New Accounting Rules for Defined Benefit Pension Plans
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Apr 18, 2008, 1:40:41 PM4/18/08
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New Accounting Rules for Defined Benefit Pension Plans
By Kenneth W. Shaw
MARCH 2008 - Issued in September 2006, Statement of Financial
Accounting Standards (SFAS) 158, Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans—An Amendment of FASB
Statements No. 87, 88, 106, and 132(R), significantly changes the
balance-sheet reporting for defined benefit pension plans. Before SFAS
158, the effects of certain events, such as plan amendments or
actuarial gains and losses, were granted delayed balance-sheet
recognition. As a result, a plan’s funded status (plan assets minus
obligations) was rarely reported on the balance sheet. SFAS 158
requires companies to report their plans’ funded status as either an
asset or a liability on their balance sheets, which will cause
reported pension liabilities to rise significantly. Although SFAS 158
also applies to postretirement benefit plans other than pensions and
to not-for-profit entities, the focus below is on for-profit
businesses with defined benefit pension plans.
Balance-Sheet Reporting Under SFAS 158
Under SFAS 87, prepaid or accrued pension cost, which is the net of a
firm’s pension assets, liabilities, and unrecognized amounts, is
reported on the balance sheet. SFAS 158 arguably improves financial
reporting by more clearly communicating the funded status of defined
benefit pension plans. Previously, this information was reported only
in the detailed pension footnotes.
Under SFAS 158, companies with defined benefit pension plans must
recognize the difference between the plan’s projected benefit
obligation and its fair value of plan assets as either an asset or a
liability. The projected benefit obligation is the actuarial present
value of the benefits attributed by the pension plan benefit formula
for services already provided. As a result, the complex and
conceptually unsound “minimum pension liability” rules, which are used
when the accumulated benefit obligation is less than the fair value of
pension plan assets, has been eliminated. (The accumulated benefit
obligation is similar to the projected benefit obligation but does not
include expected future salary increases in the calculation of the
present value of actuarial benefits.) In addition, the unrecognized
prior service costs and actuarial gains and losses that were
previously relegated to the footnotes are now recognized on the
balance sheet, with an offsetting amount in accumulated other
comprehensive income under shareholders’ equity.
Income Reporting Under SFAS 158
SFAS 158 does not change the computation of periodic pension cost,
which remains a function of service cost, interest cost, expected
return on pension plan assets, and amortization of unrecognized items.
It does, however, impact the reporting of comprehensive income.
Specifically, actuarial gains or losses and prior service costs that
arise during the period are recognized as components of comprehensive
income. In addition, the amortization of actuarial gains or losses,
prior service costs, and transition amounts recognized before
implementing SFAS 158 require a reclassification adjustment to
comprehensive income.
Applying SFAS 158
Exhibit 1 presents pension footnote data for three companies: Lockheed
Martin, Glatfelter, and AMR Corp. Lockheed Martin represents a classic
example of a scenario SFAS 158 is designed to eliminate: namely,
reporting a pension asset when the pension plan is actually
underfunded. Specifically, Lockheed Martin’s pension obligation
($28,421 million) exceeds its plan assets ($23,432 million), meaning
the plan is underfunded by the difference, $4,989 million. Previously,
Lockheed Martin’s unrecognized net losses and unrecognized prior
service costs (totaling $7,108 million) enabled it to report a pension
asset of $2,119 million ($7,108 – $4,989).
The data for Glatfelter and AMR in Exhibit 1 indicate other likely
scenarios under SFAS 158. Glatfelter, while overfunded by $155.3
million, would reduce its reported pension asset by $90 million under
SFAS 158. Although AMR currently recognizes a pension liability of
$882 million, SFAS 158 would require AMR to significantly increase its
reported pension liability to $3,225 million.
An Illustration of the Transition to SFAS 158
The following example uses the actual 2005 data from Exhibit 1 to
illustrate how each of these companies would record the transition to
the new rules. Because SFAS 158 is generally first effective for
fiscal years ending after December 15, 2006, the actual numbers these
companies record upon transition to SFAS 158 will differ from those in
this example. For simplicity, the illustration ignores tax effects.
Exhibit 1 shows that each of the three companies reports additional
minimum liabilities and related intangible assets on its balance
sheet. These items are eliminated under SFAS 158. In addition, pension
assets and liabilities and accumulated other comprehensive income are
adjusted so that their ending balances conform to the amounts required
under SFAS 158. The necessary journal entries to accomplish the
transition, using 2005 data, are presented in Exhibit 2.
Exhibit 3 shows the balance-sheet reporting for each company after
posting the entries in Exhibit 2, and exposes several important
points. First, each company reports its funded status as either a
pension asset or liability. Second, the balance in accumulated other
comprehensive income equals the amount of previously unrecognized
items. In this example, and likely for many companies with defined
benefit plans, the amount of this contra-shareholders’ equity will
increase under SFAS 158, even potentially generating negative
shareholders’ equity. The transition to SFAS 158 might impose costs on
leveraged firms due to the increased likelihood of tightening
restrictive debt covenants. Finally, the balance-sheet presentation,
and each company’s funded status, should be easier to understand after
SFAS 158 is implemented.
Subsequent Application of SFAS 158
SFAS 158 does not impact the amount of periodic pension cost reported
on the income statement, but it does impact the reporting of
comprehensive income. For example, assume that after implementing SFAS
158 Lockheed Martin were to report the financial results in Exhibit 4.
Again, these amounts are for illustrative purposes only.
Exhibit 5 shows the required journal entries. The first entry records
the service cost, interest cost, and expected return on plan assets
components of periodic pension cost. The second entry reclassifies the
amortization items from accumulated other comprehensive income to
periodic pension cost, and the third entry adjusts the pension
liability and accumulated other comprehensive income for the
difference in actual pension returns above expectations during the
year.
Tax effects. For the sake of simplicity, the illustrations above
ignore the effect of taxes on the financial results. In the real
world, however, the application of SFAS 158 requires companies to
account for the temporary differences between the book and tax bases
of pension liabilities. The balance-sheet liability most businesses
will report after SFAS 158 will in turn either lower their deferred
tax liabilities or increase their deferred tax assets. Companies will
have to consider these effects when assessing the need for and amount
of valuation allowances on their deferred tax assets.
Changes to Required Disclosures
SFAS 158 retains many of the required pension disclosures in current
GAAP. It eliminates the requirement to reconcile the plan’s funded
status and the amount recognized on the balance sheet (as the funded
status will now be recognized on the balance sheet). SFAS 158 as also
eliminates the need to disclose the plan’s measurement date (as this
date now must coincide with the firm’s fiscal year-end).
Prior to SFAS 158, companies could measure their pension assets and
benefit obligations at times other than their fiscal year-end.
Effective for fiscal years ending after December 15, 2008, companies
must measure these items as of the date of their fiscal year-end
balance sheet.
Finally, SFAS 158 expands disclosure of the effects of the pension
plan in other comprehensive income.
--------------------------------------------------------------------------------
Kenneth W. Shaw, CPA, is an associate professor and the CBIZ/MHM
Scholar in the school of accountancy at the University of Missouri,
Columbia, Mo.
By Kenneth W. Shaw
MARCH 2008 - Issued in September 2006, Statement of Financial
Accounting Standards (SFAS) 158, Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans—An Amendment of FASB
Statements No. 87, 88, 106, and 132(R), significantly changes the
balance-sheet reporting for defined benefit pension plans. Before SFAS
158, the effects of certain events, such as plan amendments or
actuarial gains and losses, were granted delayed balance-sheet
recognition. As a result, a plan’s funded status (plan assets minus
obligations) was rarely reported on the balance sheet. SFAS 158
requires companies to report their plans’ funded status as either an
asset or a liability on their balance sheets, which will cause
reported pension liabilities to rise significantly. Although SFAS 158
also applies to postretirement benefit plans other than pensions and
to not-for-profit entities, the focus below is on for-profit
businesses with defined benefit pension plans.
Balance-Sheet Reporting Under SFAS 158
Under SFAS 87, prepaid or accrued pension cost, which is the net of a
firm’s pension assets, liabilities, and unrecognized amounts, is
reported on the balance sheet. SFAS 158 arguably improves financial
reporting by more clearly communicating the funded status of defined
benefit pension plans. Previously, this information was reported only
in the detailed pension footnotes.
Under SFAS 158, companies with defined benefit pension plans must
recognize the difference between the plan’s projected benefit
obligation and its fair value of plan assets as either an asset or a
liability. The projected benefit obligation is the actuarial present
value of the benefits attributed by the pension plan benefit formula
for services already provided. As a result, the complex and
conceptually unsound “minimum pension liability” rules, which are used
when the accumulated benefit obligation is less than the fair value of
pension plan assets, has been eliminated. (The accumulated benefit
obligation is similar to the projected benefit obligation but does not
include expected future salary increases in the calculation of the
present value of actuarial benefits.) In addition, the unrecognized
prior service costs and actuarial gains and losses that were
previously relegated to the footnotes are now recognized on the
balance sheet, with an offsetting amount in accumulated other
comprehensive income under shareholders’ equity.
Income Reporting Under SFAS 158
SFAS 158 does not change the computation of periodic pension cost,
which remains a function of service cost, interest cost, expected
return on pension plan assets, and amortization of unrecognized items.
It does, however, impact the reporting of comprehensive income.
Specifically, actuarial gains or losses and prior service costs that
arise during the period are recognized as components of comprehensive
income. In addition, the amortization of actuarial gains or losses,
prior service costs, and transition amounts recognized before
implementing SFAS 158 require a reclassification adjustment to
comprehensive income.
Applying SFAS 158
Exhibit 1 presents pension footnote data for three companies: Lockheed
Martin, Glatfelter, and AMR Corp. Lockheed Martin represents a classic
example of a scenario SFAS 158 is designed to eliminate: namely,
reporting a pension asset when the pension plan is actually
underfunded. Specifically, Lockheed Martin’s pension obligation
($28,421 million) exceeds its plan assets ($23,432 million), meaning
the plan is underfunded by the difference, $4,989 million. Previously,
Lockheed Martin’s unrecognized net losses and unrecognized prior
service costs (totaling $7,108 million) enabled it to report a pension
asset of $2,119 million ($7,108 – $4,989).
The data for Glatfelter and AMR in Exhibit 1 indicate other likely
scenarios under SFAS 158. Glatfelter, while overfunded by $155.3
million, would reduce its reported pension asset by $90 million under
SFAS 158. Although AMR currently recognizes a pension liability of
$882 million, SFAS 158 would require AMR to significantly increase its
reported pension liability to $3,225 million.
An Illustration of the Transition to SFAS 158
The following example uses the actual 2005 data from Exhibit 1 to
illustrate how each of these companies would record the transition to
the new rules. Because SFAS 158 is generally first effective for
fiscal years ending after December 15, 2006, the actual numbers these
companies record upon transition to SFAS 158 will differ from those in
this example. For simplicity, the illustration ignores tax effects.
Exhibit 1 shows that each of the three companies reports additional
minimum liabilities and related intangible assets on its balance
sheet. These items are eliminated under SFAS 158. In addition, pension
assets and liabilities and accumulated other comprehensive income are
adjusted so that their ending balances conform to the amounts required
under SFAS 158. The necessary journal entries to accomplish the
transition, using 2005 data, are presented in Exhibit 2.
Exhibit 3 shows the balance-sheet reporting for each company after
posting the entries in Exhibit 2, and exposes several important
points. First, each company reports its funded status as either a
pension asset or liability. Second, the balance in accumulated other
comprehensive income equals the amount of previously unrecognized
items. In this example, and likely for many companies with defined
benefit plans, the amount of this contra-shareholders’ equity will
increase under SFAS 158, even potentially generating negative
shareholders’ equity. The transition to SFAS 158 might impose costs on
leveraged firms due to the increased likelihood of tightening
restrictive debt covenants. Finally, the balance-sheet presentation,
and each company’s funded status, should be easier to understand after
SFAS 158 is implemented.
Subsequent Application of SFAS 158
SFAS 158 does not impact the amount of periodic pension cost reported
on the income statement, but it does impact the reporting of
comprehensive income. For example, assume that after implementing SFAS
158 Lockheed Martin were to report the financial results in Exhibit 4.
Again, these amounts are for illustrative purposes only.
Exhibit 5 shows the required journal entries. The first entry records
the service cost, interest cost, and expected return on plan assets
components of periodic pension cost. The second entry reclassifies the
amortization items from accumulated other comprehensive income to
periodic pension cost, and the third entry adjusts the pension
liability and accumulated other comprehensive income for the
difference in actual pension returns above expectations during the
year.
Tax effects. For the sake of simplicity, the illustrations above
ignore the effect of taxes on the financial results. In the real
world, however, the application of SFAS 158 requires companies to
account for the temporary differences between the book and tax bases
of pension liabilities. The balance-sheet liability most businesses
will report after SFAS 158 will in turn either lower their deferred
tax liabilities or increase their deferred tax assets. Companies will
have to consider these effects when assessing the need for and amount
of valuation allowances on their deferred tax assets.
Changes to Required Disclosures
SFAS 158 retains many of the required pension disclosures in current
GAAP. It eliminates the requirement to reconcile the plan’s funded
status and the amount recognized on the balance sheet (as the funded
status will now be recognized on the balance sheet). SFAS 158 as also
eliminates the need to disclose the plan’s measurement date (as this
date now must coincide with the firm’s fiscal year-end).
Prior to SFAS 158, companies could measure their pension assets and
benefit obligations at times other than their fiscal year-end.
Effective for fiscal years ending after December 15, 2008, companies
must measure these items as of the date of their fiscal year-end
balance sheet.
Finally, SFAS 158 expands disclosure of the effects of the pension
plan in other comprehensive income.
--------------------------------------------------------------------------------
Kenneth W. Shaw, CPA, is an associate professor and the CBIZ/MHM
Scholar in the school of accountancy at the University of Missouri,
Columbia, Mo.
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