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INTM585210 - Thin capitalisation: accountancy issues: FRS 17: The impact of pensions accounting on thin capitalisation

When HM Revenue & Customs makes a thin capitalisation agreement with a company or group of companies (see, for example, INTM582000 onwards) it will include financial covenants as one of the ways by which the debt is monitored. For example, there may be a covenant involving interest cover - see INTM577000 onwards, or debt:EBITDA ratio - see INTM578000 onwards.

As indicated in INTM577010, 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 accounting entries. In looking at cash flows when considering a financial covenant, 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 and IAS 19)

The UK accounting standard FRS 17 on ‘Retirement Benefits’ applies to accounting periods ended on or after 1 January 2005. Entities applying IFRS will apply IAS 19 “Employee Benefits” - which is similar, although not identical, to the requirements in FRS 17.

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. However, any significant differences between the UK and IFRS standards are covered in the relevant sections below. If IFRS is applied and you are unsure of the accounting application, please consult your local accountant.

Approach to pensions impact on thin capitalisation

When considering how much debt a company can service, one of the indicators a bank would consider in a substantial case is the underlying free cash flows. The cash impact of pensions i.e. the contributions, and the accounting entries are often completely different. Therefore in considering what to do with the FRS 17 accounting entries, one needs 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.