FASB’s Quick Fix for Pension Accounting Is Only First Step

Hidden liabilities, understated expenses, and discretionary management assumptions make pension accounting controversial. Previous accounting standards allowed companies with underfunded pension plans to accumulate pension liabilities off the balance sheet while frequently reporting a net pension asset on the balance sheet. A new standard improves transparency by requiring that the pension’s funded status be reported on the balance sheet. In assessing the impact of the new standard, this study finds that it creates profound reductions in owners’ equity for many U.S.-listed companies. Pension cost smoothing and three primary pension assumptions—the expected rate of return on plan assets, discount rate, and expected rate of increase in employee compensation—continue to be controversial.Hidden liabilities, understated expenses, and discretionary management assumptions make pension accounting highly controversial. Previous accounting standards allowed companies to accumulate pension liabilities off the balance sheet by relegating actual pension assets and liabilities to financial statement footnotes. Financial reporting transparency was further inhibited because pension-related items recognized in the financial statements often did not portray the company’s true financial position. Indeed, many companies with underfunded pension plans have reported net pension assets on their balance sheets. For example, in 2004, General Motors’ pension plans were underfunded by more than $7.5 billion, but GM reported a net pension asset of almost $35 billion as a result of allowable income smoothing and amortization techniques established under Statement of Financial Accounting Standards (FAS) No. 87, Employers’ Accounting for Pensions.A new FASB pension standard, FAS 158, Employers’ Accounting for Defined-Benefit Pension and Other Postretirement Plans, which is effective for public companies with fiscal years ending after 15 December 2006, will greatly improve the transparency of financial reporting by requiring companies to report the actual funded status of their pension plans on the balance sheet. Nevertheless, many pension accounting deficiencies—in particular, income-smoothing techniques used to amortize actuarial gains and losses—will remain for at least three years until a more comprehensive pension rule can be issued. In addition, three primary pension assumptions—the expected rate of return on plan assets, discount rate, and expected rate of increase in employee compensation—continue to be a source of controversy and a target of regulators.We explain previous pension accounting and evaluate the effects of FAS 158. We examine pension accounting assumptions for S&P 100 Index companies over the eight-year period of 1997–2004. The use of aggressive rate assumptions can greatly affect the quality of earnings and thus cloud the transparency of financial reporting. Because many provisions established under FAS 87 will continue to affect computation of pension cost, the importance of these assumptions does not diminish under FAS 158. The varying market conditions over the eight-year period allow a comprehensive assessment of the reasonableness of managements’ pension rate assumptions.We also explain the profound balance sheet impact FAS 158 will have. We estimate that the new rule will reduce owners’ equity an average of $2.2 billion for S&P 100 companies. When we expanded the sample to S&P 500 Index companies, we found the average reduction to owners’ equity to be $767 million. Our results indicate that such declines in owners’ equity because of FAS 158 are robust across all major industries represented by S&P 500 companies. As a result of the new pension standard, some companies will report negative owners’ equity; many companies could face the risk of debt covenant violations.