Farquar Inc. is in the process of going public. The company is in the Canadian oil and gas industry

Farquar Inc. is in the process of going public. The company is in the Canadian oil and gas industry but has decided that it would like to list its shares on the London Stock Exchange. Currently, the company follows pre-2011 Canadian PE GAAP.

Farquar has a significant pension plan that is currently underfunded. For the year ended December 31, 2011, the company (under PE GAAP) did not recognize this large deficit as a liability since it related to past service costs. Farquar’s controller, Perry Barta, has on his desk the new U.S. accounting standard and the almost identical proposed Canadian PE Exposure Draft on employee future benefits. Under the new U.S. standard, companies will have to recognize such unfunded amounts through Other Comprehensive Income.

Perry also has on his desk some information about the differences between PE GAAP and IFRS.

Instructions

Adopt the role of the controller and discuss the relative strengths and weaknesses of the three differing views of accounting for the unfunded costs. Perry is very concerned about the impact on the company’s debt-to-equity ratio and the earnings per share numbers.

Overview

-       Company is going public and therefore IFRS will be a constraint.

-       The controller is concerned about the impact of accounting policies related to the pension plans will have on the debt to equity ratio and EPS. Note that EPS is not required under PE GAAP. Note further that PE GAAP is not a viable alternative for the company since as soon as the company goes public, it will have to follow IFRS. Therefore, it would require significant effort to change from pre 2011 GAAP to PE GAAP and then to IFRS. Nonetheless, the accounting choices under ASPE are presented here as requested by the controller.

Analysis and recommendations

-       Pre 2011 Canadian standard ignores the deficit and surplus and is therefore not transparent. It results in a significant off-balance sheet liability. Although note disclosures are required regarding the funded status of the plan, the real deficit or surplus is not recognized in the balance sheet. Many users of financial statements do not read the notes carefully and may miss this. The debt to equity ratio and EPS appear more favourable using this accounting treatment.

-       Under ASPE, the company would have a choice to follow essentially the same accounting as the pre 2011 GAAP noted above or use the immediate recognition model whereby the unfunded deficit would be fully recognized in the balance sheet. If the latter is used, the company would use a funding valuation measure of the obligation (more conservative) which might result in a higher deficit. The immediate recognition method would worsen the debt to equity ratio and EPS.

-       Under IFRS, the company would use a deferral and amortization method however, vested past service costs must be recognized (which would worsen the debt to equity ratio and lower EPS). In addition, the company would have the option to fully recognize changes in past service cost and actuarial gains/losses immediately in income (or through other comprehensive income for actuarial gains/losses).  This would worsen the debt to equity ratio and EPS although if the option to book through OCI were taken, EPS would not be affected.