NORWALK, Conn. - The Financial Accounting Standards Board might consider revamping the way companies report the impact of pension funds on their bottom lines, in an effort to give investors a clearer picture of the true earnings of a corporation.
The accounting standards board's review comes at a time of heightened scrutiny of corporate accounting practices, following the collapse of Enron Corp., and tighter policing by securities regulators. It also comes when the downdraft in the stock market for two consecutive years has shrunk pension surpluses at many of the nation's largest corporations, highlighting the desperate moves by some companies to preserve their pension assets.
As part of a new FASB project on the way companies report their performance to investors in quarterly and annual statements, the Norwalk-based accounting rulemaking body is contemplating stopping companies from including investment gains by their pension funds in their operating earnings. The project is expected to take at least three years.
Corporations might be overestimating their earnings by as much as $50 billion a year because of the way they disclose their pension liabilities, according to an analysis by Robert D. Arnott, managing partner at First Quadrant LP, Pasadena, Calif. (Pensions & Investments, March 18).
"It's conceivable (the board) might disaggregate the pension numbers" and let companies include only the cost of pension benefits earned in the current year as an operating expense, said Timothy S. Lucas, director of research and technical activities at the FASB.
That is precisely what some investment and accounting experts have been suggesting for years.
Under the current accounting rule, Financial Accounting Standard 87, companies are allowed to include assumed returns on pension fund investments and the interest expense on the deferred benefits as elements of pension cost - or pension income.
Investment experts believe the inclusion of the assumed returns on pension assets and interest expense distorts the true cost to corporations of providing pension benefits, and lets them turn a cost center into a profit center by artificially lowering their pension liabilities and boosting their net income.
This concern that investors might not be getting accurate information about a corporation's pension liability is borne out by preliminary research done by the FASB as part of a project on financial performance measures. Securities analysts and institutional investors expressed "considerable frustration" about companies managing earnings through manipulating pension costs and other elements of periodic financial statements, according to a summary of interviews with securities analysts and institutional investors.
"I would say it is time to make revisions to FAS 87 to make it more transparent." said Lynn Turner, former chief accountant at the Securities and Exchange Commission and now director of the Center for Quality in Financial Reporting at Colorado State University in Fort Collins.
The Association for Investment Management and Research, Charlottesville, Va., also supports this change.
"We would prefer to have a fair value standard that more accurately reflects the expenses and obligations on a real-time basis," said Rebecca McEnally, vice president of advocacy at the AIMR. The organization already conveyed its comments on the initial project proposal to the accounting standards board, she said. "We are strongly supportive of their reconsideration and we are delighted to hear that ... pension accounting could be a part of it."
In a recent white paper, Lawrence N. Bader, a retired actuary, previously in the New York office of William M. Mercer Inc.,noted the current accounting rule for pensions is flawed and can "seriously distort the valuation of companies whose defined benefit pension plans are significant in relation to their overall business."
Mr. Bader advocates what the FASB is contemplating and would, in fact, go one step further: He would calculate the service cost based only on accrued pension liabilities, and not take future salary increases and inflation into account.
The other two key components of pension costs - the assumed rate of return on pension assets and the interest expense on the deferred liabilities - are financing costs that should appear separately on the income statement with other financing costs, he wrote.
Pension funds, Mr. Bader and others suggest, are financial assets akin to mutual funds, and companies should not be allowed to include investment gains or losses from these assets in calculating their earnings.
Compounding the problem
To compound the problem, experts say, FAS 87 allows companies to take the assumed, not the actual, returns on their pension assets into account in calculating their pension expenses or pension income, and to minimize the volatility in their earnings by spreading out the gains or losses from those assumed returns over many years.
Leading actuarial and accounting experts also suggest the FASB follow the lead of the United Kingdom, which last year adopted a new standard that requires companies to value pension assets and liabilities on a real-time basis.
When FAS 87 was adopted in the mid-1980s, the standard was conceived to minimize the volatility of corporate earnings by allowing companies to "smooth" or spread out the gains or losses between their assumed rates of returns on pension assets and actual returns over many years so companies wouldn't take a big hit in any one year. Now, sources say, it's time for the United States to adopt an approach like the new British accounting standard FRS 17.
"The idea of spreading seems nonsensical," said John Exeley, a senior consultant and actuary with William M. Mercer Ltd. in Leeds, England. "It's difficult to take a smooth number and to work out what happened. It's not of any real value to the investor."