The impact of pension accounting on companies' financial statements.

ABSTRACT

The Financial Accounting Standards Statement No. 87 "Employers" Accounting For Pension" gives companies chance to choose the expected rate of return on pension assets as well as the discount rate that is used to calculate the present value of pension liabilities. Companies tend to choose these rates in such a way to reduce pension expense and pension liabilities. With the declining in stock market, actual return on pension assets is very low compared to the expected return that is used to calculate pension expense and pension liabilities. If companies used the actual return, their pension expenses are much higher and net incomes would be much lower. In addition, pension liabilities would be much higher. By using expected return and high discount rate, companies' financial statements do not reflect the economic condition of companies' pension expense or pension liabilities. The Financial Accounting Standards Board should clarify the assumptions as well as the rates that should be used by companies in calculating their pension expenses and pension liabilities.

1. INTRODUCTION

Corporate management has been accused of managing earnings to produce the target earnings that are so essential in maintaining market share. Following the collapse of Enron Corporation, World Com, and others and the down draft in the stock market for two consecutive years, the Securities and Exchange Commission and the Financial Accounting Standards Board (FASB) is taking steps to examine corporate accounting practices. One of these practices is pension accounting.

Under Generally Accepted Accounting Principles, public companies include in their operating earnings gains from pension funds because companies are allowed to use expected return on pension plan assets and expected interest on pension obligations as elements of pension expense or income.

2. TYPES OF PENSION PLANS

Company might adopt one or more of the following pension plans:

1. Defined benefits plan. In which, a company promises to pay an employee a specific retirement benefits. The benefits that employee received at retirement are calculated using some formulas. Employer's contributions to pension fund are placed in a trust and invested. Benefits are paid to retirees from the trust's accumulated assets. The employer's annual contribution is actuarially determined based on employees' ages, salary histories, mortality rates, and other factors.

Employer bears the financial risk if the pension plan assets are not adequate to meet the promised benefits that should be paid to retirees. Employees gained most of their benefits in the last few years before retirement. Retirees receive a monthly payment for a life when they retired.

2. Defined contributions plan. In which, the amount of cash that the employer puts into the plan for the benefits of the employee is known. However, employees are not guaranteed a specific benefit on retirement. An individual account is maintained for each participant. The account balance is based on contribution made by employer and/or employee and the return on investment of this money. Participant bears financial risk of investment.

3. PURPOSE OF THE STUDY

The purpose of this study is to examine the impact of pension accounting practice related to calculation of pension cost on companies' net incomes, assets, liabilities, and cash flows.

4. COMPONENT OF COMPANY'S PENSION COST

The Financial Accounting Standards Board Statement No. 87, "Employers' Accounting for Pension Plans," clarifies many of the accounting issues related to pension. However, the statement gives companies the flexibility in calculating pension cost but it requires that the same interest rate to be used for computing both the service cost and the interest cost component of pension cost. Companies are free to choose some other interest rate for computing the expected rate of return on pension plan assets. The higher the interest rate for computing service cost, the lower the reported service cost component of pension cost. However, this reduction in service cost is offset by an increase in interest cost component of pension cost. If the higher rate is also used for computing the expected return on plan assets, then pension cost is reduced. The amount of pension cost impacts pension liabilities, assets, and cash contribution to pension fund.

Pension cost might have a material impact on a company's income statement, balance sheet and statement of cash flows. For company offers define benefit plan to its employees, pension cost has the following components:

1. Service cost is the actuarial present value of pension benefits earned by employees for their services during the period. It is calculated based on the pension benefit formula. This amount increases the projected benefit obligation when employees work another period. Future compensation levels had to be considered in measuring the present obligation and periodic pension costs. Actuaries compute service cost as the present value of the new benefits earned by employees during the period. Discount rate is used to determine the service cost and interest cost component of pension costs, as well as the present value of firms' pension liabilities.

2. Interest cost equals beginning balance of projected benefit obligation times the discount rate. Projected benefit obligation represents all benefits based on expected future salaries. Choosing the discount rate has significant impact on pension obligations and the amount that will be reported in balance sheet.

In recent years, the borrowing interest rate has been declining, however, companies reluctant to reduce discount rate to reflect the low interest rate. A small reduction in the discount rate will significantly increase the pension liabilities and the pension costs. For example, in 1993 when Westinghouse reduced pension discount rate by one percent, its pension costs increased by 56 millions dollars, about 65% compare to pension costs in 1992. In the contrary, using higher discount rate will reduce the amount of pension liabilities and reduce the service cost because pension benefits earned during the year are discounted using higher rate. Using discount rate higher than interest rate that reflects the economic conditions would result in overstatement of earnings. The following example illustrates the impact of choosing interest rate on the amount of pension cost. Assume that for 2002, the service cost was $10,000 and the same interest rate was used for 2002 and 2003. The following show calculation of pension cost using two interest rates (8% and 9%).

2003 Pension cost =                              Interest     Rate

                                                   8%          9%

1. 2003 service cost = ($30,000-10,000)/1.08 =   $17,147
                       ($30,000-10,000)/1.09 =               $16,834

2. 2003 interest cost = 8,573 x 8% =                $686
                        8,417 x 9% =                            $758

3. 2003 return on plan assets = 8,573 x 8% =        (686)
                                8,417 x 9% =                    (758)

Pension cost for 2003                            $17,147     $16,834

From previous example, it is clear that companies can increase or decrease their pension cost by choosing higher or lower discount rates and/or expected rate of return on pension plan assets. Although FASB Statement No. 87 provides criteria for estimating discount rates to reduce management's ability to manipulate pension cost but it does not eliminate this manipulation.

3. Expected return on pension plan assets. It equals market-related assets value times expected rate of return. Statement No. 87 requires that the rate to be the average rate of earning on pension investments. Pension plan assets are usually invested in stocks, bonds, other securities, and real estate. Actual return earned on pension plan assets increases or decreases the pension fund balance and consequently decreases or increases net periodic pension costs and the employer's contribution to pension fund. Statement No. 87 allows companies to use expected return instead of actual return in calculation of pension cost to avoid the wide swing that might occur in the actual return on pension plan assets. If the expected return is positive (gain), it is subtracted in the computation of pension costs and if it is negative (loss), it is added in the computation of pension costs. The lower the pension costs, the less contribution needed to pension fund. Using expected return on pension plan assets distorts the true cost to corporations of providing pension benefits, artificially reduces pension liabilities and boosts net income. The choice of rate of return on pension assets has great impact on pension costs, net income, pension liabilities, and cash contribution to pension fund.

For example, in 1993, AT&T increased rate of return on pension assets by 0.4%. If AT&T reduced the rate by the same percentage, its net income for the year would be reduced by 6.1%. Another example, General Electric (GE) increased pension rate of return by 1% to show increase in its net income for 1991 by 2.4%, instead of a decline in net income by 2.5% if no change in pension rate of return. In 1999, GE had increased its earnings by 13% instead of 12% if income from pension assets was not included in the net income. In addition, in 1992, McDonnell Douglas increased rate of return by 1%. The results were increases in return on pension assets and reduced pension costs by $75 millions dollars (represent 17% of net income).

4. Amortization of unrecognized prior service cost

Prior service cost is a result of adopting or amending pension plan if employer gave credit to employees for years of service provided before the date of adoption or amendment. Actuaries compute the amount of the prior service cost. Usually, this amount increases the projected benefit obligation at the date of the change.

According to Statement No. 87, the amount of prior service cost should not be recognized as pension costs entirely in the year of amendment but it should be amortized using years-of-service method (the remaining service life of active employees covered by the pension plan) or straight-line method. The amortization amount increases periodic pension costs.

5. Amortization of deferred gains and losses

Deferred gains and losses have two items. (1) Unexpected gains or losses from pension plan assets. This might happen because of the sudden and the large changes in the market value of plan assets. (2) Unexpected gains and losses related to the pension liabilities because of the changes in actuarial assumptions that affect the amount of the projected benefit obligation.

Since the expected return on plan assets, not the actual return is a component of pension costs, the difference between expected return and actual return is asset gains and losses. The difference between actuary prediction for projected benefits obligation and actual amount is liability gains and losses.

To avoid a large impact on the financial statements of one year because of these two items, Statement No. 87 allows companies to use smoothing mechanisms and to do amortization of these gains and losses using the corridor approach. If unrecognized net gain or loss balance exceeds 10% of the larger of the beginning balances of the projected benefit obligation or the market-related value of the plan assets, then company should amortize the gain or the loss over some years.

5. THE SAMPLE

To examine the impact of pension costs on company's financial statements, a random sample of firms was selected from the Compact Disclosure Database for the period from 1991 to 2002. Firms that did not have required pension information over the study period were excluded from the sample. The final sample has 300 public firms. Pension data (such as market-related value of plan assets, projected benefit obligation, discount rate, rate of return on pension assets, and pension cost) were collected for the 300 firms.

6. THE METHOD

For each company included in the sample, the study recalculates the pension cost using actual rate of return on pension plan assets instead of expected return. Then, the impact of the amount of pension cost on assets, liabilities, and cash flows was examined. In the last three years of the study period, actual return was much lower compared to expected return due to the decline in the securities market. In some cases the actual return was negative. The amount of pension cost was much higher compared to the amount using expected return. Higher pension cost impact the assets, liabilities and the cash contribution to pension fund.

7. THE RESULTS

Table 1 shows the average interest rate and discount rate that companies used to calculate service cost and interest cost. Although interest rate was declining in the last three years of the study, companies continued to use high interest/discount rate for pension plan when they calculated service cost and interest cost. Using high rate reduces pension cost, assets, and liabilities. Table 2 compares expected return to actual return and shows both returns as percentage of net income.

The results show that expected rate of return on pension assets was higher than actual rate of return in all years. Using higher rate increases net income by 2% on average. In the last three years, companies continued to use high rate of return regardless of the declining in the actual return on securities. Higher rate reduces pension cost and increases net income or decreases net loss. In addition, decreasing pension costs reduces cash contribution to pension fund and also reduce pension liability in balance sheet.

For example, in 2000, DuPont had $469 million in pension income that represented 10% of its operating income. In 2002, its pension income fell to $179 million that represents 10 cents per share. In the same year, IBM had 11% of its operating income came from its pension plan. In 2000, Honeywell Co. had pension income $330 million but its pension expense was 10 million. When Qwest raised its expected return on pension plan assets from 8.8% to 9.4% for year 2000, its income increased by 405 million. Anheuser-Busch Cos. had a reduction of 14 cents in its earnings per share when it used actual return on pension plan assets.

In general, the study finds that older industrial companies, telecommunication companies, and companies have unionized work forces are the most affected by increasing pension expense because of declining in return on pension plan assets.

8. SUMMARY and CONCLUSION

Under the current accounting standards for pension, companies can manage their net incomes through the choice of discount rate and rate of return on pension plan assets. This can be done by (1) using (assumed) high discount rate to calculate the present value of service cost and pension liabilities and (2) using (expected) high rate of return on pension plan assets to reduce pension costs. Companies try to find ways to use return on pension plan assets to boost earnings. However, return on pension plan assets does not represent an operating income. Return on pension plan assets and interest expense on pension liabilities should be recorded as non-operating income or expense. It is misleading to show that a company is making profit just because a lot of earnings are coming from its return on pension plan assets.

The Financial Accounting Standards Board and the Securities and Exchange Commission should clarify the accounting rules related to pension discount rate and pension rate of return on plan assets to reduce the choices open to corporate management. Otherwise, companies will continue to use pension accounting practice to increase their earnings and mislead investors and shareholders.

TABLE 1

AVERAGE DISCOUNT RATE AND INTEREST RATE USED BY COMPANIES
FOR PENSION SERVICE COST AND INTEREST COST (1991-2002)

Pension Discount Rate and Interest Rate

Year    Average Discount Rate/Interest Rate

1991                   7.50%
1992                   7.75%
1993                   8.00%
1994                   8.00%
1995                   8.25%
1996                   8.50%
1997                   8.25%
1998                   8.00%
1999                   7.75%
2000                   8.00%
2001                   8.00%
2002                   7.00%

TABLE 2

AVERAGE EXPECTED RETURN AND ACTUAL RETURN ON PENSION ASSETS
AND AS PERCENTAGE OF NET INCOME (1991-2002)

Year    Expected Return    % of Net Income    Actual Return

1991          11%                10%                9%
1992          11%                 9%               10%
1993          12%                 8%               10%
1994          12%                 8%               11%
1995          10%                 9%                9%
1996          10%                10%                9%
1997          13%                11%               10%
1998          13%                 9%               11%
1999          11%                10%                8%
2000          11%                10%                6%
2001          10%                 8%                4%
2002          9%                 10%                4%

Year    % of Net Income

1991         8%
1992         7%
1993         7%
1994         7.5%
1995         8%
1996         8.5%
1997         9%
1998         8%
1999         7.5%
2000         7%
2001         6%
2002         5%

9. REFERENCES

Financial Accounting Standard Board. "Employer's Accounting for Pensions." Statement of Financial Accounting Standards No. 87, 1985, Stamford, CT, FASB.

Dr. Nashwa George earned her Ph.D. at Baruch College, CUNY in 1988. Currently she is an associate professor of accountancy at Montclair State University. Her articles have been published in the Accounting Review, the Journal of Accountancy, and the CPA Journal.