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The $1,000,000,000,000 dilemma: accounting for post-retirement benefits under FASB statement # 106.

In December 1990, Financial Accounting Standards Board (FASB) unanimously approved its statement No. 106, Employer's Accounting for Postretirement Benefits Other Than Pensions. This new statement requires employers to use the accrual method of accounting for retiree health and other postretirement benefits.

This article will present the major provisions of Statement No. 106 and discuss the various implementation issues an employer will face in complying with this standard.

The first section of presents a brief overview of the origin of the pronouncement and the applicability and effective dates for implementation. The second defines the components of an employer's benefits expense. The third presents two alternatives through which an employer can choose to record the transition liability. The final section reviews disclosure requirements for defined postretirement benefit plan and provides additional authority insight into the significance of this statement.


Statement No. 106 was introduced by the FASB after a decade of deliberations on accounting for nonpension benefits promised to retirees. Since the FASB concluded postretirement benefits are provided in exchange for employee service, companies will now have to recognize the cost of providing those benefits as an employee renders service, rather than when the benefits are paid. Currently, most employer expense these costs as they are paid and therefore do not record a liability for those costs on their balance sheets. A company's promise to pay postretirement benefits represents a liability that should be recognized using the accrual method of accounting. This new approach means a major change from the pay-as-you-go or cash basis method of accounting presently used by most companies.

For a majority of companies, Statement No. 106 will take effect no later than the fiscal years beginning after December 15, 1992. For calendar year companies, the effective date is the first quarter of 1993. For nonpublic employer with fewer than 500 employees and for plans covering employees working outside the United States, the standard goes into effect for fiscal years beginning after December 15, 1994. Although the FASB encourage companies to adopt the statement earlier than the above effective dates, the restatement of previously issued financial statements is prohibited.

Components of An Employer's Benefits Expenses

Statement No. 106 focuses on retiree health benefits more than on any other benefits because they are the most costly and the most difficult to measure. Studies indicate approximately 75% of large U.S. companies offer health care benefits to retirees and it is estimated that the total health care obligation for all U.S. companies is somewhere between $200 and $400 Billion.(1) Additionally, the U.S. spent over $650 billion on health care in 1990 -- more than 12% of the Gross National Product.(2) It is because of the magnitude of health care costs and their continuing escalation that Statement No. 106 will have such a significant impact on financial reporting.

The estimated impact of treating promises by employers for medical coverage after retirement as a balance sheet debt rather than as a pay-as-you-go expense will, for some large companies, reduce a corporation's net profit by as much as one-third.(3) Under the standard, the present value of postretirement benefits must be fully accrued by the date the employee is fully eligible to receive benefits. A combination of age and years of service comprises the components of the cost on that date.

FASB 106 covers three different groups of individuals:

1. Retirees and their dependents currently receiving benefits;

2. Active employees fully eligible for benefits; for example, eligible active employees who have reached the age of 55 and possess at least ten years of service who have not yet retired; and

3. Active employees not yet eligible; for example, those persons under the age of 55.

In order to aid organizations in defining their obligation for postretirement benefits, the FASB designed two terms specifically applicable to postretirement benefits. They are Expected Postretirement Benefit Obligation (EPBO) and Accumulated Postretirement Benefit Obligation (APBO).

EPBO represents the actuarial present value as of the measurement date (date of implementation) of all benefits expected to be paid after retirement to employees and their dependents. Included in the EPBO is the APBO plus the actuarial present value of expected future service costs of those employees who have not yet retired and reached full eligibility for benefits. The EPBO is not currently required to be recorded or disclosed in the financial statements.(4)

The APBO represents the actuarial present value of future benefits based on employees' service rendered to the measurement date. For retirees and active employees fully eligible for benefits, the APBO would be equal to the EPBO. Any differences between the APBO and EPBO would represent the future service costs of active employees not yet fully eligible.(5)

How might these costs be spread over accounting periods? According to the standard, costs are to be extended over the employee's period of service to the company. The costs end on the date the employee becomes fully eligible to receive benefits.

One of the major problems employers will face when applying this statement to their financial statements is to estimate the impact of any future changes in their plans's cost-sharing provisions. These provisions may include such items as employee deductibles, retiree contributions and plan maximums. Of course, not all changes or costs can be accurately predicted. For example, the FASB has instructed employers to use their best estimates when determining the components of expense outlined below. First, future retiree health care costs should be projected by using a health care cost trend rate that considers:

1. Health care inflation estimates;

2. Changes in health care utilization; and

3. Any technological advances and changes in the health status of plan participants.

The second major component of cost obligation should include some assumptions regarding administrative expenses. These expenses often are expressed as a percentage of an organization's health care claims. Third, employers should consider what rates of return on fixed-income investments are both currently available and expected to be available during the period retirement benefits are expected to paid out. A fourth component includes making assumptions relating to turnover, retirement age and mortality of all employees. Finally, if a company's plan contains spouse and dependent benefits, the employer is also required to estimate the costs related to future outlays for these two groups.

In an effort to offset either the total or a portion of the total postretirement benefit obligations calculated from the five cost components described above, plan assets may be used. However, FASB 106 does require companies choosing this option to segregate the plan assets from the company's general assets so that those assets will be maintained solely for plan benefits. To determine plan assets, the annual benefits expense should be computed first. On the balance sheet, the accrued liability should then reflect the difference between the cumulative accrued expense and the actual amounts that are paid or funded.

According to the statement, the transition from the cash basis of accounting for retirement benefits to the accrual accounting basis should be instituted at the beginning of the year in which the company adopts the new standard. At that time a transition obligation (asset) is to be determined based on the difference between the APBO and the fair value of qualifying plan assets that have been adjusted by any recorded liability (asset) on the employer's balance sheet when FASB 106 is implemented.(6) If a company has already been accruing postretirement benefits costs prior to its adoption of the statement, then a transition asset may be shown at the date of implementation. However, since it is estimated that most plans are unfunded and postretirement benefit costs are being accrued for the first time, a transition obligation will definitely have to be considered on the balance sheet. According to a recent survey, only about 20% of employers with 1,000 or less employees compared with 60% of larger companies had valued their retiree health liabilities. In addition, approximately 7% of companies surveyed have already pre-funded their liabilities with 60% of those companies indicating that given a favorable tax treatment they would pre-fund their plans.(7)

Alternatives to Recording Transition Liability and the Impact on Financial Statements

Following the determination of a transition liability (asset), an employer has two options under which he could recognize the transition figure at the date of adoption. The first option, Immediate Recognition, allows the employer to record the full asset or liability as (income) expense in the income statement by designating it as a cumulative effect of change in accounting principle. International Business Machines Corp. (IBM) recently announced it is taking a first quarter charge of $2.3 billion to account for the change in accounting rule.(8) For those employers who choose the second alternative, Delayed Recognition, the transition amount must be amortized on a straight-line basis over the average remaining service period of active plan participants. However, if the average remaining service period is less than 20 years, the employer has the option of electing a 20-year amortization period. In addition, for Delayed Recognition, the transition amount should be amortized over the average remaining life expectancy of the participants if almost all of them are inactive.

In order to better visualize the effect that Immediate and Delayed Recognition of the transition liability have on the income statement, Exhibit A was developed for a fictional organization called Horany Corporation. The estimated service cost related to postretirement benefits refers to the portion of the EPBO that is related to employee service for the period. The estimated interest cost pertains to the increase in the APBO that is attributable to the passage of time. Under both alternatives, the estimated service and interest costs represent the estimated expense exclusive of any adjustment for estimated benefits paid and cause a negative impact on net income. Also, under both alternatives, the estimated pay-as-you-go costs of $2.5 million reduced the negative impact the first two cost components had on net income. Under Alternative 1, Immediate Recognition, Horany Corporation chose to record the full transition obligation of $21.5 million in the year of the adoption of the statement. This effect, recorded as a cumulative effect of change in accounting principle, is shown as a separate line item on the income statement. The decision to use Immediate Recognition resulted in a $24.7 million negative impact on net income.
Horany Corporation
Postretirement Medical and Life Benefits
Recognition of Transition Liability (Millions)
 Alternative 1 Alternative 2
 Immediate Amortization
 Recognition Over 20 Years
Impact On
Net Income
Estimated Service Cost
Related to Postretirement
Benefits(*) $(2.1) $(2.1)
Estimated Interest Cost
Related to Postretirement
Benefits(*) (4.8) (4.8)
Less Estimated
Pay-As-You-Go Cost 2.5 2.5
Estimated Amortization
Related to Transition
Liability - (1.5)
Income Before
Income Tax (4.4) (5.9)
Deferred Tax
@ 27% 1.2 1.6
Income Before Cumulative
Effect of Change in
Accounting Principle (3.2) (4.3)
Cumulative Effect of Changes
in Accounting Principle (21.5) -
Net Income $(24.7) $(4.3)

In Alternative 2, the total transition amount is to be recognized over a period of twenty years. In this scenario, the estimated amortization related to postretirement transition liability is a ($1.5 million) negative impact to net income. Although the deferred tax benefit calculated at a tax rate of 27% is greater under Alternative 2, the effect to net income is $20.4 million higher when compared to that computed under Alternative 1, Immediate Recognition.

In conclusion, the impact on net income that the two different methods of recognition produce is quite substantial and should be considered when employers make the decision as to how they will recognize a possible liability or asset in their financial statements.

Other components of an employer's postretirement benefit expense not included in the model include:

1. Expected return on plan assets which represents the expected earnings rate applied to the market-related value of plan assets adjusted for contributions and benefit payments to be made during the period;

2. Amortization of prior-service cost which is the amortization of the cost of retroactive benefits resulting from plan amendments or a plan initiation taking place following the adoption of Statement No. 106; and

3. Gains and losses which represent changes in the APBO resulting from an employer's changes in plan assumptions or from plan experience that is different from what the employer first estimated.

The next issue to be analyzed is what happens if a company amends its plan either in a positive or negative manner. Positive changes to a plan are those increasing retiree health benefits. In this case, the changes are considered to be retroactive and the APBO calculation is increased. According to the statement, the APBO increase should be amortized over the remaining service periods up to the full eligibility date of all plan participants who are active at the date of the change but who are not yet fully eligible for benefits. On the other hand, if an employer alters his plan so as to reduce retiree health benefits (negative change) then any existing unrecognized prior-service cost should be reduced, followed by a reduction in any remaining unrecognized transition obligation or liability.

Disclosure Requirements For Defined Postretirement Benefit Plans and Author Insight Into The Significance of This Statement

Once the expected postretirement benefits are defined, the statement requires upon adoption, the employer should disclose the following:

1. A description of the plan -- including the employee groups covered, the types of benefits provided, the organization's funding policy and the types of assets held by the company;

2. The expense components;

3. The assumed health care cost trend rate for the following year; and

4. The effect on the APBO and the service and interest cost components of net cost of a one-percentage-point increase in the health care cost trend rate.

Implementation of Statement No. 106 will have a substantial impact on the financial statements of most companies. In a large industrial cities, the problems caused by the accounting rule change will be particularly acute due to the large concentration of present and future retirees.(9) There is no doubt the adoption of this new rule will slash millions of dollars from the net profits of many companies. In addition, new accounting procedures will be required as well as additional disclosure in the financial statements and related footnotes in annual and quarterly reports.

Of course, the effect of this statement on financial statements will vary. Companies have different claims costs, actuarial assumptions and type and amount of benefits provided to their employees. For example, Company A may pay all of its retirees health benefits while Company B may only fund 20% of the cost.

The required implementation of this standard may lead some employers to initiate a change in the design of their retirement plans such that the burden of paying for health care may be transferred to the employee by a greater and greater percentage as the years go by. The result is many retirees, including future retirees, can expect to pay a greater share of the medical insurance costs their employer currently pays on their behalf. According to a recent survey, only about 1% of employers have already eliminated coverage for retirees, about 78% have increased employee contributions and nearly 10% have modified their plans in some fashion.(10)


The implementation date of Statement 106 is fast approaching. Although the biggest problem may be in finding a way to implement the statement in a cost-effective manner, there are several recommendations companies should follow to make the transition as smooth as possible. Before acting on Statement No. 106, employers must answer some hard questions that require financial, actuarial and accounting policy analysis. For example, companies must decide whether the write off should be recognized immediately or amortized over the average remaining service period of plan participants. This decision can't be put off because it is a one-time choice with long-term consequences.

Indepth actuarial and financial analysis will be needed to provide the information necessary to make such a long-term decision. Accountants must work with their actuaries as soon as possible to determine the cost of future health care and the discount rate used to determine the present value of the transition obligation. Employers should obtain an extensive study of the options available. For example, should the company shift all or some future health care costs to retirees or set a ceiling on the costs for which it ultimately would be responsible? All these issues give signals that employers also should move quickly to understand and adopt this Statement. Companies may be surprised to find how difficult it will be to come up with some of the starting numbers and how much data they will have to collect. Don't wait until the effective date to analyze your plan; don't make plan changes without gathering sufficient facts and evidence to support those changes; and don't forget to analyze all postretirement benefits, not just health. If the above recommendations are followed, the implementation of Statement No. 106 should hopefully provide a tolerable transition for all employers although financial statement results may never be the same.


1 "Retiree Health Benefits: What Drives the Numbers" (New York City: Coopers & Lybrand (USA) Communications Department, March, 1991).

2 Understanding the New Rules for Postretirement Benefit Plans (USA: Ernst & Young, 1991), p. 1.

3 Len Strazewski, "Accounting Change Eroding Retiree Plans," Crain's Chicago Business, November 25, 1991, p. T2.

4 James R. Wilbert and Kenneth E. Dakdduk, "The New FASB 106: How to Account for Postretirement Benefits," Journal of Accountancy, August, 1991, p. 40.

5 Ibid.

6 Ibid, p. 40

7 Strazewski, p. T2.

8 Wilbert and Dakdduk, p. 40.

9 Ibid.

10 Ibid.


Retiree Health Benefits: What Drives the Numbers. New York City: Coopers & Lybrand (USA) Communications Department, 1991.

Statement of Financial Accounting Standards No. 106. Stamford, Connecticut: Financial Accounting Standards Board, 1990.

Strazewski, James, "Accounting Change Eroding Retiree Plans," Crain's Chicago Business (November 25, 1991), pp. T2.

Understanding the New Rules for Postretirement Benefit Plans. USA: Ernst & Young, 1991.

Wilbert, James R. and Kenneth E. Dakdduk, "The New FASB 106: How to Account for Postretirement Benefits," Journal of Accountancy (August 1991), pp. 36-40.

Zarowin, Stanley, "How Business is Dealing With FASB 106," Journal of Accountancy (March 1992), pp. 67-69.

Musa Al-Darayseh, PhD, is an assistant professor of accounting at Purdue University - Calumet in Hammond, Indiana. He received his PhD in accounting from the University of Nebraska in 1990. His areas of interest are corporate failure (bankruptcy), small business accounting, pensions and managerial issues.
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Title Annotation:Financial Accounting Standards Board
Author:Al-Darayseh, Musa
Publication:The National Public Accountant
Date:Nov 1, 1992
Previous Article:Postretirement benefits: a growing employment problem.
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