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Auditing employee benefit plans.

Many significant changes have occurred in accounting for employee benefit plans during the past decade. These changes have already had and will continue to have a significant impact on accountants' responsibilities for employee benefit plans. Statement of Financial Accounting Standards (SFAS) No. 87, "Employers' Accounting for Pensions," [1] standardized the method for measuring net periodic pension expense and expanded reporting requirements. Furthermore, SFAS No. 106, "Employers' Accounting for Post-retirement Benefits other than Pensions," issued in December 1990 [2] attempts to provide better uniformity and comparability in financial reporting of entries offering other post-retirement employee benefits (OPEB) such as health care and life insurance benefits. The Statement requires accrual accounting for OPEB costs rather than the currently used "pay-as-you-go" cash basis method.

All of these changes have contributed to the dawning of a new age for auditors. Though much has been written on accounting for pensions and OPEB, little attention has been placed on auditing employee benefit plans. The primary purpose of this paper is to discuss the audit ramifications of the new accounting rules on employee benefit plans and to present a systematic approach to auditing these plans. Auditing employee benefit plans should have broad interest to the accounting profession, especially academicians and practitioners because of current changes and developments in this area as well as the significance of employee benefit plans and lack of sufficient coverage in the present auditing textbook and professional pronouncements.

Significance of Employee Benefit Plans For

Accountants

Independent auditors should establish audit programs and procedures relevant to the new developments and changes in accounting for employee benefit plans for the following important reasons. First, if the auditor does not establish expertise in this area, the client will approach another CPA firm who has already established such expertise.

Second, the rapid growth of health care costs, the multi-trillion-dollar magnitude of pension and OPEB assets and the possibility of large-scale pension and OPEB fraud necessitate the establishment of a strong internal control structure by management and consideration by the auditor. [3] Third, employee benefit plans including pensions and OPEB are part of employee compensation. This implies that employees assign a value to pension and OPEB promises and are willing to accept smaller current wages because of these promises. Therefore, the auditor's examination of pension and OPEB promises is an integral part of auditing labor and salary expenses.

Fourth, both the Department of Labor and Congress have criticized the quality of the Employee Retirement Income Security Act (ERISA) auditing. The Labor Department proposed legislation that would strengthen enforcement of rules governing pensions and OPEB. [4] The proposed changes in ERISA make pension and OPEB plans more accountable to the Department of Labor and Congress. This proposal also requests that the American Institute of Certified Public Accountants (AICPA) revise its audit and accounting guide pertaining to pensions and OPEB.

The revised AICPA audit and accounting guide would expand the auditor's responsibility in the following areas: assessing risks, providing reasonable assurance of detecting and reporting material errors and irregularities, searching for the possibility of illegal acts by a client, obtaining and evaluating sufficient competent evidence to support significant accounting estimates, the form of the auditor's report, the ability of employee benefit plans to continue as a going concern, and finally the communication with audit committees and management regarding audit findings. [5] These expanded areas are directly related to the nine Statements on Auditing Standards issued in 1988 as part of "expectation gap agenda" and will be discussed in the remainder of this article.

Related Accounting

Pronouncements

Currently, the two most pervasive accounting standards concerning employee benefit plans are SFAS Nos. 87 and 106. These Statements have improved financial statements' comparability, primarily because they reduce the flexibility allowed in determining periodic pension and OPEB expense. In addition, SFAS No. 106 requires that OPEB costs and liabilities be recognized on an accrual basis as services are rendered. The provisions of these new accounting rules affect three areas of financial reporting:

1. Income statement;

2. Balance sheet; and

3. Footnote disclosure.

Income Statement Effects

According to SFAS 87, periodic pension expense is comprised of six elements: service cost, interest cost, amortization of unrecognized gains or loses, amortization of prior service cost, amortization of transition cost and expected return on plan assets. OPEB expense consists of the same basic six components. However, OPEB cost measurement would also include estimated effects of medical cost inflation and the impact of technological advancements. According to the field test sponsored by the Financial Executives Research Foundation (FERF) [6], OPEB costs determined on an accrual basis were two to seven times higher than under the currently used cash basis of accounting.

Balance Sheet Effects

Existing accounting rules require that when cash payments to the pension or OPEB fund exceed reported expense, the difference is recognized as an asset. Alternatively, when pension or OPEB expense exceeds cash payments, the difference is reported as a liability. In addition to this liability, companies may be required to recognize an additional minimum liability in their balance sheets for underfunded pension benefits; the FASB has decided to omit the minimum liability requirement for OPEB. [7] The minimum pension liability is calculated as the excess of the accumulated benefit obligation over the fair value of plan assets. The offsetting debit should be to an unamortizable intangible pension asset account provided that the amount recorded does not exceed the amount of unrecognized prior service cost. Any difference between the additional liability amount and unrecognized prior service cost must be recognized as a contra-equity account.

When SFAS No. 106 is first being implemented, companies may have to recognize a transition liability for unfunded retiree health obligations. This transition liability equals the difference between the Accumulated Postretirement Benefit Obligation (APBO) and the plan's assets, which may be recognized immediately or amortized over future years. The APBO is the present value of all the amounts that the employer anticipate spending on OPEB for current active employees and retirees under its "substantive plan." The APBO should be calculated as if benefits accrued ratably over the period from the date of hire through the date of "full eligibility" for OPEB.

Footnote Disclosure

Pursuant to SFAS Nos. 87 and 106, more information must be disclosed and, more importantly, it must be in a form that will enhance users' understanding and improve intercompany comparability of employee benefit plans. SFAS No. 87 requires that companies disclose the components of pension expense in financial statements footnotes. In addition to the net periodic cost disclosure, the employer/sponsor must provide a detailed reconciliation schedule as a link between the funding status of the plan and the amounts shown on the balance sheet.

The footnote disclosure under the SFAS No. 106 is similar to the requirements under SFAS No. 87. The Statement requires that companies disclose:

1. The components of OPEB accrual expense;

2. The substantive plan that is the basis of the accounting for OPEB;

3. A description of the accounting and funding policies followed for OPEB; and

4. Values of OPEB assets and liabilities.

Independent Auditor's

Examination

The auditor's examination is performed to provide a reasonable assurance about fair presentation of financial statement items in conformity with generally accepted accounting principles (GAAP). Given the new requirement of SFAS No. 87, its companion, SFAS No. 88, "Employers' Accounting for Settlement and Curtailments of Defined Benefit Pension Plans for Termination Benefits," [8] and SFAS No. 106, auditors should modify their audit programs to assess clients' compliance with the provisions of new accounting rules. Despite the complexity and extensive requirements of these new accounting rules, the auditor's objective has not changed. With employee benefit plans, the auditor's operating objectives are to gather sufficient and competent evidence to verify management's assertions about existence, completeness, rights, compliance, valuation and presentation of employee benefit plans related items. Table 1 presents these audit objectives and related test procedures.

The audit program for employee benefit plans can be divided into three major sections. The first section pertains to the development of an overall audit strategy. Section two presents the consideration of internal control structure (compliance tests) and the third section addresses substantiation of employee benefit plans, related financial statement items and adequacy of their disclosures (substantive tests).

Audit Strategy

The auditor should consider both audit risk and materiality in planning the audit, designing audit procedures and gathering and evaluating sufficient competent evidential matter. The auditor's assessment and judgement of audit risk and materiality is related to the field work and reporting standards and, accordingly, has a significant impact on time budgets of an audit engagement, staff assignment, the extent of supervision required, the scope of the audit and using the work of specialists (actuaries).

Both Statement on Auditing Standards (SAS) No. 47, "Audit Risk and Materiality in Conducting an Audit," and an upcoming revision to the AICPA guide Audits on Employee Benefit Plans provide guidance on the auditor's consideration of audit risk and materiality during planning and performing the audit.

Compliance Tests of Employee

Benefit Plans

Establishing strong internal control procedures over employee benefit plans is important for several reasons. First is the possibility of pension and OPEB fraud; potential problems involve including fictitious beneficiaries as well as abuse and corruption by plan trustees and administrators. Second, compliance with government and labor union laws and regulations (e.g., ERISA) must be assured. A third factor to be considered is the magnitude and vulnerability of pension and OPEB assets. According to Hyland and Maria, [9] ERISA-covered pension plans totaling nearly $1.4 trillion represent the largest source of non-bank, private investment capital in the country.

The auditor's consideration of internal control structure for employee benefit plans involves obtaining an understanding of the internal control structure, performing tests of controls and assessing control risk. These objectives can be accomplished

[TABULAR DATA OMITTED]

in the context of study and evaluation of internal control for the payroll cycle or the expenditure/disbursement cycle. The auditor's approach to considering internal control structure should be consistent with SAS No. 55, "Consideration of Internal Control Structure in a Financial Statement Audit," and SAS No.60, "Communication of Internal Control Sgtructure Related Matters Noted in an Audit."

Compliance tests of employee benefit plans require considering objectives relating to transaction authorization, execution and recording of pension and OPEB expenses, and access to pension and OPEB assets. The auditor should:

1. Identify specific control objectives;

2. Describe types of erros and irregulatirities that may arise if any objective is not achieved;

3. Consider necessary control procedures to prevent or detect errors and irregulatirities;

4. Perform tests of controls for employee benefit plans; and

5. Communicate audit findings about employee benefit plans' internal control structure to the plan administrator, management or audit committees in accordance with SAS No. 60.

Substantive Tests of Pension Plans

The nature, timing and extent of employee benefit plan substantive tests are based on the auditor's consideration of:

1. The materiality of pension and OPEB expenses, liabilities and assets to the entity's financial statements; and

2. The reliability and effectiveness of internal control structure policies and procedures as well as the related inherent, internal control and audit risk. Table 2 summarizes the list of audit procedures that should be performed in the examination of pension and OPEB accounting items. [10]

Verify Plan Participants' Data. The review of employee benefit plans files reveals participant data that is used by the actuary and management to compute the plans' benefit obligations and certain components of pension or OPEB cost. The participants' data for pension plans consists of each covered employee's name, sex, birth date, date of hire and pay history.

For OPEB plans additional data such as employees' and retirees' mortality, the percentages of employees retiring at ages 60 and 65, dependency status, life expectancy and the number of employees expected to receive OPEB also would be needed.

The review of several years of employees' records will allow the auditor to determine if the trend in compensation levels will support the participants' data used by the actuary in calculating the plan's benefit obligations and costs. Another factor of importance to the auditor is the average service life of the existing work force. The auditor should apply analytical procedures, suggested in SAS No. 56, to determine the average salary and rate of increase that could be expected over the average life of the work force. The auditor may sample the personnel records of the sponsor to determine if the average remaining life at the time of plan amendment or inception of the Statement is reasonably accurate.

Test of Benefit Payments. Measuring the employer's obligation for pension and OPEB benefits consists of three steps:

1. Projecting the amount and timing of future benefits payments;

2. Discounting projected payments back to their present value; and

3. Allocating the discounted amount among accounting periods.

The auditor should recompute the annual amortization of plan assets and obligations. Payments to beneficiaries can only be sampled and examined if the plan is also audited by the firm; otherwise these must also be confirmed by the plan trustee.

Review and Verify Reasonableness of Assumptions. Many assumptions must be made by management, perhaps guided by the actuary, in calculating pension and OPEB expenses and obligations. The key economic assumptions regarding employee benefit plans are the discount rate, rate of future compensation increases, the expected long-term rate of return on plan assets and assumptions relating to the probability of payment, such as mortality, turnover and early retirement. These assumptions are highly judgmental; both pension and OPEB costs are very sensitive to changes in the underlying assumptions. Since neither SFAS No. 87 nor the proposed Statement on OPEB provide specific guidance on making assumptions, the actuary and management must use their professional judgments and experiences.

SAS No. 57, "Auditing Accounting Estimates," provides guidance to auditors on obtaining and evaluating sufficient competent evidence to support significant accounting estimates and assumptions in financial statements. The auditor should examine the reasonableness of the selected discount rate by first obtaining a clear understanding of management's basis for estimating the discount rate and then comparing the discount rate with both rates published by the Pension Benefit Guaranty Corporation for the current period and expected rates on high-quality, fixed-income securities. The auditors should also assess the consistency and reasonableness of management assumptions underlying selection of the expected long-term rate of return on plan assets by reviewing the plan administrator's rationale for the selected rate and comparing it with the prior rate whenever it is appropriate. Finally, the auditor should ascertain that management assumptions about future conditions in the job market (e.g., the salary scale) and management practice on salary adjustments and post-retirement health care benefits are reasonable and based upon the employee benefit plan's investment strategy.

Verify the Existence and Sufficiency of Plan Assets. SFAS No. 87 requires that plan assets should be measured as of the date of the financial statements or if consistently applied as of a date up to three months earlier. The auditor should obtain a copy of the trustee's statement and confirm the beginning and ending plan asset balances directly with the trustee. The auditor should confirm the fair value for plan net assets with the trustee and reconcile these amounts to the plan records. The auditor should also verify beginning balance of the prepaid pension cost or any accrued pension liability by comparing it to the client's prior year-end balance sheet.

Search for Liabilities. The auditor should review the calculation of the minimum liability required by SFAS No. 87 and ensure that the client has properly recognized both the minimum liability for unfunded pension benefits and the corresponding intangible asset or contra-equity account. In addition, companies would be required to account for previously unrecognized unfunded OPEB liabilities. The auditor should ensure that this transition obligation is properly measured and disclosed in the footnotes to financial statements and is subsequently amortized on a straight-line basis over the average remaining service period of plan participants.

Examine the Funding and Tax Status. SFAS 87 expands the footnote disclosures related to the funding status of the company's pension plan as discussed in the previous section. According to SFAS No. 106, OPEB plans are subject to pension funding standards, therefore employers would be required to make contributions for OPEB during the year for normal cost and also for the amortization of any unfunded accrual liabilities. In the future, management may attempt to reserve unequivocally the right to change or terminate the employee benefit plan or limit services paid by the plan. Thus, management may redesign their employee benefit plans and accounting systems. The auditor should examine management's selected funding alternatives and the rationale for such selection, and be alert to the plans and systems development process as well as the integrity of resulting plan changes and system design.

Verify Proper Classification of Employee Benefit Plans. SFAS 87 prohibits the sponsor of multiple plans from netting the obligations and assets of the individual plans unless the assets of one plan may be used to meet the obligations of another. To determine compliance, the auditor must segregate the assets and obligations of the plans and determine the funding, liability and asset portions separately.

In the spirit of SFAS 87, the sponsors and plans are separate accounting entities with no material financial interest existing between the sponsor and the fund itself. To assure that the separation in fact does exist, the sponsor may borrow or finance only up to 10% of the aggregate net assets of the plan at any given time. The auditor must test notes and bonds payable to determine if these are held by the plan and, if so, the extent to which the plan is a creditor of the sponsor. Also, the auditor should ascertain that the plan has no more than 10% of its assets in the equity of the sponsoring company.

Consult with an Independent Actuary. Given the complexity of employee benefit plans accounting standards, it probably will be necessary for the auditor to seek the expertise of an independent actuary. This should not be used as a substitute for the auditor's work or judgment, but may lower the requirement for obtaining additional information and lower the auditors' exposure in the event of litigation.

SAS No. 11 states that the auditor may use the work of a specialist as an audit procedure to obtain competent evidential matter. The auditor should document the understanding that exists between the auditor, the client and the actuary as to the nature of the actuary's work. This documentation should include:

1. The objectives and the scope of the actuary's work;

2. Sufficient and competent evidence about the qualification and reputation of the actuary;

3. Evidence of sufficient understanding of the methods and assumptions used by the actuary; and

4. Evidence of adequate examination of accuracy and reliability of accounting data provided to the actuary.

A confirmation letter from the client's actuary is the auditor's primary means of obtaining pension and OPEB cost and obligation information and gathering evidence regarding reasonableness of the underlying assumptions. The standard actuary confirmation letter requests participant information, pension and OPEB cost measurements, benefit obligations and other information. A draft of the standard letter entitled "Pension Plan Actuarial Information" can be found in the AICPA Audit and Accounting Manual. The same standard letter can be used to obtain OPEB information from the actuary. The auditor should review the information furnished, discuss the content of the letter with the actuary and decide whether employee benefit plans accounting and disclosures are in accordance with GAAP.

Recalculation and Test of Mathematical Accuracy. The auditor should go beyond the information provided by the actuary in the standard confirmation letter and recalculate components of OPEB and pension expenses and obligations. For example, the actual return on assets requires both verification of mathematical accuracy and examination of the existence of plan assets. Amortization of the unrecognized service cost requires both a mathematical accuracy test and verification and confirmation of the employees who meet the criteria for this component.

Examine Adequate Presentation and Disclosure of Employee Benefit Plans. The auditor should review financial statements to determine that employee benefit plans and related accounts are properly classified and described and that all material information is disclosed (as discussed earlier). The auditor should determine that accounting and disclosures for employee benefit plans are in accordance with new accounting rules as well as government and tax related regulations and laws.

Other Test Procedures. Performance of other substantive test procedures will vary depending, among other matters, on the significance of employee benefit plan amounts and disclosures to the financial statements. The auditor should obtain representation letters from plan management or legal counsel indicating compliance with applicable accounting rules, government and Department of Labor regulations and tax laws. The auditor should review subsequent events that might have an impact on the plan's financial statements including reading the board of directors' minutes for matters relating to employee benefit plans.

Inquiring of the plan administrator and management regarding: (1) events or circumstances that may jeopardize the plan's funding and tax qualification status; and (2) prohibited transactions or breaches of fiduciary responsibilities under ERISA would assist the auditor in detecting and reporting both material errors and irregularities as well as illegal acts by the client. The auditor should assess the rik that errors and irregularities (e.g., prohibited transactions) may cause the financial statements to contain a material misstatement of employee benefit plans' assets, obligations and expenses in compliance with SAS No. 53.

A typical audit program usually does not contain audit procedures designed specifically to detect illegal acts, though normal audit procedures may alert the auditor to them (e.g., noncompliance with ERISA). In accordance with SAS No. 54, if the auditor becomes aware of a possible illegal act, the auditor should gather sufficient information to evaluate the effect on benefit plan statement amount, including the nature of the act and how it occurred. The auditor should discuss this information with the plan administrator or management at least one level above those who are involved. The auditors should inform the audit committee about occurrence of illegal acts and any misstatements having a direct and material effect on the determination of employee benefit plans financial amounts in accordance with the guidance set forth in SAS No. 61, "Communication with Audit Committees."

Finally, in accordance with the provisions of SAS No. 58, "Reports on Audited Financial Statements," and SAS No. 59, "The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern," when there is substantial doubt about the client's ability to continue delivering promised employee benefits plans, the auditor should obtain information regarding management's actions that are intended to mitigate the effect of such conditions and assess the likelihood that such actions can be effectively implemented. If the auditor concludes that it is probable that the client would terminate the employee benefit plan within a reasonable period of time (e.g., within a next fiscal year) he should disclose this fact in an explanatory paragraph following the opinion paragraph in the audit report.

Conclusion

SFAS Nos. 87 and 106, the new SASs and current amendments to ERISA have necessitated changes in the audit of employee benefit plans. The upcoming revision of AICPA guide, Audits of Employee Benefits Plans will present auditors with a set of changes and challenges that should be considered in performing the audit of employee benefit plans.

This article has addressed the development of audit procedures to assess compliance with the provisions of new accounting rules and government and tax laws. Given the magnitude, dimensions and vulnerability of pension and OPEB plans, the auditor should exercise some degree of skepticism in designing an appropriate audit program. Auditors should perform compliance tests to determine whether the plan trustees and administrators have adhered to the provisions of ERISA. If the consideration of internal control structure indicates employee benefit plans control procedures are unreliable, the auditor should increase the scope of analytical procedures and other substantive tests of plan transactions presented in this paper.

Finally, companies affected by the new accounting rules may redesign their employee benefit plans and accounting systems. Thus, the auditor must be alert to the plans and systems development process and the integrity of resulting plan changes and systems design. This article provides auditors with guidelines to:

1. Better understand the provisions of th new accounting rules on employee benefit plans; and

2. Design proper and effective audit plans and procedures for the examination of employee benefit plans' related financial statement items.

Footnotes

(1) Financial Accounting Standards Board, "Employers' Accounting for Pensions," Statement of Financial Accounting Standard No. 87, (FASB, December, 1985).

(2) Financial Accounting Standards Board, "Employers' Accounting for Post-retirement Benefits other than Pensions," Statement of Financial Accounting Standards No. 106, (FASB, December 1990).

(3) Richard A. Ippolito, "A Study of the Regulatory Effect of the Employee Retirement Income Security Act," Journal of Law and Economics, (April 1988), pp. 85-125.

(4) Albert R. Karr, "Labor Unit Seeks Tougher Enforcement of Rules on Pensions, Other Benefit Plans," The Wall Street Journal, (March 21, 1990), Section A2.

(5) Andrew J. Capelli and Ian A. Mackay, "Beyond ERISA: The Auditor's Responsibilities," Journal of Accountancy, (April 1990), pp. 67-77.

(6) Financial Executive Research Foundation, 10 Madison Avenue, P.O. Box 1938, Norristown, NJ 07962-1938.

(7) SFAS No. 106, loc. cit.

(8) Financial Accounting Standards Board, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," Statement of Financial Accounting Standards No. 88, (FASB, December 1985).

(9) James B. Hyland and Raymond Maria, "Proposals Seek to Minimize Fraudulent Reporting Activities," Pension World, (July 1988), p. 35.

(10) See also George R. Zuber, "What Auditors Should Know About FASB Statement 87," Journal of Accountancy, (March 1988), pp. 38-48 and Richard Schwartz and Michael J. Gillmore, "Auditing Pension Costs and Disclosures," CPA Journal, (June 1988), pp. 16, 18-20, 24-25.

Paula B. Thomas, CPA, CMA, DBA, is an associate professor of accounting at Middle Tennessee State University in Murfreesboro. She has published several articles in both professional and academic journals.

Zabihollah Rezaee, PhD, CPA, CMA, CIA, CFE, is an associate professor of accounting at Middle Tennessee State University in Murfreesboro. He has published numerous articles and has received several honors and awards.
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Author:Thomas, Paula B.; Rezaee, Zabihollah
Publication:The National Public Accountant
Date:Mar 1, 1992
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