WASHINGTON - When Congress passed sweeping accounting legislation last month to restore investor confidence in the stock market, lawmakers might have missed an opportunity to fix what some experts say is another problem lurking on many corporate financial statements: accounting for pensions.
Since the mid-1990s, when the rising stock market let companies artificially boost their profits with investment gains on their pension fund assets, there has been some call for changing the way companies must disclose their pension obligations to investors.
Now, with the stock market in disarray and scores of companies being forced to admit their pension funds are in the red and will need injections of cash, the cry has grown louder.
Among those in the chorus:
* Timothy S. Lucas, project manager for the pensions accounting rule at the Financial Accounting Standards Board at the time FAS 87 was drafted;
* Sen. Tom Harkin, D-Iowa, a member of the Senate Health, Education, Labor and Pensions Committee;
* Michael Peskin, an actuary and the head of asset-liability analysis at Morgan Stanley in New York;
* Lawrence N. Bader, a retired actuary whose proposal for fixing FAS 87 is appearing in the September issue of Contingencies, a publication of the American Academy of Actuaries;
* accounting analysts Patricia McConnell of Bear Stearns & Co. Inc. and David Zion of Credit First Suisse Boston; and
* Jeremy Gold, an independent New York-based actuary.
FAS 87 details
Under Financial Accounting Standard 87, companies must report their pension fund assets and liabilities only in footnotes in their annual financial reports, where they must record the difference between the present value of their pension obligations and their pension assets, adjusted to remove or smooth out the volatility of investments in the stock market.
Companies must only report on their balance sheets their cumulative pension expense and cumulative contributions since the adoption of FAS 87. If the cumulative pension expense exceeds what they have contributed over time, companies must report an unfunded accrued pension cost; if their cumulative contributions exceed their cumulative pension expense, they must record a prepaid pension cost.
When the standard was being drafted, Victor H. Brown, a member of the FASB, disagreed with the need for companies to show pension assets and actuarial liability estimates on their balance sheets because it would be confusing to investors, according to a published discussion of the rule.
Moreover, because accountants drafting the rule feared that including actual returns on pension assets would subject companies' earnings to increased volatility, FAS 87 lets companies compute their pension expense for the current year using assumed rates of return on their pension assets, instead of actual returns.
But, as the stock market's dive has forced companies to admit they can't meet those assumed rates, investment analysts and experts have begun questioning if those assumptions are unrealistic.
Requiring companies to use their actual returns on pension assets in computing their pension cost for the current year would provide investors with the "best information" about a company's pension expense, Mr. Lucas said.
Mr. Lucas also suggested requiring companies to clearly list pension obligations and pension assets at market value, without any smoothing, on their balance sheet, along with other assets and liabilities.
"It would show the complete picture of what companies are managing," he said. Mr. Lucas said the current disclosure of a "stub" amount on the balance sheets after netting the pension assets and liabilities is inadequate.
It's "usually pretty hard to find and not a terribly meaningful number anyway," he said.
Moreover, he said, putting the pension assets and liabilities on the balance sheet would be in keeping with the current trend in financial accounting - particularly after the glare on Enron Corp.'s numerous off balance-sheet subsidiaries - to require companies to give investors a complete picture of all their financial transactions by reporting them on the books.
And while requiring companies to calculate their annual pension expense using actual returns on pension assets instead of an expected long-term rate would make companies' earnings more volatile, "it would certainly tell us more about what happened," he said.
On Capitol Hill, meanwhile, Mr. Harkin said: "The Senate has recently made it very clear that it feels investors are served when accounting standards are more straightforward. FAS 87 has resulted in practices that are not just less than honest, but unwise. In the short term their books may look better, but over time the variations from reality sometimes claimed can set a company up for a huge fall."
He plans to follow up his interest in the issue when lawmakers return in September after the summer recess, and as the Senate considers the Democratic pension bill, he said.
Several other lawmakers have begun asking regulators questions about the validity of companies' assumptions for their pension funds, and the implications for the reserves of the Pension Benefit Guaranty Corp. in case companies shut down their pension funds if they can't finance their mounting pension obligations.
Late last week, Reps. George Miller, D-Calif., ranking member of the House Education and the Workforce Committee, and Rob Andrews, D-N.J., the ranking member of the House Subcommittee on Employer-Employee Relations, asked Rep. John Boehner, R-Ohio, the committee chairman, to hold hearings on the stability of the private pension system.
Mr. Miller, in particular, is interested in ensuring that "employees and investors are made aware of a company's true financial condition, including fair assumptions about the condition of the pension plan," said a legislative aide, adding that Mr. Miller plans to ask SEC Chairman Harvey Pitt what the securities regulator is doing to ensure companies are using realistic investment assumptions for their pension funds.
But officials at Standard & Poor's, New York, are not waiting for the independent accounting board to overhaul the rule.
In calculating a company's pension cost, the credit rating agency takes into account the service cost, and then offsets the interest cost of the present value of their pension obligations against actual returns on pension assets to arrive at the true pension expense of companies. If companies' actual pension fund returns fall short of the amount of the anticipated interest cost on their pension liabilities, S&P adds that to a company's pension cost for the year. If the returns on pension assets exceed the anticipated interest cost on liabilities, S&P reduces a company's pension cost by that amount, explained Robert Friedman, an aerospace and accounting analyst at S&P.
S&P also hopes to set up a framework to predict when a company's pension fund might be underfunded and require contributions.
Experts who have for years criticized FAS 87 as flawed hailed Mr. Lucas' suggestions for reform, but said they don't go far enough.
Said Morgan Stanley's Mr. Peskin: "FAS 87 is broken. It needs to be replaced."
Mr. Peskin agreed with Mr. Lucas' suggestions, but said he would break out the components of a company's pension cost, keeping only the service cost or cost of benefits accrued in the current year, and separately recording returns on pension assets, and the interest on the deferred pension liability.
That approach also is favored by Messrs Bader and Gold, and Ms. McConnell, who view the service cost component as the only measure of the benefits earned. In fact, the description of the standard notes that "both the return on plan assets and interest cost components are in substance financial items rather than employee compensation costs."