Article appeared in Corporate Finance supplement of The Birmingham Post, written by Alan Wood and John Tyerman of Pinsent Masons

The pension woes of many PLCs have been added to as the full impact of the move to new accounting rules and regulations has become clearer.  

While International Financial Reporting Standards (IFRS) have been applauded for attempting to harmonise accounting and reporting standards throughout Europe for listed companies, they have brought with them some unforeseen and worrying consequences.

Chief among these is the effect that IFRS 19, and its forerunner FRS 17, may have on the ability of PLCs to pay dividends to shareholders because of the way the new rules demand pension fund deficits are treated for accounting purposes.

IFRS affects group accounts drawn up for periods ending after 1 January this year. As a number of the recent high profile examples have illustrated, even if in the most recent period a pension fund deficit has been reduced a dividend block may still arise if the amount of that deficit remains in excess of the company's distributable reserves (as opposed to total reserves).  

The example of British Airways is typical.  Like many businesses which have traditionally offered employees participation in a defined benefit (final salary) pensions scheme, British Airways has, for some time, had a significant pension fund deficit (most recently reported to be in the region of £1.4 billion). The problem for British Airways and others in the same position is that whereas under existing UK Accounting Standards it was sufficient merely to include a note in its group accounts as to the level of its pension fund deficit, under IFRS the full amount of that deficit will have to be recognised as a liability on the company's balance sheet and set off against the company's distribution reserves. 

Unwelcome in isolation, when combined with the current UK company law restrictions for determining whether a company is able to declare and pay a dividend to its shareholders, the introduction of IFRS may cripple a company if it has the effect of wiping out distributable reserves.

In these circumstances, under current company law provisions, the company would be unable to declare and pay further dividends until either the pension fund deficit was eradicated (whether as a result of increased company contributions, and/or an upturn in equity markets) or the company could generate sufficient operating profits to offset the deficit and so create positive distributable reserves.

A dividend block such as this is likely to hit traditional manufacturing businesses particularly hard where they have relied on being able to offer investors a consistent yield on their shares to offset relatively modest capital growth opportunities.

The issue of potential dividend blocks has also highlighted the anomaly in current UK company law where the ability to pay a dividend is regulated by the relevant company (as opposed to the overall group's) level of distributable reserves rather than the amount of cash it has available to make any such payment. As a result, a growing number of people are now highlighting the significant impact which non-cash items can have on a company's balance sheet and are pushing for the criteria for determining a company's ability to pay a dividend to be moved away from the traditional capital maintenance concept to a more cash-orientated solvency test.  Although this movement is gaining support at a European level this remains some way off and, for now, PLCs caught by the move to IFRS will need to consider whether to implement some form of remedial action or face the wrath of investors by not declaring dividends. 

The ability for quoted companies to continue to use the existing UK Accounting Standards in relation to the preparation of the individual company accounts for each member of a group may provide some temporary relief from the full impact of large pension fund deficits. However, this respite may be short lived given that the adoption of the UK standard, FRS 17, is now mandatory.  (Adoption was not mandatory for financial years beginning before 1 January 2005).  Although there are some differences between FRS 17 and IFRS 19, these are subtle as one would expect given the intention of the UK Accounting Standards Board to continue to converge UK Accounting Standards with IFRS over the next few years.  In addition, directors considering mixing and matching the use of IFRS and the existing UK Accounting Standards will need to consider carefully whether their approach is safe to minimise the risk of criticism or, worse still, of liability for a breach of their fiduciary duties or under the ever-increasing body of pensions legislation.

Likewise, there may be longer term measures which PLCs can implement to rectify the issue by restructuring their group and/or freeing up other previously undistributable reserves (such as share premium accounts) to offset large pension fund deficits.  However, in considering such a course of action directors again need to take proper advice to ensure that they avoid the numerous pitfalls and anti-avoidance measures particularly those introduced in recent pensions legislation and which have created a variety of sanctions including in some circumstances a personnel obligation to contribute to a pension fund deficit.