Welcome to Luca!globe
 The CPA Journal Online Current Issue!    Navigation Tips!
Main Menu
CPA Journal
Professional Libary
Professional Forums
Member Services
March 1989

Government employers' pension accounting.

by Bramlett, Robert W.

    Abstract- The Governmental Accounting Standards Board has recently issued Preliminary Views on government employers' pension accounting. The views are discussed, with special focus on the debate over accrual accounting requirements compared to budgetary provisions in government accounting.

Pension accounting has been a subject of extensive discussion among accountants and actuaries for many years. As much as any single issue, differences about this topic contributed to the creation of the GASB. When the FASB published its Statement 35 in 1980, defining reporting standards for pension plans (but not for employers), it stated that the standard applied to governmental plans. Some governmental accountants objected, saying that the measure of the pension obligation defined in Statement 35, the accumulated benefit obligation (ABO), was too small in some cases to reflect accurately the pension obligation of governmental pension plans. Those accountants expressed their belief that the ABO as measured is a misleading measure of the government's obligation because it does not include the estimated effects of future salary increases. Some plan administrators expressed concern that elected officials would conclude that plan assets above the ABO were excess assets and that the employer's contributions to the plan could be reduced. Some also objected to reporting plan assets at current fair value, as called for by the Statement.

Those government accountants argued that, because governments are perpetual, do not terminate pension plans, and rarely reduce benefits promised, the more accurate measure of the obligation should include the effects of expected salary increases. This measure is known as the projected benefit obligation (PBO). For "flat benefit" plans that promise a set dollar amount of benefit for each year of service, the ABO and the PBO are the same amount. Most governmental pension plans, however, define the pension benefit in terms of "final average salary." This may be the employee's salary for the last year of employment, the last five years, or another period. In these plans the PBO is larger than the ABO, often by 20-40% or more. Some also believed that original cost or amortized cost of plan assets should be reported, rather than their current fair value.

The National Council on Governmental Accounting (NCGA) published its Statement 6 on this subject in 1983. That Statement called for governmental pension plans and employers to disclose the PBO and to value plan investments at cost or amortized cost. To this date, both FASB Statement 35 and NCGA Statement 6 (as amended) remain acceptable alternative sources of accounting guidance for governmental pension plans. There is a similar diversity of guidance for governmental employers' accounting.

Governmental employers reporting activity in governmental funds such as the general fund currently may use NCGA Statement 1, NCGA Statement 6 (as amended by NCGA Interpretation 8), or APB Opinion 8 to recognize their pension liability and periodic cost. Theoretically, Governmental employers are required to apply APB Opinion 8 in proprietary funds, those used to account for business-type activities such as utilities and hospitals; however, some governments continue to receive unqualified opinions from CPAs on their financial statements even when they are not fully in compliance with APB Opinion 8, probably due to the confusion about pension accounting and the mystery surrounding actuarial calculations. Readers will recall that APB Opinion 8 required employers that had made a defined benefit promise to recognize periodic pension cost as calculated within certain wide parameters by one of a variety of actuarial cost methods. The employer's liability was limited to unfunded accrued cost plus any "legal" liability. The full actuarial accrued liability was not recognized. Thus, it is sometimes said that APB Opinion 8 treated the employer's liability in a defined benefit plan as if it were a defined contribution plan.

The lack of consistent guidance, even within the governmental accounting literature, as well as the differences between private-sector standards and governmental standards, led the GASB to place pension accounting on its project agenda. The project was divided into several phases. The first phase deals with disclosure of information in footnotes and in other "required supplemental information"; the second deals with recognition and measurement of the employer's pension expense or expenditure and liability.

In 1985 the FASB published its Statement 87, Employers' Accounting for Pensions, a result of 11 years debate and deliberation. among other things, the Statement defines a single methodology for all employers replacing the variety of acturial methods previously used. It requires employers to disclose the projected benefit obligation, and also requires recognition of a liability at least equal to any unfunded accumulated benefit obligation, a major change for some employers. The FASB also changed existing practice by requiring use of "explicit," best-estimate assumptions and by defining the discount rate used to measure the pension obligation to present and future retirees by reference to rates implicit in the current market opportunities for settling pension obligations by buying annuities or "dedicating" bond portfolios.

If the GASB had not acted, governments would have been required to apply FASB Statement 87 in their proprietary funds statements. In 1986, the GASB published its Statement 4, prohibiting governments from adopting FASB Statement 87.

GASB Statement 5

GASB STatement 4 was quickly followed by GASB Statement 5, the product of the first phase of the GASB's pension project. This Statement defines certain disclosures that governmental pension plans, employers, and "nonemployer contributors" must include with their financial statements to conform to GAAP. The key element is a standardized measure. of the pension benefit obligation associated with a given pension plan. Different actuarial cost methods can produce significantly different measures of the "actuarial accrued liablity" and of the annual funding or "contribution" requirement when applied to a given set of circumstances. Some accountants had been concerned because they believed that there was no practical way for a reader of financial statements to compare different governmental entities accurately because of this lack of standardization. Furthermore, the lack of standardized terminology made it difficult for even a sophisticated user to understand exactly what information was being presented, in some cases.

The GASB considered the information needs of investors, creditors, and those acting on their behalf such as rating agencies; groups representing citizens, employees, and retirees; elected officials making decisions on program budgets, funding policy, investment policy, and benefits for employees and retirees; oversight officials of higher levels of government awarding contracts or grants; and others. It concluded that the lack of standardization limited the usefulness of governmental financial statements for such users.

The standardized measure of the pension benefit obligation required by GASB Statement 5 is calculated with an actuarial cost method known as the "projected unit credit" method. The measure is similar to, but may in some cases be slightly different from, the projected benefit obligation disclosed by private sector employers that report pursuant to FASB Statement 87. Like the projected benefit obligation, it also includes the effect of expected future salary increases.

After publishing Statement 5, the GASB began work on the second phase of its pension accounting project. The first product was Preliminary Views of the GASB on major issues related to State and Local Governmental Employers' Accounting for Pensions, published in October 1988. This document is to be followed by an Exposure Draft and a final Statement. Preliminary Views describes two possible accounting standards for governmental employers--one favored by three Board members, the other by two. Reporting by public employee retirement systems and pension trust funds will be covered later.

The subject of pension accounting remains controversial in its own right; in addition, the Board has added a new element with the change in the governmental reporting model proposed in its 1987 Exposure Draft, Measurement Focus and Basis of Accounting (MFBA ED). This ED would require noncapital debt, including the pension liability, to be reported in governmental funds rather than in the general long-term debt account group (GLTDAG). Of course, depending on how measured, the pension liability required to be recognized could be much larger than the kinds of liabilities treated in the MFBA ED. Some believe that the nature of display contemplated may influence decisions about recognition and measurement.

For this reason, at its November 1988 meeting the Board directed the MFBA staff to research certain methods for display of long-term operating liabilities; this could lead to revision and reexposure of the MFBA ED. Both Preliminary Views and the alternative proposal of the minority would change current governmental practice in pension accounting in other significant ways as well. Indeed, among the concerns of the dissenters is their belief that the change proposed in Preliminary Views, in conjunction with the change proposed in the MFBA ED, is so radical that some governments might abandon the practice of funding periodic pension cost, and might even abandon GAAP accounting.

Majority View

For most governmental employers contributing to single-employer or agent multiple-employer pension plans (essentially separate plans using a common administrator), Preliminary Views uses the accounting standard for private-sector employers--FASB Statement 87, as written or with certain modifications permitted by the GASB--to define a minimum net periodic pension cost and liability. Those employers would select one of three approaches to define their periodic cost: 1. Apply FASB Statement 87 without modification except for one minor, optional, technical change in the method used to attribute benefits to years of service--proration of step-rate benefits. 2. Apply an accounting principle that reduces the volatility of option (1) by using a market- related discount rate calculated by recognizing changes in the current settlement rate over a period of up to five years. 3. Select option (1) or option (2) as a minimum and recognize net periodic pension cost on the basis of any actuarial cost method that requires a contribution equal to or greater than the minimum net periodic cost.

The "minimum liability" provisions of FASB Statement 87 would be applied in all cases. This means that an additional liability, beyond unfunded accrued pension cost, would be recognized if necessary, so that the total liability recognized would equal the unfunded accumulated benefit obligation. An equal intangible asset would also be recognized in most cases, thus avoiding an immediate reduction in fund equity.

the intangible asset is limited to the amount of unrecognized prior service cost, but the entire unrecognized obligation at the time of transition to the new Statement is treated as unrecognized prior service cost. Losses after that date could lead to situations in which a required additional liability might not be fully offset by an intangible asset.

Under both the majority and minority approaches, most employers participating in cost-sharing plans, (in which assets and obligations of all participating employers are pooled and the employer's liability is limited to its required contribution to the plan), would recognize as net periodic pension cost the required contribution for the period and would recognize as a liability any contributions due and unpaid.

Both the majority and the minority views would also recognize pension- related bonds, now reported in the GLTDAG, as a fund liability. Both would recognize an intangible asset to avoid an immediate reduction in fund balance associated with moving this liability from the GLTDAG to a fund.

Minority View

The minority view basically accepts the actuarially determined contribution requirement from a variety of methods as the expenditure/expense for all governmental entities whether participating in single-employer, agent multiple-employer, or cost-sharing multiple- employer public employee retirement systems (PERS), and regardless of whether they are general purpose type or special purpose type governmental entities, provided that the requirement is consistent with its definition of "systematic and rational." This proposal would allow governments to continue to use any one of five of the most popular funding methods for accounting as well as for funding, provided funding policies were changed to conform to the accounting standard. If an employer did not "advance fund" the pension obligation, an accrual would be required.

Unlike the majority and unlike private-sector practice, the minority would allow use of "level percentage of projected payroll" amortization methods, consistent with current typical governmental funding and accounting practice. Because payroll is projected to increase with inflation and because new employees are projected to replace those who terminate, the base for allocating the cost under this method spreads the interest cost to future years in an increasing pattern, somewhat akin to a mortgage with an increasing payment schedule that does not cover interest in early years. Unlike such a mortgage, however, the increasing principal amount during those years is not recognized, because the actuarial liability is not recognized as an accounting liability.

The minority would not have a minimum liability akin to the provisions of FASB Statement 87. The employer's liability ordinarily would be limited to unfunded pension cost accrued since the application of the new standard. However, employers that had not been making contributions by an acceptable method would be required to compute and recognize a liability for unfunded pension costs that would have been accrued for the previous three years under an acceptable method. No intangible asset would be recognized in these cases.

Comparison of the Two Proposals--Practical Effects

It is impossible to predict the comparative effects of the two proposals without considerable information. Depending on the assumptions used, the plan's funded status, and other factors, both proposals could require a higher or permit a lower periodic pension cost than is currently reported.

The majority proposal probably contains the potential for more dramatic change, but not all employers would be affected equally. Preliminary Views contains guidance that could lead some plan sponsors to use a higher discount rate for accounting than they presently do for funding and accounting. This would tend to reduce the reported pension obligation and minimum periodic cost for those that have been using what some regard as "conservative" assumptions. On the other hand, as is discussed later, Preliminary Views also contains other features that would tend to increase both the reported liability and the periodic cost for some plans, especially for those with assets considerably less than the pension benefit obligation. The net effect could be large or negligible, depending on the circumstances.

Preliminary Views would require faster recognition, i.e., inclusion in periodic pension cost, of any unrecognized obligation at transition than would the alternative proposed. This is because the majority believes that, to measure interperiod equity, the cost of pension benefits should be recognized or charged to periods when service is rendered by the employees, regardless the employer's funding. The majority recognizes that some employers may not contribute to the pension plan an amount equal to the accountant's measurement of periodic pension cost.

the minority, on the other hand, would also call for faster recognition for future obligations but not for existing obligations. This is a natural result of the funding orientation of alternative view, which contemplates that the periodic cost should and will be funded as accrued. The minority would require recognition of existing obligations over a longer period up to forty years and by a less aggressive method, level percentage of projected payroll, that is more consistent with present practice. Future benefit enhancements that created prior service cost would be amortized over average remaining service life or fifteen years; governments currently often use thirty-five or even forty years. Either "level dollar" or the slower "level percentage of projected payroll" amortization could be used for this amortization.

For governments with assets significantly less than the ABO, the liability reported under the majority approach could be considerably larger than under the minority approach; however, the majority, by adopting the approach taken by the FASB, would also have employers recognize an "intangible asset" that would generally offset the additional liability, thus avoiding an immediate reduction to the GAAP fund balance. Because the alternative view would require employers that have been funding on a "pay as you go" basis to recognize three years' unfunded accrued pension cost without an intangible asset when first applying the new standard, the immediate effect on fund balance would actually be greater than under the majority's approach. The minority selected three years because governmental employers will have had at least that much notice of the implications of funding decisions. Presumably, relatively few governmental employers should be affected by the minimum transition liability provision of the alternative view.

Comparison of the Two Proposals--Conceptual


Traditionally, the debate on this topic has often involved comparisons with the private sector. The Trustees of the Financial Accounting Foundation have instructed each Board to justify departures from standards previously established by the other Board. Factors commonly cited to support differences include the role of budgeting, the lack of trading ownership interests, the infrequence of settlements and curtailments and asset reversions, and the different users and decision models used. Factors commonly cited to support similarity include comparability; neutrality among divergent users with divergent interests; and understandability for users, educators, auditors, and others.

The GASB Board members who favor the alternative view believe that the Board should modify present governmental accounting whenever the Board concludes that change is necessary, but they do not believe that changes in the accounting standards used by nongovernmental entities should automatically be assumed to lead to changes in governmental accounting. The majority, on the other hand, believe that users and preparers of financial statements will best be served if standards for government differ from those used by the private sector only when differences are essential.

The majority proposal, therefore, would enable governmental preparers, that believe users of their financial statements will best be served by strict comparability with the private sector, to adopt the recognition and measurement provisions of FASB Statement 87. Some governmental utilities, hospitals, and colleges may be among these preparers, along with limited-life joint ventures and contracts. On the other hand, the majority would also allow preparers to adopt a less volatile variant of FASB Statement 87, or any actuarial funding method that calls for a greater annual contribution, because of the Board's concern about the relationship between governmental accounting and sound public policy regarding funding of defined benefit plans.

From this author's perspective, the major conceptual issue is over the role of accounting vis-a-vis budgeting in government. Accrual accounting attempts to portray the effects of transactions when they occur, rather than when cash changes hands. Governmental accounting, on the other hand, has traditionally been "modified accrual" accounting, with a focus on "expendable, available resources." All members of the GASB see Preliminary Views as a move toward more accrual accounting, but the majority emphasizes the view that, although accounting may influence funding decisions, it is not based on cash transactions. The majority believe that sound public decisions can best be made by citizens and elected officials if accounting provides a neutral yardstick to measure the financial position and results of operations of governmental entities. They believe that financial markets and democratic political processes, rather than accountants, can best make decisions about allocation of resources, but if, and only if, sufficient neutral information is available.

The minority, on the other hand, believe that "public administration is eased when budgeting and accounting are in tandem" and that "accounting in government is most useful when it helps discipline the budgetary process." They believe that differences between systematic and rational funding methods and accounting measurement of periodic cost will be difficult to explain and to comprehend, and therefore will be likely to strain the credibility of either the accounting numbers, the actuarially recommended funding requirement, or both. Thus, they believe that governmental accounting should define the annual expenditure/expense as the annual contribution requirement produced by a variety of actuarial cost methods that are actually used by governments now, applied in a systematic and rational fashion and conform to the parameters established by the minority.

Those who support the alternative view believe that the goal of comparability sought by the majority is unattainable because of the estimates and uncertainties involved in pension accounting and because of the differences among governmental entities. They focus primarily on the funding decision, believing it to be more important than other decisions that may be influenced by governmental financial statements. From their perspective, interperiod equity is achieved by charging each year a constant percentage of payroll for pension expenditure/expense. They believe that "the solution to governmental accounting for pensions lies in placing appropriate constraints on funding practices to assure that they are systematic and rational so that, if the funding practices adhere to those constraints, the actuarially recommended funding requirement would be considered acceptable for accounting purposes--as is presently done."

The period for comment on Preliminary Views has ended; public hearings are scheduled for March. It is not too late to be involved in the pension deliberations, however, because the Board expects soon to publish an Exposure Draft on this topic. The Board's deliberations can be improved by broad participation in the due process. Let the Board know your thoughts on the subject!

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 cpajournal.com.