The new FASB 106: how to account for postretirement benefits; new rules will have a major impact on most companies' bottom lines.

After more than a decade of deliberations, the Financial Accounting Standards Board approved its Statements no. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, which requires employers to accrue the cost of retiree health and other postretirement benefits.

This article summarizes the statement's important provisions, including a significant amendment to accounting for deferred compensation contracts (Accounting Principles Board Opinion no. 12, Omnibus Opinion--1967). The sidebar on page 39 illustrates the ruling's financila impact on a hypothetical employer.

Statement no. 106's impact will be farreaching. It will slash millions of dollars from many companies' reported not profits and will require additional accounting procedures, including extensive recordkeeping to maintain census and claims information. International Business Machines Corp. recently reported it was taking a first-quarter charge of $2.3 billion because of the accounting rule.

For most companies, Statement no. 106 takes effect no later than fiscal years beginning after December 15, 1992 (that is, the first quarter of fiscal 1993), but for non-public employers with 500 or fewer participants and for plans that cover employees working outside the United States, the standard goes into effect for fiscal years beginning after December 15, 1994.

Currently, most employers expense these costs as paid and, therefore, do not record a liability for such costs in their balance sheets.

ACCRUAL ACCOUNTING 

Pay-as-you-go (cash basis) and terminal accrual (accrue at retirement) approaches will no longer be acceptable. Under Statement no. 106, healthcare, life insurance, housing allowances and other postretirement benefits for current and future retirees and their dependents are viewed as forms of deferred compensation earned through employee service, subject to accrual during the years an employee is working.

Other postemployment benefits, such as severance pay or wage continuation to disabled or terminated employees, generally are not covered by this standard. Although the standard applies to a wide range of benefits offered to retirees, it focuses on retiree health benefits because they are the costliest and the most difficult to measure.

Under Statement no. 106, the present value fo postretirement benefits must be fully accrued by the date the employee is fully eligible to receive benefits. The date usually is based on a combination of age and years of service.

The standard covers three groups:

* Retirees and dependents receiving benefits.

* Active employees fully eligible for benefits (for example, those eligible active employees age 55 with at least 10 years of service and not yet retired).

* Active employees not yet eligible (fore example, those under 55).

In defining the obligation for postretirement benefits, the FASB maintained certain concepts similar to pension accounting, but it also introduced some new and modified terms designed specifically for postretirement benefits. Two of the most important are discussed here.

* Expected postretirement benefit obligation (EPBO). The EPBO is the actuarial present value, as of the measurement date, of all benefits expected to be paid after tetirement to employees and their dependents. It includes the accumulated postretirement benefit obligation (APBO) plus the actuarial present value of expected future service costs of active employees who have not yet reached full eligibility. While the EPBO is not recorded or disclosed in the financial statements, it must be used in the measurement process.

* Accumulated postretirement benefit obligation. The APBO is the actuarial present value of future benefits based on employees' service rendered to the measurement date. The APBO is equal to the EPBO for retirees and active employees fully eligible for benefits. Before the date an employee attains full eligibility, the APBO is only a portion of the EPBO. The difference between the APBO and the EPBO is the future service costs of active employees not yet fully eligible.

To spread costs over accounting periods, Statement no. 106 imposes a benefit-years-of-service approach (the projected unit credit actuarial cost method). The board found no compelling reason to switch from the traditional pension accounting approach. As a result, the FASB rejected other actuarial approaches, including those under which costs are spread as a percentage of pay.

The attribution period generally begins when an employee is hired. One exception is when the plan grants credit only for service from a later date. However, Statemen no. 106 does not permit using the later date if the period which benefits are earned under the plan is only a few years compared with an employee's total years of service prior to attaining full eligibility.

Costs generally are spread ratably over the attribution period, which ends on the full eligibility date. An exception is when the plan's benefit formula attributes a disproportionate share of the EPBO to an employee's early years of service, which occurs in so-called front-loaded plans. In that case, costs should be spread according to the plan's benefit formula.

THE SUBSTANTIVE PLAN

During the comment period on the exposure draft, many respondents argued that, since employers will be required to project future costs when measuring obligations and expenses, they should be allowed to anticipate plan changes they will likely make to offset those costs. Doing so would enable the accounting to reflect the true substance of a plan. In many cases, the substance of a plan includes a policy of reacting to changes in the cost of benefits by changing, for instance, a plan's cost-sharing provisions. Although such a policy may not be found in the written plan, it may be part of thesubstantive plan as understood by the employer and its employees.

Statement no. 106 requires employers to account for the substantive plan. Thus, employers should estimate the impact of future changes to the plan's cost-sharing provisions, such as deductibles, retiree contributions and plan maximums.

Two of the key factors that employers' accountants should consider in evaluating the substantive plan are

* Whether the employer has a past practice of maintaining a consistent cost-sharing level or a consistent approach to changing cost-sharing provisions.

* If there is no history of cost-sharing or if the employer intends to modify its practice, to what extent the employer can make changes and whether it has communicated its intent to plan participants.

ASSUMPTIONS

The standard acknowledges not all measurements can be accurately predicted. Future changes in the law, such as the way Medicare will affect benefits, cannot be anticipated. The employer should use its "best estimates" in applying any of the following assumptions:

* The standard calls for the employer to project future retiree healthcare costs by using a healthcare cost trend rate that considers healthcare inflation estimates, changes in healthcare utilization or delivery patterns, technological advances and changes in the health status of the plan participants.

* Administrative expenses--both external costs and direct internal costs, if significant--should be included in obligation and expense measurement. These expenses often are expressed as a percentage of healthcare claims.

* The discount rate assumption should reflect the time value of money. In selecting this assumption, employees should consider rates of return on high-quality, fixed-income investments currently available and expected to be available during the period the benefits are expected to be paid. Assumed discount rates are used to determine the EPBO, the APBO and the service and interest cost components of net cost.

* The assumptions used in pension accounting, such as employee turnover, retirement age and mortality, also apply to postretirement benefits.

* For plans that extend benefits to spouses and dependents, Statement no. 106 requires the employer to estimate future outlays for these groups.

DEFINITION OF ASSETS

Plan assets may be used to offset postretirement benefit obligations for balance sheet purposes, but these assets must be segrated (usually in a trust) from the company's general assets and maintained exclusively for plan benefits.

Liability recognition. In performing the accounting, annual expense should be computed first; the accrued liability reported in the balance sheet will then reflect the difference between the cumulative accrued expense and the actual amounts that are paid or funded.

Transition to accrual accounting. At the beginning of the year of adoption, a transition obligation or asset will be computed based on the difference between the APBO and the fair value of qualifying plan assets adjusted by any recorded liability or asset on the employer's balance sheet when Statement no. 106 is implemented. Employers with substantial plan assets and those that have been accruing postretirement benefit costs before the standard's adoption may show a transition asset at that date. However, since most plans are unfunded and most employers will be accruing postretirement benefit costs for the first time, a transition obligation most likely will have to be considered.

Immediate recognition. At the adoption date an employer may elect to record the full transition obligation (asset) amount as an expense (income) in the income statement by a cumulative catch-up adjustment. However, the transition amount must exclude the following:

* The effect of a plan initiation or benefit improvement adopted after December 21, 1990.

* The amount that relates to a purchase business combination consummated after December 21, 1990.

Delayed recognition. Employers choosing delayed recognition must amortize the transition amount on a straight-line basis over the average remaining service period of active plan participants unless.

* The average remaining service period is less than 20 years, in which case the employer has the option of electing a 20-year amortization period.

* Almost all of the plan participants are inactive, in which case the employer should amortize the transition amount over the average remaining life expectancy of the participants.

Amortization of the transition obligation must be accelerated if, and Statement no. 106 is implemented, aggregate cumulative benefit payments to all plan participants exceed cumulative expenses.

AMENDMENTS AND INITIATION

Positive plan amendments (amendments that increase retiree health benefits) or a plan initiation generally are considered retroactive and immediately increase the APBO. The increase in the APBO for the cost of benefit improvements or initiations (that is, prior-service cost) should be amortized over the remaining service periods (to the full eligibility date) of plan participants who are active at the date of the amendment but are not yet fully eligible for the benefits.

A reduction in the obligation due to a negative plan amendment (one that reduces the retiree health benefits) first will reduce any existing unrecognized prior-service cost. Any remaining unrecognized transition obligation would then be reduced, and any excess also would be amortized--similar to positive amendments.

COMPONENTS OF EXPENSE

The new rule requires an employer's postretirement benefit expense to include these components:

* Service cost: the portion of the EPBO that is attributable to employee service for the period.

* Interest cost: the increase in the APBO attributable to the passage of time. It is calculated by applying the beginning-of-the-year discount rate to the beginning-of-the-year APBO, adjusted for benefit payments to be made during the period.

* Expected return on plan assets: for funded plans, the expected earnings rate applied to the market-related value of plans' assets, adjusted for contributions and benefit payments to be made during the period.

* Amortization of prior-service cost: the amortization of the cost of retroactive benefits resulting from plan amendments or a plan initiation that takes place after Statement no. 106 is adopted.

* Gains and losses: in general, changes in the APBO resulting from changes in assumptions or from experience difference from that assumed. For funded plans, this component also includes the difference between the actual and expected return on plan assets. Gains or losses can be recognized immediately or based on the "corridor approach" similar to that used for pension accounting (see FASB Statement no. 87, Employers' Accounting for Pensions).

* Amortization of the transition obligation or asset: the straight-line amortization of the unrecognized APBO at the time Statement no. 106 is adopted. However, this component of expense is not present if the transition obligation is recognized immediately.

OTHER ACCOUNTING ISSUES

The new standard amends paragraph 6 of APB Opinion no. 12. Under Statement no. 106, amounts to be paid under individual deferred compensation contracts must be fully accrued by the full eligibility date. This amendments is effective for fiscal years beginning after March 15, 1991. For contracts that provide postretirement benefits other than health and welfare, companies must record a cumulative catch-up adjustment to be fully accrued as of the full eligibility date.

Once Statement no. 106 is adopted, companies that acquire other companies must consider in the allocation of the purchase price the benefit obligation assumed in a business combination accounted for by the purchase method.

DISCLOSURES

The disclosures for defined postretirement benefit plans include

* A description of the substantive plan or plans, including the employee groups covered, types of benefits provided, funding policy and types of assets held.

* The components of expense.

* A funded status reconciliation.

* The assumed discount rate.

* The assumed healthcare cost trend rate. for the next year. For years thereafter, disclosures must include a general description of the direction and pattern of change with disclosure of the ultimate trend rate and when that trend rate is expected to be achieved.

* The effect on the APBO and the service and interest cost components of net cost of a one-percentage-point increase in the healthcare cost trend rate.

Management will be addressing this complex issue soon. CPAs should become familiar with the new standard to advise management and help it to consider the options in dealing with the new rules.

JAMES R. WILBERT, CPA, is a partner in the national accounting and SEC technical services unit of Coopers & Lybrand, New York City. He is a member of the American Institute of CPAs. KENNETH E. DAKDDUK, CPA, is a manager in that unit. He is an AICPA member.