Postretirement benefits other than pensions.DEBITS & CREDITS
Postretirement Benefits Other Than Pensions
The new standard on postemployment benefits other than pensions has finally arrived. The final version includes numerous differences from the exposure draft, some of which are major. Changes were made regarding measurement and attribution, and the recognition of a minimum liability was eliminated completely. In addition, the transition provisions and effective date have been altered. This article includes a description of the new standard, highlighting differences from the exposure draft, and a look at the standard's impact on small businesses.
During the mid 1970s there were many horror stories horror story
Story intended to elicit a strong feeling of fear. Such tales are of ancient origin and form a substantial part of folk literature. They may feature supernatural elements such as ghosts, witches, or vampires or address more realistic psychological fears. about investors buying apparently healthy companies that had huge unfunded pension liabilities Pension liabilities
Future liabilities resulting from pension commitments made by a corporation. Accounting for pension liabilities varies widely by country. not shown on the balance sheet. By the time FASB FASB
See: Financial Accounting Standards Board
See Financial Accounting Standards Board (FASB). got around to requiring the recognition of underfunded pension plans Underfunded pension plan
A pension plan that has a negative surplus (i.e., liabilities exceed assets). in 1987, the federal government had already taken steps toward resolving the problem with the passage of ERISA See Employee Retirement Income Security Act.
See Employee Retirement Income Security Act (ERISA). , the Employee Retirement Income Security Act The Employee Retirement Income Security Act of 1974 (ERISA), 29 U.S.C.A. § 1001 et seq. (1974), is a federal law that sets minimum standards for most voluntarily established Pension and health plans in private industry to provide protection for individuals enrolled in these plans. of 1974.
The provisions of ERISA required companies to fund their pension plans and gave them 10 years to fund prior service costs. Most plans, therefore, were almost fully funded by 1987, thus reducing the negative impact of the new pension standard. Also, the new pension standard applies only to defined benefit plans Defined benefit plan
A pension plan obliging the sponsor to make specified dollar payments to qualifying employees at retirement. The pension obligations are effectively the debt obligation of the plan sponsor. Related: Defined contribution plan , thereby exempting the vast majority of the medium and small companies because they have defined contribution plans Defined contribution plan
A pension plan whose sponsor is responsible only for making specified contributions into the plan on behalf of qualifying participants. Related: Defined benefit plan or no plan at all. This is not the case for the proposed standard on post employment benefits other than pensions. Many medium to small businesses offer health care and other benefits after retirement. The passage of a standard requiring the recognition of other postretirement benefits will affect these companies.
Arguments for and against the new standard were hotly debated, primarily by large companies and large accounting firms. However, this is not just a "Big Company" problem. The financial statements of many smaller companies will take direct hits. It is estimated that 62% of companies with fewer than 1,000 employees offer health care benefits after retirement. Further, a recent study of companies with 50 or fewer employees found that 42% of these companies offer health care benefits after retirement. (Donald C. Bacon, "Benefits-Rule Migraine migraine (mī`grān), headache characterized by recurrent attacks of severe pain, usually on one side of the head. It may be preceded by flashes or spots before the eyes or a ringing in the ears, and accompanied by double vision, nausea, ," Nation's Business, October, 1988, p. 22.) Small corporations and public accounting firms need to brace for lower reported profits that will change financial rations used to assess profitability.
The New Standard
The new standard applies to all postretirement benefits expected to be provided by an employer to current and future retirees (including those employees deemed to be on a disability retirement), their beneficiaries and covered dependents, pursuant to the terms of an employer's undertaking to provide those benefits. Postretirement benefits include, but are not limited to, postretirement health care, which is thought to be the most significant in terms of cost and prevalence; life insurance provided to retirees outside a pension plan; and other welfare benefits such as tuition assistance, day care, legal services legal services n. the work performed by a lawyer for a client. and housing subsidies provided after retirement.
For fiscal years beginning after December 15, 1992 (one year later than planned in the exposure draft), the new standard would require the expected cost of providing other postemployment benefits The examples and perspective in this article or section may not represent a worldwide view of the subject.
Please [ improve this article] or discuss the issue on the talk page. to employees, their beneficiaries and covered dependents to be accrued during the years the employees render services. (Nonpublic businesses with plans that cover no more than 100 participants will not be affected until after December 15, 1995.)
This is in direct contrast to the expense-as-you-pay (cash) basis currently in effect. The obligation will be based on a number of assumptions, including employee and retiree demographics, each company's retiree health care experience and health care cost trends. A change in the exposure draft requires the basis of accounting for the plan to be the substance of the plan rather than the strict interpretation of the written plan. This revision was necessary because employers often change the way they allocate postretirement benefits without changing the written plan.
When the standard is adopted by a company, a transition amount will be calculated based on the present value of obligations to retirees, other eligible employees and a proportional amount of ineligible employees. The transition amount would be amortized over the average remaining service years of active employees or 20 years, whichever is longer. (This is a change from the 15-year minimum in the exposure draft.)
Additional disclosures to be required include a description of the plan, components of expense, funding status, key assumptions used and a sensitivity analysis showing the effect of a one percentage point change in health care cost trends on the expense and obligation. Disclosure of "vested benefit obligation" (the obligation if all eligible employees retired immediately) is no longer required.
A major reversal by the FASB involves eliminating the recognition of a minimum liability. This provision would have had a major impact on debt ratios. Thus, prior concerns regarding loan covenants requiring a minimum debt-to-equity ratio debt-to-equity ratio
The relationship between long-term funds provided by creditors and funds provided by owners. A firm's debt-to-equity ratio is calculated by dividing long-term debt by owners' equity. Both items are shown on the balance sheet. are alleviated. Assuming a company's yearly funding is not substantially less than the expense to be recognized, the effect of this new standard on a company's liabilities will be minimal. However, information related to the overall funded status must be provided in the notes to the financial statements Notes to the financial statements
A detailed set of notes immediately following the financial statements in an annual report that explain and expand on the information in the financial statements. . Therefore, underfunded un·der·fund
tr.v. un·der·fund·ed, un·der·fund·ing, un·der·funds
To provide insufficient funding for.
underfunded adj → infradotado (económicamente) plans will be revealed.
Higher Expense Means Lower Profits
The Wall Street Journal reported a study indicating that the changes to the accrual method of accounting for post employment benefits other than pensions could cut corporate profits by up to half. Another study, conducted by Coopers and Lybrand, found companies decreasing their pretax income pretax income
Reported income before the deduction of income taxes. Pretax income is sometimes considered a better measure of a firm's performance than aftertax income because taxes in one period may be influenced by activities in earlier periods. by 2 to 20%. This decrease in income, associated with the increase in expenses related to post employment benefits other than pensions, will negatively impact a company's financial picture.
To illustrate the effect of a decline in income on a number of ratios, Table 1 shows a hypothetical company's ratios prior to and after implementing the proposed standard, assuming the increased expense causes a net of tax decline in income of 20%. A perusal of Table 1 indicates that profit margin on sales, rate of return on assets Return on assets (ROA)
Indicator of profitability. Determined by dividing net income for the past 12 months by total average assets. Result is shown as a percentage. ROA can be decomposed into return on sales (net income/sales) multiplied by asset utilization (sales/assets). and earnings per share decline by 20%, proportionate to the decline in net income. The price earnings ratio changed from 12 to 15. Clearly, the financial picture of this company has been negatively impacted.
Minimizing the Negative Effects
Forewarned is often forearmed. First, assess the impact of the proposed standard on the companies' financial position. If the expense for other retirement benefits is found to substantially increase due to the new standard, action can be taken to mitigate the effect on income. The components of periodic other retirement benefit cost are similar to those used to compute pension cost -- service cost, interest cost, return on plan assets and amortization of unrecognized prior service cost. To reduce the future periodic expense, a company could increase funding now so the fair value of the plan assets is substantially higher when the new standard is implemented. This will increase the return on plan assets, which is a contra to the expense, and reduce the transition amount which is amortized as part of the expense. A prudent approach to the potential problem would be to determine ways to limit the negative effect of the accounting change. It is possible for companies to adopt defined contribution plans whereby the employee would receive a set amount toward the payment of health insurance premiums and then would be required to pay the balance. If a corporation is considering changing employee benefits, management should evaluate the effect of such changes on the financial statements in light of the changes to postretirement benefits other than pensions.
For most companies, the new standard will increase the expense related to other postemployment benefits. The higher after-tax expense will lower reported profits which will adversely affect income related ratios such as profit margin, rate of return on assets and earnings per share. The FASB is giving companies several years to fully implement the new standard, therefore there is time to mitigate some of the potential damage. Companies need to plan now for the remifications of the change -- not just wait around for it to happen. (Tabular Date Omitted)
Richard Coppage, DBA, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , CMA CMA - Concert Multithread Architecture from DEC. , is an associate professor in the school of business at the University of Louisville See also
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