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Accounting for postretirement health benefits.

Since its inception, the Financial Accounting Standards Board has tackled many important and controversial topics, including foreign currency translation, inflation, pensions, cash flows and income tax accounting. Few topics, however, have generated as much overall concern among companies, accountants and users of financial statements as the reporting of postemployment health benefits (commonly referred to as OPEB-Other Postemployment Benefits). Reasons for this concern are easy to understand.

First, the sheer size of the potential liability for these OPEB raises concern. Estimates of the unfunded portion of postemployment health benefits range from anywhere in the $100 billion area to a staggering $2 trillion. [1] But as important as the size of the obligation is the uncertainty which revolves around the nature of the benefits themselves.

Unlike defined benefit pension plans which promise a future benefit based upon a predetermined formula, OPEB is dependent upon other factors such as rapidly rising health care costs, changing technologies and governmental policies, factors largely beyond the control of the company offering the benefits. Consequently, the obligation for OPEB is much more difficult to estimate than its pension counterpart, and the dynamic nature of these factors has caused disagreement regarding both the reliability of the OPEB measurement and the best way to disclose its impact on the company's operations. Some question whether the offering of postretirement health benefits even satisfies the definition of a liability, since in most cases, at least as far as current employees are concerned, these benefits can be eliminated altogether by the company without further obligation or notice.

Add to this pervasive state of uncertainty the fact that there has been no history of accruing the expense for OPEB and the stage is set for the current debate. Although the reporting of pension obligations has its own stormy past ending in the promulgation of Statements No. 87 and 88, the controversy centered upon specific measurement approaches and the appropriate disclosure of the pension liability, not upon the need to accrue the expense for future obligations. OPEB, on the other hand, has generally been accounted for on a cash or pay-as-you-go basis, with companies picking up the expense only when they paid out on claims. Even under SFAS No. 81, Disclosure of Postretirement Health Care and Life Insurance, accural accounting is not mandated; only a disclosure of current cost (usually based upon a pay-as-you-go approach) and a brief description of the existence of a plan is required. But this situation is about to change.

Under the FASB's proposals released in its Exposure Draft, [2] the accrual of expenses for OPEB where there was no accrual before will be required, and this has sent shock waves throughout the financial community Again, the reasons for this concern arc easy to understand. in addition to having a new, potentially huge liability to deal with on their balance sheets, most companies will experience a drop in net income, One source estimates that if accrual accounting for OPEB is adopted, average companies may find their reported earnings per share decreased by 30 to 35%. [3] However, the impact of the change in reporting OPEB expenses will be heavily dependent upon the demographics of the particular firm (number of active and retired employees, specific benefits offered, the assumptions used to calculate future benefits, and so on). Furthermore, there is no guarantee that all the elements of the FASB exposure draft will survive the rounds of public debate and be incorporated into the final standard. What is almost certain is that accrual of OPEB, in one form or another, will be the future of accounting for postemployment health benefits.

Given this backdrop, the purpose of this article is to highlight the FASB's proposals, particularly as they apply to the calculation of the OPEB expense. An example of how to measure and disclose the OPEB amounts is included with numbers based upon the multiples found in a recently completed field test of 25 companies, conducted by Coopers & Lybrand and the Financial Executives Research Foundation.4 Armed with this information, accountants and users can approach the controversial topic of accounting for OPEB with greater understanding and less trepidation.

OPEB Expense

The measurement of OPEB expense proposed by the FASB consists of many of the same components found in pension accounting (SFAS No. 87). These include:
 Service cost
 Interest cost
 Return on plan assets
 Amortization of transition assets
 or liabilities
 Amortization of prior service
 Amortization of gain and losses
(See Exhibit 1 for definitions of these

Service Cost and Its Assumptions

The service cost is the portion of future OPEB which is attributed to employee service during the current period. It is based upon several assumptions which, together with such other components as the interest cost and the amortization of a transition liability, should produce an expense in the first year of adoption which is considerably higher than the OPEB expense recorded under the currently accepted pay-as-you-go method. Indeed, most firms participating in the Cooper & Lybrand/FERF field test would have reported an expense which was two to seven times as large as their pay-as-you-go expense. The size of the multiple was, and will be, highly dependent upon the particular company's ratio of active to retired employees. Firms characterized as "highly mature" (relatively few active employees to retirees) experienced lower multiples than firms characterized as "immature" (a relatively higher number of active employees to retirees).

The calculation of the service cost component requires three important assumptions-all of which arc somewhat controversial in their own way. The first, the health care cost trend, is unique to OPEB accounting. It reflects future changes in health care costs provided under a plan and, as such, is dependent upon such variables as health care inflation, advances in technology and changes in health care utilization. [5] In arriving at this trend or rate of increase, a company must combine detailed data on past and present per capita claims by age for its employees with an analysis of the impact of Medicare and other insurers on future outlays. Consequently, new information will be needed by companies that may not be presently maintained or provided by their accounting information systems and will require substantial time to accumulate. In point of fact, several firms were unable to participate in the C&L/FERF study because they could not provide the necessary data for compilation. Thus, regardless of any other impact, the adoption of accrual accounting for OPEB will undoubtedly increase the reporting costs for many companies and will require careful planning in order to meet the provisions of the new standard.

The second assumption used in arriving at the service cost component, the discount rate, is familiar to most accountants and users from their present value calculations. As was the case with accounting for pension obligations, the discount rate is used to find the present value of the firm's expected postretirement health benefit obligations. Consistent with its pension pronouncement, the FASB indicates that this discount rate should be the rate at which the OPEB obligation could be settled. However, unlike the pension obligation, companies do not usually settle OPEB obligations in this way (e.g. by the purchase of an annuity contract). As a result, a settlement rate may not be known or calculable. Therefore, as an alternative, companies are permitted to select a rate based upon the yield of fixed income securities which mature over a similar time period as the expected benefit payments.

It is interesting to note that the companies participating in the C&L/FERF field test would have used a company specific rate in a range about one to three percentage points higher than the range for general settlement rates (9 to 15% vs. 7.5 to 11% ). Since the use of a higher discount rate can have a significant bearing on the resulting obligation (the higher the discount rate, the lower the obligation), this issue should be carefully evaluated. Although specifically not permitted in the current FASB proposal, perhaps a better approach would be to allow a company to use its own internal cost of funds as its estimate, as this would be a better approximation of the true cost of settling the obligation.

The final assumption used in service cost calculation is the expected rate of return. This rate, when applied to the fair value of the plan assets, reduces the OPEB expense for the period. Given the size of past funding which companies have made for their pension plans, this return is of major significance in pension accounting. However, since almost no firms have contributed any assets to their OPEB plan, in part due to the lack of accrual accounting for OPEB and in part due to lack of incentive to pre-fund under current income tax law,6 the rate of return selected will have little initial impact on the calculation of OPEB expenses. In short, at least in the early years after adoption, this assumption will have seemingly little relevance to OPEB accounting. As companies more heavily fund their plans, expected returns will take on increasing importance, and the similarities between the impact of the rate of return selected on the resultant OPEB and pension expenses will become greater.

A Hypothetical Example

The XYZ Company is a leading manufacturer whose products span several industries, As one of the benefits it provides for its employees, XYZ pays for the postretirement health care of those workers who have satisfied certain years of service requirements. it is considered to be a mature firm since it has four active employees for each retiree. As expected, XYZ currently measures its OPEB expense on the basis of actual payments to claimants and insurers. These amounted to $10,000 for the current year. The company is now changing its accounting for OPEB to comply with the FASB's proposals for the accrual of these expenses. Exhibit 1 presents the calculation of the expense under the provisions of the exposure draft.

As a result of adopting accrual accounting, OPEB expense increases by $30,000 (from $10,000 to $40,000). As noted in the exhibit, this expense is comprised of three components: the service cost of $8,000, based upon the required actuarial assumptions discussed previously and individual cost data for its employees; an interest cost of $20,000 (10% of the transition liability of $200,000); and the amortization of $12,000 of the transition liability.

The Transition Liability

The transition liability which figures in two of the three components of the OPEB expense is the difference between the present value of the future obligations (called the accumulated postretirement benefit obligation or APBO) and the fair value of the assets contributed to the OPEB plan. Since, as noted earlier, companies have generally not funded their plans, this transition liability can be expected to be sizable and must be amortized over the average remaining service life of the employees or, alternatively, over 15 years if the average service life is shorter For the XYZ Company, the $200,000 initial transition liability is being amortized on a straight line basis over the 16.6 years of average remaining service life, thereby increasing OPEB expense by $12,000.

The conceptual parallels between the OPEB transition liability and the transition asset/liability under SFAS No. 87 and pension accounting are obvious. However, the practical impact is quite different. Although an area of controversy during the promulgation process, by the time SFAS No. 87 became operative, many companies had well funded pension plans in which the fair value of their plan assets exceeded their pension obligations. As a result, these companies had a transition asset to amortize which (when combined with other changes dictated by SFAS No. 87) actually served to reduce their pension expense below that calculated under previous pension accounting. This will not be the case with OPEB for a couple of reasons.

First of all, most companies have not funded their OPEB plans so there will be no transition assets, only transition liabilities. Secondly, the proposed standard has incorporated a pay-as-you-go constraint into its required calculations. In general, this precludes a company from applying the delayed recognition provisions of the standard in such a way that its OPEB cost would be lower than that recognized under the old pay-as-you-go approach. [7]

The Expense

The largest part of XYZ's OPEB expense (50% ) is comprised of interest costs on the accumulated postretirement obligation (APBO). Since most firms have never funded this obligation, this will be the rule and not the exception.

Similarly, the amortization of the transition liability can be expected to account for the second largest component of total OPEB expense in the years immediately following adoption of accrual accounting. For the XYZ Company, this item represents 30% of the total expense. Of course, for any particular firm, the exact proportion of this amortization to total expense will depend upon the amortization period chosen (viz. average service life or 15 years, whichever is greater, as modified by the pay-as-you-go constraint).

In sum, a significant portion of the OPEB expense will be the result of companies' failure to fund this retirement benefit in previous years. Yet despite this overall increase in OPEB expense, the actual cash outlays for postemployment health benefits will not change. For the XYZ Company, the amount funded will continue to be the $ 10,000 it had recognized under the pay-as-you-go accounting for OPEB. This pattern can be expected to continue as long as deductions for income tax purposes are limited to the amounts paid out on claims.

Sensitivity Analysis-A New Feature

One new item of disclosure proposed by the FASB exposure draft is the impact of a 1% change in the health care cost rate assumption on the resulting OPEB obligation and expense. This is in part a recognition of the importance of this assumption (which has outpaced the rate of inflation through most of the 1980s) and the difficulty in estimating it accurately. In a broader sense, it signals the FASB's recognition of the need for more useful information-information-which will allow analysts and other users to make their own analytical adjustments to reported numbers. A similar disclosure for a 1% change in the discount rate, though not required in the proposed standard, might prove useful, particularly given the discrepancies between settlement and company specific rates.

In the hypothetical example, the XYZ Company would disclose that a 1% increase in its health care cost trend assumption (from 8% to 9% ) would result in an increase of $5,210 in its OPEB expense (from $40,000 to $45,210) and an increase in the APBO of $26,000 (from $200,000 to $226,000).

OPEB and The Balance Sheet

Although this article has been concerned primarily with the calculation of the expense, some discussion of the OPEB liability is warranted. In fact, it is the disclosure of this liability which has raised much of the furor and which has been the subject of most of the articles written on the postretirement health care controversy. [8]

As noted previously, as a result of implementing the FASB's proposals, the XYZ Company would have calculated an accumulated postretirement obligation of $200,000 as of the beginning of the year of adoption. Since no assets were contributed to the plan prior to this period, the full APBO becomes the transition liability which will be amortized over the average remaining service life of its employees. Since $12,000 of the liability is amortized during this period and has already been included in the current expense, only $188,000 remains as the unamortized transition liability at the end of the year. However, this amount will not be included on the face of the balance sheet itself, at least not immediately.

Instead, the FASB exposure draft has proposed a five-year implementation period before the full OPEB liability must be included in the financial statements. This is similar to phase-in allowed for the recognition of the minimum liability of pension accounting and, as a result, the only liability required to be booked in the first year is the $30,000 difference between the OPEB expense which was accrued and which appears on the income statement and the $10,000 which was actually funded. Until companies adopt the liability provisions of OPEB accounting, users will have to look to the footnote disclosures for the additional information needed to calculate the full liability for postretirement health benefits.

In the case of the XYZ Company, an additional liability of $158,000 could be picked up from an examination of the footnote disclosure. This represents the difference between the unamortized transition liability at year-end of $188,000 and the $30,000 liability which has already been included in the balance sheet.


A major change is about to take place in the way in which companies will have to report the postretirement health benefits which they offer to their employees. Although the exact method mandated by the final standard may be different from that proposed in the FASB exposure draft, its future reporting will have to be consistent with accrual accounting.

This new treatment is at the same time familiar and different. It shares many of the same characteristics of pension accounting, but care must be taken to recognize the inherent differences in the nature of the two benefits, OPEB v& pension, and the consequential differences in reporting which will be required. Since most firms have never accrued postretirement health benefits before, adoption of the new standard will increase OPEB expenses for many firms and create a corresponding OPEB liability that has never been disclosed.

Finally, the implementation of the new proposals will require both an accumulation of new data necessary to estimate costs and an appreciation of how the new provisions affect the financial results and future operations of the company. For many this will be the most difficult aspect of the future of accounting for postretirement health benefits. [2]


[1] ID. Gerald Searfoss & Naomi Erickson, "The Big Unfunded Liability: Postretirement Healthcare Benefits, "Journal Accountancy, (November 1988), pp. 28-39, at p. 32.

[2] FASB, "Postretirement Benefits Other Than Pensions," Exposure Draft FASB, February 1989).

[3] Robert F. Randall, "The Coming Crunch in Employee Benefits," Management Accounting, (january 1989), pp 18-22, at p. 19.

[4] Coopers & Lybrand, Retirees Heal Benefits.. Field Test of the FASB Proposals. (FEFR 1989).

[5]A range of 5.7% to 13.3%, with a median of 7.9%, was used by participants in the C&L/FERF Field Test; given that health care costs have been rising faster than the Consumer Price Index during the 1980's, the selection of these health care cost trends indicates that many firms expect these increases to continue.

[6] Deduction of the OPEB expenses for income tax purposes is limited to actual cash disbursements for benefit claims.

[7] More accurately stated, additional amortization of the transition obligation is required when the cumulative benefits payments to fully eligible plan participants exceed the sum of the cumulative amortization of the entire transition obligation and the cumulative interest on the unpaid transition obligation. For the specific details of the "pay as you go" constraint see paragraph 106 of the Exposure Draft.

[8] For example see Diana J. Scott, jane B. Adams & joyce A. Strawser, "Retiree Welfare Benefits Come Out of Hiding," CPA journal (November 1988), pp. 26-34, and Dale L. Gerboth, "Accruing the Cost of Other Postemployment Benefits-the Measurement Problem," CPA Journal (November 1988), pp. 36-44.
 Exhibit 1
 Components of the OPEB Expense
 The XYZ Company
 Current New
 GAAP Proposals
 Service Cost -0- $8,000 (a)
 Interest Cost -0- 20,000 (b)
 Amortization of the Transition -0- 12,000 (c)
OPEB Expense $10,000 $40,000
Actual Cash Disbursed $10,000 $10,000

(a) Service Cost = the actuarial present value of the expected postretirement obligation for employee services during the period; for the XYZ Company, based on an assumed health care cost factor of 8% and a discount rate of 10%.

(b) Interest Cost = the increase in the accumulated postretirement benefit obligation (APBO) due solely to the passage of time; for XYZ, based upon 10% interest on an initial transition liability of $200,000.

(c) Amortization of Transition Liability = the delayed recognition into expense of the difference between the fair value of the plan assets and the APBO at the date of adoption; for XYZ, the initial transition liability of $200,000 is being amortized in a straight-line manner over the 16.6 years which constitute the average remaining service life of its employees.

Other Elements in OPEB Expense:

Actual Return on Plan Assets = actual return on the fair value of the plan assets; since XYZ has contributed no assets at the measurement date, there is no return to reduce its OPEB expense.

Amortization of Prior Service Cost = the delayed recognition into expense for an increase in the APBO due to plan amendments; there have been no such amendments in this hypothetical.

Amortization of Gains & Losses = the increase or decrease in pension expense resulting from the differences between expected and actual returns on plan assets as well as from changes in actuarial assumptions (subject to a threshold of the greater of 10% of plan assets or the APBO).
COPYRIGHT 1990 National Society of Public Accountants
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Author:Prober, Larry M.; Sherman, W. Richard
Publication:The National Public Accountant
Date:Feb 1, 1990
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