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A new reality ahead for pension accounting: the recession's aftermath and IAS 19R prompt changes in accounting practices.

The accounting for defined benefit pension plans has been the subject of contentious debate for nearly three decades. Disparate stakeholders--regulators, academics, analysts, investors, preparers, and others--have criticized the complex assumptions, arcane rules, and techniques used to minimize the inherent volatility of pension assets and obligations. Many claim that these practices produce an opaque and misleading portrayal of a sponsor's true obligations and negatively impact the quality of reported earnings. Many companies that sponsor defined benefit plans have long advocated for the delayed recognition techniques and other mechanisms to reduce earnings volatility. In Statement of Financial Accounting Standards (SFAS) 87, Employers' Accounting for Pensions (par. 177-178), FASB acknowledged that particular conclusions on these issues were "pragmatic" and "without conceptual basis." Most now agree that an overhaul of existing accounting practice is long overdue, and FASB is proceeding with a phased approach, in tandem with the International Accounting Standards Board (IASB).

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During 2010 and 2011, several prominent U.S. companies (AT&T, Verizon Communications, UPS, and others) changed their longstanding accounting practices from the delayed recognition of pension costs to a fair-value approach that now provides immediate recognition of most changes in plan assets and liabilities. These changes appear to be motivated by two key factors. First, plan sponsors experienced a significant buildup of unrecognized losses during the depths of the recession, which had a devastating impact on the health of such plans (particularly in 2008). The accounting changes resulted in retrospective adjustments to prior-year financial statements for these unrecognized net losses and eliminated a "drag" on future earnings. Second, recent revisions to International Accounting Standard (IAS) 19, Employee Benefits, will dramatically change existing practices used by companies reporting under International Financial Reporting Standards (IFRS). Essentially, IAS 19R (effective in 2013) will eliminate all delayed recognition mechanisms and require a fair-value approach to the recognition of changes in plan assets and liabilities. The most far-reaching change is that actuarial gains and losses will be immediately reported in other comprehensive income (OCI) and will no longer be amortized to earnings. Several U.S. companies have pointed to the fair-value approach under IAS 19R as support for their accounting changes.

The following is an examination of emerging issues in U.S. GAAP and IFRS, with respect to defined benefit pension plans. First, an overview of existing accounting practices under U.S. GAAP and IAS 19 is provided, with a particular focus on delayed recognition mechanisms present in both sets of standards. Particular provisions of 1AS 19R are discussed and contrasted with existing standards, along with consequences for U.S. companies if convergence with IFRS is achieved. Recent accounting changes by certain U.S. companies are examined, including likely motivations and related financial impact. Finally, a snapshot of the health of U.S. defined benefit pension plans is provided, along with strategies that may warrant consideration.

In the near term, more U.S. companies with accumulated unrecognized losses will likely contemplate a change to a fair-value approach for pension accounting. Given FASB's commitment to convergence with IFRS, and despite the lack of a formal decision by the SEC regarding the timing or method of incorporating IFRS into the U.S. financial reporting system, U.S. companies should consider the impact of IAS 19R on their financial condition and future earnings.

Overview: Expense Recognition for Defined Benefit Plans

One of the overriding objectives of accounting for defined benefit pension plans, under both U.S. GAAP and is to recognize compensation cost in the periods in which the eligible employee renders services. Inherent in this process is a benefit formula that provides the basis for determining the amount of payment to which a participant may be entitled, and a number of actuarial and other underlying assumptions about future events, including mortality, employee turnover, retirement date, changes in future compensation, and other factors. The long-term nature of defined benefit plans, coupled with a multitude of assumptions that are often beyond a sponsor's control, can produce volatility in the reported annual cost of such plans. Moreover, retroactive plan amendments, revisions to underlying assumptions, and differences between actual experience and expectations can complicate the predictability of annual costs.

In reaction to constituents' concerns about these uncertainties, FASB incorporated provisions for the deferral or delayed recognition of particular changes in plan assets and liabilities. SFAS 87 (par. 85) describes the delayed recognition feature as a concept where "certain changes in the pension obligation (including those resulting from plan amendments) and changes in the value of assets set aside to meet those obligations are not recognized as they occur but are recognized systematically and gradually over subsequent periods." These mechanisms are discussed below. Though this discussion is particular to defined benefit pensions, the concepts are largely applicable to other postretirement plans (e.g., medical).

U.S. GAAP: Net Periodic Pension Cost and Delayed Recognition Mechanisms

Accounting Standards Codification (ASC) 715-30-35 identifies the components of the net periodic cost of defined benefit pension plans. Below is a brief description of each component followed by the relevant provisions, where applicable, that permit delayed recognition or "smoothing" of costs over future periods.

Service cost. This cost component represents the actuarial present value of benefits computed using the plan's benefit formula related to services rendered by employees during the period.

Interest cost. This cost component represents the increase in the projected benefit obligation (i.e., the actuarial present value of accrued benefits at a point in time) during the period, due to the passage of time. It is computed using a discount rate multiplied by the balance of the pension benefit obligation at the beginning of the period. This discount rate should reflect current prices of annuity contacts or rates on high-quality, fixed-income investments at which the pension benefits could be. effectively settled at the measurement date.

Return on plan assets. For a funded plan, the actual return on plan assets represents the difference between the fair value of plan assets at the 'end of the period and the fair value at the beginning of the period, adjusted for employer contributions and benefit payments made during the period; however, ASC 715-30 permits companies to smooth period-to-period fluctuations in plan assets by using the "expected return on plan assets" in computing net periodic pension cost. The expected return is used by most companies and is computed using two components. One is the "expected long-term rate of return on plan assets," which reflects expectations of the average rate of earnings on existing plan assets, as well as related reinvestment rates. The second is the "market-related value of plan assets," in which companies can use the fair value of plan assets or, more commonly, "a calculated value that recognizes changes in fair value in a systematic and rational manner over not more than five years" (ASC 713-30-20). For example, it can represent a moving average of fair values for up to five years based on the composition of the portfolio of plan assets. The difference between the actual and expected return on plan assets is also recognized as a gain or loss in accumulated OCI, and it is included in the amortization of gains and losses discussed below.

Amortization of prior service cost (or credit). Plan amendments (or the initiation of a plan) generally provide increased benefits that are associated with employee services rendered in prior periods. This results in an immediate increase in the pension benefit obligation and an offsetting debit to OCI. Plan amendments can also reduce benefits and have the opposite effect. ASC 715-30-35 stipulates that prior service cost should be amortized over the remaining service period of participants expected to receive benefits under the plan. Other amortization approaches are permitted, depending upon whether plan participants are active or inactive when an amendment is made. A company is also permitted to choose a less complex approach that amortizes the cost of retroactive amendments more rapidly, provided that the method is used consistently and is properly disclosed. ASC 715-30-35-16 precludes a policy of immediate recognition.

Gain or loss. These represent changes in the value of either the projected benefit obligation or plan assets resulting from 1) differences between actuarial assumptions and actual experience, or 2) a change in actuarial assumptions (e.g., retirement age, mortality, employee turnover, discount rate). The difference between the actual and expected return on plan assets (noted above) is also included.

Gains and losses are initially recognized in OCI. The cumulative amount of these gains and losses impact future net pension cost through an amortization process. ASC 715-30-35-24 requires that the minimum annual amortization of the net gain or loss be computed using the "corridor approach." Amortization under the corridor approach is required "if, as of the beginning of the year, that net gain or loss exceeds 10 percent of the greater of the projected benefit obligation or the market-related value of plan assets." If such an excess exists, "the minimum amortization shall be that excess divided by the average remaining service period of active employees expected to receive benefits under the plan." The corridor approach is used by most entities, and it often results in amortization over periods of 10 to 15 years. (A calculation of the minimum amortization using the corridor method is illustrated in Exhibit 1.) Alternative approaches are permitted including--

* immediate recognition of gains and losses in annual defined benefit cost, or

* another systematic approach that amortizes gains and losses more rapidly than under the corridor approach, provided that the alternative is consistently used and is applied similarly to both gains and losses (ASC 715-30-35-20 and 25).
EXHIBIT 1

Amortization of Gains and Losses: The Corridor Approach
Nanco Inc. sponsors a defined benefit pension plan that covers
substantially all full-time employees. In computing the amortization
of gains and losses for 2013, the company uses the corridor
approach. The following information is available as of January
1, 2013 (all figures in thousands of dollars):

Market-related value of plan assets (MRVA)              $ 2,500,000

Projected benefit obligation (PBO)                        3,200,000

Unrecognized net (gain) or loss in other comprehensive      750,000
income

Average remaining service life of active employees         10 years

Amortization of net loss for 2013 is computed as
follows:

Greater of the MRVA or the PBO                          $ 3,200,000

Corridor (10% x $ 3,200,000)                              $ 320,000

Unrecognized net loss as of January 1, 2013               $ 750,000

Less corridor                                               320,000

Excess over corridor                                        430,000

Average remaining service life of active employees              /10

Amortization for 2013 included in defined benefit          $ 43,000
cost


IAS 19 and Differences from U.S. GAAP

Under IAS 19, the annual expense of defined benefit plans consists of five main components. Two elements--current service cost and interest cost--have equivalent counterparts under U.S. GAAP. The other three elements, existing delayed recognition provisions, and pertinent differences from U.S. GAAP are discussed below.

Expected return on plan assets. This value is computed using an expected long term rate of return, multiplied by the fair value of the plan assets. Unlike U.S. GAAP, however, use of the market-related value of plan assets to smooth asset gains and losses is not permitted. The difference between the actual and expected return on plan assets is an actuarial gain or loss (see below).

Past service cost Changes in past service costs (prior service costs under U.S. GAAP) from the initiation of a plan or a plan amendment are expensed immediately for fully vested employees and amortized into income on a straight-line basis over the remaining period for employees who are not vested. U.S. GAAP provides delayed recognition of both vested and nonvested benefits.

Actuarial gains and losses. Similar to gains and losses under U.S. GAAP, actuarial gains and losses under IAS 19 include differences between actuarial assumptions and actual experience, changes in actuarial assumptions, and differences between the actual and expected return on plan assets. Entities are permitted to choose among three alternatives to recognize actuarial gains and losses to profit or loss. First, the corridor approach to amortization (similar to U.S. GAAP) may be used to delay recognition until future periods. Second, any systematic method that results in faster recognition than the corridor approach is acceptable, including immediate recognition. A third alternative--not permitted under U.S. GAAP--is to recognize all actuarial gains and losses in OCI in the period they occur, without subsequent amortization to the income statement. This alternative serves to reduce the volatility of defined benefit costs in the income statement, as compared to U.S. GAAP.

IAS 19 does not require that the components of pension cost be reported as a single net amount, as is required under U.S. GAAP. Accordingly, entities reporting under IFRS often report interest cost and the expected return on plan assets as financing costs on the income statement.

IAS 19R: A New Direction?

FASB and the IASB have comprehensive projects on their respective agendas concerning particular aspects of postretirement benefits. Phase 1 of FASB's project was completed in 2006 with the issuance of SFAS 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans--An Amendment of FASB Statements No. 87, 88, 106, and 132(R), which requires that the funded status of postretirement plans be recognized on the balance sheet. Meanwhile, the IASB agreed to address recognition, presentation, and disclosure issues in phase 1 of its agenda. Phase 1 of the IASB's project was concluded in June 2011 with the issuance of IAS 19R, which is effective beginning January 1, 2013 (early application permitted).

FASB has indicated that the conclusions reached by the IASB will provide a roadmap for future changes to U.S. GAAP. At its August 29, 2007 meeting, FASB decided to "leverage the IASB 's work," and it indicated that once the IASB completed phase 1 of its project, it "will consider whether adopting similar measurement requirements would improve reporting in the United States." The final step is a joint project to comprehensively reconsider the current accounting model for pensions and other postretirement benefits.

IAS 19R eliminates the delayed recognition mechanisms, reconfigures the components of defined benefit cost, and enhances disclosures concerning the characteristics and risks associated with defined benefit plans. Selected changes included in IAS 19R are briefly discussed below. Exhibit 2 compares the delayed recognition provisions under U.S. GAAP and IAS 19 as well as the changes in these practices included in IAS 19R.
EXHIBIT 2

Summary of Delayed Recognition Provisions: U.S. GAAP, IAS 18, and
IAS 19R

Delayed          U.S. GAAP          IAS 19 (Present)   IAS 19 (Revised)
Recognition
Provision

Prior (Past)     Vested and         Expensed           Delayed
Service Cost     unvested benefits  immediately for    recognition
                 are generally      employees who are  attributable to
                 amortized over     vested. For        unvested benefits
                 the remaining      nonvested          is eliminated.
                 service period of  employees,         All past service
                 participants       amortized on a     costs are
                 expected to        straight-line      expensed in the
                 receive benefits   basis over the     period the plan
                 under the plan.    remaining vesting  is amended or
                                    period.            curtailed.

Market-Related   Used to compute    Use of a           Use of a
Value of Plan    the expected       calculated         calculated
Assets           return on plan     market-related     market-related
                 assets.            value of plan      value of plan
                 Represents either  assets is not      assets is not
                 the fair value of  permitted. The     permitted. The
                 plan assets, or a  fair value of      fair value of
                 calculated value   plan assets is     plan assets is
                 that permits       used.              used.
                 gains and losses
                 on plan assets to
                 be smoothed for
                 up to five
                 years.

Expected Return  Calculated as the  Calculated as the  Expected return
on Plan Assets   expected           expected           on plan * assets
                 long-term rate of  long-term rate of  and interest cost
                 return on plan     return,            on the pension
                 assets,            multiplied by the  benefit
                 multiplied by the  fair value of      obligation have
                 market-related     plan assets.       been eliminated.
                 value of plan                         Interest on the
                 assets.                               net defined
                                                       benefit liability
                                                       or asset (using
                                                       the discount
                                                       rate) is
                                                       introduced.

Gains and        Permitted          Permitted          Single Approach
Losses           Alternatives       Alternatives       All actuarial
                 Recognized in      Recognized in      gains and losses
                 defined benefit    profit or loss     (i.e.,
                 cost under         using the same     remeasurements)
                 alternative        alternative        are recorded in
                 approaches: *      approaches         OCI in the period
                 Corridor approach  permitted under    they occur,
                 * Immediate        U.S. GAAP or       without
                 recognition of     Recognized in OCI  subsequent
                 all gains and      in the period      amortization to
                 losses * Any       they occur,        profit or loss.
                 other systematic   without
                 method that        subsequent
                 results in faster  amortization to
                 amortization than  profit or loss.
                 under the
                 corridor
                 approach.


New Components of Pension Cost

Net interest on the defined benefit liability or asset. IAS 19R eliminates the interest cost component and the expected return on plan assets and introduces a single "net interest" component. This is calculated as the discount rate times the net defined benefit liability (if underfunded) or plan asset (if overfunded). Accordingly, net interest expense is recognized if the plan is underfunded or net interest income is recognized if the plan is overfunded. The IASB views the net pension liability (or asset) as the equivalent of an amount payable to (or receivable from) the plan. The elimination of the expected return on plan assets will result in higher annual expenses compared to U.S. GAAP and existing IAS 19 because the expected long-term rate of return on plan assets will be replaced with the lower discount rate.

Past service cost. IAS 19R eliminates the delayed recognition for the unvested portion of past service costs and requires that all past service costs be recognized when a plan is amended or curtailed. Compared to U.S. GAAP and existing IAS 19, this change will increase the volatility of profit or loss for those companies with significant plan amendments.

Actuarial gains and losses. As mentioned above, IAS 19R eliminates the corridor approach and other amortization alternatives. All actuarial gains and losses are immediately recognized in OCT and not amortized or "recycled" into income in subsequent periods. Accordingly, IAS 19R will result in greater volatility of OCT but will reduce volatility of profit or loss compared to U.S. companies and those companies that presently recognize profits or losses under IAS 19.

Presentation of Defined Benefit Cost

IAS 19R introduces changes in terminology and definitions that impact financial statement presentation; however, it does not require that net pension cost be reported as a single component on the income statement, but suggests that presentation be consistent with prior practice (par. BC201). Defined benefit cost will consist of three components:

* Service cost. This component consists of current-period service cost, past service costs, and certain gains and losses on nonroutine plan curtailments. It is reported in profit or loss.

* Net interest on the net defined benefit liability (asset). The component (discussed above) is also reported in profit or loss.

* Remeasurements of the net defined benefit liability (asset). This component primarily includes 1) actuarial gains and losses on the defined benefit obligation, and 2) the difference between the actual return on plan assets and the interest income included in the net interest component. It is reported in OCI.

Changes by U.S. Companies: Motivations and Financial Impact

Under U.S. GAAP, companies may elect to change certain existing practices related to the delayed recognition provisions of defined benefit costs. One option is to change the method used to determine the market-related value of plan assets by smoothing asset gains and losses over a period shorter than five years, or by changing from a calculated value to the fair value of plan assets. Entities may also elect to change from the corridor approach to a policy that accelerates the amortization of gains and losses. Examples include changing the size of the corridor (e.g., from 10% to 5%), recognizing all gains and losses in excess of the corridor, or eliminating the corridor completely and immediately recognizing all gains and losses in the year they occur. Each represents a change in accounting principle under ASC Topic 250, "Accounting Changes and Error Corrections," and requires retrospective application of the new method to all prior years. A preferability letter from the external auditors is also requited.

During 2010 and 2011, certain U.S. companies changed their longstanding accounting policies related to the recognition of defined benefit costs. Each company had employed some variant of the delayed recognition provisions related to gains and losses. One key factor prompting these changes appears to have been the desire to eliminate the precarious accumulation of unrecognized losses experienced in 2008 during the depths of the recession and to avoid the related drag on future earnings. For example, AT&T Inc. implemented the following two accounting changes at the end of 2010: it discontinued use of the corridor method and the use of a calculated market-related fair value in order to smooth asset gains and losses and to compute the expected return on plan assets. The company adopted a fair value approach to immediately recognize all gains and losses in the income statement. The after-tax impact of the changes amounted to a $1.64 billion (8%) reduction in net income for the year ended December 31, 2010. In accordance with ASC 250, prior-year financial statements were also retrospectively adjusted to reflect the impact of the change. The previously reported net income for 2008 was reduced by $15.5 billion (120%).

Verizon Communications Inc. reported accounting changes in 2010 similar to those adopted by AT&T; however, the after-tax amount of the change for the year ending December 31, 2010, amounted to a $531 million (26%) increase in net income, compared to previous accounting practices. Prior-year financial statements were retrospectively adjusted, with a reduction in previously reported net income for 2008 of $8.6 billion (134%).

Honeywell Inc.'s management noted that its accounting practices were more conservative than its peers. Previously, Honeywell had smoothed asset gains and losses over three years (compared to five years for most companies) using a calculated market-related fair value of plan assets. Gains and losses in excess of the corridor were previously amortized over a shorter period of six years. Though Honeywell discontinued the smoothing of asset gains and losses using a market-related fair value of plan assets, the company elected to retain the 10% corridor but immediately recognize gains and losses in excess of the corridor each year. On a retrospective basis, the reduction in after-tax net income totaled $605 million (28%) for 2009 and approximately $2 billion (71%) for 2008. Other companies that also changed their pension accounting practices during 2011 included Reynolds American Inc. and United Parcel Service Inc. Exhibit 3 includes a sample list of companies, the changes made, and the impact to previously reported net income.
EXHIBIT 3

Changes in Accounting Practices for Defined Benefit Plans During 2010
and 2011: After-Tax Impact on Net Income for Selected U.S. Companies

Below are 10 companies that changed their pension accounting practices
during 2010 and 2011. A brief description of the accounting change(s)
and the impact on after-tax net income for the year of the change and
three prior years are provided. The highlighted areas reveal the impact
of 2008, when many corporate plans experienced significant unrecognized
losses during the depths of the recession. All figures are in millions
of dollars.

                                      After-Tax Increase (Decrease)
                                                    in Net Income *

                                        Year of              Prior
                                         Change               year

Company Name     Year of    Type of           $  % [double       $
                  Change     Change                dagger]
                          [section]

AT&T Inc.           2010        1,2    ($1,644)       (8%)  ($397)

Honeywell           2010        1,3         $57         3%  ($605)
International                          [dagger]
Inc.

Verizon             2010        1,2        $531        26%  $1,243
Communications
Inc.

Fortune Brands      2011        1,3     ($41.6)     (693%)    $6.6
Home & Security
Inc.

Kaman               2011          1        $2.4         5%  ($2.7)
Corporation

PerkinElmer         2011        1,2     ($39.3)      (84%)    $7.1
Inc.

PolyOne             2011          2     ($45.3)      (21%)      $0
Corporation

Reynolds            2011        1,3         $20         1%      $8
American Inc.

United Parcel       2011       1, 3      ($409)      (10%)  ($150)
Service Inc.

Windstream          2011          2     ($77.6)      (31%)    $1.9
Corporation

                        Two years             Three
                            prior             Years
                                              Prior

Company Name         %          $       %         $      %

AT&T Inc.         (3%)  ($15,492)  (120%)    $5,081    43%

Honeywell        (28%)   ($1,986)   (71%)      $150     6%
International
Inc.

Verizon            34%   ($8,621)  (134%)    $1,691    31%
Communications
Inc.

Fortune Brands     12%       $2.9      7%   ($57.8)   (9%)
Home & Security
Inc.

Kaman             (7%)     ($7.6)   (23%)      $2.8     8%
Corporation

PerkinElmer         2%     ($3.5)    (4%)   ($57.1)  (45%)
Inc.

PolyOne             0%      $57.2    116%  ($156.8)  (60%)
Corporation

Reynolds            1%       ($7)    (1%)    ($894)  (67%)
American Inc.

United Parcel     (4%)     ($184)    (9%)  ($2,348)  (78%)
Service Inc.

Windstream          1%        $64     19%  ($241.1)  (58%)
Corporation

Notes:

* After-tax amounts were determined from 10-K reports for each company.

[dagger] Impact for year of the change was determined from
fourth-quarter earnings releases or other company sources.

[double dagger] Percentage change is calculated as: change in net
income/net income as originally reported before the accounting change.

[section] The accounting changes fall into three main categories:

1. Changed from the use of a calculated market-related value of
plan assets to fair value in the computation of the expected return
on plan assets

2. Discontinued the use of the corridor approach (10% or other
percentage) and immediately recognized all gains and losses

3. Continued the use of the corridor approach, but immediately
recognized gains and losses in excess of the corridor


In corporate announcements, press releases, and investor presentations, the management of such companies explained the nature of the accounting changes and the impact on financial results. The following were common themes in their rationales:

* Existing accounting practices are simplified.

* Accounting is now better aligned with preferable fair value concepts.

* Gains and losses due to market fluctuations are recognized in the period they arise.

* Expense recognition is better aligned with current market returns, interest rates, and actuarial assumptions.

* There is consistency with new international accounting standards.

* Current period results have improved transparency.

* There is no impact to cash flows, plan funding, employee benefits, or dividend policy.

* There is minimal impact to the balance sheet. The change is reflected as a reduction in retained earnings and an increase to accumulated OCI.

Some corporate announcements referred to the fair value approach in IAS 19R in their explanations. In its press release announcing the change, Honeywell noted that "independent auditors have agreed as to the preferability of this change, and importantly International Financial Reporting Standards (IFRS) utilize a MTM [mark-to-market] methodology for pension accounting" (November 16, 2010). Similarly, in an analyst call to explain the accounting change, Verizon CFO Francis J. Shammo indicated: "This is actually a preferable accounting method and one that aligns with the fair value accounting concepts and current lFRS proposals" (January 21, 2011).

The benefits of these changes, however, must be weighed against concomitant risks. The predictability of annual defined benefit cost from existing smoothing techniques will be replaced with increased volatility in earnings and added difficulty in accurately forecasting future results. In fact, during several investor conference calls held by companies to explain their recent pension accounting changes, analysts appeared to be more interested in the impact on forecast accuracy and the risk of "surprises," since the fair value adjustments for gains and losses will be reported only in the fourth quarter of the year.

The Economic Crisis and its Aftermath

Standard & Poor's (S&P) reported that defined benefit pension plans for companies in the S&P 500 were overfunded by $63.4 billion at the end of 2007--that is, before the global economic crisis hit (S&P 500 2011: Pension and Other Post-Employment Benefits, July 2012). Since then, the recession and other factors have had a devastating impact on the health of corporate pension plans. The S&P 500 index had a negative total return of 37% in 2008, and the pension plans of S&P 500 companies experienced (on average) "a 43% gap" between expected and actual returns. Total plan assets declined by 26.9%, or approximately $400 billion, contributing to a record underfunding of $308.4 billion at the end of 2008. The S&P 500 index rebounded with total returns of 26.5% in 2009 and 15.1% in 2010, but these gains were on a significantly lower asset base. Further complicating this situation is that the historically low interest rate environment has resulted in a drop in the average discount rates used to measure pension liabilities, from 6.3% in 2008, to 5.8% in 2009, and 5.3% in 2010. Unfortunately, lower discount rates serve to increase the present value of existing pension liabilities, generate additional unrealized losses, and exacerbate the funded status of plans.

At the end of 2010, the pension plans of S&P 500 companies had an aggregate underfunding of $245 billion. During 2011, a further decline in the average discount rate to 4.7%, coupled with a meager total return of 2.1% for the S&P 500 index, helped increase aggregate pension underfunding to a record $354.7 billion. Accordingly, higher future pension contributions will be necessary, either from existing resources or additional borrowing.

These economic results present a unique situation for companies with defined benefit pension plans. Moreover, given the significant overhang of unrecognized losses from prior years, the continued use of the calculated market-related value of plan assets and the corridor method will have a negative impact on earnings for years to come.

What's Ahead?

The recent accounting changes and revisions to IAS 19 have provided U.S. companies with a preview of the challenges ahead. Some may view this as an opportunity to eliminate the overhang of unrecognized losses and the drag on future earnings. But the risks of increased volatility in earnings and forecasting difficulties should not be dismissed.

Now is the time to examine long-term strategies. Although the SEC final staff report (Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers, issued July 13, 2012) does not clarify the timing or method of incorporating IFRS into U.S. GAAP, U.S. companies should consider the impact of IAS 19R on their financial condition and future earnings. IAS 19R will likely reduce volatility in earnings, but increase volatility in OCI. Moreover, the elimination of the expected return on plan assets will likely increase defined benefit costs, because returns in excess of the discount rate will be reported in OCI--not earnings. Current investment strategies to support a higher long-term rate of return could warrant a shift away from equities and riskier assets to a portfolio better matched to the plan's liabilities. Finally, companies anticipating future plan amendments should also consider the immediate recognition of vested and unvested benefits, as provided in IAS 19R.

Overall, the movement toward a fair value model and away from delayed recognition represents a major step toward improving accounting practices that have lingered for the past 25 years. But it does not settle the broader issue concerning the measurement of defined benefit costs, which represents the next step for FASB and the IASB in their long-term effort to overhaul pension accounting practices.

James M. Fornaro, DPS, CPA, CMA, CFE, is an associate professor in the department of accounting, taxation, and business law at SUNY at Old Westbury, Old Westbury, N.Y.
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Title Annotation:accounting; International Accounting Standard
Author:Fornaro, James M.
Publication:The CPA Journal
Geographic Code:1USA
Date:Oct 1, 2012
Words:5174
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