Perfect Storm Prompts Changes in Pension Accounting

EXECUTIVE SUMMARY

FASB has issued Statement no. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, to reform accounting for pension and other postretirement benefit plans. The new statement requires companies to move off-balance-sheet items onto their financial statements. The schedule of comprehensive income would show changes to prior service costs and accumulated actuarial gains caused by new events and amortization. FASB has also changed required footnote disclosures for pension and other postretirement benefit plans. Companies must disclose the nature and amount of changes in plan assets and benefit obligations recognized in net income and in other comprehensive income for each reported period. They also must disclose changes in plan assets and benefit obligations that have been deferred and recognized in other comprehensive income. Companies can consider using an alternate footnote disclosure that contains the same information required by Statement no. 158 but also presents additional information, specifically reconciliations of the beginning and ending balances of the deferred components. Financial analysts and other financial statement users may find this information useful. The new provisions apply to other postretirement benefits as well as pensions. Once the calculations for all plans are complete, the employer must aggregate the net balances of all overfunded plans into a single asset. The employer then must aggregate the net balances of all underfunded plans into a single liability. FASB’s new pension rules will improve access to pension-related information and make it easier for financial statement users to understand. FASB has already initiated a second phase of the project to identify and eliminate other flaws in pension accounting in the future. Paul B.W. Miller, CPA, Ph.D., is professor of accounting at the University of Colorado at Colorado Springs. His e-mail is pmiller@uccs.edu . Paul R. Bahnson, CPA, Ph.D., is professor of accounting at Boise State University in Boise, Idaho. His e-mail is pbahnson@boisestate.edu .

Over the first half of the decade, pension and other postretirement benefit plans were hit hard by a perfect storm of economic forces. Investment returns were irregular and often less than expected. Falling interest rates caused employers’ obligations to soar. And many old-line industries experienced a cash crunch that encouraged management to offer increased pension benefits in lieu of higher wages. A shift in demographics has resulted in far fewer younger workers and many more who have retired or are about to do so.

These factors combined to create severely underfunded pension and other benefit plans with growing expenses and losses. The then-applicable accounting standards kept these effects off financial statements, possibly diverting public attention. Only when large bankruptcies aroused concerns that the Pension Benefit Guaranty Corp. would not have the wherewithal to bail out the troubled plans did the crisis draw widespread interest.

This confluence of events heightened awareness that accounting standards needed substantial repair, if not outright replacement. In response, FASB created a two-phase project. The goal of the first phase, now complete in the form of FASB Statement no. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, was to move off-balance-sheet items onto the financial statements. The second phase, in cooperation with the International Accounting Standards Board (IASB), will take a more careful look at the issues including assumptions used in measuring benefit obligations and whether postretirement benefit trusts should be consolidated with sponsors’ financial statements.

Statement no. 158 was released in September 2006, with an effective date that requires public companies to implement it for fiscal years ending after Dec. 15, 2006. Private companies are required to implement the new standard for fiscal years ending after June 15, 2007.

FASB 158 IN A NUTSHELL
FASB’s action established new practices in several areas without changing the basic measurements under Statement no. 87, Employers’ Accounting for Pensions, and Statement no. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. Basically, Statement no. 158 requires companies to take information out of the footnotes and put it into the body of the financial statements as follows:

The balance sheet reports a net asset or net liability equal to the difference between the estimated values of the projected benefit obligation and fund assets as of the balance sheet date.

The balance sheet also presents a positive or negative component of accumulated comprehensive income equal to the sum of the previously off-the-books memo accounts for deferred effects of plan amendments and accumulated deferred gains and losses.

The statement or schedule of comprehensive income presents changes in the prior service costs and accumulated actuarial gains caused by new events and amortization.

The minimum liability reporting requirements have been eliminated. The standard changes employers’ balance sheets but doesn’t alter the annual cost calculation. The required footnote disclosures now include an estimate of the coming year’s amortization of prior service cost and any corridor amortization (an expense adjustment that occurs when accumulated unrecognized gains or losses exceed 10% of the greater of the plan assets or projected benefit obligation).

A NEW WORKSHEET
The changed status of the formerly off-the-books amounts means employers must complete a different set of calculations. This section describes a worksheet CPAs can use to produce the required results, including the annual cost, as well as reconciliations of the beginning and ending balances of the asset, obligation and components of other comprehensive income. The worksheet also supports the journal entry needed to record the year’s events (for simplicity, the entry does not include deferred tax effects).

Exhibit 1 shows the information for the first three years in the life of a new defined benefit plan. In 2006, the employer creates a plan with no prior service costs and incurs a service cost of $2,000. Because no liability existed during the year, no interest expense was incurred. No return was earned because the $3,000 funding occurred at year-end.

Example Data Year 2006 2007 2008 Service cost $2,000 $2,400 $2,800 Interest rate on benefit obligation 7% 8% 8% Expected return on pension assets (rate) 9% 9% 9% Actual return (loss) on pension assets n/a $(200) $700 Plan amendment (prior service cost) n/a $750 n/a Actuarial liability increase (decrease) n/a $800 $(300) Employer contributions (at end of year) $3,000 $3,500 $500 Benefits paid (at end of year) n/a $400 $440 Average service life of participants (years) n/a 5 5

No worksheet is needed for the first year because there are no deferred items. This journal entry records the effects of the plan:

Annual pension cost	$2,000
Plan assets	$3,000
Pension obligation	$2,000
Cash	$3,000

The 2006 balance sheet reports a net plan asset of $1,000.

In 2007, $160 of interest accrues on the obligation. The plan assets suffer a $200 loss instead of earning the expected $270 gain (9% of $3,000). The plan is amended to increase benefits by a present value of $750. Despite an increase in the market interest rate used to discount the future cash flows, the actuary’s measure of the obligation increases by a net amount of $800 because of changes in economic and demographic factors for the covered population. The employer contributes $3,500 at year-end and benefits of $400 are paid out. As part of the annual cost measurement, the plan amendment cost of $750 is amortized straight-line over the five-year average remaining service life of covered employees at $150 per year. The worksheet appears in Exhibit 2.

Worksheet for 2007

The leftmost column lists pension-related factors, starting with the beginning balances, moving through the year’s events and finishing with the ending balances. The first numerical column compiles the reported annual cost. The next five show how individual events affected the balance sheet accounts, including the last two that show the changes in the two pension-related components of accumulated other comprehensive income (AOCI), which is reported in equity.

The following worksheet entries capture these events:

Service cost. Records the $2,400 increase in the obligation from new accrued benefits with a credit in the fourth column while the offsetting debit increases annual pension cost in the first column.

Interest expense. Records $160 (8% of $2,000) of accrued interest as a credit that increases the obligation and a corresponding debit that increases the annual pension cost.

Actual return. Records the year’s actual loss with a $200 credit to the pension assets balance and debits the loss to the year’s annual pension cost.

Unexpected return adjustment. Adjusts the annual cost to equal what it would have been if the plan assets had earned the expected return of $270 (9% of the $3,000 beginning balance). The $470 credit in the first column counteracts the effects of the actual $200 debit to achieve the desired net credit of $270. The offsetting $470 debit is recorded in the deferred actuarial gain/loss column as part of AOCI.

Plan amendments. Records the $750 increase in the obligation from the prior service amendment. Notice that the full amount is initially deferred with a debit entry to the comprehensive income account for the effects of amendments.

Actuarial changes. Records the $800 increase in the liability for the actuary’s adjustment while the corresponding debit is added to the deferred actuarial gain or loss component of other comprehensive income.

Amortization. Prior service cost is not deferred indefinitely but amortized over the employees’ remaining service period, in this case at the rate of $150 per year. The amortization is recorded with a debit to the annual cost and a credit to the deferred amendments component of other comprehensive income.

Contributions. When the employer puts cash in the fund, the event is recorded with a $3,500 credit to cash and an equal debit to the plan assets account.

Benefits. When benefits are paid, they are recorded by reducing the pension assets balance with a $400 credit, while reducing the liability with an equal debit.

The “total” line in the worksheet shows the aggregate pension cost is $2,440, with the other changes as shown. The information on this line leads to the year’s journal entry:

The 2007 balance sheet reports a $190 net pension asset ($5,900 – $5,710). A later section describes our recommendations for disclosures that go beyond Statement no. 158’s minimum requirements.

Exhibit 3 shows the 2008 worksheet. The year’s events are both similar to and different from 2007. The similar items include service cost and interest, amortization of the plan amendment’s effects and the contributions and benefit payments. The actual return was larger than expected and another actuarial change reduced the pension obligation. Conditions at the beginning of the year also called for corridor amortization of the deferred actuarial gain/loss.

Worksheet for 2008

Here are details of items that are different in 2008:

Actual return. Records the year’s actual gain with a $700 debit to the pension assets balance and deducts it from the year’s cost by crediting the same amount in the annual cost column.

Unexpected asset return. Adjusts the annual cost to equal what it would have been if the plan assets had earned the expected return of $531 (9% of the $5,900 beginning balance). The $169 debit in the first column accomplishes the adjustment. The net effect of the $700 credit and the $169 debit is the desired $531 credit. The offsetting $169 credit reduces the deferred actuarial gain/loss component of other comprehensive income.

Actuarial changes. Records the $300 decrease in the liability for the actuary’s adjustment with a debit in the obligation column and a credit to other comprehensive income in the deferred actuarial gain/loss column.

Corridor amortization. Because the beginning deferred actuarial loss of $1,270 is larger than the $590 corridor (10% of beginning plan assets of $5,900), the $680 excess deferral ($1,270 – $590) is divided by the five-year service period to produce the $136 one-time adjustment that is added to the year’s pension cost and deducted from comprehensive income. (To help financial statement users predict the future expense, Statement no. 158 requires management to disclose this anticipated amount in the prior year’s footnote along with the $150 expected amortization of the prior service costs.)

This journal entry for 2008 can be derived from the “total” line in the worksheet:

Annual pension cost	$3,012
Plan assets	$760
AOCI–plan amendments		$150
AOCI–deferred gain/loss		$605
Pension obligation		$2,517
Cash		$500

After this entry, the 2008 balance sheet will report a $1,567 net pension liability ($6,660 – $8,227).

THE RECOMMENDED FOOTNOTE
Among other items, FASB’s required footnote disclosures include:

The nature and amount of changes in plan assets and benefit obligations recognized in net income and in other comprehensive income for each reported period.

The changes in plan assets and benefit obligations that have been deferred and recognized in other comprehensive income.

After reviewing the standard, we believe the disclosures can be made even more complete and transparent. Exhibit 4 uses the 2007 and 2008 data to illustrate our recommended schedule. Although it reports the same numbers in the spreadsheet, we designed it to present the facts in a readily interpretable format, as described below:

The first numeric column presents the components of the annual cost, including the basic items plus the effects of the deferrals and amortization for the year.

The second column describes the changes that occurred in the pension assets for the actual return, contributions, and benefits paid out.

The third column describes the changes that occurred in the pension obligation for the year’s service and interest cost, benefits paid, and changes from plan amendments and actuarial adjustments.

The fourth column summarizes the year’s changes in AOCI; the total change for the year is reported on the statement or schedule of comprehensive income.

The fifth and sixth columns reconcile the beginning and ending balances of the two items of other comprehensive income for plan amendments and deferred gains and losses.

Footnote for 2007-2008

Our recommended footnote meets the minimum requirements imposed by Statement no. 158 but also presents additional useful facts, specifically the reconciliations of the beginning and ending balances of the deferred components. This information can occasionally be inferred from the required minimum presentations, but only with much extra effort, to the frustration of some financial analysts. We believe our format offers substantial advantages over the status quo in terms of completeness and accessibility.

ADDITIONAL POINTS
FASB addressed three other key issues. First, the board decided it would not require managers to apply the new standard retrospectively to the beginning of the earliest year on the comparative income statement in their financial reports. However FASB recommends the restatement be accomplished; doing so will improve the comparability and usefulness of the financial statements.

To get the accounts into their needed condition as of that earlier date, the employer will record an adjustment that debits a new pension assets account for its market value and credits a new pension obligation account for its estimated value. Then, the adjusting entry will create accounts as needed for accumulated other comprehensive income items describing deferred prior service costs and actuarial gains and losses. In addition, the employer will close the Statement no. 87 prepaid/accrued pension cost account. The employer will then debit or credit any remaining difference to retained earnings as needed. This last amount will equal the balance, if any, of the deferred transition gain or loss left over from the initial application of Statement no. 87. This analysis is illustrated in Exhibit 5 using year-end 2004 numbers from ExxonMobil’s 2005 form 10-K.

Journal Entry for ExxonMobil as of Jan. 1, 2005

FASB also amended accounting practices for settlements and terminations as governed by Statement no. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, which used to require that the financial statements recognize changes in various on- and off-the-books accounts. With suitable modifications, the basic worksheet and footnote schedule can deal with these events.

The new standard applies to other postretirement benefits as well as pensions. Once the calculations are complete for all plans, the employer must aggregate the net balances of all overfunded pension and other benefit plans into a single asset on the balance sheet. Then, the employer will aggregate the net balances of all underfunded plans into a single liability.

AN INTERIM FIX
Despite its significant changes, Statement no. 158 is only FASB’s interim solution for improving users’ access to pension-related information. The new standard should reduce uncertainty and lower users’ risks while decreasing their processing costs, with the ultimate result of higher stock prices. Some managers objected to the proposal, perhaps out of fear the new presentation would reduce the market values of their securities. This reduction could happen only if moving information from the footnotes to the balance sheet would cause users to lower their estimates of the employer’s future cash inflows or to perceive greater risk. In either event, the managers’ premise seems to be that their companies’ shares were previously overpriced because the market was misinformed. We don’t expect such downward adjustments to occur. Even if they were to happen, the new standard would be working for the best because the goal of sound financial reporting is to boost capital market efficiency by increasing the quality of information.

WHAT’S NEXT?
While Statement no.158 will provide more transparent information about companies’ postretirement benefit obligations, influential bodies including the SEC, the CFA Institute, and the Financial Accounting Standards Advisory Council have called for a more complete reformation of GAAP, even to the point of calling for consolidating the financial statements of the parent and the pension plan. FASB, together with the IASB, has pledged to consider these issues in the second phase of its project on pension accounting. Specific areas to be addressed include comprehensively considering how the elements that affect the cost of postretirement benefits are best recognized and displayed in the statement of earnings and comprehensive income, how to measure an entity’s benefit obligations and whether postretirement benefit trusts should be consolidated by the plan sponsor.