Will accounting reform be bad for sponsors? The effects of pending pension and other postemployment benefit accounting reform on corporate plan sponsors will be numerous and complex, and require analysis instead of a gut reaction. Indeed, a thorough analysis may yield a very different picture than expected.
The first phase of the Financial Accounting Standards Board's (FASB) two-part comprehensive review of pension and OPEB accounting will dramatically change corporate balance sheets. On March 31, FASB released an Exposure Draft (ED) with a comment period through May 31, and an effective date of fiscal years ending after Dec. 15, 2006 for the most substantial changes. FASB plans to host a public roundtable on the proposal on June 27.
A study by Watson Wyatt indicates that 10 percent of the aggregate shareholders' equity in the Fortune 1000 will be wiped out, with even greater changes in some industries, such as manufacturing.
Changes of this magnitude are not something that corporate finance executives take lightly, but how should they be taken? How should this situation be viewed--where the theoretical economics of the plans does not change, but the reported accounting measurement of that economics changes substantially? To what extent does changing the way FASB mandates how to measure postretirement plan economics affect the economics itself? How do all of these things affect the thinking process that plan sponsors should use to make decisions?
These questions have no simple answers. To address them requires a step back from the mechanics of how FASB requires calculating items for financial statements and a review of how the financial community uses those statements.
Financial statement users look at the reported financials with a critical eye, and make many adjustments to those financials before incorporating them into their models. They do this for several reasons, one of the key reasons being that many people believe that the reported financials do not always paint the best picture of economic reality. The practice of adjusting financial statements is extremely common among equity analysts and credit rating agencies, and postretirement benefits are one of the key areas with which they make these adjustments.
Consequently, while an analysis of postretirement benefit finances should include the reported financials, it should also address the question of how markets view and treat those financials. For this, we can analyze the effects of postretirement benefit accounting reform by looking at how the financial market's view of plans will change--that is, we will ask how accounting reform will affect the share prices of plan sponsors.
Market Impacts of Accounting Reform
In order to discuss how markets will react, we must first examine why pension and OPEB accounting reform is needed, and who is driving the accounting reform initiative.
* If FASB is saying that accounting reform is needed because analysts and investors are viewing pension and OPEB plans the wrong way, then this will create a huge market disturbance as analysts and investors adjust to the new paradigm.
* If analysts and investors are saying that accounting reform is needed because the current standards do not represent the way they view pensions, and the FASB rules should reflect how these plans are viewed in the marketplace, then there should be minimal market disturbances.
These two points represent extremes of the spectrum, with reality probably somewhere in between. The following will explore the entire spectrum, presenting perspectives on aspects that will contribute to the decline of plan sponsors' stock prices, those aspects that indicate accounting reform will have minimal effect on stock prices and those aspects that will work to increase stock prices. None of these possibilities should be dismissed before considering several factors.
FACTORS THAT COULD LEAD TO DECREASING STOCK PRICES:
1 Less shareholders' equity on the balance sheet. For most corporate plan sponsors, accounting reform will result in the reported balance looking less favorable. To the extent that analysts and investors are viewing the current corporate balance sheets as economic reality, accounting reform will likely make corporations appear weaker.
2 More reported earnings volatility. The anticipated accounting reforms of Phase II will remove some of the smoothing mechanisms embedded in the current accounting rules. This increase in the volatility of reported earnings could hurt share prices.
3 Credit-event implications. Most of the major credit rating agencies say that their models already adjust the reported balance sheets for the full value of the pension's projected benefit obligation (PBO) or accumulated benefit obligation (ABO) liability, and either some or all of the value of the retiree medical accumulated postretirement benefit obligation (APBO) liability. However, some debt covenants were written based on the reported shareholders' equity, not the analyst-adjusted shareholders' equity, and this may give bondholders additional rights at the expense of equity owners.
FACTORS THAT COULD LEAD TO ACCOUNTING REFORM HAVING MINIMAL EFFECT ON STOCK PRICES:
1 Analysts have already incorporated accounting reform changes into their models. Over the last half decade or so, analysts and investors have become dramatically more sophisticated with respect to their treatment of pension and OPEB plans. Many of the major analyst firms--both credit and equity analysts--have published papers discussing the methodologies they use to take the details in the pension footnote and adjust their models to better reflect their view of the companies' true positions.
Their methodologies are generally consistent with the FASB's anticipated changes to the accounting statements in these areas:
* They almost always mark the balance sheet to market, and make corresponding adjustments to the shareholders' equity and deferred tax accounts; and
* On the income sheet, they decompose pension expense into its component pieces, and treat each one differently. Service cost and possibly prior service cost amortizations are the only components treated as operating costs of the core business.
The other components are marked to market and treated as non-operating costs. This is very similar to what is expected for FASB's Phase II accounting reform--marking everything to market, eliminating the netting of components and categorizing different components differently. To the extent that the "new" accounting will conform to the methodologies analysts are already using, the accounting reforms may have minimal impact on markets.
2 Efficient market. Would you believe someone who told you that a large group of people could use publicly available information to easily and confidently predict where stock prices will go over the next few years? Probably not. That's because markets are generally efficient (though anomalies do exist). The market prices of stocks generally reflect all publicly available information.
Given that the basic nature of FASB's proposed pension and OPEB accounting reform is publicly known, it is unlikely that thousands of pension professionals could look at the publicly available information in the pension and OPEB footnotes of a corporation's financials and know that the stock price will drop. When news is public information, it will already be baked into the price of the stock. Thus, accounting reform may not further affect stock prices, unless FASB actually surprises the market by doing something different from what most people anticipate.
3 Corporations with big pension problems already have low market prices. It is well known among the financial community which corporations have the biggest pension and OPEB issues--these companies and industries are often in the news--and the majority of their share prices are already suffering.
This is the empirical face of the theoretical "efficient market" effect in the discussion above: the market is quite likely to have already fully incorporated the ramifications of pension and OPEB plans into share prices.
FACTORS THAT COULD LEAD TO STOCK PRICES INCREASING:
1 Less volatility in operating earnings. FASB has noted that one of its major problems with FAS 87 is excessive netting of components. Service Cost, Interest Cost, Expected Return on Assets and Amortizations all have very different personalities, and Phase II of accounting reform is likely to report them separately. As noted earlier, the only components that will remain in operating earnings--the type of earnings that is most critically viewed with respect to volatility--will be Service Cost and possibly Prior Service Cost amortizations. Year-to-year changes in these components are relatively stable.
In contrast, FAS 87 currently reports all of the components of pension expense as operating costs. To the extent that analysts and investors are focusing on operating costs without adjusting the reported financials, accounting reform will reduce the volatility of operating income.
2 More accounting transparency. The investment community generally considers transparency to be a good thing, and it is one of the major reasons why P/E multiples have increased over the last century. Accounting transparency promotes better analysis and decision-making by corporate leaders and investors alike. Because of this, many investors view accounting transparency as going hand-in-hand with risk reduction.
Accounting reform might help more investors say, "I know what's happening with this company's pension and OPEB plans," instead of, "I think there's a bogeyman hiding in this company's closet, but I don't know for sure."
3 CFOs who manage to reported earnings will be managing plans better. CFOs have the difficult task of simultaneously managing the reported financials of their business and the underlying economics. When it comes to pension and OPEB plans, the current accounting rules are so different from the underlying economics that CFOs are sometimes forced to make trade-offs.
Accounting reform that better aligns reported financials with the underlying economics of the plans may allow CFOs to manage their plans better. As an example, some CFOs today might not be willing to shift their asset allocation to a more conservative mix, primarily because they don't want to reduce their FAS 87 Expected Return on Assets assumption.
However, they might be more willing to do this after the mark-to-market features of accounting reform make the risk-reduction properties of a conservative asset allocation more apparent in the reported financials. Certainly, it will be more transparent when the CFO is trying to leverage the balance sheet through investing in risky assets.
To the extent that CFOs are managing their plans towards reported financials that distort the plans' true economic nature, then accounting reform that reduces these distortions will result in better decisions by management and thus higher share prices.
Consider the following:
* In the late 1990s, many investment professionals thought it was virtually impossible for the stock market to experience an extended downturn over three consecutive years. But shortly after the turn of the millennium, it did just that.
* From 2003-05, people have been predicting that the long-term corporate bond yields used to determined pension and OPEB discount rates would rise to 1990s levels, but they haven't; in many instances, they've done the opposite.
Accounting reform for pension and OPEB plans is a complex topic, and it will likely affect markets--but we just don't know what the effects will be, or even in which direction their impact will move the markets. If accounting reform leads to better decision-making by plan sponsors and less uncertainty in the eyes of investors, it's possible that the impact could very well be positive.
Eric Friedman is a consulting actuary in the Chicago office of Watson Wyatt Worldwide who specializes in financial, administrative and compliance strategies for retirement benefits. He can be reached at email@example.com or 312.525.2500.
RELATED ARTICLE: takeaways
* Accounting reform of pension and other post-employment benefits (OPEB) will dramatically change corporate balance sheets.
* Three scenarios could result for plan sponsors: stock price declines, minimal effect on stock prices or an increase in stock prices.
* Accounting reform for pension and OPEB plans is a complex topic, and it will likely affect markets, but it is not known what the effects will be, or even in which direction markets will move. If reform leads to better decision-making by plan sponsors, and less investor uncertainty, the impact could be positive.
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|Date:||May 1, 2006|
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