Hidden Financial Risk phần 5 pps

If the health-care cost trend rate increased by 1 percentage point in each future year, the aggregate of the service and interest cost ponents of postretirement expense would increase fo

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Amortization of prior service

Assumed trend rates for health-care costs have an important effect on the amounts

reported for the postretirement benefit plans If the health-care cost trend rate increased by

1 percentage point in each future year, the aggregate of the service and interest cost ponents of postretirement expense would increase for 2002 by $5 million, and the postre-tirement accumulated benefit obligation as of May 26, 2002, would increase by $51

com-million If the health-care cost trend rate decreased by 1 percentage point in each futureyear, the aggregate of the service and interest cost components of postretirement expensewould decrease for 2002 by $4 million, and the postretirement accumulated benefit obli-gation as of May 26, 2002, would decrease by $44 million

Corporate Pension Highlights

These remarks help us understand recent corporate events with respect to pensions andOPEBs As I discuss in more detail later in this chapter, pension costs are a function ofwhat the firm promises to its employees, the interest rate, and changes to the pensionplan In addition, as the pension fund generates returns, these gains reduce the pensioncost (Losses, of course, would increase the pension cost.) A few months ago, NorthwestAirlines reported that its pension costs would exceed $700 million in the fourth quar-ter.6Chevron Texaco will take a pension hit of $500 million.7In particular, the weakfinancial markets will depress earnings by pension funds and thus boost pension costs.Cassell Bryan-Low maintains that this fragility by pension funds will have a majorimpact on AMR, Delta Air Lines, Avaya, Goodyear, General Motors, Delphi, Navistar,and Ford.8

The balance sheets are also under attack The PBGC states that unfunded pension

increase in pension debts foreshadows some potentially dramatic problems in corporateAmerica and on Wall Street unless either business enterprises can pump cash into thepension plans or the economy rebounds sufficiently to produce good returns on the pen-sion assets

The cash flow statement can be severely impacted as well, as General Motors

bil-lion, Ford will put up almost $1 bilbil-lion, and many other corporations will have to make

up the shortfalls

These ideas also help us understand why so many companies in recent years havemodified their pension plans For example, IBM announced in 2000 that it would shift

as a function of the employees’ last years of work, while cash-balance plans computethe pension payments on the basis of the average salary earned over the employee’s entirecareer with the firm This change reduces the benefits to the workers and so reduces pen-sion costs to the firms

Yet another tactic is tapping an underfunded pension plan by selling it the firm’s

pen-sion plan and making it weaker Not only does management take cash out of the penpen-sionplan so less cash is available to the retirees, but also the pension plan is left with the lessvaluable and undiversified stock of the company

Basic Example

This section continues to focus on defined benefit plans, and I develop the conceptsthrough an example Nittany Fireworks begins operations with one employee namedRed Management offers Red suitable compensation plus a defined benefit pensionpackage The firm estimates that Red will work for five years, retire, and then liveanother five years These projections have to be made so that the company can estimatehow much it will owe him for the promised pension and estimate the cost to the busi-

For each year of work Red will receive $1,000 at the end of each year during

6 percent and that it can earn 10 percent on its pension assets The funding policy

of Nittany Fireworks is to contribute $2,000 at the end of each year that Red works forthe company

The service cost is the cost to the employer incurred as the result of the employee’s

working for the firm and earning pension benefits upon retirement In the case ofNittany Fireworks, for each year that Red works, the company must pay him $1,000 peryear during retirement, which we assume lasts five years These cash flows are dia-

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As shown in Exhibit 5.4, there are five cash flows, one for each year during ment These cash flows constitute an ordinary annuity With an interest rate of 6 per-cent, Nittany Fireworks would compute this present value as $4,212 But this present

back another four years Treat the $4,212 as a single sum and discount it back four years

at 6 percent, and the present value is $3,337; this is the service cost for that year WhenRed works a second year, he will earn another pension benefit of a second $1,000 eachyear during retirement To obtain the service cost for the next year, Nittany Fireworks

In like manner, Nittany Fireworks establishes that the service cost for Red’s third,fourth, and fifth years of work is $3,749, $3,974, and $4,212

The projected benefit obligation measures how much the business enterprise will

obli-gation and service cost are similar inasmuch as the entity determines the present value

of the ordinary annuity at the date of retirement and then the present value of this

By agreement, for each year of work the pension pays the employee $1,000 at the end ofeach year during retirement This forms an ordinary annuity where the rent is $1,000

With an interest rate of 6 percent, the present value of this ordinary annuity at t= 0 is

$4,212

To obtain the service cost for a particular year, discount this amount to the end of that

year For Red’s first year of work, from t = −5 to t = −4, we discount $4,212 back four

more years and the present value is $3,337 Likewise, we can discount the amount foreach of the other years he works as well We determine the service cost to be:

After first year of work: $3,337After second year of work: 3,537After third year of work: 3,749After fourth year of work: 3,974After fifth year of work: 4,212

Red Dies

amount for both constructs The projected benefit obligation differs from the servicecost because service cost quantifies the effects of only that year’s impact on the pensioncommitments, while the projected obligation assesses the cumulative effect from all theyears worked by the employees Consider Red’s second year of work The service costmeasures the present value of the incremental $1,000 per year he will receive duringretirement, and this service cost is $3,537 To measure the projected benefit obligation,

we must realize that Red will get $2,000 per year during retirement since he has workedtwo years for Nittany Fireworks, each year earning him $1,000 per year during retire-ment The projected benefit obligation is a present value of $2,000 per year for five

shortcut for computing this is to multiply the numbers of years worked by the currentyear’s service cost (2 times $3,537 equals $7,074) Similarly, the projected benefitobligation for the next three years is $11,247, $15,896, and $21,062, respectively.Let us complete this basic pension example by adding other components, as depicted

in Exhibit 5.5 We have already computed the service costs and the projected benefitobligations, and we copy them to the service cost column and to the projected benefit

obligation column in this exhibit The interest cost is the interest rate multiplied by the

projected benefit obligation at the beginning of the year In this case, it is 6 percenttimes these amounts For example, for the second year, the interest cost is $3,337 times

6 percent for $200 The expected return on plan assets is 10 percent times the plan

assets at the beginning of the year For Nittany Fireworks’ second year, the amount is

10 percent of $2,000, or $200 (That the service cost and the return on plan assets are

equal is an artifact of this example—do not read anything special into this.) The net

pen-sion cost is the service cost for the year plus the interest cost minus the expected return

on plan assets For example, in the second year, the net pension cost is $3,537 plus $200minus $200, for $3,537 This amount is shown on the income statement

The funding is $2,000 in this example by assumption In practice, managers can

pre-paid pension cost (an asset account) or accrued pension cost (a liability account) is the

previous balance minus the net pension cost plus the funding It is prepaid pension cost

if this amount is positive but accrued pension cost if the amount is negative We obtain

$(2,874) in the second year as the previous balance of $(1,337) minus the net pensioncost of $3,537 plus the funding of $2,000 Since this amount is shown on the balancesheet as an asset when positive and as a liability when negative, Nittany Fireworks has

a liability of $2,874

The plan assets equal the previous balance plus the expected return on plan assets

plus any additional funding For the second year, we have the previous balance of

$2,000 plus the return of $200 plus additional funding of $2,000, for a new balance of

$4,200 At this point, there is an internal check on our computations The prepaid sion cost or accrued pension cost should equal the plan assets minus the projected ben-efit obligation

pen-While these items are important to comprehend pension accounting, only two of them

go on the financial statements The net pension cost or pension expense goes on theincome statement, although its components are disclosed in the footnotes If there is a

prepaid pension cost, it goes on the asset section of the balance sheet; if there is anaccrued pension cost, it reaches the liability section of the balance sheet The constituents

of this asset or liability are also revealed in the footnotes

Prior Service Cost

Often real-world pension plans are started after the corporation has been in existencefor a while The corporation might decide to grant employees some pension benefitsbased on their prior years’ working for the enterprise The cost for this generosity is

termed the prior service cost.

Continuing with the above illustration, assume that Red has worked three years prior

to the pension plan Nittany Fireworks grants him three years toward his pension plan,

so he will receive $3,000 per year ($1,000 for each year) during his retirement Because

of this prior service cost, the managers increase the yearly funding up to $4,000 Allother assumptions remain the same, so this $3,000 each year for five years represents

an ordinary annuity, which yields a present value at the date of retirement of $12,637

becomes the initial projected benefit obligation at the beginning of this year

The new question is when to inject this prior service cost into the income ment While it should go into the income statement in the year that this prior servicecommitment is made because that is when the cost is incurred, the FASB appeasedmanagers by allowing them to add this cost into the income statement gradually overtime We shall amortize this amount on a straight-line basis over the rest of the periodthat the employee works for the firm, which is five years Therefore, the amortizationcost equals one-fifth of $9,443, or $1,889 per year With these computations, we cre-ate a new pension schedule that is shown in Exhibit 5.6 As can be seen, this schedule

state-is similar to that in Exhibit 5.5

Nothing changes with respect to the service cost, so that column stays the same Theinterest cost is computed the same as before The numbers in this column are biggerthan those in the previous exhibit since this example begins with a larger projected ben-efit obligation The expected return on plan assets in Exhibit 5.6 is computed in thesame way as in Exhibit 5.5 As explained, the amortization of the prior service cost is aconstant $1,889 We amend the net pension cost, so that now it is the service cost plusthe interest cost minus the expected return on plan assets plus the amortization of priorservice cost The funding is $4,000 per annum by assumption The prepaid pension cost

or accrued pension cost is the previous balance plus the funding minus the net pensioncost Both the projected benefit obligation and the plan assets are calculated in the samemanner, making allowances for changes in the demonstration Again, a built-in checkexists, for the prepaid pension cost or accrued pension cost must equal the plan assetsplus the unrecognized portion of the prior service cost minus the projected benefit obli-gation Exhibit 5.6 also presents the unrecognized prior service cost, that is, the amount

As before, only two of these constructs go on the financial statements The net sion cost or pension expense goes on the income statement, and the prepaid pension cost

pen-or accrued pension cost enters the balance sheet The other ingredients of this pension

recipe can be found in the footnotes, including the unrecognized prior service cost.Exhibit 5.3 shows these accounts and others for General Mills.

Financial Statement Effects

The income statement for the basic example makes sense, but the amortization of theprior service cost does not A more accurate view of what is going on requires investorsand creditors and their analysts to adjust the reported numbers and place the entirequantity in the year of adoption The smoothing that the FASB allows is arbitrary andirrational, for the amortization expense relates to nothing in those later years

A second thing to notice on the income statement is the net pension cost includes the

expected return on plan assets It would seem that the actual return should be reported,

as the actual numbers are purportedly used elsewhere in the financial report instead ofsome fantasy amounts What the FASB did in SFAS No 87 was permit entities to reportthe expected return as part of the pension expense and then compute pension gains orlosses as the difference between the expected and actual returns on the plan assets Itgets worse, however, because the FASB permits business enterprises to amortize thesegains and losses over a long period of time, thus obfuscating any bad news when it

corpo-rations report, for the FASB engages in some fairy-tale magic This fact also explainswhy I applaud S&P’s use of actual returns when it determines core earnings of businessentities

The netting of the projected benefit obligation against the plan assets is likewise silly.Given that managers have some discretion for removing some of the assets from thepension plan, the netting is improper A correct balance sheet would report these twoaccounts separately, as I shall illustrate later in the chapter

Finally, the unamortized prior service cost is not recognized in any account Theentire prior service cost represents a commitment made by the managers of the corpo-ration Given that the firm has an obligation, the ethical thing to do is to report the debtrather than conceal it

While the discussion has concentrated on pension accounting, the points generallyapply to OPEBs as well Some of the terminology differs between them, but the com-putations and the methods are the same This fact becomes obvious by looking at theGeneral Mills footnote in Exhibit 5.3 and observing that both pension plans andpostretirement benefit plans can be put into the same schedule

ADJUSTING PENSION ASSETS AND LIABILITIES

To obtain a better view of the business enterprise, readers should employ analyticaladjustments In this case, we shall adjust the balance sheet and ignore the effects on

equity method in Chapter 3 and accounting by lessees in Chapter 4, these adjustments

may improve the reported numbers Whether they in fact do this depends on whetherthe corporation is hiding pension gains or losses and amortization expenses.

Interest Rate Assumption

As the company performs the pension calculations, it must make some estimate of theinterest rate on the projected benefit obligation and of the expected return on planassets The interest rate on the projected benefit obligation should be the rate that a thirdparty would charge the company to settle the pension debt In other words, if the busi-ness enterprise would pay another entity to take over its pension debt, the interest ratethat would be embedded in that contract is the interest rate that the firm should use whencomputing the pension expense This settlement could be accomplished by buying anannuity contract from an insurance company The expected return on the plan assetsought to be the long-run return from interest, dividends, and capital appreciation.Investors and creditors and financial analysts grasp the fact that managers haveincentives to “cook” these rates Managers look better if they overstate the interest rate

on the projected benefit obligation, because lower interest rates result in higher jected benefit obligations while higher interest rates result in lower liabilities To hideits pension debts, managers can choose higher interest rates This masquerade often car-ries a cost to the managers; namely, they usually report higher interest expenses because

pro-of the higher rate But this higher rate is multiplied by the lower projected benefit gation, so the interest cost can be either lower or higher In the early years of a pensionplan, the interest rate tends to be lower, but in the later years, it can become quite large.But the managers might themselves be retired by then

obli-Managers also can play with the expected return on plan assets In this case theyunambiguously prefer higher rates, which reduce the accrued pension liability shown onthe balance sheet and decrease the net pension cost Because of these incentives,investors and creditors and their agents must investigate the interest rate assumptionsmade by a business enterprise

If financial statement users do not like the interest rate reckoned by managers, theycan formulate a simple adjustment Let us assume that the pension cash flows are con-stant and that they constitute a perpetuity, that is, the cash flows go forever Given thatpensions actually cover a long period of time, say 40 to 50 years, this assumption doesnot introduce very much error As stated in Chapter 4, the present value of a perpetuity

is the cash flow divided by the interest rate In this context, the value of the projectedbenefit obligation is the present value of the annuity Statement users can take thereported projected benefit obligation and multiply by the assumed interest rate to arrive

at the presumed cash flows (“rents” as defined in Chapter 4), then take this presumedannual cash flow and divide by the interest rate they think is proper The answer is thesuitable projected benefit obligation

As an example, let us reconsider the pensions of General Mills, as reported in Exhibit5.3 In 2002 General Mills had a projected benefit obligation of $2.1 billion under a dis-count rate of 7.5 percent Suppose one thinks that a more appropriate rate is 6 percent.One would then compute the implied annual cash flow as $2.1 billion multiplied by.075 for $157.5 million, then divide this rent by 06 to obtain a projected benefit obli-gation of $2.6 billion Notice how such a simple assumption increases the liabilities by

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$500 million These assumptions therefore are critical to a proper analysis of a firm’seconomic well-being.

Similar calculations can be conducted for the plan assets and for OPEBs

Eliminating the Netting and the Amortizations

As explained, it is improper to net the projected benefit obligation and the pension planassets, and it is foolish not to include the prior service cost in the pension cost and theprojected benefit obligation Now we shall make two analytical adjustments to discoverthe more accurate balance sheet The first adjustment unnets the projected benefit obli-gation and the pension assets The pension assets are placed in the assets section of thebalance sheet, whereas the pension debts are situated in the liabilities section of the bal-ance sheet Since the prepaid pension cost/accrued pension cost equals the differencebetween those two accounts, the balance sheet will stay in balance

The second adjustment puts all of the unrecognized prior service cost and any otherunrecognized items into both the pension expense and the projected benefit obligation.Since revenues and expenses are transferred into retained earnings, that is where we shallput them Keep in mind that some of these unrecognized items might be unrecognizedpension gains, so this adjustment could decrease the debt levels of some organizations

We shall again use General Mills as an example, and we report the process in Exhibit5.7 We obtain the assets, the tangible assets (assets minus the intangible assets), debts,equities (including minority interest), and tangible equities (equities minus the intangi-ble assets) from the 10K Panel A reveals these reported numbers and computes fourindicators of the financial structure of General Mills (The assets are so much bigger in

2002 than in 2001 because of acquisitions that General Mills made during the year.)Panel B of Exhibit 5.7 gives the three numbers needed for the adjustments for unrec-ognized items, plan assets, and projected benefit obligations (They also appear inExhibit 5.3.) These quantities apply for both pensions and OPEBs We then adjust thereported numbers in panel A utilizing these items in panel B We add plan assets to thereported assets, and we subtract the unrecognized items from stockholders’ equity.Since the balance sheet has to balance, we calculate adjusted liabilities as the adjustedassets minus the adjusted equities Alternatively, the adjusted liabilities equal thereported debts minus the accrued pension costs (not shown in the exhibit) plus the pro-jected benefit obligation plus the unrecognized items

Panel C of Exhibit 5.7 shows the resulting accounts along with the subsequent ratios.Notice that all of the debt ratios deteriorate, thus disclosing the effects of the hiddendebts For example, the debt-to-assets ratio increases in 2002 from 0.77 to 0.81 and in

2001 from 0.99 to 1.02

Exhibit 5.8 depicts the results of these analytical adjustments to a random sample ofcorporations Some companies, such as Conseco, show little change Some companies,such as Nicor and AK Steel, experience large modifications in the ratios The debt ratios

of a few companies, such as the Washington Post, improve

These analytical adjustments serve as a way to better assess the financial structure of

a business enterprise The unnetting of the pension asset and the pension liability andthe recognition of the items not recognized in the financial statements are importantsteps in understanding company performance

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Panel A: Reported Numbers (in Millions of Dollars) and Ratios

Panel C: Adjusted Numbers and Ratios

Exhibit 5.8 Analytical Adjustment with a Sample of Firms

Debt to Tangible Asset 2.44 2.87 2.04 2.34

AK Steel Holding Corporation

SUMMARY AND CONCLUSION

Debt matters, and that includes pension debt Given the huge amounts of money that areinvolved in pensions, it behooves the investment community to obtain a right under-standing of what pension accounting is about Pension expense includes the service costplus the interest on the projected benefit obligation minus the expected return on planassets plus the amortization of various unrecognized items, such as the unrecognized

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prior service cost The only item found on the balance sheet is the prepaid pension asset

or the accrued pension cost, which in turn equals the pension assets minus the projectedbenefit obligation minus various unrecognized items

While the FASB made great strides over existing practice when it issued SFAS No

87 and related statements, interpretations, and amendments, it still falls short of what iscorrect and appropriate The netting of the projected benefit obligation and the pensionassets is wrong; consequently, investors and creditors and financial analysts must unnetthem to gain a better understanding of what is really going on Additionally, the lack ofrecognition of the prior service cost and the actual gains and losses on the plan assetsand other items is incorrect; investors and creditors and financial analysts must addthese items to the pension liability and remove them from stockholders’ equity Theseanalytical adjustments will help financial statement readers to discover the effects ofthis hidden debt

Last, managers’ interest rate assumptions can greatly influence the reported numbers.The investment community should examine these interest rates carefully and assesswhether they are appropriate By assuming that the cash flows form a perpetuity,investors and others can easily adjust the values for other interest rates

NOTES

1 A short history of pension accounting is given by H I Wolk, J R Francis, and M G

Tearney, Accounting Theory: A Conceptual and Institutional Approach, 3rd ed (Cincinnati,

OH: South-Western Publishing, 1992), pp 476–509 As to still-existing loopholes, analystsare beginning to cover this topic with much fervor As examples, read: J Doherty, “Pay MeLater? An Increase in Underfunded Pension Plans Could Pose Trouble for Companies and

Shareholders.” Barron’s, October 21, 2002; D Kansas, “Plain Talk: Pension Liabilities a Big Concern,” Dow Jones News Service, October 1, 2002; J Revell, “Beware the Pension Monster,” Fortune, December 9, 2002; and B Tunick, “The Looming Pension Liability: Analysts Focus on Problem that FASB Rules Ignore,” Investment Dealers Digest, October

14, 2002

2 C Bryan-Low, “Heard on the Street: Pension Funds Take Spotlight—Numbers Released by

S&P Bring Attention to Issue of Accounting for Costs,” Wall Street Journal, October 25,

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9 K Chen, “Unfunded Pension Liabilities Soared in 2001 to $111 Billion,” Wall Street Journal,

July 26, 2002

10 M W Walsh, “Companies Fight Shortfalls in Pension Funds,” New York Times, January 13,

2003

11 CBS News, “IBM Workers: Pension Change Hurts,” CBS News, April 25, 2000.

12 M Brannigan and N Harris, “Delta Air Changes Pension Plan to Slash Costs over Five

Years,” Wall Street Journal, November 19, 2002

13 F Norris, “Using a Weak Pension Plan as a Cash Cow,” New York Times, December 20, 2002

14 For more details about accounting for pensions and OPEBs, see: P R Delaney, B J Epstein,

J A Adler, and M F Foran, GAAP 2000: Interpretation and Application of Generally Accepted Accounting Principles 2000 (New York: John Wiley & Sons, 2000), pp 635–667;

G Georgiades, Miller GAAP Financial Statement Disclosures Manual (New York: Aspen, 2001), section 22-24; B D Jarnagin, 2001 U.S Master GAAP Guide (Chicago: CCH, 2000),

pp 871–1068; D E Kieso, J J Weygandt, and T D Warfield, Intermediate Accounting, 10th

ed (New York: John Wiley & Sons, 2001), pp 778–848; L Revsine, D W Collins, and W

B Johnson, Financial Reporting and Analysis, 2nd ed (Upper Saddle River, NJ: Hall, 2002), pp 689–757; and G I White, A C Sondhi, and D Fried, The Analysis and Use

Prentice-of Financial Statements, 2nd ed (New York: John Wiley & Sons, 1997), pp 591–670.

FASB’s SFAS No 132 standardizes pension disclosures; see Financial Accounting Standards

Board, Employers’ Disclosures about Pensions and Other Postretirement Benefits: An Amendment of FASB Statements No 87, 88, and 106, SFAS No 132 (Norwalk, CT: FASB,

1998)

15 These calculations require present value tools To brush up on how to compute a presentvalue, read about this topic in Chapter 4

16 Of course, in practice pensions are typically monthly payments I assume annual payments

to simplify the arithmetic at no loss of generality

17 Trying to estimate when one person will die has obvious measurement error, but if the poration has hundreds or thousands of employees, this error becomes much smaller as somepeople die before and some after their life expectancy, and the errors begin to cancel out

cor-18 A related concept is accumulated benefit obligation The two concepts are the same, except

that accumulated benefit obligation ignores future salary raises, but projected benefit tion includes them Since accumulated benefit obligations enter the picture only in the deter-mination of minimum pension liability, we ignore them

obliga-19 The movie Wall Street reminds us that managers usually do not want to put too many funds

into the pension plan because it sets up the firm as a potential takeover target

20 There are several other components of net pension cost, including amortization of effects ofamendments and the transition to adoption of SFAS No 87 (and SFAS No 106) Thesedetails are omitted here, but they are treated in a manner similar to the prior service cost

21 Actually the FASB creates a complicated method termed the corridor approach, which

cre-ates certain boundaries The firm must show gains and losses that exceed these limits For

details, see Delaney et al., GAAP 2000, pp 635–667; Georgiades, Miller GAAP Financial Statement Disclosures Manual, section 22–24; and Jarnagin, 2001 U.S Master GAAP Guide,

pp 871–1068

22 White, Sondhi, and Fried discuss one process for making these income statement analytical

adjustments; see Analysis and Use of Financial Statements, 2nd ed., pp 541–547.