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Financial Reporting

FASB May Finally Require Pension Obligations To Be On The Balance Sheet

April 2006
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The primary U.S. accounting rule maker (the Financial Accounting Standards Board or FASB) last week proposed an important change in the accounting for pensions.  As now proposed, starting at the end of 2006, public companies with pension plans will have to:

  1. Show the underfunded amounts from their pension plans as a liability. (Similarly, overfunded plans will cause an asset to be recognized on the sponsor’s balance sheet.) Currently this information is relegated to a footnote.
  2. Perform all calculations of the plan’s funding status as of the same date of the sponsor’s annual financial statements.  Currently, the plan’s calculations can be as much as three months earlier.

Private companies and not-for-profit entities will have an additional year (until the end of 2007) to make these changes.

The portion of pension accounting that is now being changed has been widely criticized.  Consequently, it is likely that these proposed changes will occur.  For example, existing standards allow an employer to:

  1. Recognize an asset on the sponsor’s balance sheet (in some situations), even though the plan is underfunded;

  2. Show a liability for the plan obligations that are significantly less than the underfunded status of the plan, and;

  3. Delay recognizing on the sponsor’s balance sheet changes in plan assets and benefit obligations that affect the cost of providing the plan.

The Big Controversy Lies Ahead

The second stage of the FASB's pension changes is considerably more controversial, and will take years of debate on issues that are being sidestepped for now.  The second phase will address (i) the way pensions affect current corporate earnings, (ii) the calculations of pension costs and future obligations, and (iii) accounting for other retirement obligations, such as for health insurance.  In short, these delayed questions address how quickly pension obligations and changes in plan assets (for example, because of market declines) affect current earnings.  Some believe that since pension obligations are intended to be addressed over very long periods, it is acceptable to recognize the related expense over an equally long-term period.

This second phase will be addressed as a collaborative effort with the International Accounting Standards Board, since the accounting rules of the U.S. and the rest of the world are to be standardized in the future.

Immediate Impact on Companies

U.S. pension (defined benefit) plans are currently estimated to be underfunded to the tune of $450 billion – a staggering sum by almost any measure.  Much of this is concentrated in large unionized companies in the manufacturing, steel and airline industries.  These companies have plenty of problems even without pension funding obligations.

It is unclear how financial analysts use the financial information that is already in the footnotes.  If stock prices already affect the true pension funding status, there should be no impact on the stock prices of the companies involved.  While some academic studies conclude that markets already completely consider this subject, this author is not so sure.  For example, under the new rules, both Ford and General Motors will show that there is no remaining stockholders’ equity left after including pension liabilities on the balance sheet.  Stated otherwise, the balance sheet will show these companies as being insolvent.  While most know that the automotive companies have substantial liabilities, many do not realize how serious the challenge is.

Once pension underfunding is included on the balance sheet, loan indentures and credit agreements that include required financial ratios could be a challenge.  These agreements were likely negotiated without pension obligations in mind, so amendments will likely be necessary.  Lenders looking to reset loan terms might use this as the basis for demanding new concessions or constricting credit availability.

Investment allocations within plans may change.  Under the prior accounting rules, asset volatility was not immediately recognized in the plan sponsor’s financial statements.  Once plan asset shortfalls are immediately recognized as a liability in the sponsor’s financial statements, there may be a tendency to move from more volatile equities to fixed income instruments like bonds.

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