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Oct 1991

The impact of SFAS 88 transactions: puff or economic reality? (Statement of Financial Accounting Standards No. 88)

by Lilien, Steven B.

    Abstract- Corporate financial statements containing substantial off-balance sheet amounts, such as unamortized projected benefit obligation and transition amounts, unamortized gains and losses, and unamortized prior service costs, have utilized discretion available under the Statement of Financial Accounting Standards Number 88 (SFAS 88) to substantially augment reported profits of a company. Companies have been utilizing SFAS 88 to increase reported earnings even when such gains do not result in reversions of cash for the firm's over-funded pension plans. Termination of employees, under SFAS 88, allows for the charging of termination benefits as reflected from the time when the termination offer was accepted by the employee, as long as a fairly estimable amount can be made. Curtailment and settlement transactions were surveyed in terms of termination benefits accounted for under SFAS 88.

In December 1985, FASB issued both SFAS 87, "Employers Accounting for Pensions" and SFAS 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits." Under SFAS 87 there is a delayed recognition in net periodic pension cost of certain elements arising from adoption or modification of a pension plan; namely projected benefit obligation gains and losses, plan asset gains and losses, transition amounts, and costs of retroactive plan amendments.

In most cases, the delayed and unrecognized portion of these elements do not appear in any of the employer's financial statements - they are "off-balance sheet" amounts. On occurrence of either a settlement or curtailment, SFAS 88 requires immediate recognition in current reported earnings of certain of these delayed and unrecognized amounts. Our observations on the frequency, magnitude, and statement presentation of these types of transactions lead us to suggest that FASB reconsider some aspects of pension accounting.

A number of public companies with overfunded plans appear to be using SFAS 88 to substantially increase their reported net earnings, even when resulting gains do not lead to any cash reversions of excess pension assets to the company. This is a change from prior practice, where such gains from pension-related events were deferred and typically accompanied by substantial reversions of cash. In fact, the gain was measured by the cash reverted. Under the new pronouncement, companies can obtain the benefits to earnings of such pension-related gains without the approval of Pension Benefit Guaranty Corporation (PBGC) and the resultant cash reversion.



A brief description of off-balance sheet amounts prescribed by SFAS 87 will enable the reader to follow this article more readily.

Transition Amounts

An employer having a defined benefit plan determines, as of the measurement date when SFAS 87 is first applied, the net effect of the projected benefit obligation (PBO) and fair value of the plan's assets. This amount may be increased by any previously recognized, unfunded accrued expenses or reduced by a previously recognized, prepaid pension cost. If no other pension related event occurs, the resulting previously unrecognized net amount at initial application of SFAS 87 (either an asset or an obligation and, in any event, an off-balance sheet amount) is amortized on a straight-line basis over the average remaining service period of employees expecting to receive plan benefits. However, if this period is less than 15 years, the employer may elect to use a 15-year period.

Plan Assets' Gains and Losses

Asset gains and losses are the differences between actual and expected return on plan assets during a period being reported. At any given measurement date, asset gains and losses may fall into two categories: those reflected in market-related value of plan assets, and those not yet part of market-related value. This distinction has impact on financial statements, since those not reflected in market-related value at the beginning of the period are not amortized in the current period.

PBO Gains and Losses

These gains and losses result from changes in obligation-related assumptions, such as discount rates and future compensation levels, as well as variances between actual and assumed experience, as in mortality rates or turnover.

Amortization of Unrecognized Gains and Losses

At any given measurement date, the unrecognized gains and losses are the sum of 1) unamortized asset gains and losses excluding asset gains and losses not yet reflected in market-related value, and 2) PBO gains and losses. A minimum amortization is required if such unrecognized net gain or loss at the beginning of the year exceeds 10% of the greater of 1) PBO or 2) market-related value of plan assets; both of which are measured at the beginning of the year. The 10% amount that is used is commonly known as the corridor.

The minimum amount amortized is the amount in excess of the corridor, divided by the remaining average service period of employees expected to receive benefits.

Prior Service Costs

Prior service costs arise from plan amendments. They are not charged to prior periods, but are amortized by assigning an equal amount to the future service period of each employee active at each amendment date who is to receive benefits over an assumed future benefit period. Once an amortization period is established, the amortization period remains the same, absent special circumstances such as a curtailment.


At any point in time, the off-balance sheet amounts are the sum of: * Unamortized transition assets or obligations; * Unamortized gains and losses; and * Unamortized prior service costs.



A company can enter into an irrevocable action that relieves itself of responsibility for a PBO and eliminates the risks associated with the obligation and assets employed. For instance, the purchase of a nonparticipating annuity contract discharging all or part of the benefit obligations constitutes a settlement. The maximum gain or loss subject to recognition on a settlement is the unrecognized net gains and losses plus any remaining unrecognized transition amount, if an asset, arising from adoption of SFAS 87. This rule is based on the concept that there is no longer a reason to delay recognition of these net gains and losses, because an irrevocable action has occurred eliminating significant risk involving either PBO or plan assets. However, since employee services continue to be rendered after the settlement, any unrecognized transition obligation and unrecognized prior service costs are not immediately recognized but continue to be amortized over time even after the company enters into a settlement. An unrecognized transition obligation is treated the same as prior service costs.



A curtailment is an event that significantly reduces the expected future years of service of present employees or eliminates for a significant number of employees the accrual of defined benefits for some or all of their future services. Unrecognized prior service cost and the remaining unrecognized net obligation existing at transition date related to years of service no longer expected to be rendered are written off as a loss. A second component of curtailment gains or losses arises from decreases or increases of the PBO.

In determining the maximum curtailment gain from decreases in PBOs, the sum of net gains and losses and unrecognized net transition assets is calculated. If that sum results in an unrecognized loss, the curtailment gain is limited to the amount that the reduction in PBO exceeds the unrecognized loss. If the sum results in an unrecognized gain the entire reduction in PBO is recognized as a curtailment gain.

Similarly, a curtailment loss is recognized in full when the sum of the net gains and losses and unrecognized net transition assets results in an unrecognized loss. To the extent that this sum results in an unrecognized gain, the maximum curtailment loss is limited to the excess over the unrecognized gain.

If the curtailment related activities (i.e., sum of the effect identified with unrecognized prior service costs associated with years of service no longer expected to be rendered and any projected benefits obligation adjustment) results in a net loss, it is recognized in earnings when it is probable that a curtailment will occur and its effects are reasonably estimable. If the sum of the effects is a net gain, it is recognized in earnings when the related employees terminate or the plan suspension or amendment is adopted. The effects of settlements and curtailments resulting from a pension plan termination may be recognized in different accounting periods, since under SFAS 88 timing of recognition of losses can differ from recognition of gains.

In analyzing the accounting treatment for deferred pension related amounts accompanying a curtailment, the off-balance sheet deferred prior service costs and delayed transition losses from curtailment are recognized immediately.

The second source of gains and losses arises from changes in PBO, the accounting for which can be thought of as an offsetting process. For instance, assume the sum of net gains and losses plus delayed transition assets is a loss. This loss might have been generated from portfolio losses on investments. The gain from reductions in PBO is first offset against these losses, and only the excess flows through the income statement.


An example of such an action appears in the accompanying sidebar. Other illustrations from a plan termination and curtailment are presented in Appendix B of SFAS 88 and should be carefully studied by those interested in the mechanics of these transactions or in advising clients thereof. The incidence of federal excise tax or any cash reversions is not dealt with herein.


A survey of transactions accounted for under SFAS 88, recorded in NAARS (National Automated Accounting Research System) was conducted from December 1985, the period immediately following promulgation of SFAS 87 and SFAS 88, to 1988. The search disclosed 71 companies reporting settlement transactions and 21 companies reporting curtailment related transactions. Of 21 curtailments, we identified 10 arising from disposal of lines of business. An additional 19 companies offered special termination benefits, which are also accounted for under SFAS 88. Another 21 companies reported adoption impacts of recognizing amounts which were previously deferred under earlier authoritative pronouncements, principally APB 8 (see Figure 1).







Recognition of previously deferred



More companies engaged in settlements than in curtailments. Curtailments typically modify benefits available to employees under defined benefit plans. A settlement typically locks in a benefit, and companies may find settlement a less costly action in terms of employee reactions than a curtailment. It simultaneously offers the employer substantial accounting flexibilities. Special termination benefits are also accounted for under SFAS 88, and involve benefits offered to employees in connection with leaving the company.

Previously deferred gains relate to terminations occurring prior to adoption of SFAS 87 that are now being accounted for under SFAS 88. They are presumably a dying class of transactions; since accompanied by a reversion of cash or other assets there was a related tax payable.

Comparative balance sheet information for all sample companies as to plan assets and PBO was not available, but the data available indicated that sample companies had an excess of plan assets over their PBO and also had accrued liabilities related to their plans.


The mean impact of the SFAS 88 transactions by the sample companies on their income statements is set forth in Figure 2. Figure 2 shows that the 71 companies having settlements reported a mean of $17 million in settlement gains; the mean of their net income before the gains was $18.2 million. An additional tabulation for the 71 settlements shows that 36 companies had gain effects in excess of 20% of their reported net income before the settlement transaction. Tabular Data Omitted

The 21 companies with curtailment transactions experienced a mean of immaterial curtailment losses; other data from the study leads us to conclude that 19 companies experienced curtailment gains, suggesting that companies engaging in curtailments reduced employee benefits.

Under SFAS 88, companies that terminate employees will charge special termination benefits against the period when employees accept the termination offer and the amount is reasonably estimable. The mean cost was $10.4 million for 19 companies offering such benefits.

The 21 companies recognizing previously deferred gains did so as a result of asset reversion transactions occurring prior to adoption of SFAS 87. These deferred amounts are recognized under SFAS 88 as a cumulative impact of a change in accounting principle resulting from adoption of the pronouncement.

Many companies appear to be using discretion available under SFAS 88 to substantially increase reported earnings. Companies with plan assets exceeding PBO have a substantial pool of off-balance sheet deferred reductions in their pension provisions (i.e., deferred revenues). They have substantial discretion over timing and recognition of those deferrals. A number of companies appear to have taken advantage of that discretion to substantially increase their reported earnings. Even though these gains are quite material, only 20 companies showed them as separate line items within the income statements. Other companies reported them as reductions of pension costs, combined them with other income/unusual items or did not even separately mention them.

The mechanism for these transactions appears to be through settlement of portions of their pension plans. Companies can control the period in which these off-balance sheet amounts are realized using a transaction that need not be accompanied by a cash reversion.

Perhaps FASB should reassess the manner of presenting SFAS 88 transactions, and consider requiring accounting treatment comparable to that used for early debt redemptions, i.e., extraordinary items. Since many settlements are unaccompanied by cash reversions and appear to be largely accounting transactions without cash flow impact, FASB may also wish to reassess the theory underlying in SFAS 87 and SFAS 88. Much of these gains may be attributable to unrecognized transition assets arising upon adoption of SFAS 87, which may suggest an alternative accounting treatment for the remaining unamortized amounts. Tabular Data Omitted

In-Mu Haw, PhD, is an Associate Professor of Accounting in the M.J. Neeley School of Business, Texas Christian University.

Kooyul Jung, PhD, CPA, is an Assistant Professor of Accounting in the M.J. Neeley School of Business, Texas Christian University.

Steven B. Lilien, PhD, CPA, is Professor and Chairman of the Department of Accounting at Baruch College.

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