A Smoother Approach to Pension Accounting

The IASB's proposed rules for pension accounting could dampen the effect of asset gains and losses on the bottom line.

The International Accounting Standards Board's long-awaited exposure draft on IAS 19, the standard that governs pension accounting, may turn out to be good news for companies. In a reversal of the proposals that were originally floated, under the exposure draft the impact of asset gains and losses would be reflected in other comprehensive income (OCI) rather than in profits and losses, lessening their impact on a company's earnings.

"Previous proposals would have magnified the volatility. But with this change we may actually see less volatility," both compared with current IASB standards and current U.S. standards, says Jim Verlautz, senior actuary and principal for Mercer US. Verlautz participated in a webcast with IASB officials last week to discuss the draft.

Currently, U.S. companies can "smooth" the asset changes over time, dampening the impact of any given year's stock markets. Under the proposed method, "you're taking them out entirely," says Verlautz, with the expected rate of return on assets being set at the discount rate the company chooses for liabilities.

What's unclear is whether that would encourage companies to take on more or less risk in their pension investments. "One could argue that doing away with the expected return on plan assets could result in there being less incentive for companies to hold risky assets . . . as they would no longer need to do so to support a higher expected rate of return to reduce pension costs," wrote Credit Suisse First Boston analyst David Zion in a recent report on the proposal. "On the other hand, this proposed change could drive them to take more risk in their asset allocations, since gains and losses from re-measurement will never be reflected in earnings."

Among the negatives of the proposal, total pension expense as recorded in the income statement may increase, mostly depending on whether the decrease in expected return is greater than the now-forgone amortization of actuarial losses, notes Verlautz. How a plan's administrative costs are reflected in financial statements may also change, along with other items. And changes to a plan, such as an increase in benefits promised to a union, would have to be reflected immediately instead of amortized over a period such as the length of the contract.

The net-income effect could vary widely from company to company, according to Zion's analysis. Had the proposed rules been in effect for 2009, financial companies included on London's FTSE 100 would have seen 225% sliced out of their collective earnings, while energy companies would have recorded a 1% increase. Other sectors, including consumer staples, materials, and utilities, would have had modest decreases, according to Zion's modeling. (To create the adjusted figures, Zion and his team added back the reported pension cost, then subtracted service cost and an estimated net-interest cost, and then applied standard corporate tax rates.)

The same variability would hold true for U.S-based companies in the S&P 500, though the impact on any given sector would be less severe, and no greater than about a 6% loss in net income. Materials and industrials would have lost the most due to the pension rules in 2009, while energy companies could have recorded a 3.8% gain.

In the long run, though, the actual gains and losses may become more evident, Zion notes, since the Financial Accounting Standards Board and the IASB are expected to propose this month that all OCI items be shown on the face of the income statement, which would likely be renamed.

While CFOs of U.S.-based companies aren't immediately affected by the proposal, Verlautz and others expect it to ultimately become the law of the land. "I expect this draft to pass with minimal changes," says Verlautz, "and eventually, either because the U.S. adopts IFRS or because FASB decides to converge toward it, I think this will pretty much be the rule for U.S. companies as well." Indeed, "the IASB's proposal could help get the FASB's pension project moving again," Zion wrote in his report.

To that end, Verlautz is encouraging CFOs of U.S. companies to make their voices heard now. The exposure draft is open for comments until September 6. The IASB has said it intends to issue final rules by mid-2011.