Perhaps it's time for a model that more faithfully
represents an entity's pension fund activities
By Frank D'Andrea
There is nothing simple about pension accounting and how to report related financial results. When markets are spinning up or down, pension accounting always seems to come to the fore.
Most recently, media releases have been focusing on pension accounting rules that allow companies to estimate their pension funds' average annual return over time, and report that amount as income, regardless of actual results. Indeed, some stakeholders are calling for greater financial reporting transparency of pension fund results. But the call for greater financial reporting transparency is nothing new in accounting circles.
Before addressing how best pension accounting results can be reported, it is useful to step back and look at some of the fundamental principles underlying pension accounting.
Peccadillos of pension accounting
Pension accounting is particularly complex because it dabbles in an array of accounting applications, including estimation, deferral, smoothing and offsetting. At a high level, it is unique in at least three different areas:
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Delayed recognition. At any point in time, changes in the pension obligation and in the value of assets accumulated to meet the obligation, even though the changes have been identified and quantified, have not been recognized for accounting purposes. These changes stem from experience, actuarial revaluations and changes in the past service obligation related to plan amendments.
Net cost. The recognized pension-related events and transactions are reported as a single net amount of pension expense. This practice aggregates at least three items that would be reported separately under generally accepted accounting principles (GAAP) for nonrelated operations: compensation cost, interest cost and returns earned.
Offsetting. The offsetting feature is for the balance sheet what the net cost feature is for the statement of operations. Rather than carry pension fund assets as assets and the unsettled pension obligation as a liability on the balance sheet, a net pension asset or net pension liability is carried on the balance sheet. |
The pension accounting peccadilloes don't stop there. For example, entities can smooth the impact of market downturns by using market-related values, instead of market values in determining pension expense. Similarly, cumulative gains or losses that are less than a corridor amount can be ignored. Clearly, with the array of accounting options available to an entity, making heads or tails of pension accounting results can be confusing to most of financial statement readers.
What's good is bad?
During the bull market of the late 1990s, corporate pension plans were brimming with surpluses, which were a boon to corporate bottom lines. In fact, in late 1999, the size of pension income being generated by the pension surpluses began to raise the eyebrows of the Securities and Exchange Commission (SEC) in the U.S.
In late 1999, the SEC began taking a hard look at broadening disclosure rules for pensions. The concern stemmed from the need to increase the visibility of the contribution of pension surpluses to a company's earnings. At the time, a report released by Bear Stearns & Co. said the net cost feature of pension accounting "distorts earnings from core operations, growth rates, and intercompany comparisons."
The Financial Accounting Standards Board (FASB), while aware of the issues surrounding pension surplus, had no plans to make changes to Financial Accounting Statement 87, Employers' Accounting for Pensions. Even then, however, the FASB was aware that such issues would form the basis of a larger project to determine how items are to be displayed on a company's income statement (see Need for Transparency below).
Aside from visibility, the surpluses were generating a more thorny accounting issue: how to measure the reported balance sheet asset. The issue of measurement arose since the pension surpluses being generated were so large that employers could not otherwise use the surplus beyond contribution holidays, nor, in most cases, could the funds be withdrawn.
Here in Canada, the CICA produced guidance under Section 3461, "Employee future benefits," which indicates how to measure what effectively is an impairment test on the adjusted pension benefit asset. While the actual mechanics under Section 3461 are complex, the basic premise is that an entity should recognize a valuation allowance for any excess of the adjusted benefit asset over the expected future benefit.
The recommendations in Section 3461, and previously in the Emerging Issues Committee (EIC) abstract EIC-1, "Pension surplus recognition," originally received scrutiny from pension accounting traditionalists. For example, stakeholders expressed concern over the treatment of changes in the valuation allowance treatment since, in all other respects, pension gains or losses are normally amortized over time, consistent with the offsetting principle. The CICA justified the current period treatment for changes in valuation allowances as being consistent with other areas of accounting where such allowances are used, e.g., loan loss provisions, future tax assets, etc.
What's bad is good?
Like all good things, the bull market of the late 1990s came to an end. The stock market downturn in 2001 resulted in some entities experiencing significant actuarial losses that have substantially eroded or eliminated previous accumulated plan surplus. As well, the decline in interest rates has led to further actuarial losses as a result of revaluing the accrued benefit obligation.
You would expect the market downturn to lead, quid pro quo, to an increase in pension expense – but not necessarily so. What some entities found when attempting to follow the guidance in Section 3461 was a credit to income from reversing a valuation allowance, a somewhat counterintuitive result when the plan's financial position had deteriorated substantially.
In reaction to what was becoming a common occurrence for many entities, the Accounting Standards Committee (AcSB) issued an additional Q & A 89.1 that addressed this particular situation, affirming the treatment that a gain could in fact result, and was entirely consistent with traditional pension accounting. In short, the cumulative effects of profits and losses reflected in income as a result of fluctuations in the valuation allowance make most sense when viewed over a number of years. For example, a decrease in the valuation allowance offsets or reverses higher charges to earnings in prior years, and gets an entity back to the position where it would have been had it never recorded a valuation allowance in the first place. Timing is everything!
The International Accounting Standards Boarddy (IASB) recently faced this very issue in response to constituents' concerns over "perverse" accounting results in applying the asset ceiling under IAS 19, "Employee benefits." In addressing this issue, the IASB took a different position: that a gain should not be recognized solely as a result of an actuarial loss or past service cost in the current period. The IASB issued a limited amendment to IAS 19 to avoid such "counter-intuitive" results. Admittedly, the IASB concluded that there were further conceptual and practical problems with these provisions, and that it would conduct a comprehensive review of these aspects of IAS 19 as part of its work on convergence of accounting standards across the world.
At a recent meeting, the IASB and FASB agreed to consider the scope of a joint project on convergence of pension accounting standards. The project will consider how the total change in value of plan assets should be reported in a statement of comprehensive income; disclosure of an allocation of plan assets across broad categories; whether the immediate recognition of actuarial gains and losses arising on the defined benefit obligation should be retained as an option, made mandatory, or prohibited, and whether the 'asset ceiling' of IAS 19 should be retained.
Need for transparency
Whether entities are recording valuation allowances or reversing them when troubled times arrive, the message is clear that pension accounting needs to become transparent.
In January 2002, the AcSB approved a project proposal on reporting financial performance, to be undertaken in close consultation with the FASB and the IASB. The project will deal primarily with the display and presentation of items that are reported, at present, in the income statement. However, it will also consider the display and presentation of items in the cash flow statement, as well as whether certain items that are not presently recognized in the income statement should be recognized in a statement of financial performance.
The AcSB intends to discuss the issues at the same time as the FASB and IASB, with a view to issuing a document for comment in Canada after the third quarter of 2003.
Two of the key principles underlying the performance reporting project are that:
| (i) |
a statement of comprehensive income should be able to distinguish the return on total capital employed from the return on equity; and |
| (ii) |
income and expenses resulting from re-measurement of an asset or liability should be reported separately. |
In respect of pension costs, the application of these principles would result in the following reporting for the separate components of pension cost.
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Income Flows |
Valuation adjustments |
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Operating |
(a) |
(b) |
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Financing |
(c) |
(d) |
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(a) + (c) |
(b) + (d) |
Pension cost components would be reported as:
| (a) |
operating, income flow – current service cost. |
| (b) |
operating, valuation adjustment – actuarial gains and losses related to changes in assumptions about future cash outflows. |
| (c) |
financing, income flow – interest cost, expected return on assets. |
| (d) |
financing, valuation adjustment – actuarial gains and losses relating to return on assets and changes in discount rate assumptions. |
Earlier in 2002, FASB had discussed whether to address certain specific issues on a faster track. Based on user interviews and task force discussions, FASB staff identified certain narrow scope issues as potential candidates for a fast-track effort. Those issues include, for example, potential amendments to FASB Statement No. 87 to require the amounts and captions in which net pension costs are reported and perhaps quarterly disclosures of the components of net pension costs.
In a similar initiative surrounding concerns over the continued use of "pro-forma earnings" and other non-GAAP measures, Standard & Poors (S & P) issued guidance to define core earnings, and the rating agency will use their proposed definition of core earnings to rate filing companies.
To arrive at core earnings, S & P starts with "as reported" earnings, which is the GAAP reported earnings adjusted for extraordinary items, discontinued operations and cumulative effects of changes in accounting policy (the latter being an issue for US filers). The "as reported" figure is then adjusted for a number of items, including stock-based compensation costs and pension- related items, to arrive at "core earnings."
Interestingly, the S & P takes what some might view as a conflicting approach with respect to pension-related items. That is, "core earnings" include pension expense, but does not include pension income. S & P views this differing treatment as no conflict at all. That is, pension costs are part of employee compensation and arise because people are hired to work and produce revenues, i.e., core earnings. In contrast, pension gains have nothing to do with the corporation's core business or the creation of core earnings. The size and timing of pension gains is instead a function of fund investment performance.
Time for good again?
With the current bear market, an entity could experience future actuarial gains. For example, entities purchasing investments will forecast expected returns that, in the unusual world of pension accounting, will drive the current period's expense. The actual return will drive out an experience loss (or gain), but for the current period, the return reported is the expected return at the beginning of the year. In other words, pension fund losses are not immediately recognized into earnings.
Little wonder, then, that most practitioners have difficulty coming to grips with pension accounting.
Jack Ciesielski, who writes for the The Analyst's Accounting Observer, may have put it best in a recent letter addressing what projects the FASB should be working on:
"Much has been made about the shrinking contributions of pension assets to the bottom lines of American companies as a result of the bear market. Much has also been made of the desire to present earnings with smooth trends in them for the sake of appeasing Wall Street, and the fostering of 'earnings management' mentalities. Statement No. 87 is 15 years old, and while it was a vast improvement at the time of its implementation, it is now time to re-examine it."
As Mr. Ciesielski implies, rather than working within each pension accounting peccadillo individually, perhaps it's time to step back and look at developing a model that more faithfully represents the activities of an entity's pension fund. That way, some steps can be made toward achieving greater financial transparency in the current marketplace.
Frank D'Andrea, CA, is a financial policy & reporting advisor with Hydro One Inc. and a member of FEI Canada's committee on corporate reporting
