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"Guesstimating" liability: measuring the OPEB obligation.

Many companies have promised their employees assistance with health care costs after the employees retire. Medicare and medicaid have reduced both the amounts and the types of benefits paid. The current economic climate suggests that companies will have to reduce promised benefits but health care costs for retirees will continue to escalate.

Fortune has reported |February 27, 1989~ that large, publicly traded nonfinancial companies have off-balance-sheet debt related to future health care promises of approximately $2 trillion dollars, which is nearly as large as the total debt listed in their published financial reports. The Employee Benefit Research Institute puts the present value of this liability for all private employers at $169 billion. The General Accounting Office has estimated that the total liabilities of all companies to current and retired employees for future health benefits is $402 billion. This large variation, from $169 billion to $402 billion to $2 trillion, shows just how difficult it is to measure the obligation and focus on the problem.

Other Post Employment Benefits

This unrecorded debt arises from liabilities related to Other Post Employment Benefits (OPEBs). "OPEB" is the acronym used to describe postretirement benefits including health care items as well as benefits like tuition assistance, housing subsidies, day care, legal services and financial advisory services. Health care cost, however, is by far the most significant and difficult cost to measure. When the FASB, in 1985, issued Statement of Financial Standards No. 87, "Employers' Accounting for Pensions," it did not address other types of postretirement benefits. In 1990, the FASB addressed the problem directly when it issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The requirements of Statement No. 106 are supposed to be implemented for fiscal years beginning after December 15, 1992; however, small non-public companies can defer implementation until 1994.

When IBM adopted the requirements of Statement No. 106, it reported a $2.26 billion expense and liability in 1991 (early adoption of the requirements). The loss reduced IBM's earnings per share by nearly $4. General Electric estimated the charge would be $2.7 billion and it is estimated that General Motors will need to record from $16 to $24 billion when it adopts the requirements of Statement No. 106. While adopting the statement requirements will have no immediate effect on cash flow, the effect on net income will be significant. The effect on the financial statements is significant; however, other effects are also important. These effects are even more difficult to evaluate since they involve social issues and management responses. According to a survey reported in Business Week, about 70% of the companies providing health care benefits for retirees have already cut back on their coverage. Many companies have decided not to cut back on current retirees' benefits but to cut back or eliminate future retirees' benefits. Libby-Owens-Ford Co. has instituted large co-payments to be paid by the retirees. AT&T has limited the amount it will spend per retired employee to $1,800 per year. International Paper has stopped promising OPEB benefits to employees hired after 1987.

These companies and others have reduced future benefits because they have recognized the amount of their future liabilities. Increased health care costs and decreased Federal payments will force additional companies to limit their future liabilities by reducing or eliminating benefits or look for alternative methods of funding health care for retired employees. Decreasing the companies' participation will, however, shift the future health care costs to other entities such as the retirees themselves or the public through state and Federal taxation or health care subsidies.

Statement No. 106

Statement No. 106 significantly changes practice from a "pay-as-you-go" or cash approach to an accrual basis similar to accounting for pension plans. The benefits to be provided are quite often specified in a formal or contractual plan or in an informal set of practices the company follows with employees. Statement No. 106 has several objectives:

* to expense OPEB costs when earned by the employees;

* to record the associated liability of providing these OPEBs;

* to disclose the extent and effects of granting OPEBs; and

* to make financial disclosure consistent from company to company.

The accounting requirements are similar to the requirements for pensions. The major differences are that most pension plans are defined benefit plans where future payments are determinable by an actuary with some degree of confidence, funding is specified by law in the Employee Retirement Income Security Act (ERISA) of 1974, and contributions are generally tax deductible, while future payments for OPEBs are not easily measured and funding is not legally required nor is it tax deductible if contributed prior to being paid for benefits. Companies have naturally hesitated to record an expense and the related liability when that recognition was not required under GAAP and the expense was not tax deductible. A related measurement problem is that a defined pension plan is generally not indexed but health plans by their nature are indexed because they are not a defined benefit--they are promises to provide health/dental/miscellaneous care. As the costs increase, so do the associated retiree benefits and the company's liability.

Prior to Statement No. 106, companies accounted for OPEBs using the cash basis. Companies did not accrue the costs as they were earned or granted to employees as they did with pension costs. Because of the higher costs (and the associated liabilities) caused by inflation, increasing health care costs, decreasing medicare participation, increasing numbers of retirees (who are living longer) and the trend toward earlier retirement, the FASB determined that companies needed to record the liabilities they were creating when they promised these benefits to employees.

OPEB Costs

If companies wish to continue providing a level of service instead of a fixed dollar contribution to postretirement benefits, they will need to estimate the amount of future spending on health benefits for retirees and all covered dependents. The companies must estimate what medical costs will be over the lifespan of the employee and dependents taking into account inflation, frequency of medical needs, the impact of changing medical technology, the future role of medicare/medicaid and changing life expectancy pattern, all of which make estimating the cost of the benefits extremely difficult. They must then discount these obligations to a present value and begin charging them gradually to earnings.

Statement No. 106 requires companies to measure OPEB expense similar to measuring pension expense. The postretirement benefit expense includes:

* Service cost--the present value of the expected postretirement benefit obligation attributed to services rendered by the employees during the current period.

* Interest cost--the increase in the accumulated postretirement benefit obligation due to the passage of time.

* Actual return on plan assets (deducted)--the difference between the end of period and the beginning of period fair value of the plan assets adjusted for contributions to the plan and payments of benefits to retirees.

* Amortization of unrecognized prior service costs--costs of benefits awarded to existing participants for prior periods when a plan is adopted or amended.

* Gains or losses--gains or losses in the accumulated postretirement benefits of the plan assets because of changes in the assumptions or differences between actual experience and the assumptions.

* Amortization of the transition obligation--the accumulated postretirement benefit obligation less the plan assets at the adoption of the plan amortized over the longer of 20 years or the average remaining service life of the active employees.

Since most companies do not fund benefit plans (since payments are not tax deductible until used to pay for actual benefits), there is usually no gain or loss on the plan assets, no deduction for actual return on plan assets and the amortization of the transition obligation is computed on the total liability. Companies can also elect to recognize all of the transition obligation in the year Statement No. 106 is adopted by recording a cumulative effect adjustment due to a change in accounting principle. Most companies will not choose this alternative because of the significant and negative effect on reported net income.

Example of Accounting for OPEBs

Several significant amounts are not recorded in the financial statements, just as with pension accounting, and instead are part of the "off-balance-sheet" disclosures. Consequently, accounting for OPEBs requires that these amounts be disclosed in the notes to the financial statements. To keep track of them, a spreadsheet program is helpful in reconciling the amounts.

To illustrate the accounting for postretirement benefits, assume that the Generic Accounting Firm adopted the requirements of Statement No. 106 on January 1, 1992. The accumulated postretirement benefit obligation (APBO) on that date was $600,000. The appropriate discount/interest rate was 10%. The Company had never funded the plan prior to adopting Statement No. 106 so there were no plan assets on that date. During the 1992 fiscal year, the following were calculated:
Service cost for 1992 $ 30,000
Contributions during 1992 45,000
Benefit payments to retirees
during 1992 18,000

In practice, most companies will not fund OPEB plans because contributions in excess of payments to retirees are not tax deductible. For this example, the Generic Accounting Firm is making contributions in excess of benefit payments to show the extent of the reporting requirements and the calculations necessary to reconcile the accounts. This will give rise to a deferred tax asset because of the timing difference but is ignored in this example. Using this data, the Generic Accounting Firm completes a worksheet to prepare the journal entries and the footnote disclosure required by Statement No. 106.

The annual OPEB expense in this example is the total of the service cost, the interest on the APBO and the amortization of the transition obligation. Each of these amounts is also used to adjust the off-balance-sheet accounts. The service cost and the interest are added to the APBO while the amortization of the unrecognized transition amount is deducted from the balance in that account. Contributions to the plan are added to the plan assets while payments to the retirees are subtracted. At the end of the period, the off-balance-sheet amounts reconcile to the balance sheet account, Accrued OPEB Liability:
APBO $672,000
- Plan assets 27,000
- Unrecognized transition amount 576,000
- Unrecognized net gain/loss 0

= Accrued OPEB liability$ 69,000

The company would disclose these amounts in the balance sheet and in the notes to the balance sheet.
In 1993, the company reported the following:

Service cost for 1993 $35,000
Contributions during 1993 75,000

Benefit payments to retirees

during 1993 25,000

In addition, during 1993 the company expected to earn $3,000 on the plan assets, but actual earnings were only $2,500. Also, at the end of the year, the actuary reported changes in the assumptions about the costs of changes in medical technology, medicare co-payment requirements and increasing life expectancy of retirees. This results in an increase in the APBO of $115,000. Using this data, the Generic Accounting Firm completes a worksheet for 1993.

The calculation of the OPEB expense includes the service cost, the interest on the APBO, the expected return on plan assets ($2,500 + $500) and the amortization of the unrecognized transition obligation. The service cost and the interest are added to the APBO while the amortization of the unrecognized transition amount is deducted from the balance in that account. The actual return on plan assets is added to the plan assets while the loss, because the return on plan assets was lower that expected, is added to the unrecognized gain/loss account. Contributions and benefits paid are used to adjust the balance in the plan assets. At the end of the period, the off-balance sheet amounts reconcile to the balance sheet account, Accrued OPEB Liability:
APBO $864,200
- Plan assets 79,500
- Unrecognized transition amount 552,000
- Unrecognized net gain/loss 115,500

= Accrued OPEB liability $117,200

The company would disclose these amounts in the balance sheet and in the notes to the balance sheet.

The company will amortize the balance in the unrecognized loss account beginning in 1994, since both losses were recognized at the end of 1993. The approach to use is the same as required in pension accounting--the "Corridor" approach. The Company will amortize the excess of the unrecognized loss balance over 10% of the greater of the plan assets or the balance in the APBO. In this example, in 1994 the company would amortize $1,163 determined as follows:
Balance in unrecognized loss $115,500
10% of the greater of APBO
or plan assets 86,420

Excess or "corridor" 29,080
Average years to retirement 25

1994 amortization of unrecog
nized loss $ 1,163

This calculation will be made every year the balance in the unrecognized loss exceeds the corridor amount. This amount will be added to the annual OPEB expense. When the balance in the net loss/gain account is less than the corridor amount, no amortization adjustment is made.

Disclosure in Financial Statements

In addition to the accounts appearing in the financial statements, various other amounts, assumptions and rates need to be disclosed in the notes to the financial statements. The disclosure requirements for other postretirement benefits are as extensive as those required for pension plans and include the following:

* Descriptive information about the plan and the accounting procedures;

* Separate identification of all components included in the annual postretirement benefit expense;

* A schedule (as shown in the worksheets above) reconciling the funded status of the plan with the amounts shown in the financial statements; and

* The assumptions used in computing the Accumulated and Expected Postretirement Benefit Obligation, including assumptions about future health care cost trends and the effect of a one percent increase in the assumed health care cost trend on the measurement of the APBO, the service cost and the interest cost. The FASB determined that companies would not have to report a "minimum liability" for OPEBs, as they do for pensions, because users could obtain sufficient information from the notes to the financial statements. The reporting requirements are extensive and will need a worksheet approach to compute the various amounts needed to comply with the requirements of Statement No. 106. Conclusions

It is estimated that by the year 2020, 18% of the population will be over 65 and drawing benefits that were promised years earlier. The moral and legal difficulties of cutting benefits for existing retirees have caused many companies to concentrate on reducing the benefits of future retirees--the current employees. One of the alternatives adopted by some companies is to adopt "cafeteria" type plans that limit the amount they will pay per employee. Other companies will continue to cover future health care costs of their current and retired employees but will now have to recognize the liability they have created.

Gordon D. Pirrong, DBA, CPA, CMA, is professor of accounting at Boise State University.
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Title Annotation:Other Post Employment Benefits
Author:Pirrong, Gordon D.
Publication:The National Public Accountant
Date:Feb 1, 1994
Previous Article:Retirement programs: assembling the best possible plan.
Next Article:Qualifying as the innocent spouse.

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