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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: accountancy issues: FRS 17: defined benefits and defined contributions schemes

There are two types of pension scheme:

  1. a defined benefit scheme (where benefits are based on salary and calculated according to a formula based on earnings and length of employment). These schemes are often referred to as final salary schemes.
  2. a defined contribution scheme (where benefits are based on amounts contributed by employees and the employer plus accumulated investment returns).

The accounting for defined contribution schemes (DCS) is straightforward: contributions payable are recognised as an expense in the profit and loss account and any unpaid contributions are a creditor. Relevant cash flows are therefore easily determined for thin capitalisation purposes.

This remainder of this chapter looks at defined benefit schemes and the accounting entries required by FRS 17 and how they should be treated in the context of cash flows for thin capitalisation purposes.

Under FRS 17, it is common to find that a group pension scheme is accounted for as a defined benefit scheme in the group accounts but as a defined contribution scheme in the subsidiary accounts. This is generally permissible under multi-employer schemes rules where, for instance, a company may be unable to identify accurately its share of the overall pension expense. In these circumstances, it will account for the scheme as if it were a DCS in its own accounts, namely, contributions payable are recognised as an expense in the profit and loss account.

IAS 19 (see INTM523210) differs slightly in its approach to group schemes if there is a contractual agreement or stated policy for charging the net defined benefit cost. In this situation, the cost is recognised on that basis in each group entity. Otherwise the defined benefit cost is recognised in the entity that is legally the sponsoring entity for the plan, and other group companies account for the plan on a defined contribution basis.

The requirements of New UK GAAP (FRS 101 or FRS 102) and revised IAS 19 are consistent with the IAS 19 approach to group schemes.

The rest of the chapter focuses on defined benefit schemes.

Defined benefit schemes

Defined benefit schemes are known as contributory schemes when both the employer and employee contribute to the scheme. If only the employer makes contributions, it is known as a non-contributory scheme.

The benefits under these schemes are usually quite independent of actual contributions made to the scheme or the performance of the investments held by the pension fund. The benefit is typically defined by reference to the employee’s final salary, based on an accrual rate determined by the employer. For example, an individual working for a company may have an accrual rate of 1/60th of final salary for each full year of service and reach the maximum benefits from the defined scheme of two-thirds final salary after 40 years of work (two thirds being 40/60).

A company or group sponsoring a defined benefit pension scheme includes scheme assets and liabilities in its accounts. Assets are recognised when employees and/or employers make contributions into a pension fund. Pension funds typically hold assets in the form of shares, bonds and other investments. Liabilities are recognised as pension obligations accrue to current and former employees. The difference between scheme assets and scheme liabilities will either be a net surplus or a net deficit recognised in the accounts of the sponsoring entity.

Under FRS 17, a pension scheme surplus is recognised as an asset in the balance sheet to the extent that the employer can recover a surplus through reduced contributions or refunds. A pension scheme deficit is recognised as a liability to the extent that it reflects the employer’s legal or constructive obligation.

The requirements of New UK GAAP (FRS 101 or FRS 102) and IAS 19 (revised) are broadly comparable in respect of the treatment of scheme surplus and deficits.

FRS 17 primarily impacts the balance sheet, with the charge to the profit and loss account being relatively stable. There are also various adjustments, as we will see later, that are accounted for in the statement of total recognised gains and losses (STRGL) - although typically, these STRGL entries do not concern us for thin capitalisation purposes.

The accounting under IAS 19, IAS 19 (revised) or New UK GAAP (FRS 101 or FRS 102) which results in the recognition of a deficit or surplus does differ to FRS 17. This will be dealt with in each respective section of the INTM as and when it arises.