In January 1990, the GASB issued an Exposure Draft (ED), "Accounting for Pensions by State and Local Governmental Employers," which differs in some significant respects from the FASB's Statement No. 87, "Employers' Accounting for Pensions" (see Exhibit 1). (The GASB's document is not yet final and could possibly change based on comments received during the exposure process.) Although the two standards are aimed at different groups, many prepares, auditors, and users of financial reports will have to be familiar with both. Some will question why there should be two sets of accounting rules for employers who participate in defined benefit plans. (The two documents contain almost identical provisions for employers participating in defined contribution plans.) An understanding of the rationale for the FASB's and GASB's conclusions helps to explain the technical differences between their standards.

Differences Are Not New

Anyone who follows the two Boards is aware that differences of opinion between them are not uncommon. So it should not be surprising that on a topic as complex as pensions there would be disagreement on some issues. Although individuals would argue the theoretical and practical merits of each document differently, one can probably best approach the documents by recognizing that each Board's goal is to develop standards that will provide the most useful information reasonably possible to users of the financial statements. Both Boards follow extensive due process procedures, sometimes producing different responses on similar issues. The two Boards' constituencies and their environments are not identical, and financial statement users in the public and private sectors are frequently looking for different information. This, in turn, gives rise to varying reporting objectives and different accounting models. Add to this the fact that discussions on pension accounting inevitably result in a wide variety of opinions, then it can begin to be understood why the two documents are as different as they are. Many of the technical differences between the two standards stem from overall differences in the two Boards' approaches to financial reporting in general, and pension reporting in particular. In this article we briefly discuss these general differences and how some of the provisions of SFAS 87 and the GASB ED relate to them. We also discuss some similarities between the two Boards' conclusions.

The Two Statement Objectives

Both the FASB and the GASB view pension benefits as deferred compensation for employee services. A fundamental objective of both the GASB ED and SFAS 87 is to ensure that an appropriate portion of the total cost of pension benefits is recognized as pension expense, on the accrual basis, in the periods when employees provide services. The two documents differ in how pension expense should be measured. The FASB adopted a single accounting approach to measuring expense and concluded that comparability of employers' financial statements would be enhanced if the free choice of funding methods was not carried over to expense measurement. The GASB ED, in contrast, is based on the view that pension accounting in government is more useful when expense measurement and funding requirement calculations are in tandem. It is the funding method that affects the actual flow of financial resources, and no single method is appropriate for all plans and employers. The GASB believes that as long as the funding method is systematic and rational a different method should not be required for accounting purposes.

The GASB ED focuses on the operating statement and the measurement of interperiod equity (whether current-uear revenues were sufficient to pay for current-year services). This approach is consistsent with the objectives of governmental financial reporting and the Board's recent proposal to adopt a flow of financial resources measurement focus for governmental fund operating statements. The cornerstone objective of governmental financial reporting is accountability, including, for example, reporting how the entity has used financial resources provided by citizens for purposes approved in a legally adopted budget. the laws of most governments require balanced budgets. The intent of those laws is the conceptual basis for the GASB's emphasis on the operating statement and the Board's belief that governmental financial reporting should assist users in assessing whether interperiod equity has been achieved.

Adoption of an operating statement orientation for pension accounting is a logical extension of these concepts, and the GASB ED addresses primarily how annual pension expense should be measured. Pension liabilities or assets are not measured independently but result from the difference between expense accruals and the amounts funded, similar to SFAS 87. However, in contrast to SFAS 87, the ED does not require recognition of an additional liability.

Instead, the ED continues the GASB 5 (1986) requirement to disclose standardized measures of the plan's funded status and funding progress for at least a three-year period. We will compare this requirement later with the FASB's requirement to recognize a minimum liability on the balance sheet.

The primary focus of SFAS 87 is on reporting pension expense, with the added objective of improved reporting of the employer's financial position. The amount of expense to be recognized, however, is not simply the change in the employer's pension obligation from one period to the next. In measuring pension expense, SFAS 87 provides for delayed recognition of many elements that change the pension obligation from period to period. The Statement also requires balance sheet recognition of a minimum liability that represents any unfunded pension obligation. Because of these basic objectives--expense measurement and liability recognition--the FASB does not characterize its Statement as having either a strictly balance sheet or operating statement orientation. Rather, the Statement is a compromise between the balance sheet and income statement with a view towards improved overall financial reporting.

Accounting and Funding

An important issue addressed by both Boards--and one of the main reasons for the differences between their standards--was the extent to which a plan's funding methodology should influence the determination of annual pension expense. Readers will recall that APBO 8 required accrual accounting but permitted pension expense to be measured using one of several actuarial cost methods.

FASB Uses Single Accounting

Method

In SFAS 87, the FASB reaffirms the usefulness of accrual-basis pension accounting but does not accept funding requirement calculations as appropriate measures of pension expense. In the FASB's view, the plan terms are the best indicator of how employees earn benefits, and the accumulation of benefits each year should be the basis for measuring the economic cost of the resulting change in the employer's pension obligation. Most funding methodologies, however, do not calculate the employer's annual actuarially required contribution in this way (the projected unit credit approach is the exception). Partly for this reason and partly because different actuarial cost methods produce different measures of actuarially required contributions, the FASB developed a methodology for measuring expense that is independent of the way funding requirements are calculated. This methodology must be used by all employers who participate in single-employer plans.

The separation of expense measurement from funding measurement does not mean that the FASB considers funding unimportant. However, the Board views the choice of a funding methodology as a financing question that is influenced by many factors, including ERISA requirements, tax considerations, and alternative investment opportunities--factors that are unrelated to how thepension obligation itself is incurred. In the FASB's view, the considerable discretion an employer can exercise in funding a plan should have no effect on determining the cost of providing benefits under the plan.

The Board concluded that measurement of the economic cost of pension benefits, not the employer's plan for funding those benefits, provides the most meaningful information to financial statement users.

GASB's Accounting Follows

Funding Requirements

Similar to the FASB, the GASB believes annual pension expense should be recognized on the accrual basis, regardless of how, when, or whether the plan is funded. However, in the GASB's view, accrual-basis recognition does not mean that expense measurement has to be different from funding measurement.

The GASB's approach is similar to APBO 8: funding methodologies can be used to measure pension expense, provided that the methodology is systematic and rational. According to the ED, systematic and rational methodologies are those that are consistent with the principles of accrual accounting and interperiod equity. That is, a) they set aside assets in each period when employees provide services and earn salaries on which future pension benefits are based, and b) they are designed so that citizens of some periods are not expected to pay more than citizens of other periods for similar employee services. Pay-as-you-go methods and terminal-funding (recognizing total pension expense when employees retire or terminate) are not considered systematic and rational and should not be used for accounting purposes.

As stated earlier, the GASB's view of pension measurement is influenced by the significance of the public budget, which is the government's funding plan. If a governmental entity chooses a particular funding methodology to meet its current and future pension obligations in a manner that it believes appropriate to the economic, social, and political circumstances of the community it represents, then that methodology is the financial reality for that particular entity. It is the funding methodology, not a substitute accounting determination, that affects the actual flow of financial resources, both currently and in the future. From this perspective, pension accounting is more useful if it is not separate and distinct from pension funding. A distinction is warranted only when the funding methodology is incompatible with accrual accounting and the measurement of interperiod equity.

Instead of developing independent accounting measures of pension expense or adopting the FASB's measures, the GASB examined various actuarial methodologies that are commonly used for funding public pension plans. The Board developed a set of "Parameters" that define characteristics of a systematic and rational determination of an employer's actuarially required contribution, as summarized in Exhibit 1. The Parameters reduce the number of alternatives currently available for measuring pension expense. However, provided that the employer's actuarially required contribution is determined according to the Parameters, employers will not need to make a separate calculation of pension expense; they will accrue the actuarially required contribution.

Delayed Recognition

Although SFAS 87 and the GASB ED differ in the ways described above, they are similar in some important respects as well. Both standards contain the concept of delayed recognition of certain events that impact pension expense. Delayed recognition means that changes in the pension obligation and in the value of assets set aside to meet the obligation are not fully recognized in pension expense as soon as they occur; instead, they are recognized (amortized) systematically and gradually over future accounting periods.

The concept of delayed recognition impacts the accounting treatment for the pension obligation or asset that exists at the time of transition to the new standards, the effects of plan amendments (e.g., an increase in benefits for past as well as future service), gains and losses due to differences between the expected and actual plan experience, the method of valuing plan assets, and changes in actuarial assumptions. Under the GASB proposal, delayed recognition also applies to the effects of changing the actuarial cost method, a change that is not possible for accounting purposes under SFAS 87.

Amortization Periods and

Methods

Although SFAS 87 and the GASB ED provide for delayed recognition of essentially the same items, there are some differences in the required amortization periods and methods. SFAS 87 generally requires amortization periods based on the average remaining service life of active employees for all components. This reflects the view that pension benefits are service related and the total cost should be recognized, to the extent possible, before employees retire. If all or almost all of a plan's participants are inactive, the average remaining life expectancy of the inactive participants is to be used instead of average remaining service life.

The GASB generally agrees with that view and has adopted the same amortization period for plan amendments affecting active employees and for actuarial gains and losses. However, a shorter period is required for retiree plan amendments because the average remaining life expectancy of retirees is generally shorter than the average remaining service life of active employees. Also, the GASB ED permits a longer (or shorter) period than average remaining service life for amortizing the transition obligation or asset. Plans may continue their existing amortization schedule provided that the number of years remaining in the schedule does not exceed the 40-year maximum permitted by APBO 8. Many public plans have been systematically amortizing their unfunded liabilities for many years according to existing accounting standards for governmental plans (NCGA Statement 6 or APBO 8), and the GASB believes it would be unreasonable to require a change in existing schedules that meet those requirements. The Board does believe, however, that amortization periods should be shorter in the future, as shown by the 30-year maximum proposed for new plans and plans without a previously established schedule.

Interest (Discount) Rate

Assumption

The calculation of annual pension expense requires the use of estimates and assumptions about the outcome of future events that will affect the timing and amounts of benefit payments. In practice, the general principles for selecting assumptions are similar in both standards, although the provisions are worded differently. The best estimate should be selected for each individual assumption, with attention to consistency between similar assumptions.

The FASB and GASB documents are also similar in that both single out the interest (discount) rate assumption for special attention. This is because the rate at which projected future benefits are discounted to the present has a greater effect on pension expense than any other single assumption. (As a general rule of thumb, a change of one-fourth of a percentage point in the discount rate changes pension expense by about 6% to 7%.) The two standards set forth different requirements for the discount rates, however.

Current Settlement Rates

SFAS 87 requires use of discount rates based on current settlement rates in determining the three required measures of the pension obligation (projected, accumulated, and vested) as well as the service and interest cost components of net periodic pension cost. For determining the expected return on assets, the FASB uses another rate-- the expected long-term rate of return on plan assets based on a market- related valuation of assets. The FASB concluded that the discount rate relates to the liability side of pension accounting and has nothing to do with plan assets. Therefore, in their view, it would be inappropriate to require the same rate to measure pension obligations as is used to measure investment return on assets.

Long-term Investment Yield

The GASB ED, in contrast, requires use of the same expected long-term rate of return on plan assets for obligation-related as well as asset- related computations, consistent with actuarial methodologies and GASB 5 requirements for note disclosures of funded status and funding progress.

Because pension expense and pension obligations are highly sensitive to the choice of an interest rate assumption, the fact that the FASB and the GASB require different rates for discounting is a significant difference between the two standards. Each Board's choice of discount rate is related to its overall approach to pension accounting, as discussed earlier. The FASB's preference for settlement rates--"the rates at which the pension benefits could be effectively settled" as of the balance sheet date--reflects a balance sheet orientation--a current point-in-time view of the employer's obligation. In the GASB's view, however, the use of settlement rates is not appropriate for governmental pension obligations, partly because the Board takes a longer-term view of reported pension information, consistent with the perpetual nature of governments and their pension obligations. Governments do not terminate; they are not bought and sold like private firms, nor for all practical purposes is the current settlement of the obligation likely to occur. Therefore, the GASB does not consider the use of a current settlement rate appropriate in the public sector.

Volatility is a Concern

The GASB is also concerned about the degree of year-to-year volatility that could occur in pension expense if projected benefits are discounted at current settlement rates, which are subject to frequent and sometimes large changes. The expected long-term investment rate of return, in contrast, is much more constant from year to year, and, when a change occurs, it is usually quite small relative to changes in settlement rates. The GASB believes that frequent and, possibly, wide swings in pension obligations and expense that do not reflect actual changes in the plan's funded status or the total cost of pension benefits from a long-term perspective impede users' abilities to assess interperiod equity and the effect of pension commitments on the employer's resources. From the GASB's perspective, the long-term investment rate of return is more consistent with the economic reality of governmental pension obligations than the current settlement rate.

The FASB, in contrast, rejected the view that material changes in interest rates should be ignored solely to avoid adjusting assumed discount rates and impacting pension expense. In their view, the current settlement rate is the best reflection of the employer's liability and, therefore, provides the best current estimate of the pension obligation based on current conditions. Although that obligation is one element in the calculation of expense, the Statement provides for significant smoothing of changes in the obligation and of pension assets so that volatility of expense is reduced.

Both documents provide additional guidance for selecting the discount rate assumption. SFAS 87 refers employers to available annuity rates, including those published by the Pension Benefit Guaranty Corporation, and rates of return currently or expected to become available on high- quality fixed income securities. In both cases, a range of rates is available to choose from but no additional restrictions are imposed beyond the requirement to choose the best estimate. The GASB, in contrast, would require employers to test the reasonableness of the rate selected using the two guidelines described in Exhibit 1. Employers that use an interest rate outside the guidelines would have to disclose the reason for selecting the rate, to help users assess the reasonableness of the assumption.

Balance Sheet Recognition

Both documents require balance sheet recognition of differences between pension expense and the amounts funded. A liability is recognized if pension expense exceeds the amounts the employer has contributed to the plan, while an asset is recognized if the expense is less than the employer's contributions. Differences between pension expense and the amounts funded are common under SFAS 87 because the two amounts generally are calculated differently; therefore, assets and liabilities will frequently result. This situation should be much less common under the proposed GASB standard because the Board expects that the majority of employers will calculate expense and the employer's actuarially required contribution in the same way. Thus, for most employers, assets and liabilities will occur only when the employer fails to fully fund the actuarially required contribution.

Reporting of Unfunded

Obligations

Although both Boards believe the plan's funded status is important information to financial statement users, they reached different conclusions about how the information should be reported to meet the needs of their respective constituencies. The FASB believes that an employer with an unfunded pension obligation has a liability and that liabilities generally should be reported on the balance sheet.

The FASB considered two measures of the unfunded pension obligation (the excess of the pension obligation over the fair value of plan assets) for recognition in the employer's balance sheet: the unfunded accumulated benefit obligation (ABO) and the unfunded projected benefit obligation (PBO). The ABO is based on the plan terms and salaries in effect and service completed at the balance sheet date. The PBO is also based on service through the balance sheet date but it is measured using assumptions as to future compensation levels if the benefit formula is based on those future levels. For plans with those benefit formulas, the PBO is a larger number than the ABO.

The FASB concluded that a liability based on the PBO was the most theoretically sound approach but, for practical reasons, decided that recognizing the unfunded PBO on the balance sheet would be too big change from the then prevailing practice. Therefore, SFAS 87 requires recognition of a minimum liability at least equal to the unfunded ABO. The Board believed this approach would at least limit the extent to which the delayed recognition of events affecting pension expense would cause liabilities to be omitted from the balance sheet. Recognition of some liability for the most underfunded plans was deemed to be more representationally faithful than no recognition at all.

The GASB believes the ABO is not a useful measure in a governmental environment. Most public pension plans base pension benefits on final average salaries. Since the ABO is based on current salaries, and current settlement of the obligation is not a realistic possibility for governmental employers, reporting the unfunded ABO could be misleading because it understates the employer's obligation for eventual benefit payments. In the GASB's view, the unfunded PBO is a more realistic and useful measure. But the GASB decided not to require recognition of the unfunded PBO on the balance sheet for some of the same conceptual and practical reasons that had previously led the FASB to a similar conclusion.

Given the long-term, going-concern nature of governmental pensions, the GASB believes disclosure of the trend in funded status over several years, based on the PBO, is more useful to users of governmental financial reports than balance sheet recognition of the unfunded ABO. The GASB decided, therefore, to continue the GASB 5 requirement to disclose the plan's assets, PBO, and unfunded PBO, or assets in excess of the PBO, for at least the past three years. SFAS 87 requires similar disclosures to reconcile the plan's funded status at the balance sheet date with amounts reported in the employer's balance sheet. Although the reporting mechanisms are different, both Boards believe the information provided helps users assess the trend over time in funded status and funding progress, and the likely future effect of pension obligations on the employer's resources.

Conclusion

This article presents a brief overview of the differences, and the main reasons for them, between SFAS 87 and the GASB's proposal for pension accounting by governmental employers. We have also discussed some similarities between the two Board's conclusions.

One additional similarity is of interest. Both standards were influenced by practical as well as theoretical considerations, some of which recognized the evolutionary character of pension accounting and the need for a compromise between each Board's conceptual framework and practical problems of measuring pension expense, obligations, and assets. Despite the differences between the two documents, each Board believes its pronouncement is a significant improvement over past practice and will result in more useful information for decision makers in the sector it serves--public or private.

Penelope S. Wardlow, PhD, GASB Academic Fellow (George Mason University) and George C. Schleier, CPA, FASB Practice Fellow (Ernst & Young)