Accounting Changes and the ‘Oh Good Grief Standard’
JULY 2007 -
Even when we all try to do the best we can, sometimes that just
makes things worse. Right now, the world’s accounting commissions
are trying to make standards more uniform by using the best practices
available. Sir David Tweedie, chairman of the International Accounting
Standards Committee (IASC), is one of the key players in trying
to minimize accounting differences around the world. He is in favor
of two rules for defined benefit (traditional) pension plans that
do not seem to be best practices: 1) using only the market value
of assets (instead of something more stable) when estimating the
pension plan’s expected investment income, and 2) booking
a significant special income or loss entry that fully recognizes
changes in a pension plan’s balance between assets and liabilities.
How sound are these two ideas?
in the United States can calculate a “market-related value”
of a pension plan’s investments, which might take up to
five years to fully reflect deviations from expected returns.
That smoothed asset value is then used to calculate the year’s
expected investment return, thus smoothing out one component of
net pension expense by avoiding a lot of the extremes (upside
and down) inherent in snapshot market values. This was not by
accident. Otherwise, according to SFAS 87, Employers’
Accounting for Pensions (paragraphs 120 and 121), short-term
changes in asset values “would produce unacceptable volatility
and would be inconsistent with the present accounting model.”
International Accounting Standard (IAS) 19, Retirement Benefit
Costs, lacks a similar mechanism. In short, the U.S. standard
allows enterprises to smooth secondary expenses (e.g., for pensions)
so attention is better-focused on fluctuations in performance
due to the core enterprise, just the sort of better practice that
should be embraced when standards are made more uniform.
In the United
States the two changes in the rules for pension plans (disallowing
smoothing expected investment returns and focusing more attention
on simple assets and liabilities) would have the following effect:
the apparent volatility of the business. One potential standard
for gains and losses relating to pensions would recognize them
immediately, probably in a special category. For example, the
balance sheet and part of the bottom line at General Motors
would irrationally swing between incredibly good and incredibly
be disruptive. Similar changes in the United Kingdom have been
partially responsible for roughly 65% of their traditional pension
plans now being closed (not covering new employees).
the focus on the current and future profitability of the core
- Do a
reasonable job for failing companies but probably overstate
the underfunding risk for most companies by not assigning a
reasonable likelihood of an immediate plan termination and settlement.
macro-level stock prices, because declining stock values would
significantly reduce the expected investment income from pension
plan assets and reduce reported earnings. This in turn reduces
stock values further. The world’s accounting rules should
not be designed to destabilize capital markets.
it more difficult to continue providing a traditional pension
actually be best to expand the smoothing techniques available
in SFAS 87 to allow the market-related (smoothed) value of assets
to follow the liability’s changes due to interest rate fluctuations
too. Such a technique can smooth out funding requirements for
pension plans facing severe volatility in contribution levels
due to fluctuations in liabilities, and it can dramatically smooth
the results. The IRS has approved it, so FASB might want to consider
instant recognition of all gains and losses in pension plans seems
more like assuming all possible warranty claims will be made now
(a similarly gloomy assumption). A pension plan’s investments
in the stock market can significantly affect the stability of
the sponsor’s earnings, which in turn affects the plan’s
price/earnings ratio. Some people want to make sure volatility
is not masked. Rather than trying to recognize every last dollar/euro/yen
of the annual fluctuations in the market value of a pension plan’s
assets, it would probably be more worthwhile to investors to know
how pension investments affect an appropriate “risk reserve”
that would factor in the likelihood that the plan will be terminated
and settled in the future—which would require an additional
charge to the books at such time. Stochastic actuarial models
are available that could probably set suitable reserves. Such
a concept is similar to carrying a reserve for warranty claims.
smoothing could be allowed under international standards, and
a measurement of pension costs calculated without smoothing could
be reported in a footnote. Because there are disagreements on
the smoothing issue, this could be the sort of well-balanced compromise
that is going to be needed.
‘Oh Good Grief Standard’
who believe that asset-smoothing has no place in solid accounting
practices seem to be getting caught up in narrow objectives without
seeing the bigger picture. People who are good with numbers sometimes
have to work harder at making well-balanced decisions, but two
things can help: 1) cultivating a good relationship with someone
with numerical abilities and a strong “right brain”
(for making balanced, holistic judgments), and 2) the “Oh
Good Grief Standard.”
are from an actuary, whose profession requires a mastery of math,
strategies, and following rules. Fortunately for me, I can “borrow”
a more balanced perspective from an associate. She explained the
“Oh Good Grief Standard” to me as follows: When something
feels out of whack, try saying “Oh Good Grief” and
judge how reasonable it feels. Often, this lets you recognize
that there are fundamental questions about what you are trying
changes to IAS 19 do not seem to pass the “Oh Good Grief
Standard,” especially with regard to the immediate recognition
of the full annual change in the balance between pension assets
and liabilities in a special income or loss entry. SFAS 158 has
already been changed to make this information available, but only
on the balance sheet and not on the bottom line. The liabilities
used are future pension payouts discounted using bond yields,
whereas these plans will typically operate for many more years
using investments in equities and bonds, making the proposed liabilities,
including those under SFAS 158, close to “liquidation”
liabilities. Such “liquidation” liabilities can be
50% higher than they would be from an “ongoing plan”
perspective using the trust’s expected rate of return.
liquidation values seems potentially worthwhile, especially for
enterprises nearing bankruptcy. However, the reporting needs to
be comprehensive and to reflect changes in liquidation values
for assets such as factories, equipment, real estate, stock options,
and patents, and for insuring warranty claims. Still, such values
are poor guides to how well a reasonably healthy enterprise is
doing, so either they should not be used in that context or an
alternative should also be presented. Whenever liquidation values
are presented, the reader should be made aware of the perspective
In any event,
the proposed values have almost no relevance for a healthy plan
sponsor. How would reporting them in a major way for all enterprises
(without a more rational measurement, at least in a footnote)
clarify pension costs for the readers of financial statements?
focusing on liquidation values, the reader of the typical financial
statement would probably be much better served by seeing an estimate
of the price-per-share value of the sponsor as if it were offered
for sale as a continuing enterprise. This seems much closer to
the objectives espoused by the mark-to-market advocates.
Rules and Other Sources of Irritation
extra rules that traditional pension plans have to follow make
it harder and harder to justify keeping these plans, even when
the plans are truly cost-effective. Pension accounting issues
are already a significant source of irritation in the board room.
Ideally, effective accounting standards should present the important
financial aspects of the enterprise to the public in a way that
keeps each part of the financial picture in perspective.
can, I believe, comment on alternative measurements of performance,
so the concepts above might be adaptable to other situations.
For example, if the price of a major raw commodity is erratic
but its long-term trend is reasonably well understood, a hypothetical
“smoothed” bottom line calculated assuming that a
mainstream price had been paid might help the company’s
board or the broader public better understand the future by eliminating
the “noise” due to price fluctuations.
tidbit: Many pension plan sponsors use asset-smoothing to set
contribution levels so they will be more stable from one year
to the next. That might cost the sponsor nearly 20 basis points
in average return over the long haul. Why? When the raw market
value is used to set contribution levels, you “buy low”
(contribute more when the market is low) and “sell high”
(keep paying out benefits but contribute less when the market
is high). It is ironic that smoothing is under attack for setting
the accounting charges, where it clarifies results, and is probably
much more common when setting contribution levels, where it is
inefficient for strong companies.
on proposed changes can be sent to FASB at firstname.lastname@example.org
and to the IASB at email@example.com.
These comments were shared with FASB and the IAS.
ASA, is a consulting actuary with the Cleveland, Ohio, office of
the human resources consulting firm Findley Davies (www.findleydavies.com).