disclose any restriction on the use of any surplus; (c) identify the need to warn about the effect of an ageing population (e.g. for schemes that are closed to new entrants); (d) consider the potential impact of any substantial deficit (on the funding basis) on their distribution policy and take advice as appropriate; and (e) consider the potential reaction to the disclosures of key users of the financial statements. 7