New Accounting Rules for Postretirement Benefits
How SFAS 158 May Affect a Company’s Financial Statements

By Jalal Soroosh and Pouran Espahbodi

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JANUARY 2007 - On November 10, 2005, FASB added a comprehensive project to its agenda to reconsider accounting for pensions and other postretirement benefits. The impetus for adding this topic to the agenda was partly the SEC’s release in June 2005 of “Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off–Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers.” In that report, submitted to the President of the United States, the Senate Committee on Banking, Housing, and Urban Affairs, and the House Committee on Financial Services, the SEC staff recommended that FASB reconsider the accounting guidance for defined-benefit pension plans and other postretirement benefits.

FASB’s overall objective for that project was to improve the transparency and usefulness of postretirement benefit (i.e., pensions and other benefits) accounting information for investors, creditors, employees, retirees, and other users. The FASB staff, however, recommended that the board address the issues raised in the project in two phases. In the initial phase, the FASB staff called for an improvement in the transparency, understandability, and representational faithfulness of the sponsoring employers’ balance sheet. In this phase, FASB evaluated footnote disclosure versus recognition of the net funded asset (liability) of postretirement benefit plans—that is, the question of whether such information presently disclosed in the footnotes should be recognized in the company’s balance sheet. On March 31, 2006, FASB issued an exposure draft titled “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” In September 2006 the board issued a final standard, SFAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, thus completing the first phase of its pension accounting project.

In the second, more comprehensive phase of the project, FASB will reconsider all issues for postretirement benefit obligations, including:

  • How the items that affect the cost of providing postretirement benefits should be recognized and displayed in earnings or other comprehensive income;
  • How an employer’s benefit obligations should be measured, including whether more or different guidance should be provided about measurement assumptions; and
  • Whether postretirement benefit trusts should be consolidated by the plan sponsor.

Accounting Standards for Pensions and Postretirement Benefits

Exhibit 1 lists the GAAP pronouncements that deal with pensions and postretirement benefits other than pensions. As Exhibit 1 shows, accounting for pensions was first prescribed by Accounting Research Bulletin (ARB) 47, Accounting for Costs of Pension Plans, published in 1956. Not until 1984, however, when SFAS 81, Disclosure Of Postretirement Health Care and Life Insurance Benefits, was issued, was there any disclosure required for postretirement benefits other than pensions. The most comprehensive accounting standard for pensions was SFAS 87, Employers’ Accounting for Pensions, issued in 1985; for other postretirement benefits, it was SFAS 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, issued in 1990. In more recent years, SFASs 87 and 106 were revised by SFAS 132, Employers’ Disclosures About Pensions and Other Postretirement Benefits, issued in 1998, and SFAS 132(R), in 2003, and SFAS 158, in 2006. [For a comprehensive review of the differences among SFASs 87, 132, and 132(R), see “New Pension Disclosure Rules: Getting Beneath the Surface of SFAS 132(R),” by Bonnie K. Klamm and Roxanne M. Spindle, The CPA Journal, October 2005.]

Basically, SFAS 87 requires the recognition of pension expense, which consists of the following items: service cost; interest cost; expected return on plan assets; amortization of unrecognized prior service costs; amortization of unrecognized transition obligations (or assets); and amortization of unrecognized actuarial gains and losses. In addition, a portion of the pension-related assets and liabilities is also recognized on the balance sheet. Although SFAS 87 significantly improved accounting for pensions, it did not cause a big shock wave in the financial community, because some companies were already recognizing pension expense using accrual-basis accounting. A good amount of historical data made the estimates of pension costs and liabilities relatively reliable. Later on, FASB issued SFASs 132 and 132(R) to improve the disclosure requirements for pensions.

The accounting for postretirement benefits other than pensions, however, has been a different story. In 1990, when FASB issued SFAS 106, only a handful of companies accounted for this expensive obligation using accrual-basis accounting. It was common practice to account for these obligations on a “pay-as-you-go” (i.e., cash) basis. Although SFAS 106 covered all types of postretirement benefits other than pensions, its primary focus was on healthcare costs. Given the magnitude and the nature of healthcare costs, the statement significantly affected companies’ income statements and balance sheets. For example, an as-yet-unpublished study by one of the authors found that SFAS 106 reduced the basic earnings per share of 74 randomly selected companies by an average of 92%.

SFASs 87 and 106 improved the quality of information for postretirement benefit plans. Those standards did not, however, provide a comprehensive solution to these complicated accounting problems. There has been much criticism and disagreement among the preparers and users of financial information concerning the usefulness and reliability of the information required by SFASs 87 and 106. For example, a 1992 study of 600 preparers (CFOs) and 600 users of financial information (CFAs) found that although these two groups agreed that the provisions of SFAS 106 were needed to improve the usefulness of financial statements, they disagreed on how such information should be calculated and reported (Jalal Soroosh and Alfred Michenzi, “OPEB and SFAS 106: Controllers and CFAs Speak Out,” Corporate Controller, January/February 1992). FASB also recognized at the time both of those statements were issued that they were not likely to be the final steps in the standards-setting process for postretirement benefit arrangements. According to FASB’s summary in SFAS 158:

Prior standards did not require an employer to report in its statement of financial position the overfunded or underfunded status of a defined benefit postretirement plan. Those standards did not require an employer to recognize completely in earnings or other comprehensive income the financial effects of certain events affecting the plan’s funded status when those events occurred. Prior accounting standards allowed an employer to recognize, in its statement of financial position, an asset or liability arising from a defined benefit postretirement plan, which almost always differed from the plan’s overfunded or underfunded status. Those standards allowed an employer to:

  • Delay recognition of economic events that affected the costs of providing postretirement benefits—changes in plan assets and benefit obligations—and recognize a liability that was sometimes significantly less than the underfunded status of the plan.
  • Recognize an asset in its statement of financial position, in some situations, for a plan that was underfunded.

SFAS 158 is expected to improve the quality of information for these expensive arrangements.

SFAS 158

According to the aforementioned summary, SFAS 158 amends SFASs 87 and 106 by requiring that a business entity:

  • Recognize the funded status of a benefit plan—measured as the difference between the fair value of plan assets and the benefit obligation—in its statement of financial position. For a pension plan, the benefit obligation is the projected benefit obligation; for any other postretirement benefit plan, such as a retiree healthcare plan, the benefit obligation is the accumulated postretirement benefit obligation.
  • Aggregate the status of all overfunded plans and recognize that amount as an asset in its statement of financial position. A business must also aggregate the status of all underfunded plans and recognize that amount as a liability in its statement of financial position. A business entity that presents a classified statement of financial position must classify the liability for an underfunded plan as a current liability, a noncurrent liability, or a combination of both. The current portion (determined on a plan-by-plan basis) is the amount by which the actuarial present value of benefits included in the benefit obligation payable in the next 12 months (or operating cycle, if longer) exceeds the fair value of plan assets. The asset for an overfunded plan shall be classified as a noncurrent asset in a classified statement of financial position.
  • Recognize as a component of other comprehensive income the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost of the period pursuant to SFASs 87 and 106.
  • Recognize corresponding adjustments in other comprehensive income when the gains or losses, prior service costs or credits, and transition assets or obligations that remain from the initial application of SFASs 87 and 106 are subsequently recognized as components of net periodic benefit cost pursuant to the recognition and amortization provisions of SFASs 87, 88, and 106.
  • Apply the provisions of SFAS 109, Accounting for Income Taxes, to determine the applicable income-tax effects of the above items.

FASB believes that SFAS 158 will improve financial reporting by making it more complete and more representationally faithful. An employer that sponsors a defined-benefit postretirement plan must now report the overfunded or underfunded status of the plan in its statement of financial position rather than in the footnotes. SFAS 158 is effective for fiscal years ending after December 15, 2006, for employers with publicly traded securities, and fiscal years ending after June 15, 2007, for employers without publicly traded securities.

Background. Based on the staff proposal, FASB considered the following broad issues in developing this statement:

  • Definition and scope;
  • Measurement;
  • Recognition; and
  • Classification.

Exhibit 2 summarizes the current treatment of the items outlined in FASB’s pension accounting project and the issues surrounding them.

As the exhibit shows, accounting for pensions and postretirement benefits other than pensions involves two significant issues. The first is the question of transparency of information. It is very difficult for the reader of a financial statement to learn about a company’s expenses, obligations, or assets associated with its postretirement benefit plans. The numbers are there, but buried under a pile of other numbers. Users of the financial statements have to plow through the footnotes to gain even a limited understanding of the impact of these obligations on the company’s financial statements. Presently, the total obligations and assets of these plans are not consolidated into the sponsor’s financial statements. They are instead netted against each other, and part of the net amount is recognized on the company’s balance sheet as a liability or an asset. Unfortunately, these amounts have no fixed address on the balance sheet either. They are recognized in different places on the balance sheet, making it difficult for the users of financial statements to see the entire picture. As the Chartered Financial Analysts (CFA) Institute commented in 2005 [in the SEC’s “Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers”]:

[B]ecause the pension and other postretirement benefit accounting standard fails to provide full recognition in the financial statements of the effects on the firm of the pension and postretirement benefit contracts, a huge and very costly burden has been shifted to those for whom the statements are prepared, analysts and other users.

Second, adding to the above problem is the question about the nature of the underlying assumptions used to calculate the assets and liabilities of these plans. For example, the discount rate used to calculate the present value of future benefit obligations, the growth rate used to estimate future healthcare costs, and the expected return on plan assets in the long term are all subject to much discretion.

The discount rate has attracted much attention. The postretirement benefit obligations are the present value of the amounts to be paid for the retirees in the future. SFASs 87 and 106 do not, however, dictate what discount rate companies should use. The underlying assumption is that the rate chosen should be such that if the calculated present value amount is invested at the measurement date, it will generate enough cash flow in the future to pay for the obligations as they become due. This guideline leaves it up to companies to decide on an appropriate rate. This can be justified by the fact that different companies (or their plans) use different investment strategies to handle their assets. A study of 200 issuers, however, led the SEC staff to conclude, as stated in the previously cited CFA Institute report, that “it appears that on average issuers may be using discount rates that are at the high end.” Clearly, the higher the discount rate, the lower the present value and the reported obligations for postretirement benefits would be.

Similar to estimating future salary levels to calculate pension obligations, companies must estimate future healthcare costs to calculate postretirement healthcare obligations. The difference is that there is a much more reliable base on which to estimate salary levels than there is for estimating future healthcare costs. Increases in salary levels are partially controlled by the company itself. In addition, much more historical data are available to use in estimating future obligations than are available for healthcare costs. Healthcare costs have increased significantly in recent years. For example, Merck & Co. disclosed in its 2004 financial statements that the cost of healthcare and life insurance for its active employees increased from $241.7 million in 2002 to $295.3 million in 2004—an increase of more than 22% over a two-year period.

To project future healthcare costs, companies must choose a healthcare-cost growth rate (healthcare inflation rate). In a series of interesting and comprehensive studies, Jack Ciesielski evaluated the impact of postretirement benefit obligations on the financial statements of S&P 500 companies (Jack Ciesielski, “Pondering Pensions: How They Affected S&P 500 in 2004,” The Analyst’s Accounting Observer, June 22, 2005; “Pension Puzzlement: Effect on S&P 500 Balance Sheets,” The Analyst’s Accounting Observer, June 22, 2005; and “Ugly OPEBs of the S&P 500: Searching for Sense in the Figures,” The Analyst’s Accounting Observer, November 29, 2005). His study reveals that close to 81% of companies used a healthcare inflation rate of between 8% and 11% in 2004. Of the 309 companies covered in that study, 144 of them (47%) used a 10% rate for their healthcare cost inflation.

Whether these rates are reasonable is difficult for financial statement users to determine. As Ciesielski argued, “There’s no disclosure requirement of the existing per capita health care costs, so current inflation cannot be compared to future expected inflation to see if the assumptions are reasonable or just smoke.” In addition, he also discovered that from those 309 companies, 120 decreased their rates, while only 86 companies increased their rates from 2003 to 2004. Once again, it would not be possible for financial statement users to determine if such changes were justified. Using a lower healthcare-cost growth rate is advantageous to the companies because it reduces their estimated future obligations. For example, in the case of Merck & Co., a 1% decrease in the rate results in a $28.8 million decrease in healthcare expense for 2004, and a $243.5 million decrease in the estimated healthcare benefit obligation as of the end of 2004. Given the unpredictable nature of healthcare costs, additional disclosure may be necessary to add to the usefulness of financial information.

Impact of the Changes in GAAP on Financial Statements

As mentioned above, the first phase of FASB’s pension accounting project considered only two primary items: the transparency of financial information, and unrecognized gains and losses. For the transparency issue, there are at least two alternatives to bring the information about postretirement benefit plans to light. One alternative is to adjust the balance sheet by first removing the recorded net postretirement benefit assets/liabilities as they are currently required under SFASs 87 and 106, and then recognizing the gross amounts of such assets and liabilities separately on the balance sheet. The second alternative, now required under SFAS 158, is to aggregate the status of all overfunded plans and recognize that amount as an asset, and similarly aggregate the status of all underfunded plans and recognize that amount as a liability in the balance sheet. For the unrecognized gains and losses, SFAS 158 calls for their recognition on the balance sheet as part of other comprehensive income.

To consider how SFAS 158 might be implemented, the authors examined Merck & Company’s 2004 financial statements. (It should be noted that the issues and problems discussed here are not unique to Merck, but are common to all companies with postretirement benefit plans.) A review of Merck’s financial statements does not reveal any information about cost, assets, and liabilities arising from its postretirement benefit plans. This information can be obtained only from the footnotes. Exhibit 3 provides a summary of selected Merck financial information in Panel A, and the footnote disclosures on postretirement benefit plans in Panel B.

Exhibit 3, Panel A, Column 1, shows a summary of the company’s balance sheet for 2004 as reported. Column 2 provides the adjustments to strip the assets/liabilities recognized under SFASs 87 and 106 from the existing balance sheet, and to show the gross assets and liabilities of postretirement benefit plans separately on the balance sheet. These adjustments are equivalent to making the two journal entries based on the data in footnote disclosures provided in Panel B.

The adjusted balance sheet, in column 3, fully and separately recognizes the assets and liabilities of the company’s postretirement benefit plans. The bolded numbers are the gross amounts of projected benefit obligation (PBO) for pensions and accumulated benefit obligation (ABO) for other post-employment benefits (OPEB); their related assets, including the deferred tax assets; and a charge to other comprehensive income.

Column 4 is an implementation of the SFAS 158: netting each postretirement benefits plan’s assets and liabilities, and reporting the unrecognized gains and losses as a charge to other comprehensive income. This column is the same as column 3, except that only a net asset/liability is recognized for each postretirement benefit plan. Although this approach provides more information about the company’s postretirement benefits plans’ obligations than is currently available, it does not provide detailed information about the plans’ assets and liabilities. This offsetting of the plans’ assets and liabilities will have a noticeable impact on the company’s financial ratios, as discussed below.

Columns 3 and 4 provide clear transparency to the impact of the postretirement benefit plans on the company’s financial position. Comparing columns 1, 3, and 4 leads to an interesting result: The removal of the amounts recognized under SFASs 87 and 106, and the full recognition of the impact of postretirement benefit plans result in a decrease in owners’ equity of more than $1.8 billion. The magnitude of this amount demonstrates the transparency problems associated with SFASs 87 and 106—that is, the quasi-recognition of postretirement benefits has resulted in understatement of assets and especially liabilities.

Exhibit 4 shows the calculation of a few financial ratios for 2004 based on the reported and adjusted financial information in Merck’s financial statements. Alternatives 1 and 2 in this exhibit correspond to those in Exhibit 3. Because, as a result of the adjustments, the amount of equity has decreased compared to that in the first column, the return on equity (ROE) has improved by 11% for 2004. The return on assets (ROA), however, will drop by about 10% from its previous level, due to the increase in reported assets, if the full amounts of the plans’ assets and liabilities are reported separately on the balance sheet—that is, if alternative 1 is followed. If these assets and liabilities are netted, as they are reported in Column 4 of Exhibit 3, ROA will increase slightly. More important, the debt/equity ratio will increase about 48%, from 1.32 to 1.95, and the debt/assets ratio will increase by about 17% from 0.54 to 0.63, under alternative 1. These ratios under alternative 2, which are based on the net amount of each plan’s assets and liabilities, are not as adversely affected by the recognition of the additional liabilities as they are under alternative 1.

Expect Similar Results for All Companies

Based on the impact of recognizing the net funded assets/liabilities of postretirement benefit plans on the balance sheet as required under SFAS 158, and the financial ratios of Merck, the authors can safely say that the financial statements of all companies with such plans will show similar results. Regardless of the impact of SFAS 158 on companies’ financial statements, the changes it requires would improve financial reporting in two ways. First, SFAS 158 requires companies that sponsor defined-benefit postretirement plans to report the current economic status (overfunded or underfunded) of their plans in their statement of financial position. This change will eliminate the need for reconciliation of the footnotes to the financial statements, which will add to the transparency of financial information. Second, SFAS 158 also requires companies to measure their plan assets and plan obligations as of the end of their fiscal year, rather than as of a measurement date that can be up to three months before the end of their fiscal year. These changes should improve financial reporting by making the financial statements more complete and more representationally faithful.

Jalal Soroosh, PhD, CMA, is a professor of accounting at Loyola College, Baltimore, Md.
Pouran Espahbodi, PhD, CPA, is a professor of accounting at Western Illinois University, Macomb, Ill.





















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