A rare audit qualification relating to FRS 17, the financial reporting standard on pensions, at the UK subsidiary of the US drugs group Merck, recently raised a few eyebrows within the accountancy and actuarial professions.
In the accounts, the auditor, PwC, qualified its report on the basis that they believed that the company had used an inappropriate discount rate in valuing the pension scheme liabilities. Rather than Merck’s discount rate of 6.0 per cent, PwC suggested that a more appropriate rate would have been in the range of 5.25 to 5.75 per cent. The auditor took the view that, in the absence of an actuarial calculation using a more appropriate discount factor, it was unable to quantify the extent of the understatement of the pension liabilities.
Under FRS 17, pension liabilities are not yet required to be incorporated in the balance sheet and are confined to disclosure in the notes. As most other companies reduced the discount factor used against a background of falling bond yields over the period covered by the accounts, the auditor had a point.
Worthy of note is the fact that, rather than make a change, Merck was instead willing to tolerate a qualified audit report, a reflection, it might be argued, of the limited interest taken by US parent companies in the statutory accounts of subsidiaries reporting in foreign jurisdictions
It’s should be noted, however, that, under FRS 17, an actuary will arrive at an estimate of the pension liabilities based on both disclosed and undisclosed assumptions. Variation in some of the undisclosed assumptions, such as life expectancy, can have as significant an impact on the value placed on pension liabilities as the use of an inappropriate discount rate.
Understandably auditors are unlikely to feel comfortable questioning the appropriateness of mortality assumptions without expert actuarial support. However, without requesting details from the actuary, the auditor may be totally unaware of what assumptions were actually used.
A substantial volume of statistical information has recently been produced in relation to life expectancy trends in the UK. This indicates that people currently retiring and expected to retire in the future will live much longer than was previously envisaged.
Where companies are using mortality assumptions, which do not take account of these expected improvements, they may well be disclosing pension scheme liabilities, which are much lower than they could, or even should, be. The likely outcome, of course, is that the next few years will see actuaries revising these assumptions, with pension scheme costs – and the level of liabilities – likely to rise.
The rare incidence of an audit qualification on FRS 17 serves to highlight that whilst the recently introduced financial reporting standard on pensions has resulted in an improvement in the disclosure of pension costs, it remains far from perfect. Whilst there is a growing recognition that changes made to actuarial assumptions can have a material impact on the value of pension scheme liabilities, some of these assumptions are undisclosed and auditors should be taking the steps necessary to ascertain whether such assumptions are reasonable.
Given that part of an auditor’s responsibility is to ensure that the audit figures show an appropriate estimation of the company’s pension scheme liabilities, before signing off an audit report the auditor should have a general understanding of the assumptions used. It may therefore be prudent for auditors to seek their own actuarial advice. In practice, whilst the big accountancy practices will invariably have an in-house actuarial resource available to provide back office support to the audit practice, smaller accountancy practices are less likely to have such a resource at their disposal and may need to call upon the services of independent actuarial consultants to provide the expertise required in this area.
The more familiar auditors are with all of the assumptions upon which the actuary bases his estimate of the pension scheme liability, the better for all concerned. Ultimately, of course, responsibility for the assumptions, both disclosed and undisclosed, rests not with the auditor or the actuary, but with the company itself.
Published in CA Magazine on 01/11/04 and Financial Adviser 10/2/05.