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Auditing postretirement benefits: how to deal with FASB 106.

Much has been written about the financial statement impact of Financial Accounting Standards Board Statement no. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (see "The New FASB 106: How to Account for Postretirement Benefits," by James R. Wilbert and Kenneth E. Dakdduk, JofA, Aug. 91, page 36). However, little attention has been given to how to audit amounts to be reported under Statement no. 106, which requires employers to accrue the cost of retirees' health care and other postretirement benefits.

So far few auditors have had to tackle the issues--with the exception of those auditing financial statements of companies that have already adopted the standard or have made disclosures under Securities and Exchange Commission Staff Accounting Bulletin (SAB) no. 74, Disclosure of the Impact That Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period (see "How Business Is Dealing with FASB 106," by Stanley Zarowin, JofA, Mar. 92, page 67). Many companies, particularly smaller ones, have not yet decided how they will manage these benefit costs, nor have they calculated the amounts that will need to be reported under Statement no. 106. If they don't act this year, most companies will be required to adopt the standard beginning with the first quarter of 1993--except for small nonpublic companies and those with non-U.S. plans, which have until 1995.


Although Statement no. 106 applies to a variety of postretirement benefits, including retiree life insurance, housing, tuition and legal subsidies, health benefits are generally the most significant and the most difficult to measure. and audit. Accordingly, the focus here is on benefits provided under defmed benefit retiree health plans. Similar considerations may apply to other benefits.

Auditors should recognize that the data required by Statement no. 106 are actuarially determined. Therefore, the relevant auditing standard is Statement on Auditing Standards no. 11, Using the Work of a Specialist, under which auditors

* Audit input data used by the actuary.

* Consider the actuary's professional qualifications, reputation and independence.

* Review the methods and assumptions used.

* Compare the resulting output with amounts in the financial statements.

Although conceptually this seems rather straightforward, auditors need a good knowledge of their clients' plans and Statement no. 106 itself, as well as considerable audit judgment. While auditors should not repeat the actuary's calculations or make actuarial judgments, they are required to understand the actuary's methods and assumptions and to determine whether they meet Statement no. 106 requirements. The auditor, should recognize that many Statement no. 106 factors-such as health care cost trend rates, the substantive plan terms and per-capita claims costs development-- can have a material impact on the measurements of reported obligations and expenses, yet often are not easily determined. So, an appropriate understanding and timely and detailed discussions and close coordination between the auditor, the actuary and the client are often critical in formulating a Statement no. 106 strategy.


The basic approach to auditing retiree health benefits is the same as auditing pension amounts under FASB Statement no. 87, Employers' Accounting for Pensions; however, dealing with Statement no. 106 often will require more difficult judgments. The considerations discussed here are intended not to be all-inclusive, but only a general guide to the more significant audit issues. As with any such program, the specific audit steps will vary, depending on, among other factors, the materiality of the amounts, results of the auditor's consideration of inherent and control risk factors and how Statement no. 106 is adopted.

Auditing standards do not require an actuary to be on the engagement team, but because of the complexity of Statement no. 106, there may be circumstances when an auditor may wish to consult with another actuary. Experience has shown that this may be particularly helpful in improving audit efficiency in the year Statement no. 106 is adopted.

The auditor must consider the qualifications of the actuary, focusing on credentials and reputation. Because many of the health-care-related assumptions under Statement no. 106 may require specialized actuarial expertise, casualty insurance or pension actuaries may not have the necessary qualifications. If the auditor finds the actuary's qualifications unsuitable, a review of the actuary's work by another actuary may be necessary. The auditor also should consider the actuary's relationship to the client; an actuary who is unrelated to the client usually provides greater assurance of reliability.


Statement no. 106 requires accounting for the terms of the substantive plan. This may require that changes to the current written plan be anticipated in measuring obligations and expenses. For example, if the employer's cost-sharing policy, as evidenced by past practices or communications made to plan participants, differs from the written plan, that policy becomes the substantive plan. This area will require considerable audit attention.

To determine whether the client has identified the substantive plan, the auditor needs a clear understanding of the nature, coverage and other aspects of the plan. This may require

* Reading the summary plan description, internal memorandums and union contracts.

* Asking management and possibly the plan administrator or insurance carrier about actual plan operations that differ from the plan documents.

* Determining whether it is appropriate to anticipate plan changes as part of the substantive plan. Generally, the auditor considers past practices of maintaining a consistent level of cost sharing between the employer and retirees or regular increases or decreases in the employer's share of benefit costs. The auditor also considers whether the employer has the ability, and has communicated its intent, to change the plan's cost-sharing provisions.

The auditor must determine whether the actuary's valuation report reflects a reasonable interpretation of the substantive plan terms. This involves determining whether significant changes since the prior year have been properly accounted for and disclosed. This is particularly important in the adoption year, since the transition obligation is measured as of the beginning of the year, and plan changes during the year may need to be accounted for separately--unless they were reflected as part of the substantive plan at the beginning of the year. The auditor also should be sure the client representation letter addresses the substantive plan, specifically focusing on the employer's ability and intent to make changes in the plan.


The auditor should test the basic census data used by the actuary for completeness and accuracy. While these data often parallel information used for pensions, they may not be identical. Pension data, for example, usually exclude retirees who receive lump-sum pensions and include employees who were vested but left before retirement.

Actuaries sometimes estimate certain census data, such as number and ages of covered dependents, when that information isn't readily available. In such cases, the auditor should assess such estimates' appropriateness.


Statement no. 106 says the employer's historical claims data for the plan should be used to develop per-capita claims costs by age if these data are considered indicative of the employees current cost of providing benefits. The statement recognizes that sufficiently reliable data are not always available, in which case per-capita claims cost should be based, entirely or partially, on claims information of other employers.

Many employers' historical records are not sufficiently reliable for use as the sole basis for computing per-capita claims costs. Accordingly, the actuary will commonly use data compiled by an actuarial firm, an employee benefits consultant or an insurance company. In some cases, the actuary will not use the employer's claims data at all, concluding it is more appropriate to rely solely on external data sources.

The above scenarios are consistent with the findings of recent studies and with current actuarial standards. The studies, conducted by Coopers & Lybrand on behalf of the Financial Executives Institute, the Institute of Management Accountants and the National Association of College and University Business Officers, indicated the health care claims administration systems of most employers, particularly small and medium-sized ones, are incapable of providing sufficiently reliable information to eliminate the need for actuarial adjustments to historical claims data. Actuarial Standards Board Standard no. 6, Measuring and Allocating Actuarial Present Values of Retiree Health Care and Death Benefits, says actuaries, in determining per-capita claims costs, may make various adjustments to historical claims data after considering their volume, availability, credibility, quality and consistency with similar information.

The variety of sources. of claims data poses a conceptually challenging auditing issue: To what extent does the auditor need to test the underlying data? Two schools of thought are emerging. One holds that clients' historical claims data represent input data to the actuary, similar to census data, which must be tested. The other holds that, because Statement no. 106 considers per-capita claims cost as an assumption, the auditor, regardless of the underlying data used, needs to consider only the assumption's reasonableness.

No matter what auditing approach is used, the auditor must consider whether the per-capita claims cost is based on sufficiently appropriate and reliable sources. In our view, this is accomplished best by basing the audit approach on the data source's nature: When the actuary makes greater use of client historical data, the auditor will focus more attention on that data's appropriateness and reliability, which may be audited by testing the employer's records. On the other hand, when the actuary emphasizes an outside data source more, the auditor will direct more attention to the reliability of that source by looking at its nature and underlying makeup and at how it was applied. In the latter case, the auditor might consider how the actuarial profession accepts the data source and how it is assembled and maintained.

The auditor should remember that if a client's historical claims data are indicative of the current cost of providing plan benefits, then that data must be used. Even in such cases, however, the actuary also will use other sources in making appropriate adjustments. Therefore, the auditor will usually consider both client and external data sources.


In a valuation, an actuary may use 20 or more assumptions, each of which could affect the valuation materially.

Some of the assumptions used in computing benefit obligations are unique to health care. Others are similar to the assumptions used in computing pension benefit obligations, but they may have an even greater effect on nonpension benefit obligations. For still other assumptions, the audit considerations are virtually the same as when the assumptions are used for computing pension obligations.

Assumptions unique to retiree health benefit obligations include health care cost trend rates, spousal and dependent assumptions and assumed plan participation levels for future retirees. Of these assumptions, determining that health care cost trend rates are not unreasonable can be particularly difficult. The auditor should review the method of determining cost trends, the direction and pattern of change and the ultimate rates.

In light of the significant rise in health care costs over the past several years and the lack of specific guidance in Statement no. 106 for determining trend rates, considering the rates' appropriateness will require a high. level of professional audit judgment. An analysis of the rates used in selected actuarial valuations completed under Statement no. 106 in 1990 and 1991 indicates a wide variation. Initial trend rates varied from 8% to a few that were over 20%; the rates then declined gradually, with the final rate generally at between 5.5% and 7%. These numbers do not indicate what might be acceptable but illustrate the rate range an auditor might face. The trend rates used must reflect the particular client facts and circumstances.

In reviewing health care cost trend rates, the auditor usually should

* Review recent historical trends actually experienced by the employer, taking into account plan changes and other factors, and compare them with the near-term trend assumptions.

* Consider how quickly the near-term trends are anticipated to change.

* Review general inflation estimates and consider the extent to which medical inflation is expected to exceed general inflation.

As to demographic assumptions, such as turnover, mortality and retirement ages, the auditor should determine whether the actuary applied the same assumptions used in calculating pension benefits. It's appropriate to discuss any variances-which may make sense because of different participant groups, retirement eligibility, etc.--with the actuary.

These assumptions generally have a greater impact on retiree health care obligations than on pension obligations. For example, the early retirement assumption may not be as significant in a pension valuation because pensions to early retirees are usually reduced, whereas health benefits to early retirees are usually significantly higher before age 65 because retirees are not eligible for Medicare until then.

For assumptions such as discount rates, expected long-term rates of return and future compensation levels, the audit focus and procedures parallel those for testing measurement of the pension obligation. Here, too, audit procedures typically should include determining whether the rates are consistent with or reconcilable to those used in calculating the pension obligation.


SAS no. 11 says specialists-that is, actuaries--are responsible for the appropriateness of the methods used during the course of their work. Auditors, however, retain the responsibility for determining whether the methods employed by the actuary are in accordance with generally accepted accounting principles as prescribed by Statement no. 106. These include the

* Attribution method and period (Statement no. 106, paragraphs 43-44).

* Amortization of unrecognized prior service cost (paragraphs 50-55).

* Amortization of net gain or loss (paragraphs 56-62).

* Calculation of the transition obligation (or, in rare cases, the transition asset) and its immediate or prospective recognition (paragraphs 108-113).

The auditor should consider whether any business combinations, plan settlements, plan curtailments or special termination benefits have been properly accounted for. Audit procedures for funded plans generally are consistent with those used in testing pension plan assets.


Following are other procedures the auditor might consider:

* Determine whether the disclosures required by Statement no. 106 have been made. If Statement no. 106 has not been adopted, determine whether disclosures required by SAB no. 74 have been made, if applicable.

* If the plan is funded through a Voluntary Employee Benefit Association trust, determine whether the trust has obtained a tax determination letter and consider whether it is subject to unrelated business income tax. Consider whether reports are filed with the appropriate regulatory agencies as required.

* Consider whether significant events that occurred after the measurement date would materially affect the computation of benefit costs.

* Determine whether all appropriate items related to the plan have been included in the client representation letter.

Auditing an employer's accounting under Statement no. 106 creates new and highly judgmental issues for auditors. As a result, it is critical that they begin early to understand the key issues and discuss them with clients. Close coordination between the client, the auditor and the actuary is vitally important. Perhaps most important, auditors should "get behind" the numbers-and that means using the work of, not simply relying on, the' actuary.

RICHARD M. STEINBERG, CPA, is a partner, national auditing directorate, of Coopers & Lybrand, New York. He served as a .member of the American Institute of CPAs committee on pensions and ERISA, the task force on pension plans and pension costs, the employee benefit plans and ERISA special committee and the employee benefit plans committee. He is chairman of the AICPA FASB 106 communications with actuaries task force and a member of the Labor Department liaison task force. MURRAY S. AKRESH, CPA, is a director in Coopers & Lybrand's actuarial, benefits and compensation technical services unit, New York. He was a coauthor of research studies on retiree health benefits conducted by the firm for the Financial Executives Institute, the Institute of Management Accountants and the National Association of College and University Business Officers. KEITH F. JENSEN, CPA, is a manager in the Coopers & Lybrand national auditing directorate, New York, where he is responsible for auditing issues relating to retiree health and pension benefits.


HERE IS A typical checklist for a FASB Statement no. 106 audit:

* IDENTIFY THE client's postretirement benefit plans subject to Statement no. 106.

* READ AVAILABLE plan documents and ascertain the specific plan terms currently in effect and, by examining relevant documents, consider the substantive plan terms.

* CHECK THE qualifications of the client's actuary and assess his or her reputation and relationship to the client.

* DETERMINE WHETHER the valuation report prepared by the actuary contains the correct plan terms and whether the substantive plan has been determined in accordance with Statement no. 106.

* TEST THE census data used by the actuary for completeness and accuracy.

* OBTAIN AN understanding of the actuary's use of historical employer-specific health care claims data in the development of per-capita claims costs. If the actuary used external data sources, obtain an understanding of the makeup of these sources and how they were used.

* IF CENSUS or health care claims data are provided by a third-party administrator, consider obtaining an auditor's report on the administrator's internal control structure.

* TEST THE underlying health care claims costs that were used by the actuary, as necessary.

* OBTAIN AND read the actuarial valuation report and discuss key issues with the actuary and the client, as necessary.

* DETERMINE THAT the assumptions that were used by the actuary are not unreasonable.

* ASCERTAIN WHETHER methods that were used are those prescribed by Statement no. 106.

* IF THE PLAN is funded, obtain a copy of the plan trustee's report and determine whether the funding arrangement meets the definition in Statement no. 106. In addition, review the valuation of plan assets.
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Title Annotation:Financial Accounting Standards Board Statement
Author:Jensen, Keith F.
Publication:Journal of Accountancy
Date:Aug 1, 1992
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