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June 1994

Time for realism in accounting for employers' pension plans. (Accounting)

by Mellman, Martin

    Abstract- The popular sentiment that employers should account for pension plan obligation net of plan assets and reflect these amounts in their company's balance sheets has finally found support from the FASB. In deliberating Statement of Financial Accounting Standard No. 87, 'Employers' Accounting for Pensions,' the Board acknowledged the logic of including plan assets and projected benefit organizations on the balance sheet. It also admitted the soundness of recognizing a net pension obligation or asset, which is the projected benefit obligation minus the plan assets, in either of two approaches. One of these is the immediate recognition of gains and losses while the other is the current reporting of gains and losses in comprehensive income, but not earnings.

Under SFAS No. 87, Employers' Accounting for Pensions, companies disclose the market values of pension plan assets and the projected benefit obligations of the plans but do not recognize them on their balance sheets. Furthermore, they disclose changes in those values, but only a filtered amount flows to the income statement.

In deliberating SFAS No. 87, the Board recognized the logic of reflecting plan assets and projected benefit obligations on the balance sheet. The Board acknowledged that plan assets are assets of the corporation, and pension plan obligations are liabilities of the corporation. Specifically the Board was aware that the liabilities have not been settled, the assets may still be controlled, and substantial risks and rewards associated with both are clearly borne by the employer. In the past, often through settlements, firms were able to retrieve some of those assets or, through future reductions of contributions, reduce future cash outlays. The fact that future contributions to the plan are increased or decreased by the performance of the plan assets supports the view that the employer bears the risks and reaps the rewards associated with those assets.

It is important to note that IRC Sec. 401 (a) (2) stipulates that for a plan to be qualified, the trust instrument must make it impossible, any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be used for, or diverted to, purposes other than for the exclusive benefit of employees or their beneficiaries. Of course, corporations have always reserved the right to terminate their plans, and in the past through settlements employers have retrieved some of those assets. This would provide compelling evidence that rebuts the argument that plan assets are not the assets of the corporation. However, this opportunity for asset retrieved has been severely curtailed, if not eliminated, by the amendment of IRC Sec. 4980, which imposes a nondeductible 50% tax on the reversion of qualified plan assets to an employer. Reversion means the amount of cash and the fair market value of other property that is received directly or indirectly by an employer from the qualified plan.

It is for these reasons we agree with the Board's view, expressed in SFAS No. 87, that it would be conceptually appropriate and preferable to recognize a net pension obligation or asset (offset) measured as the difference between the projected benefit obligation and plan assets, either with no delay in recognition of gains and losses, or perhaps with gains and losses reported currently in comprehensive income but not earnings.

These approaches were not adopted at the time of issuance of SFAS No. 87 because they were deemed to be too great a change from the then current practice.

In lieu of immediate recognition of pension related gains and losses, under current accounting under SFAS No. 87, there exists, off the books, three pools of pension-related amounts. These amounts are the unrecognized transition assets and obligations from the initial adoption of the pronouncement, unrecognized prior service costs, and the deferred gains and losses from actuarial experiences and plan asset performance. The off-the-book amounts together with pension-related amounts already accrued equal the funded status of the pension plan. Funded status is the difference between the projected benefit obligation and plan assets.

Differences Can Be Quite Great

If pension plan assets and the projected benefit obligations of General Motors were included in its balance sheet at 12/31/91 on a net basis, shareholders' equity would decrease by $1.8 billion. This would reduce shareholders' equity by 7.6%.

If the full amount of gains and losses flowed through income, the effect on General Motors earnings for 1988-1991 would be as shown in Table 1.

The question may well be asked, which of the earnings numbers is more likely to be useful for investment and credit decisions. We think that immediate recognition should be applied because it will give us more useful information about General Motors' net assets and net income. Thus we contend the truth is that GM earned $901 million in 1988 and not $4,856 million. Truth never hurts, and if we know the truth, we ought to report it. To argue that filtered truth is more useful is an abandonment of neutrality. The current practice reducing volatility of the income stream by delayed recognition does not help investors and creditors concerned with return/risk assessment. The point to emphasize for timely recognition of gains and losses is that value did change, which means that probable TABULAR DATA OMITTED future cash inflows and outflows changed, and that view meets the definition of relevant information.











Some would contend that if a change in accounting rules had been adopted to require General Motors in 1988 to report earnings of $901 million instead of the $4,856 million it actually reported, that this effect would contribute to the demise of defined benefit pension plans. Others would argue that the long-term nature of the projected benefit obligation is one of the major reasons to smooth or eliminate volatility. In response to the first criticism we would contend that economic consequences should not dominate accounting recognition and measurement. To do so would tend to corrupt accounting principles and lead to more serious economic consequences such as we have witnessed in the S&L crisis. The recent change in accounting for loan losses (SFAS No. 114) is a positive example of a step in the direction of a sound standard of accounting replacing the flawed principles of SFAS No. 15, that allowed creditors to avoid recording loan losses, bowing to "economic consequences" and introducing bias in financial reporting.

In the latter point, it is clear that pension obligations are of a long- term nature and that over time gains and losses may tend to reverse, but this does not justify the exclusion of changes in value in the determination of annual earnings or perhaps comprehensive income and net assets. Concepts of financial accounting would dictate recording the effects of such changes when they occur and would be supported by the rationale underlying mark-to-market accounting.

Significance of Recognized Gains and Losses

The current recognition of gains and losses in income in the case of General Motors shows that the differences between that approach and accounting for employee's pension costs under SFAS No. 87 with delayed recognition can be quite great. To assess the significance of changes in unrecognized gains and losses in relation to reported earnings, as well as the significance of the accumulated unrecognized gains and losses in relation to stockholders' equity, we referred to the 1988-91 annual reports of the top Fortune 100 companies. After eliminating foreign companies, companies in bankruptcy, companies with significant asset transfers and missing data, we arrived at a final sample of 88 companies. Table 2 presents relevant financial data for 20 of the 88 companies having particularly significant amounts of unrecognized gains and losses over the four-year period. The same data was accumulated for the remaining 68 companies and summary statistical information is provided for all 88 companies.

The change in the unrecognized gain/loss was determined on a company basis for the years 1988-91 using disclosures of five years of unrecognized gains/losses contained in the annual reports. For each year the difference between the year-end balance and the corresponding amount from the previous year was computed. The change in the unrecognized amount was then reduced to an after-tax basis using a 33 1/3% tax rate. The after-tax gain or loss was then compared to net income.

Table 2 shows that in 1988 unrecognized gains or losses ranged from 3% to 123% of net income. In 1989 the range was 2% to 5345% and 39% to 950% in 1990. In 1991, the range was 1% to 1376%. For all 88 companies, the mean and median of absolute values of unrecognized changes in pension related gains and losses, net of tax, as a percentage of net income are as follows:






Clearly, the changes in unrecognized gains and losses, net of tax in each of the four years are material in relation to net income and often the unrecognized gain/loss exceeds the reported income of the company.

To test the notion that gains and losses tend to offset, we computed for 1991 the accumulated unrecognized gain/loss, net of income tax, as a percentage of stockholders' equity. The range for the 20 companies in Table 1 is 0%-55%. Some amounts for individual firms are clearly material in relation to net assets, as for example Northrop 55%, Westinghouse 11%, Monsanto 12%, and Chrysler 16%. For all 88 companies, the mean of accumulated unrecognized net gains and losses, net of related taxes, as a percentage of stockholders' equity is 2% and the median is 2%. Of course, SFAS No. 87 has been in effect only since 1986.

Overall, we conclude that there is considerable usefulness in extending immediate recognition to accounting for employer pension plans.

Does Suppression Serve a Useful Purpose?

We could support the practices of SFAS No. 87 if we thought they served a useful purpose. However, we don't think that they do because they suppress information about volatility. Reported volatility can come from two sources. Significant changes in the net pension liability could result when actuarial assumptions are changed and when experience in a particular period is different from the expectations encompassed in the assumptions.

Some have argued that the lack of precision inherent in estimates of future events including mortality, turnover, and settlement rates (rates of interest), and rates of increase in wage levels, make a reliable measure of the obligation impossible. The Board recognized that the precision attainable in a measure of the pension obligation is less than that of many financial statement measures but concluded that the relevance of the information is sufficient to compensate for lack of precision.

A second source of volatility arises from changes in the market valuations of plan assets. The measurement change affecting the plan's investment assets is the net appreciation or depreciation in fair value (including both realized and unrealized gains and losses) to the extent that the change in fair value differs from the appreciation implicit in the assumed rate of return for the period. Delayed recognition is the device created to accommodate the conflict between recognizing a liability affected by changes in actuarial calculations, and current market valuations of plan assets, while at the same time attempting to shield equity and earnings from fluctuations by allocating the effects of changes over future employee services. Delayed recognition responded to the concern that measurement of pension benefit obligations would be volatile and would result in reported assets and liabilities that would change so much from one period to the next as to be meaningless, if not misleading. Apparently, the conclusion was that a significant part of volatility is the result of the nature of the measurement process that requires the prediction of future events rather than real changes in the underlying obligations. Delayed recognition shields equity and earnings from fluctuations.

Real Volatility Comes from a Volatile Phenomenon

Changes in the market values of pension plan investments are real. Fluctuations in settlement rates, rates of turnover and changes in mortality and rates of salary increases are also real events and cause changes in actuarial assumptions. These actuarial assumptions are continually being made and revised and acted upon as evidenced by plan settlements and curtailments. The Board felt that actuarial methods were reliable enough to deal with these factors. Of course false volatility comes from a poor measurement approach that makes a stable phenomenon look volatile. However, false stability comes from a poor measurement approach that fails to transmit information about real volatility. Most would agree that reporting false volatility does not faithfully represent real events. SFAS No. 87 shows that not everyone agrees that real volatility should be reported; instead, we find that the standard promotes reporting a false stability which goes under the euphemism "delayed recognition." Immediate recognition would present what happens- -if the market values of assets and liabilities are volatile, then the amounts reported in the statements are volatile; if they are stable, then the reported amounts are stable.

If the market is interested in long-run trends, the financial statements should help it detect year-to-year variations, and we should let it determine for itself what is expected to happen. Under SFAS No. 87, management's judgment supplants the market's judgment, and useful information about market values is suppressed. We believe that the market for public companies' stock is fairly efficient, so we are comfortable with the idea that stock prices reflect reasonably expected future cash flows; however, we don't see why the market should incur the unnecessary costs of interpreting complex information provided by SFAS No. 87, which, depending on the nature of disclosures, can effectively camouflage changes in assumptions and their impact. For instance, under current disclosure we can't disentangle deferred amounts attributable to actuarial revisions from gains and losses on pension plan assets that are also deferred. In effect, SFAS No. 87 allows management to recognize unreal measures in the financial statements and partially disclose real measures in the notes to financial statements.

Elements qualifying for recognition should be recognized in the basic financial statements. Disclosure is not an adequate substitute for recognition. The argument that the information is equally useful regardless of how it is presented could be applied to any financial statement element, but the usefulness and integrity of the financial statements is impaired by each such omission.

We think it would be better if GAAP required immediate recognition for pension assets and liabilities, and they allowed managers to recognize their version of events and amounts in the notes to financial statements and management discussion and analysis sections. If managers think that the volatility didn't really exist (or, if it did exist, that it didn't matter) then they can use the notes to financial statements to argue their case, instead of basing the financial statements on these assertions. Applying immediate recognition to changes in value of pension assets and liabilities would reduce the market's cost of interpreting the financial statements and certainly would increase the credibility of financial reporting.

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