ACCOUNTING

May 2000

THE EFFECT OF SFAS 135 TECHNICAL CORRECTIONS ON MEASUREMENT OF NET PERIODIC PENSION EXPENSE

By Kathryn M. Means and Julia L. Higgs

For fiscal periods ending after February 15, 1999, the net periodic pension cost will reflect the actual return on assets held by corporate pension funds. The inclusion of the actual return instead of the previously required expected return is due to the issuance of SFAS 135, Rescission of FASB Statement 75 and Technical Corrections. The standard is presented as a "clean up" addendum to rescind SFAS 75 and to rectify other inconsistencies in the authoritative literature. However, one of these corrections changes the accounting for defined benefit pension plans adopted under SFAS 87, Employers' Accounting for Pensions. The change requires all gains and losses on pension plan assets to be immediately recognized in income instead of being deferred and amortized over future periods.

This amendment, which constitutes a de facto new measurement methodology for net periodic pension cost, can tremendously impact the net income of firms that sponsor defined benefit plans. For users, this change may significantly complicate the interpretation of net income and the creation of earnings forecasts. Income may now contain a major component influenced by market fluctuations.

For auditors and preparers, this change presents several challenges. First, the current standards are contradictory, so the practitioner is faced with trying to discern the appropriate application of GAAP. A literal reading of SFAS 87, as amended, mandates a change in the calculation of net periodic pension cost. However, when SFAS 87 was originally issued, FASB seemed committed to the concept of delayed recognition. Second, if practitioners determine that the rules for the calculation have changed, issues of implementation and communication become important. Issuers of financial statements may need to apprise users of the expected impact on earnings trends and expectations.

Background to Pension Rules for Defined Benefit Pension Plans

Under SFAS 87, net periodic pension cost includes service cost, interest cost, actual return on plan assets, amortization of prior service cost, gain or loss, and amortization of the net transition amount. The gain or loss component is defined as the sum of

1) the difference between the actual and expected returns on plan assets and
2) amortization of unrecognized net gains and losses from previous periods. This calculation results in net periodic pension cost, effectively including expected rather than actual returns.

When SFAS 87 was issued, FASB decided to retain the practice of delaying recognition of certain events when applying accrual accounting to pensions. FASB specified that the delayed recognition feature means that certain changes in the pension obligation and in the value of the associated assets are not recognized as they occur but rather recognized gradually over subsequent periods. FASB stated that plan amendments and gains or losses are to be recognized as part of pension expense over a number of periods and concluded that the difference between actual and expected returns on plan assets should be recognized in pension expense on a delayed basis. That conclusion was based on

1) the probability that future gains and losses would offset and
2) respondents' arguments that immediate recognition would produce unacceptable volatility. FASB explicitly stated: "This statement does not require recognition of gains and losses as components of net pension cost of the period in which they arise." SFAS 135 does not amend the language in paragraph 29 of SFAS 87.

SFAS 135 changes the methodology for measuring net periodic pension cost by deleting a portion of paragraph 34 of SFAS 87. This deletion was made to "revise" the amendments made by SFAS 132, Employers' Disclosures About Pensions and Other Postretirement Benefits. As noted, prior to this amendment, expected rather than actual returns were effectively included as part of net periodic pension cost due to the mathematically precise approach in defining its components. Now, firms are effectively required to immediately include the actual returns as part of net periodic pension cost, thus eliminating the concept of delayed recognition as it relates to pension fund earnings. Herein lies a contradiction, because the amended calculation instructions do require recognition of gains and losses, which is in conflict with the original intent to defer gains and losses as stated.

To illustrate the effect of the recent change, examples of pension cost calculations are provided in the Exhibit. The components of net periodic pension cost (both before and after the recent change) consist of

1) service cost,
2) interest cost,
3) actual return on plan assets,
4) amortization of unrecognized prior service cost,
5) gain or loss, and
6) amortization of net transition amount. SFAS 135 changes the calculation of the gain or loss component. Originally, under SFAS 87, the gain or loss consisted of

1) the difference between the actual return on plan assets and the expected return on plan assets and
2) amortization of the unrecognized net gain or loss from previous periods. Combining actual returns with the gain or loss component as originally defined yielded the following effect for pension asset returns under SFAS 87:

­ Actual Return + (Actual Return ­ Expected Return)

The mathematical effect of this equation is to include only the expected return in the calculation of net periodic pension cost. The change made by SFAS 135 eliminates the portion of the equation in parentheses (item 5a in the Exhibit) leaving only actual return in the calculation.

In the example in the Exhibit, service and interest costs total $90,000. These costs are reduced by positive returns on the pension asset portfolio. The expected returns are $28,000, and the actual returns are $20,000. Before SFAS 135, net periodic pension cost would have totaled $62,000, calculated as the service and interest costs of $90,000 reduced by the expected returns of $28,000. Using the new measurement method, the $90,000 is reduced by actual returns of $20,000 to yield a net periodic pension cost of $70,000.

Intentional Change or Error?

Since this change was issued as part of a technical correction standard, some preparers may view the measurement change as an error and continue to calculate pension expense under the old method. An opposing argument might be made that FASB has been moving toward an accounting model that reflects market-related events. Furthermore, since the language of this newest pension guidance explicitly states exactly how net periodic pension cost should be calculated, a deviation from the specific instructions might be viewed as a violation of GAAP.

The new standard is currently effective, but depending on the fiscal year-end, there may be time to seek clarification from the SEC or request an interpretation from FASB. Although we believe that the change is likely due to an oversight, defending a position based on supposition regarding FASB's intent is difficult. *