New Pension Accounting: Volatility City?
If FASB makes companies run plan assets through their
income statements, they can expect herky-jerky profits, a new study
suggests.
Marie
Leone, CFO.com | US
January 21, 2008
Nothing is official yet. But the next phase of pension-accounting rulemaking
is likely to affect the income statement. That means that the Financial
Accounting Standards Board is considering changing the way companies report
profits. If that happens, it's sure to cause a stir.
Under the current rule, FAS 158, Employers' Accounting for Defined Benefit
Pension and Other Postretirement Plans, companies measure changes in the
value of pension assets and liabilities caused by stock market upswings and
downturns. They record those changes as "other comprehensive income" in the
shareholder's equity section of their financials.
After that, the changes in value are allotted into the income statement over
several years, using the so-called "corridor" approach. The method is a way of
amortizing the changes to smooth the effects on net income.
But FASB members, staffers, and other accounting experts are discussing the
idea of requiring companies to record changes in value on the income statement
immediately. Such a move would be in keeping with FASB's recent role as a
fair-value advocate. "I think [FASB] will do it because it moves pension
accounting to full fair value," says Charles Mulford, the director of the
Georgia Institute of Technology's Financial Analysis Lab.
Further, according to new
research Mulford released this month, the effects of the accounting change
could be big enough to dwarf the impact of the company's core business and
"render the income statement useless," Mulford predicted.
For example, consider a year in which stock market returns are strong. A
company records a $1 billion increase in the value of its pension assets above
what it had estimated. If the billion-dollar change flows through the income
statement, the company looks more profitable than it would have if the stock
market had been down. The billion-dollar gain would offset that year's pension
expense.
Conversely, a $1 billion drop in pension-asset value flowing through the
company's income statement making it look, at first blush, that profits are
down. "FASB's argument [for considering the revision], which I don't disagree
with, is that the change reflects what is happening. And that ought to show up
in the financial statements," Mulford told CFO.com.
The first phase of FAS 158 made that happen on the balance sheet. FASB issued
the rule in 2006, forcing companies to recognize overfunded or underfunded
pension plans, and
record any changes in value on their balance sheets at fair value. The rule
revision caused some companies to rework debt covenants based on debt-to-asset
and other affected ratios. Others had to revise internal strategies. And while
many companies didn't like taking the short-term hit, it didn't cause
earth-shattering changes to results unless a company was already on the brink of
insolvency and its covenants were also teetering.
In fact, Moody's Investors Service, the credit-rating agency, was underwhelmed by the
effect of the pension rule. Moody's noted that even though FAS 158 would
boost total liabilities "significantly," the change would shake neither company
fundamentals nor credit ratings.
While the same will probably be true for the second phase of pension
accounting, adjustments to net income are simply harder to swallow than
balance-sheet changes. For its part, FASB hasn't released any official
discussion papers about the second phase, agreeing to work in tandem with the
International Accounting Standards Board to come up with a proposal. For now,
FASB is leaving the door open to criticism of the new idea.
To that end, Mulford, along with graduate student associates Erin Quinn and
Ryan Swanson, produced a study issued this month that seeks illustrate the
impact of running changes in pension-plan value through the income statement. In
a nutshell, the accounting change would spur a big rise in volatility stemming
from the percentage changes in pension expense and in income from continuing
operations. (The latter refers to net income before such one-time events as
extraordinary items and discontinued operations.)
The study looked at 24 of the 30 companies represented in the Dow Jones
Industrial Average. Six companies were eliminated from the report because they
either didn't have pension plans or pension data wasn't clear or available. The
researchers applied the full fair value treatment to changes in asset values for
each company for a five-year stretch (2002 to 2006). The study compared actual
returns on pension plan assets to expected returns, reflecting the market swings
of bull and bear markets.
In 2002, for example, all 24 companies — including 3M, Boeing, Caterpillar,
Citigroup, Dupont, JP Morgan Chase, and Merck — predicted positive returns. But
weak markets led to actual losses on plan assets for all two-dozen
companies.
Thus, the pension expense for median companies that year climbed by 887
percent. Run through the income statement, and evaluated by an untrained eye,
that increase in pension expense could make the median company look quite a bit
less profitable. Further, company profits would look extremely volatile compared
to 2006, when the median company adjusted pension expense dropped by 109
percent.
To see the effects the change in accounting treatment might have on a single
company, consider Dupont's pension expense over the five years (see chart). The
chemical company's adjusted expense figure swung from a 2,077 percent deviation
between expected and actual results in 2002 to a negative deviation of 374
percent in 2006.
The study's results for percentage change to income from continuing
operations was similarly "all over the map," said Mulford. Using the revised
accounting treatment, the median company would have reported a 51 percent drop
in income from continuing operations in 2002, while income would have risen by
9.8 percent in 2006.
When it comes to the volatility of individual companies, Boeing stands out as
being especially affected by fair-value pension accounting (see chart). The
aircraft manufacturer would have recorded a 177 percent dip in income in 2002,
but a 168 percent rise in 2006. Alcoa would have suffered from a big swing in
volatility as well, going from a 306 percent drop in income in 2002 to a 9.8
percent rise in 2006. Caterpillar's fair-value adjustments would have been
recognized as a 171 percent decrease in income in 2002 and an 11 percent jump in
2006.