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Dec 1992

Planners cope with SFAS 106. (Statement of Financial Accounting Standard) (Personal Financial Planning)

by Langer, David

    Abstract- The FASB's Statement of Accounting Standard No (SFAS) 106 requires all companies providing post-employment benefits to recognize the future costs of benefits in advance. Instead of the present pay-as-you-go practice, these firms will have to start accruing the postretirement benefits' future costs over the employee's year of service. Under SFAS 106, companies need to disclose the net periodic cost's elements, the assumptions employed, a sketch of the substantive plan, the plan assets' types and amounts, the impact of the increase in the assumed health care trend rates on the accumulated postretirement benefit obligation ad service cost. The new standard takes effect for fiscal years starting after Dec 15, 1992 for all firms, except for nonpublic companies where the postretirement benefit plan will not benefit more than 500 plan participants. SFAS 106 will apply to fiscal years beging after December 15, 1994 for these firms.

Postretirement benefits other than pensions are all forms of benefits, primarily health care and life insurance, provided by an employer to retirees. Under FASB SFAS 106, "Employers Accounting for Postretirement Benefits Other Than Pensions," companies providing such postretirement benefits will have to begin to accrue the expected future costs of such benefits over the employment period of employees, much as is now required under SFAS 87 for retirement plans. Many clients of CPA planners are business owners who will have to consider the effects of SFAS 106.

The promised benefits are considered to be in exchange for an employee's period of service, and the cost is therefore to be expensed over the years of such service. To date, most plans have been recorded on a pay- as-you-go basis. Beginning with the effective date of SFAS 106, the annual cost will require advance recognition of expected future benefits. This will frequently be a multiple of several times the pay- as-you-go cost that companies are used to, and profits will be affected accordingly.

If an unwritten or incomplete plan is in existence, a "substantive" plan may still be in effect for the purpose of SFAS 106 if employees can expect to receive benefits based on prior company practices.

Effective Date

SFAS 106 generally applies to fiscal years beginning after December 15, 1992. However, for employers that are nonpublic and do not expect more than 500 of the current plan participants to benefit under the postretirement benefit plan, SFAS 106 is effective instead for fiscal years beginning after December 15, 1994.

Example. Consider a nonpublic employer with 100 retirees and 600 active employees. If less than 400 of the active employees are actuarially expected to benefit under the plan, then fewer than 500 are ultimately expected to benefit. SFAS 106 will therefore not require the employer to comply until the fiscal year beginning after December 15, 1994.


SFAS 106 first requires the determination of the present value of expected payouts, called the expected postretirement benefit obligation (EPBO). This is determined by taking into account the benefits expected to be provided under the plan net of Medicare benefits and employee cost sharing and after adjustment for expected health care cost trends (inflation, health care utilization, etc.) Assumptions such as turnover, life expectancy, dependents, and an interest discount rate, must also be used.

The EPBO is allocated between past service and future service. For active employees, the past service portion is called the accumulated postretirement benefit obligation (APBO). For retirees, the EPBO is all attributable to past service and is therefore equal to their ABPO.

Net Periodic Cost

Each year a net periodic cost is to be booked made up of the following components:

Service Cost. The portion of the active employees' EPBO allocated to the current year of service.

Interest. Interest on the APBO and the service cost for the year.

Amortization of the Transition Obligation. Any unfunded APBO as of FASB 106's effective date is called the transition obligation. This is to be spread over the average expected future service of participants to full eligibility age, but 20 years may be used if greater. However, the company can alternatively elect to realize the entire transition obligation in the first year.

Amortization of Prior Service Costs, Gains, and Losses. Unrecognized gains and losses that exceed 10% of the larger of the APBO and the plan's assets, and increases in the APBO due to plan amendments, are to be amortized over the average expected future service of participants.

Actual Return on Plan Assets. The net periodic cost is to be reduced by interest earned during the year on plan assets, if any.

Disclosure Requirements

Required to be disclosed annually are the components of the net periodic cost, the assumptions used, a description of the substantive plan, the amounts and types of plan assets, if any, and the effect on the APBO and service cost of a 1% increase in the assumed health care cost trend rates.


SFAS 106 comes at a time when many companies are necessarily cost conscious. Those with a plan may be thinking of cutting costs. Those without a plan will either keep the thought of one on the backburner or consider offering a lower cost benefits package. However, at the same time employees are becoming painfully aware of the potentially ruinous cost of health care and may be wary of retiring early without adequate coverage. On the other hand, their continued employment primarily to maintain health care coverage may not serve a company's needs. Benefit reductions in the Medicare system could also result in pressure for companies to provide postretirement health benefits supplementing Medicare.

Some companies may at a minimum wish to assist retired employees in understanding available coverages prior to and after age 65. Pre-65 benefits would primarily include COBRA and group contract conversion privileges. Post-65 benefits are available from Medicare, Medigap policies, and long term care policies. Medicaid, of course, may also be available for those with limited resources.

Suggested review procedure.

Adequate time should be made available for a review of the following items where a company either has a plan of postretirement benefits covered by SFAS 106 or wishes to explore having one:

* Existing or contemplated benefit program for active employees, retirees below and above age 65, and beneficiaries;

* Impact of SFAS 106 on the financial statement and any deferred tax asset that may arise under SFAS 109, Accounting for Income Taxes;

* Desired changes in design and costs, including cost sharing with employees and retirees;

* Legal requirements;

* Competitors' plans; and

* Whether to prefund benefits.

SFAS 106 requires getting into a lot of complex considerations, but the effort can produce enlightenment in an area of great importance for both companies and their employees and is a requirement of GAAP.

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