Will Accountants Get It Right This Time?
By: Barry Gros
While the good news is that accounting standards bodies are trying to harmonize the rules globally, the bad news, writes Barry Gros, of Morneau Sobeco, is they may be keeping the flaws with the current rules.
In response to widespread dissatisfaction with current accounting rules for Defined Benefit pension plans, various accounting bodies are reviewing the current rules.
The good news is this review is being done by the international accounting standards body, in conjunction with regional accounting standards bodies, with a view to harmonizing pension accounting standards globally. The bad news is these accounting bodies seem bent on perpetuating some of the major flaws inherent in the current rules.
Why The Current Dissatisfaction?
Companies are required to disclose extensive information regarding Defined Benefit pension plans in notes to their financial statements. However, the current situation has come under criticism for a number of reasons:
- The pension expense charge is seldom shown separately in the income statement itself.
- In past years, pension income (actually negative expense) has masked possible problems with operating results by being buried in with operating result numbers.
- Most users of financial statements, and many of the accountants preparing them, really don’t understand how pension expense is calculated.
- Many pension plans reporting a balance sheet ‘pension asset’ are actually underfunded.
- One of the key components of the pension expense formula is a credit based on the expected return on the plan assets. This assumption, which is a management input item, has a huge impact on the eventual pension expense charge and there is concern about the credibility of some of the assumptions currently being used.
- The current pension expense algorithm allows the use of extensive smoothing techniques to spread out volatile asset returns and shifts in long-term interest rates (the latter being used to determine the liability to be recognized for the benefits promised). So it may take many years for ‘bad news’ to actually show up in the pension expense and the company’s balance sheet.
- There is concern that information in the footnote disclosure isn’t being used well.
It’s not exactly a short list! It’s easy to see why a review of the current rules might be worth considering.
How We Got To Where We Are
Before the existing pension accounting rules were developed, the expense charge for Defined Benefit pension plans was simply the cash the company put into the plan during the fiscal year. These rules worked reasonably well until the pension surpluses of the late 1970s started to accumulate and contribution holidays became the norm. The concept of a pension plan having a cost, even if there was no cash going into the plan, made sense since benefits continued to accrue to plan members regardless of whether the plan sponsor actually contributed to the plan. And how could one compare the pension costs of a company taking contribution holidays with one that wasn’t?
So the accountant standards bodies proceeded with the very laudable intention of changing the system to allow for greater consistency and comparability of companies’ pension expense charges. The focus was the income statement. The goal was to ensure that a reasonable charge would accrue for pension benefits as they were earned. The solution was to move from a cash accounting approach to an accrual accounting approach, recognizing the time value of money nature of the pension liabilities (the liabilities simply being the present value of expected future pension plan benefit payouts). In Canada, these rules were initially established in 1987 under Section 3460 of the Canadian Institute of Chartered Accountants’ handbook. These rules were replaced in 1999 with the expanded Section 3461.
What Went Wrong In 1987
The goal of having a rational charge for pension benefit accruals not linked to cash contributions was, and still is, a good one. The approach developed was based on sound, if not elegant, principles. But it hasn’t delivered the desired results because its application has had major practical shortfalls.
The real problem we have is fundamentally the way in which the pension expensing issue has been approached. We have tried to solve all of the ‘problems’ related to Defined Benefit pension plans, whether they concern just the pension cost or the risk of financing the benefits, by focusing primarily on what is the most appropriate charge for the pension accruals.
What we need to realize is that these two aspects of a company Defined Benefit pension plan – cost and financing risk – need to be dealt with separately in the financial statements for the disclosure to be useful to the broad range of users:
The ‘cost’ of the benefits being earned. Leaving aside how ‘cost’ should be computed for the time being, for the vast majority of companies, this isn’t that material a number.
The risks to the company of having to finance the benefits being earned. These risks are directly related to:
- Whether the benefits are backed by assets
- The nature of the assets and the investment policy being applied
- The interest rate sensitivity of the benefits (their ‘duration’)
- Any difference between the wind-up and ongoing liabilities related to the benefits earned
- Regulatory restrictions on the use of surplus
- The nature of any surplus sharing agreements that might be in place with employees or collective bargaining agents
What the drafters of the current rules failed to realize is that the pension expense formula they created actually combines these two disparate aspects, which actually works counter to the original objectives.
Let’s expand on these two aspects:
The Value of Benefits Earned –
The kernel to the “value of the benefits being earned” is the service cost component of the pension expense formula, which often isn’t that material a number. If we look at the financial statements for 2002 of 10 of the top Canadian publicly traded companies that have Defined Benefit pension plans, the disclosed pension service cost ranges from 0.15 per cent to 1.13 per cent of revenue, with a median of 0.47 per cent of revenue. Even though these values are leveraged, based on changes in interest rates, they really aren’t that volatile from one year to the next. What’s really created the volatility that we’ve seen recently is the financing risk – swings in the return on the assets and swings in liability discount rates.
The Financing Risk –
What I’m finding harder and harder to understand over time is why the accountants want to include the pension financing risk directly in the measurement of the cost of pensions. Granted the risk is there; it varies from company to company and plan to plan. The risk that a company might have to infuse substantial amounts of cash into their pension plan isn’t a pension expense issue that needs to be recognized in the current year income statement; it’s an operating risk issue. There are other risk factors that can influence the viability of a company’s operations that are not embedded in the current period finances including currency fluctuation risks, environmental risks, technology risks, and geopolitical risks. The pension financing risk is just one more.
One of the major problems with current pension disclosure and the direction that future reviews seem to be headed is that they mostly ignore the ‘hows’ and ‘whys’ of what a company is putting, or may have to put, into the pension plan. And although it is easy to require companies to disclose what they contribute; the tougher issue is one of anticipating large increases in the cash funding requirements resulting from events that are known but haven’t yet influenced the cash funding requirements.
Where Do We Go From Here?
When one looks at the dissatisfaction being expressed today, most of it results from the nature of the financing risk of pensions, not the inherent underlying value of the benefits being earned. As indicated above, the inherent value of benefits being earned may not be that material. We have built an extremely elaborate mouse trap to deal with a relatively small and inconsequential rodent.
Firstly, we need to come up with a simpler measure for what should flow through the income statement as the charge for benefits being earned. The ‘right’ rule for pension expense for many years was the cash contribution that went into the pension fund. For the past 17, it has been the current elegant accrual accounting methodology. Accounting is not an exact science and pension expense is one area where there is no one single right answer. We just need something that is reasonable.
Secondly, we need to ensure that the nature of the pension financing risk is embedded in corporate financial statements in a way that is useful and informative to the users of the statements. The current rules confuse risk exposure with expense charge.
Continuing to accept the current pension algorithm as the holy grail and simply tinkering with disclosure will not only lead to greater confusion in the short run, it will lead to a situation that is no more satisfactory than the current one in the long run. By proposing a rethink of how to approach the issue, by simplifying matters, and by focusing on the fundamentals, we may, in fact, be able to achieve the original objectives of the mid-1980s.
Barry Gros is a partner at Morneau Sobeco.
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