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How
the New Pension Accounting Rules Affect the Dow 30's Financial
Statements
Potential
Implications for Policymakers and Equity Research Analysts
By
Stephen H. Bryan, Steven Lilien, and Jane Mooney
MARCH
2007 - The Sarbanes-Oxley Act of 2002 (SOX) charged the SEC
with studying off–balance sheet financing, special purpose
entities (SPE), and reporting transparency. The SEC completed
its study on June 15, 2005, and pension accounting was a primary
target of the report’s standards-setting recommendations.
Noting that pension plan trusts are conceptually similar to
SPEs, the SEC pointed out that large amounts of pension liabilities
are not recognized on the balance sheet. The SEC further observed
that the current demographic and political environment made
the accounting for these benefits of critical interest at
the highest levels of both the public and private sectors.
The
SEC report focused on the incompleteness of balance-sheet
recognition of pension assets and liabilities, noted the
lack of transparency and clarity, and concluded that pension
accounting should be reconsidered. It identified three issues
of concern: 1) consolidation; 2) deferral of actuarial gains
and losses; and 3) asset valuation. The report also criticized
the complex smoothing mechanisms inherent in SFAS 87, Employers’
Accounting for Pensions (1985). The report also cited
remarks that then–SEC Chief Accountant Michael H.
Sutton made at the December 1996 AICPA National Conference—“good
disclosure doesn’t cure bad accounting”—suggesting
that the revised and expanded disclosures relating to pensions
and other postemployment benefits (OPEB) promulgated in
SFAS 132(R), Employers’ Disclosures About Pensions
(December 2003), left the essence of the SEC’s concerns
unaddressed.
At
its November 10, 2005, meeting, FASB added to its agenda
a comprehensive two-phase project on accounting for defined-benefit
pension plans and OPEB. The first phase resulted in an exposure
draft (ED) issued on March 31, 2006. In September 2006,
it was adopted with slight modifications as SFAS 158, Employers’
Accounting for Defined Benefit Pension and Other Postretirement
Plans, an Amendment of FASB Statements Nos. 87, 88, 106,
and 132(R). The new standard requires balance-sheet
recognition of the funded (or unfunded) status of pension
and OPEB plans. Notably, companies are required to use the
projected benefit obligation (PBO), the more comprehensive
measure of the pension liability. Furthermore, SFAS 158
allows net asset or liability recognition rather than the
separate asset and liability recognition that the SEC preferred.
SFAS 158 still maintains the smoothing mechanisms currently
in force, protecting the income statement from the full
effects of actuarial gains and losses. Those amounts, however,
would be included in other comprehensive income. The second
phase of the project will further consider how these deferred
amounts should be recognized and reported, as well as other
liability measurement issues.
The
authors studied a sample of high-profile companies—the
Dow 30—to illustrate SFAS 158’s potential effects
on the balance sheet and on select ratios commonly used
by the analyst community. The authors also illustrate how
the new standard has affected the social policy debate and
how analysts will need to reconsider their measurements
of certain classes of ratios, especially in longitudinal
comparisons.
How
SFAS 158 Addresses the Accounting Issues
The
SEC and FASB focus in the first phase of the project has
been on balance-sheet deficiencies in pension accounting.
SFAS 158 continues the income-smoothing mechanisms of SFAS
87. Changes in liabilities recognized under the new standard
will be offset in accumulated other comprehensive income
(AOCI) with only gradual income statement recognition. The
reasoning behind smoothing is that, over time, experiential
gains and losses should reverse themselves. Accumulated
net income would be correctly reported and undue volatility
resulting from mark-to-market measurement would be avoided.
Unrecognized
gains and losses may arise on both the asset and the liability
side of the pension plan. Returns on plan assets may differ
from the expected returns, and in any given year, a difference
would be expected; as noted above, over time, differences
should reverse themselves.
On
the liability side, differences between actuarial assumptions
and plan experience also may result in gains or losses.
While the actuarial assumptions may differ from actual experience,
the most critical assumption in terms of liability measurement
is the choice of the discount rate used to convert expected
benefit payments to their present value. As the assumed
discount rate changes, the impact on the PBO is substantial:
Decreases in the rate produce significant increases in the
liability. The recognition of the change in value is deferred.
If these gains and losses reach a sufficient magnitude with
respect to the PBO and market value of plan assets, they
are gradually amortized and recognized as part of pension
expense (the so-called “corridor” method).
Other
items temporarily excluded from recognition as part of pension
expense include unrecognized prior service costs (which
stem from plan amendments that can make benefits more or
less generous) and the transition obligation that existed
when the relevant pension and OPEB accounting standards
were put into effect. (When SFAS 87 was adopted, most companies
chose to amortize the transition obligation. Curiously,
most companies opted to fully recognize the liability for
nonpension postretirement benefits, primarily medical-care
related, when adopting SFAS 106, Employers’ Accounting
for Postretirement Benefits Other Than Pensions, in
1993.) At the present time, the transition obligations have
been completely or almost entirely amortized, meaning that
the current amount of deferrals is predominantly from unrecognized
actuarial gains and losses, and from unrecognized prior
service costs.
SFAS
158 calls for full balance-sheet recognition of the net
pension liability (or asset, if the plan is overfunded),
using the PBO as the measure of the pension obligation.
All deferred amounts (any remaining unamortized transition
obligation, unrecognized gains and losses, and unrecognized
prior service costs) would be reported as AOCI, and would
gradually trickle down to the income statement, following
the corridor approach currently used to measure pension
expense.
Methodology
The
authors obtained the relevant pension data from the most
recent 10-K for each company in the Dow 30. They then measured
the balance-sheet effects of SFAS 158. Exhibit
1 presents portions of the 10-K for a sample company—Caterpillar,
Inc.—and illustrates the adjustments made using the
provisions of SFAS 158.
The
authors also documented the sources of the off–balance
sheet amounts. First, they tallied whether the unrecognized
amounts were from deferred actuarial gains and losses, from
prior service, or from transition obligations. These findings
shed light on whether the unrecognized gains and losses
over the 20 years of SFAS 87 show evidence of reversals.
Additionally, they tallied the unrecognized amounts by plan
source: U.S. pension plans, non-U.S. pension plans, and
OPEB.
The
authors also analyzed all comment letters submitted to FASB
by the Dow 30 and categorized the issues raised. Finally,
they calculated popular ratios both before and after the
impact of the new standard. Caution must be exercised in
interpreting results, both when making longitudinal and
cross-sectional comparisons. Analysts must consider the
reasons for the shocks to certain ratios exhibited by companies
affected by SFAS 158, both when studying changes in ratios
over time and when comparing results among companies.
Findings
The
estimated impact of SFAS 158 on owners’ equity and
debt for the Dow 30 companies is reported in Exhibit
2. The net pension liability is recognized on the balance
sheet; previously deferred amounts are charged to AOCI,
offset by a deferred tax asset, using an assumed tax rate
of 35%. As a result, aggregate owners’ equity is reduced
by over 12%; aggregate total liabilities are increased by
almost 4%. These changes could require renegotiation of
debt covenants in certain instances. As discussed later,
the impact on key financial statement ratios can be enormous.
Exhibit
2 also shows the impact on retained earnings of full
mark-to-market accounting for pension liabilities. The authors
included this analysis because it enables the user to gauge
the cumulative impact of pension accounting’s smoothing
techniques on past profitability. Aggregate total retained
earnings of the Dow 30 (with defined-benefit plans) would
be reduced by almost 16%. (Three Dow 30 companies—Home
Depot, McDonald’s, and Microsoft—have no defined-benefit
pension plans. A fourth, Wal-Mart, reported only foreign
plans with insufficient disclosure to calculate the adjustment.)
While General Motors is the obvious standout, with retained
earnings reduced by an astounding 1,885%, 11 companies would
have seen retained earnings diminished by 20% or more, and
four would have seen a decrease of 50% or more. The implications
likely mean that analysts who use earnings multiples for
setting target prices for companies’ stock will either
adjust their multiples or normalize the companies’
earnings streams. (The authors would not be surprised if
in some cases analysts “pro-forma-out” the effects
of SFAS 158, as some analysts did, at least initially, when
FASB began requiring expense recognition for stock options.)
Panel
1 of Exhibit
3 shows the sources of the off–balance sheet amounts.
The deferral of unrecognized gains and losses is responsible
for the largest share of the understatement, almost 96%.
Unrecognized prior-service costs account for 4%, while,
as expected, the unrecognized transition obligation is insignificant.
The
conceptual reasoning for deferring recognition of prior
service costs was related to the appropriate benefit attribution
period, which was viewed as the continuing period of active
service following the change in the benefit formula. The
reasoning behind deferring recognition of other gains and
losses, however, rested on the belief that these would reverse
themselves over time. The finding that these significant
off–balance sheet amounts remain suggests that the
expectations of reversals were not fulfilled.
Panel
2 of Exhibit
3 shows the breakdown of the source of off–balance-sheet
liability: 56% stems from U.S. defined-benefit plans; 15%
from foreign plans; and 29% from OPEB. With respect to OPEB,
the authors expect underfunding, because there are limited
tax benefits, as well as different regulatory requirements,
for their funding.
According
to research by Grant Thornton, LLP, 87% of 122 executives
surveyed agreed that balance-sheet recognition should be
required for pension obligations. The comment letters from
the Dow 30 companies on the SFAS 58 exposure draft were
consistent with this survey. As shown in Exhibit
4, the major concerns expressed in the comment letters
pertain to the implementation date, measurement date, transition
provisions, social policy (discussed more fully below),
and the appropriate measurement of the liability. With regard
to the last item, six Dow companies argue that the accumulated
benefit obligation (ABO) fits better with the definition
of the liability than the PBO. The ABO is less than the
PBO if the benefit formula is based on final years of pay
(most are), because the ABO does not include the impact
of projected future salary increases. Despite these arguments,
FASB retained PBO as its measure of the pension liability
to be used in determining the net liability under SFAS 158.
In
the final standard, FASB did modify other, less significant,
elements of the exposure draft. Prospective, rather than
retrospective, application is mandated. Also (trivially
in most cases) the remaining transition obligation will
still be amortized rather than being charged immediately
to retained earnings.
The
conformity of the pension measurement date to the financial
statement reporting date was another area of concern to
commentators. A measurement date up to three months prior
to the fiscal year end was permitted under SFAS 87. SFAS
158 eliminated the use of an early measurement date effective
for years ending after December 15, 2008. This gives companies
additional time after the new standard’s implementation
to synchronize actuarial and financial reporting. Early
adoption of this provision is encouraged.
Policy
Implications
Exhibit
4 shows that AIG and Citicorp cited social-policy issues
in their comment letters to FASB after the exposure draft
was released. While these companies provide financial services
and may have vested interests in their companies’
continuing pension plans, their observations are worthy
of FASB’s attention. AIG’s director of accounting
policy, Anthony J. Valoroso, wrote (Letter of Comment 94,
May 31, 2006): “[T]he final decision may lead to suboptimal
behavior by plan sponsors … We believe transparency
can be significantly enhanced without creating an incentive
for responsible companies to abandon the most secure form
of delivering retirement benefits to the employee.”
Citigroup’s vice president and deputy controller,
Robert Traficanti, commented (Letter of Comment 176, May
31, 2006): “[T]he proposed ED could cause companies
to reevaluate their existing retirement plan. [It] will
likely increase earnings volatility, impacting price earnings
ratios and shareholder value … [and would] likely
lead to a reduction in the number of pension plans, causing
a significant impact on employee welfare across the country.”
Finally, EDS’s vice president and corporate controller,
Scott McDonald (Letter of Comment 110, May 26, 2006), urged
FASB to “consider the fact that virtually all companies
have the option to eliminate or freeze their plan …
[which] leads us to believe that the issuance of this pronouncement
in its current form will likely accelerate the current trend
of elimination of traditional pension plans in the U.S.,
at a time when the U.S. savings rate is extremely low and
global market development is increasing pressure on the
U.S. worker.” (Although EDS is not a Dow 30 company,
the authors thought these comments worth including.)
In
Concepts Statement 2, discussing neutrality, FASB argued
against consideration of “undesirable consequences”
in standards setting, while recognizing that the economic
impacts of standards should not be ignored. The voices of
caution may prove to have been prescient, but it will take
some time for the standard’s actual economic and social-policy
implications to become clear. Indeed, this standard may
well be used as justification for firms to abandon defined
benefit pension plans and other postemployment benefits.
Demographic trends, combined with the curtailments, could
shift significant economic burdens to retirees. Arguably,
accounting debates, such as those surrounding the reform
of pension accounting, should not preempt social policy.
Cautions
for Market Analysts
In
addition to social-policy implications, users of financial
statements will have to adjust their measurements of key
financial ratios in order to consider the effects of SFAS
158, as well as the results of FASB’s second phase
of the pension accounting project, which will focus on income
effects.
Exhibit
5 shows the effects of SFAS 158 on three common ratios
that use debt or equity amounts: market-to-book, return
on equity, and debt-to-equity. The reduction in equity leads
to an average increase in the market-to-book ratio of 35%.
That same reduction in equity “increases” return
on equity by more than 60%. The debt-to-equity ratio also
increases, by 19%.
In
one interesting case, GM’s unadjusted return
on equity (ROE) is calculated as follows: –$10.567
billion (net loss) divided by $14.597 billion (equity),
or –72.4%. If the pension adjustment to equity is
made, equity becomes approximately –$30 billion, resulting
in a “healthy” ROE of about 35% (–10.567
billion/–30.000 billion = 35%). In Exhibit
5, General Motors’ adjusted ROE is listed as “not
meaningful” in light of the spurious inference that
the company is doing well. In this case, analysts may even
decide to deconsolidate the newly booked pension plans to
accommodate comparisons with earlier periods.
Time
to Reconsider Models
FASB,
prodded by the SEC, is promulgating major changes in pension
accounting, coincident with a larger national debate over
social policy. Already, certain influential companies have
suggested potential corporate reactions. The SEC, in its
role as regulator, may be influencing the legislative process
to the extent that legislators may find themselves in a
reactive situation.
Users
of financial statements will need to reformulate their models,
if they have not done so already. Some analysts may have
already incorporated off–balance sheet amounts for
these liabilities (and for others, such as leases and purchase
commitments); other analysts surely have not. The impact
of SFAS 158 will be seen in December 31 year-end reporting.
Failure to fully understand the implications of this standard
will hinder effective assessment of the financial statements.
Disclosure
in the notes to the financial statements has often been
used as a compromise solution to difficult issues, and pension
accounting is such an example. In the wake of the Enron
bankruptcy, however, the days of this form of compromise
appear numbered. The authors do not advocate one position,
but rather urge those with a stake in this debate—and
in future policy debates—to consider carefully whether
changes in accounting measurement and recognition might
simply be used as smokescreens by companies wishing to change
their corporate behavior, albeit in ways inconsistent with
what policymakers intended. A parallel consideration is
whether changing the location of disclosure (notes versus
statements) really enhances the efficiency of capital markets.
Stephen
H. Bryan, PhD, is an associate professor in the
Babcock Graduate School of Management at Wake Forest University,
Winston-Salem, N.C. Steven Lilien, PhD, CPA,
is a professor in the Stan Ross Department of Accountancy
at the City University of New York–Baruch College,
New York, N.Y. He is a member of The CPA Journal Editorial
Board. Jane Mooney, PhD, CPA, is an assistant
professor of accounting at Simmons College, Boston, Mass.
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