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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: accountancy issues: FRS 17: the impact of pensions accounting on thin capitalisation

When a thin capitalisation agreement is concluded with a company or group of companies (see, for example, INTM520090 onwards) it will include financial covenants as a means of monitoring the borrower’s continuing capability of servicing the debt. For example, there may be a covenant involving interest cover - see INTM516000 onwards, or debt:EBITDA ratio - see INTM517000 onwards.

As indicated in INTM516010, interest cover is regarded as an indication of the ability of the company to pay interest while still having sufficient profit left to meet other obligations.

The impact of pensions accounting on the cash position needs to be considered carefully because there is a significant difference between contributions made and the expense recognised in the accounts. When considering financial covenants, the accounting entries must be examined to discover their impact on the calculation of a company’s debt capacity.

As with all thin capitalisation cases, the solution to a particular problem lies in a combination of understanding exactly what is happening, and the use of common sense to decide how a third-party lender might be expected to respond.

Accounting standards (FRS 17 / IAS 19 / revised IAS 19/ Section 28 of FRS 102)

The accounting for pensions is affected by whether the entity applies IFRS, New UK GAAP or Current UK GAAP. There are currently 6 potential variations:

  • Entities reporting under current UK GAAP will apply FRS 17 for pension’s scheme accounting.
  • Entities reporting under New UK GAAP (FRS 101) prior to accounting periods beginning 1 January 2013 will apply IAS 19.
  • Entities reporting under New UK GAAP (FRS 101) on or after accounting periods beginning 1 January 2013 will apply the revised IAS 19 (hereafter ‘revised IAS 19’).
  • Entities reporting under New UK GAAP (FRS 102) will apply section 28 of FRS 102. This is broadly aligned with the revised IAS 19.
  • Entities reporting under IFRS prior to accounting periods beginning 1 January 2013 will apply IAS 19
  • Entities reporting under IFRS on or after accounting periods beginning 1 January 2013 will apply the revised IAS 19 (hereafter ‘IAS 19 (revised)’).

The impact of these pension standards and their effect on thin capitalisation is discussed further below. The impact of the pensions accounting is discussed in the context of FRS 17, the UK accounting standard applicable under current UK GAAP. However, any significant differences between FRS 17 and the other standards are covered in the relevant sections below. If you are unsure of the accounting application, please consult a compliance accountant.

Approach to pensions impact on thin capitalisation

When considering how much debt a company can service, one of the indicators a third party lender would consider is the underlying cash flows. The cash impact of pensions, that is, pension payments and the pension expense are often completely different. It is therefore necessary to consider the impact of the pension accounting on the reporting of cash flows and hence on the entity’s debt capacity.

One option in adjusting profits to cash flow would therefore be to remove all the pension accounting entries from the accounts and then deduct actual contributions payable (in a similar way that depreciation is sometimes removed and an adjustment made for actual capital expenditure). This should be a relatively easy adjustment to monitor, as a similar adjustment is made in the tax computations, although this is for contributions paid rather than payable.

The alternative is to leave in the FRS 17 entries and make adjustments so that the accounts reasonably reflect the cash cost of the pension scheme to the group, as a step towards evaluating cash flow information. This approach is less straightforward, although commonly applied, and so is the main focus for the remainder of this chapter.