Financial statements and the FASB retiree health proposal.

Financial statements and the FASB retiree health proposal

If the FASB's proposal on accounting for retiree health benefits is made a standard, companies will need to reevaluate their plans. How will financial statements fare after a transition to accrual accounting? Two experts, who now are analyzing the results of a field test on the subject, discuss the impact of the proposal. Concern has been mounting among employers about the costs of their retiree health care benefit plans. Costs have increased significantly in recent years and companies have a substantial financial obligation on their hands. The Financial Accounting Standards Board (FASB) recently published a summary of its proposed Statement of Financial Accounting Standards calling for companies to begin to accrue the costs of these benefits in 1992. Since many companies could face significant reductions in net income and increases in liabilities, the FASB's issuance of proposed new accounting requirements is expected to focus managements' attention on their retiree health care plans, not only from a financial reporting viewpoint, but also from a broader business and economic view. [Note that this article was prepared before the issuance of the FASB exposure draft on accounting for retiree benefits.--editor]

Because only a few companies follow accrual accounting or have established trust funds to pay for these benefits, these obligations are not currently included in the company's balance sheet. Although some companies have "rough" estimates of their future liabilities, few employers that account for postretirement benefits on a "pay-as-you-go" basis have detailed analyses of their current costs, future expenses, and potential liabilities for their retiree health benefit plans. Some companies may even find it difficult to measure their retiree obligations because they do not separate current expenditures for retirees from those for active employees.

The FASB project and the field test

The FASB would require most companies to switch to accrual accounting for retiree health care and other postretirement benefits by 1992 and would require a "minimum" liability to be recorded on the balance sheet by 1997. Because the FASB believes that an employee earns these benefits in exchange for service rendered to the company--as another form of deferred compensation--the accrual for future benefits should take place during an employee's working career, not at the time of retirement or after retirement. Thus, pay-as-you-go (cash basis) and terminal accrual (accrue at retirement) approaches would no longer be acceptable.

The FASB encourages interested parties to study, evaluate, and comment on its proposal. Once issued, the Board's exposure draft is expected to have a six-month comment period, followed by public hearings. By taking an active role in the standard-setting process and making their views known, companies may have an impact on the outcome of this FASB project. A final statement is expected to be issued by the FASB in mid 1990.

Recognizing the need to help the FASB and other interested parties assess the potential impact of the proposed new accounting standard, the Financial Executives Research Foundation (FERF) sponsored a field test study currently being conducted by Coopers & Lybrand. Using benefit and cost data from 25 participating companies, a team of health and pension actuaries, accountants, benefit consultants, and other professionals is analyzing the measurement and implementation problems that could affect accounting for these benefits. In other words, the actuarial measurement of obligations and expense will be done for the field test companies based on the specific requirements of the exposure draft. FERF is expected to publish a field test report summarizing the findings during the FASB's comment period.

The effect of adopting accrual accounting

It is generally necessary to analyze existing coverage, demographics, and current health care claims experience to reliably measure the impact of the proposed new rules on a company's financial statements. We can, however, make some general observations based on the preliminary results of the field test and other actuarial valuations performed by Coopers & Lybrand. As indicated in the figure at right, the proposed new requirements are generally expected to have a substantial impact on financial reporting--sharply higher expense and significant recorded liabilities.

A comprehensive analysis of the data needed to adopt accrual accounting will also put management in a far better position to establish financial benchmarks and controls over their retiree health care programs. Any evaluation of benefit program alternatives must begin with an analysis of what is currently in place--understanding what is being paid, to whom, and how much. With this information, employers can make informed choices and establish basic strategies to modify benefit promises over time to control costs--if they so choose. Data analysis should also allow companies to better understand and evaluate the effects of the Medicare Catastrophic Coverage Act of 1988.

The major accounting issues

Some of the more important points related to measuring the obligation and expense for retiree health care plans follow. "Baseline" costs--Current average per capita costs for retirees generally form the starting point--the baseline costs--for the measurement of expense and obligations under accrual accounting. Per capita costs can vary greatly depending on a variety of factors, including demographics, plan design, geographic location, and industry. They also can greatly affect an employer's expense and liability estimates.

The field test's preliminary results and other information indicate that some companies that have attempted to measure their retiree health benefit obligations have encountered problems with the accuracy, availability, or reliability of the information needed. Some of the information that would be helpful in understanding and measuring these obligations has been difficult to extract from the various available data bases, or may not even be captured in the company's current system, in the records of insurance carriers, or by the claims administrator. For example, disabled individuals are often not distinguished from retirees, distorting the analysis of retiree costs because disabled individuals generally receive larger amounts of health care. Actuarial assumptions--According to the FASB, the principal actuarial assumptions include health care cost trend rates, discount rates, the amount and timing of future benefit payments, and the probability of payment considering employee turnover, retirement age, mortality, and dependency status. Each significant assumption would reflect the best estimate solely with respect to that individual assumption (an explicit approach). Estimates of future costs would be based on a health care cost trend assumption applied to per capita baseline costs. Future cost containment or plan design changes could not be anticipated in estimating costs and Medicare reimbursement estimates would be based on the current law.

In the FASB's view, changes in the law and in the plan should be accounted for as a gain or loss, or as a plan amendment, when they occur. In addition, the FASB proposes that the discount rate assumption change annually with changes in market interest rates and that employers may look to current rates of return on high-quality, fixed-income investments in selecting those rates.

Companies would need to carefully consider the actuarial assumptions to be selected, particularly the relationship between the health care cost trend rate and the discount rate. A small change in the spread between these assumed rates can create dramatic differences in the expense, the obligation, and certain disclosures. Attribution period--The FASB spent a great deal of time deliberating the period over which costs should be accrued for active employees. For plans that contain a formula that ties benefit levels to individual years of service, the FASB would require that costs be spread using the formula in the plan. However, few plans today contain such a formula. If a formula is not specified, the FASB proposes that costs be spread ratably from the date of hire to the date the employee first becomes eligible for maximum benefit coverage.

Transition to accrual accounting

The obligation at the date the statement is adopted--the "transition obligation"--would be based on the present value of the obligation for retirees and employees eligible for benefits, plus a proportionate amount for other active employees, less any plan assets or accrued liabilities on the company's balance sheet. The transition obligation would not be immediately recorded on the balance sheet or on the income statement; however, it would be disclosed in the notes to the financial statements.

According to the FASB, the transition obligation would be amortized to expense over future years on a straight-line basis over the average remaining service period (to the date of expected retirement) of active employees expected to receive a benefit. However, a company can elect to use 15 years if the computed period is less than 15 years. In addition, the FASB proposes that additional amortization of the transition obligation be recorded if the computed amortization on a cumulative basis is less than the amount that would be recognized on a pay-as-you-go basis.

Because of the significant unfunded obligation, a practical solution to transition is extremely important for retiree health benefits. Since almost all companies account for the cost of these benefits on a pay-as-you-go basis, a practice that has been generally accepted for many years, interested parties will likely comment that a 15-year amortization period is too short and that greater flexibility is appropriate in transition.

Liability recognition

While liabilities are not recognized under pay-as-you-go accounting, under any type of accrual accounting a method of liability recognition is needed. The FASB concluded that annual expense would be computed first. Thus, the accrued liability on the balance sheet would reflect the difference between cumulative accrued expense and amounts paid (or funded).

The FASB also proposed that, in five years from the effective date of the proposed statement (i.e., 1997), an additional liability be recognized when the unfunded obligation for retirees and employees eligible for benefits--the "minimum liability"--exceeds the accrued liability on the balance sheet. Under this approach, when an additional liability has to be recorded, an intangible asset would also be recognized to the extent there are unamortized prior service costs (arising from unamortized transition obligation or plan amendments after transition). If the additional liability exceeds unamortized prior service costs, the excess would be charged directly to stockholders' equity.

Suggested corporate actions

The new standard on accounting for postretirement benefits, if adopted as proposed, will have a dramatic impact on many corporate financial statements. Since virtually every employer sponsoring a retiree benefit plan would be affected, companies should weigh the consequences of the FASB's proposal and consider taking some or all of the following actions.

Specifically, companies should strongly consider implementing a broad business approach to analyzing the effects of the proposed standard and the adoption of possible changes to plan design, funding, and systems.

A comprehensive plan is needed to provide an effective means of dealing with the complex business issues and the potential impact of the proposed new accounting standard. First, consider measuring the potential impact of the proposals and, second, assess alternatives for cost management, improve control of your plans, and evaluate possible actions on your company's part.

Actions to consider in measuring the potential impact include the following. * Identifying affected plans and the associated benefits promised. * Accumulating the required data. * Determining assumptions to be used. * Actuarially estimating the obligation and expense under accrual accounting. Following this measurement process, managers should consider the following steps in meeting cost containment objectives. * Ascertain that plan documents and other corporate communications unequivocally describe the benefits contractually or are otherwise guaranteed by the company. * Begin identifying and analyzing possible cost management and advance funding options and possible plan design changes. * Implement systems controls and modifications as necessary to ensure the ready availability of sufficient and reliable data. The temptation to perform a "quick fix" by drastically reducing or canceling benefits should be evaluated carefully. Instead, companies should consider implementing gradual benefit program changes that will result in future cost savings. To start, an in-depth analysis of the current program is needed; management must know the extent of its obligation to make informed choices.

The impact of accrual accounting on financial statements

Higher expense

In almost all situations, expense under accrual accounting would be higher than under pay-as-you-go. The difference will vary company by company, but for many companies, expense for their retiree health care plans will likely be three to six times higher initially (and, for some companies with few retirees, over ten times higher), depending upon specific company demographics, the richness of plan benefits, and the assumptions used to determine expense.

No tax deduction 

The higher expense under accrual accounting would not generally be deductible under current tax laws because tax deductions are based on actual benefit payments. Unlike pensions, few tax advantages exist for advance funding. Although some companies have begun to lobby for tax deductions for prefunding retiree health care costs, others are concerned about "ERISA-like" mandated eligibility, vesting, and other requirements which may be tied to any tax-advantaged funding vehicle.

Limited book tax benefit

Under FASB Statement 96, Accounting for Income Taxes, the excess of the accrued expense over the deductible benefit payments would be a "temporary" difference. However, recognition of a recordable deffered tax benefit on the company's financial statements would be limited to amounts that could be offset against deffered tax credits in the same future year. For some companies, this would result in a portion (or all) of the higher expense falling right to the "bottom" line"--with no offsetting tax benefit--directly reducing net income.

Significant recorded liabilities

For some companies with unfunded plans, recorded liabilities could be significant, affecting their debt-to-equity ratio. This could cause some companies to fail to meet restrictive covenants in their debt agreements.