Video | Newsletters | Alerts | Subscribe

Accounting

You are here: Home : Topics A-Z : Accounting : Article

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.