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

E-mail Story
Print Story
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.


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.


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.




















The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

©2009 The New York State Society of CPAs. Legal Notices


Visit the new