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Postretirement benefits other than pensions: a look at the new rules.

In December 1990, FASB issued SFAS 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions," which is effective for many employers in 1993 and the remainder in 1995. Under the new rules, companies will be required to recognize expense under the accrual basis of accounting for the benefits promised rather than the pay-as-you-go (cash basis) method currently used by most employers. Adoption of this standard is expected to have a significant impact on financial statements since the eggregate unfunded obligation in the private sector has been estimated in the hundreds of billions. The purpose of this article is to briefly discuss how the accrual method differs from the popular pay-as-you-go method and how the requirements of this standard may affect the financial statements of those employers who provide their employees with postretirement benefits other than pensions.

Pay-As-You-Go and Accrual

Basis of Accounting

Most employers currently account for postretirement benefits on a cash basis method in which the amount of premiums or claims paid is recorded as expense for the period. Future benefits are not funded since there are no legal requirements and funding is unattractive due to limited available tax incentives. Therefore the pay-as-you-go method results in an expense equal to cash paid and no ecording of liability for future benefits of existing employees.

The accrual basis of accounting measures and estimated cost of providing future benefits and recognizes it over the employee service pperiod since the promise to provide benefits in exchange for service constitutes a form of deferred compensation. Under SFAS 106, two obligations are measured: the Expected Postretirement Benefit Obligation (EPBO) and the Accumulated Postretirement Benefit Obligation (APBO).

EPBO is the actuarial present value as of a particular date of the benefits expected to be paid on behalf of an employee reduced by the present value of contributions expected to be received from the employee.

APBO is the actuarial present value of benefits attributed to employee service rendered to a particular date. The APBO and EPBO are equal on or after the date of full eligibility.

SFAS 106 requires that the cost of the postretirement benefits be accrued ratably over the service period to full eligibility. By requiring that the cost be allocated over service period to full eligibility rather than to expected date of retirement, expense is recognized sooner and the liability increases quicker. Once EPBO and APBO have been calculated and the full eligibility identified, net periodic postretirement benefit cost (OPEB) can be determined.

Net Periodic OPEB Cost

Net periodic OPEB cost is measured as the net of potentially six components.

1. Service Cost. The service cost component is the portion of the EPBO attributable to the current year's service and may be determined as: Service Cost = (1/Total Service to eligibility) X EPBO

2. Interest Cost. Since APBO is recognized on a present value basis, interest cost reflects the imputed growth in APBO during the period at the assumed discount rate. Interest cost is calculated as follows: Interest Cost = Beginning of Year APBO X Discount Rate

3. Actual Return on Plan Assets. Actual return on plan assets represents the investment return on any plan assets set aside to fund the benefits promised and will reduce net periodic cost. Since few employers have funded any of their OPEB liability, this component will be negligible for most employers, at least initially.

4. Prior Service Cost Amortization. Prior service cost is incurred when there is a plan amendment or initiation that increases benefits and provides credit for employee service rendered before the amendment. Since the underlying presumption is that plan amendments are granted with the expectation of future economic benefit, the prior service cost is amortized into income over the remaining service period to full eligibility. Amortization begins the accounting period immediately following the amendment or initiation.

5. Gain or Loss. The gain or loss included as a component of net period OPEB cost consists of three elements: (1) the difference between actual and expected return on plan assets, (2) immediate recognition of gain or loss or amortization of the unrecognized net gain or loss from previous periods, and (3) any amount immediately recognized because of a decision to temporarily deviate from the substantive plan.

Gains and losses that are not immediately recognized are amortized over the average remaining service life to expected retirement. Amortization is required only if the beginning of the year unamortized amount exceeds the greater of 10% of the APBO or the market-related value of plan assets.

6. Transition Obligation. The transition obligation is the unfunded APBO as of the date the statement is initially applied. Since most employers have not funded their plans, the transition obligation will equal APBO. This obligation can be immediately recognized in income or amortized over the average remaining service period to retirement. If this period of tie is less than 20 years, employers may elect to amortize over 20 years. Immediate recognition will be treated as an accounting change and will not be included as net periodic cost. Only if amortization is elected will transition obligation be included as a component of OPEB cost.

OPEB expense calculated according to SFAS 106 will be greater than amounts presently reported on a cash basis for most companies. For companies with a relatively large number of retirees, it has been estimated that the annual OPEB expense would only increase two to seven times amounts reported on a cash basis. But companies with a young work force and few retirees may experience a much higher increase in expense. This higher expense will result in a drain on equity and an increase in recorded liabilities.

Alternative Treatment of

Transition Obligation

The transition obligation is the amount of the unfunded APBO for the beginning of the fiscal year in which the statement is adopted. This off-balance sheet amount will equal APBO for almost all employers, because few plans have been funded. The transition obligation may be recognized immediately or may be amortized over the average remaining service period or 20 years if the average remaining service period is less than 20 years.

Companies that elect to recognize the transition obligation immediately as the cumulative effect of an accounting change and a corresponding unrecognized liability will experience


a large negative impact on their reported earnings in the year of change and a significant reduction in reported equity. This OPEB liability, if significantly large, could result in violation of financial covenants of loan agreements.

Deferral and amortization of the expense, accompanied by a rapidly increasing liability, would be a drain on reported earnings for many years and would still result in a reduction of reported equity, although more gradual than with immediate recognition. An example of the alternative treatment of the transition obligation is included in Illustration 1. When the obligation is immediately recognized into income as a cumulative effect, no part of the $1,600,000 is included in OPEB cost. The OPEB cost for 1993 and 1994 is just the sum of service cost and interest cost. If the transition obligation is deferred and amortized, no cumulative effect exists. The $1,600,000 is amortized over 20 years ($80,000/year) since the average remaining service period is less than 20 years. Therefore OPEB cost under the deferral method is $80,000 higher in 1993 and each of the following 19 years. However, the first year, net income will be $1,520,000 higher under the deferral method which will be offset by lower net income of $80,000 for each of the next 19 years ($1,520,000). The OPEB liability, which is the part of the OPEB cost and cumulative effect that has not been paid, is $1,520,000 lower for the deferral method. However, the liability will increase by $80,000 more than immediate recognition method each year for the next 19 years.

To minimize the negative impact on future earnings, some companies will recognize the transition obligation immediately. Future earnings would not include the expense associated with amortization of this amount. The higher earnings with the lower equity as a result of the immediate recognition will improve return on equity, dramatically in some cases. A lack of comparability will exist between companies choosing different alternatives.

Negative Plan Amendments

Since requiring accrual basis accounting for postretirement benefits may have a major impact on reported expense and corresponding liability, employers may implement changes in plan design to reduce the amount of benefits promised. For example, employers could impose or increase retiree contribution levels or deductibles, reduce benefits and coverage, establish ceilings on the level of benefits to be provided, and/or require employee prefunding.

Changes in the plan made prior to the adoption of SFAS 106 will reduce APBO, and therefore the amount of transition obligation and future service cost. Changes established after the adoption of the standard which reduce benefits will be considered a negative plan amendment.

Negative plan amendments reduce APBO, resulting in a gain. However, immediate recognition of this gain is not permitted by the standard. The effect of the amendment must be offset first against any unrecognized prior service cost and second against any unrecognized transition obligation. Any excess must be amortized over the period to full eligibility or life expectancy when virtually all participants are fully eligible.

The reduction of benefits does not have an immediate impact on income, but reduces what otherwise would have been expensed in future periods. Employers who immediately recognized the transition obligation will recover the effect on its equity through the excess reducing future net OPEB expense, while those who chose to defer and amortize the transition amount can offset the transition obligation and not have this transition amount included in expense and liability for future periods.

Deferred Taxes

Employers using the pay-as-you-go method to account for postretirement benefits would record as expense the same amount as deducted on the tax return. No temporary difference would exist, and therefore no deferred taxes would result. When the accounting for the expense changes to the accrual basis, a temporary difference will arise. Since health care costs are rising, generally the accrual basis will result in an amount recorded as expense which exceeds the cash paid out. Therefore, the temporary difference will be a deductible difference. Deductible temporary differences will either create deferred tax assets or reduce what otherwise would have been a deferred


tax liability.

The standard on Accounting for Income Taxes currently requires that deductible temporary differences either carry back to taxable income or taxable temporary differences of a prior year in order to create a deferred tax asset or carry forward to a taxable temporary difference to reduce what would have otherwise created a deferred tax liability. This temporary difference may be large and may not have enough taxable income or taxable difference to offset. According to the current standard, the excess would not be recognized as a deferred tax asset. An example is provided in Illustration 2. The temporary deductible is assumed to reverse equally over the next 20 years. The net deductible difference through 1996 for the immediate recognition method can be carried back three years creating a deferred tax asset of $50,000. The remaining deductible difference $1,275,000) will not result in a deferred tax asset according to SFAS 96. The deferral and amortization method creates a smaller deductible difference. Assuming again that the difference reverses equally over the next 20 years, 1994 and 1995 have net taxable differences that result in a deferred tax liability and 1996, 1997 and 1998 net deductible differences will carry back to taxable income of 1993 and taxable differences for 1994 and 1995. This carryback will result in a deferred tax asset. The remaining deductible difference ($422,500) will not create a deferred tax asset.

However, FASB is considering a less stringent approach that would amend SFAS 96 to allow recognition of deferred tax assets if realization of income is considered "more likely than not." The project's importance on income tax accounting may influence companies to postpone early adoption until FASB decides whether to amend Statement 96.

Sensitivity of Assumption

Changes on Estimates

Many medical and nonmedical assumptions are required such as gross eligible charges, Medicare paid charges, retiree coinsurance payments, discount rate, employee turnover, retirement rate, spouse age difference, and pre-65 retirement. The assistance of an actuary is needed to help gather information necessary to assist in development of the assumptions and to perform the calculations necessary to measure the EPBO, APBO and net period cost.

The benefit cost computations are extremely sensitive to even minor changes in the health care cost trend rate. A FASB-sponsored field test indicated that a change of only one percent in the trend rate assumption could change the annual cost by as much as 20%. Therefore, one of the required disclosures of the statement is the effect of a 1% increase in the health care cost trend rate assumption on the APBO and on the aggregate of the service and interest cost components of net period OPEB cost. Since estimates (and therefore amounts recognized in the financial statements) are highly sensitive to assumption changes, the assumptions established by the actuary could have a major impact on financial statements.


The recently issued SFAS 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" will affect almost all companies that provide retirees with health care benefits. The statement requires employers to recognize the estimated future cost of providing these benefits as an expense as employees render service rather than when benefits are paid. This new requirement will have a significant impact on companies' financial statements in that postretirement benefit expense will increase considerably for many employers, and equity will be substantially reduced.

In order to minimize these effects of implementing the new rules, many companies are beginning to explore and implement plan design changes. These changes include, but are not limited to, increasing contribution levels, increasing deductibles and coinsurance levels, reducing coverage, establishing ceilings on level of benefits provided, and adopting flexible plants. The real impact of this standard may be on the employees/retirees since companies may reduce or even eliminate postretirement benefits to avoid the negative effect on the financial statements.

Arlette C. Wilson, CPA, PhD is an associate professor of accounting at Auburn University at Auburn, Alabama.

Atha Beard, CPA, is an assistant professor of accounting at Auburn University at Auburn, Alabama.
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Author:Wilson, Arlette C.; Beard, Atha
Publication:The National Public Accountant
Date:Nov 1, 1991
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