Sorting through the Dramatic New Retiree Health Care Accounting Rules
Spalding, Albert, Reinstein, Alan, Gray, Peter C., Journal of Commercial Lending
Bankers and other financial statement users will see financial statements in coming months that will reflect the most dramatic plunge in earnings ever reported by U.S. businesses.(1) And the drop will not be the result of economic recession, industry turmoil, the ravages of imports, or management inefficiency.
The drop in earnings will be the result of a change in accounting rules. In particular, the "hit" is the result of the issuance of SFAS No. 106 by the Financial Accounting Standards Board (FASB).(2) The rule requires the accrual of postemployment health care benefits in lieu of the traditional "pay as you go" method of accounting for these costs.
Effect on Corporate Earnings
The accounting change, which has already triggered or exacerbated huge corporate losses, is one of the most significant and complicated modifications to financial statements ever announced by the accounting profession. Its effects have been immediate and striking. Some companies, for example, have already reported that a significant portion of their net worths will be consumed by the charge to earnings caused by the new rule.
For example, General Motors Corporation has a net worth of $28 billion, but this accounting rule is expected to absorb $24 billion. Ford Motor Company's entire $6 billion net worth will be virtually wiped out by the change. And USX's net worth of $5.3 billion is expected to shrink to less than half that amount after the change is implemented.(3)
Smaller companies will be affected just as seriously. In a survey by William M. Mercer, Inc., it was reported that companies with fewer than 1,000 employees will experience an increase in their retiree health benefit expense by a factor of three or more, as indicated in Figure 1.(4)
The implementation of SFAS No. 106 can also have an adverse impact on the financial statements of commercial banks. Citicorp has disclosed that the application of SFAS No. 106 will result in a 4% reduction in stockholder equity, an amount of approximately $400 million. Other banks maintaining retiree health programs will be similarly affected.
A major employee benefits consulting firm, Towers, Perrin, Forster & Crosby, analyzed the potential effect of SFAS No. 106 on 200 mid- to large-size companies. It concluded that if the new rules had been in effect in 1990, those companies would have had to accrue $2,500 per active employee (rather than the current cost of $340 per employee) on their 1990 financial statements. About 30% of that $2,500 covers prior year service (and could therefore be amortized over 20 years), and the rest covers the costs expected to be incurred between now and retirement.
The Old Rule
Until now, most companies have accounted for the cost of postemployment health care, life insurance, housing allowances, and similar benefits under the cash basis method or have otherwise accrued those benefits on their financial statements as employees have retired. Several reasons governed this prior method of accounting:
1. The quantitative difference between preretirement accrual of these costs and the cash method was often thought to be immaterial.
2. The benefit (in terms of more useful or more fair financial statement information) of early accrual of these postemployment benefits did not appear to outweigh the costs, including the actuarial costs of obtaining such information.
3. The mix of ages in various companies within an industry did not differ so significantly that an intercompany comparison of financial statements reflecting such accruals would yield substantially different analytical results from a comparison of the same statements without such accruals.
The New Rule
As health care costs have soared, however, the impact of postemployment health care costs has increased. In the 11 years from 1976 to 1987. spending for medical care generally exceeded inflation by almost 80%.(5) In 1988, national health care expenditures exceeded $500 million and constituted more than 11% of the U.S. gross national product--up from $27 billion, or 5.3% of the gross national product, in 1960.(6)
Part of the reason for this increase has been the fact that people are living longer.(7) As individuals enter the last decades of life, their needs for long-term care and the resultant costs increase exponentially. One study showed that 62% of women and 46% of men 85 years old and older either reside in nursing homes or need assistance to live at home.(8)
SFAS No. 106 establishes standards for employers, accounting for postemployment benefits other than pensions, under the theory that postemployment benefits are a form of deferred compensation provided by employers in exchange for preretirement services rendered by their employees. In requiring employers to accrue the cost of retiree health and other postemployment benefits, the FASB has concluded that the costs of these benefits should be reflected on the financial statements of employers when they are "earned," that is, when the employees are performing services on behalf of the corporation, in a manner similar to the accrual of pension benefits.
The process of projecting future health care costs for older persons, however, is a difficult one. Several "soft" variables, such as the following, must be employed:(9)
* Projected number of individuals
age 65 years and older (and their
distribution within specific age subgroups).
* The estimated prevalence of various
categories of disease and disability
at specific ages.
* The estimated costs of providing
health care at different ages for specific
Despite these difficulties, the FASB has concluded that proper accounting theory calls for some rational effort at estimating and accruing these costs. In this regard, SFAS No. 106 follows the general pattern of SFAS No. 87, "Employers, Accounting for Pensions":
The financial statements of employers reflect the cost of postemployment compensatory obligations.(10) In so doing, SFAS No. 106, like SFAS No. 87, requires that the accounting for these obligations reflect such factors as:
* Turnover rates.
* Provisions for vesting.
* Future increases in wages or salaries
that would, in turn, trigger increases
in postemployment obligations.
* Rate of earnings on assets set aside
to fund the future obligations.
Reasons for SFAS No. 106
In promulgating SFAS No. 106, the FASB has attempted to:
1. Upgrade the relevance and representational
faithfulness of employers,
financial statements. This result
will be brought about--or so
the FASB intends--by including
on the balance sheet a measure of
the present value of future retiree
health care obligations and by including
on the income statement
an expense reflecting current earnings
of those future obligations by
2. Disclose to financial statement users
the extent and effects of employers,
3. Foster comparability of financial
statements by requiring employers
with similar postemployment plans
to use the same method of accounting
for those plans.
Components of Accounting
Under SFAS No. 106, employers must accrue the cost of postemployment benefits as soon as employees are eligible to receive those benefits. This requirement will move expenses of future years (under pre-SFAS No. 106 accounting methods) onto current year income statements. Benefits owed to both active and retired employees are accounted for, and even employees not yet fully eligible for benefits are considered. The calculation of the balance sheet liability to be accrued, as part of this process, is accomplished under SFAS No. 106 as indicated in Figure 2 . Each of the components noted in Figure 2 are discussed briefly below.
The expected postemployment benefit obligation (EPBO) is the actuarial present value of the estimated future costs of postemployment benefits to be paid to employees and their dependents. It includes those costs associated with employees who are not fully eligible for those benefits, as well as costs associated with retirees and with active employees fully eligible for benefits.
The EPBO is derived from the employer's substantive postemployment benefit plan(s) as applied to its existing work force on an employee-by-employee basis. Actuarial and related assumptions concerning life expectancy, claims experience, health care cost trend rates, Medicare reimbursements, employee turnover, and number of dependents are considered.
For example, a company must estimate the probability of an employee retiring. The employee's life expectancy upon retirement, the costs of health care for this employee, the possibilities of children or additional children, and the types of treatments available for treating certain diseases--and the present value of these and many other actuarial assumptions--are reduced to a single balance on the current financial statements.
The accumulated postemployment benefit obligation (APBO) is the actuarial present value of the future costs of those benefits that have been "earned" by active employees who are fully eligible for the benefits, as well as benefits owed retired employees.
Once an employee is fully eligible for the postemployment benefits of the plan(s), all the employee's benefits be come part of the employer's APBO, and none are part of the EPBO.
The EPBO represents the contractual amount of the actuarially computed present value of all future postretirement benefits expected to be paid to the employee and to the employee's beneficiaries and dependents. For purposes of this calculation, the EPBO for each employee is measured over a period commencing with the hire date (or a later date if the plan does not grant credit for service from the hire date) and terminating with the date of full eligilibity. This accrual period is known as the "attribution period."
For example, assume that the an employee was hired on January 1, 1982, and will become fully eligible for postemployment health care benefits after 20 years of service--December 31, 2001. The attribution period is the period from 1982 (hire date) to 2002 (full eligibility date); the APBO for the 1992 financial statements would be approximately one-half of the total amount to be accrued eventually.
Figure 3 summarizes the accrual process for each relevant time period with respect to that employee. Figure 4, in turn, depicts the accrual of the employee's postemployment benefits from 1982 to 2002, with the projected amortization of the accrued costs during the retirement years (2012 through the employee's life expectancy).
The Difference Between EPBO and APBO
The difference between an employer's EPBO and APBO is the future service costs of active employees not yet fully eligible. Figure 5 shows the relationship between EPBO, APBO, and these future service costs. The annual increase in APBO "drives" the financial statement recognition of the postemployment benefit costs.
If an employer recognizes the entire unfunded APBO as of the date SFAS No.106 is first implemented on the employer's financial statements, the financial statement effect can be drastic. To mitigate such a dramatic negative impact, SFAS No. 106 provides for the amortization of the unfunded APBO on the financial statements of the employer as of the implementation (referred to as the "transition amount") .
If the employer elects to amortize the transition amount, it is done on a straight-line basis over the average remaining service period of active plan participants. The average remaining service period is determined actuarially. It is based on the period commencing with the first day of the fiscal year during which the employer implements SFAS No.106, and it ends with the expected retirement dates of employees who are in place at the time of transition and expected to receive postemployment benefits.
If the average remaining service period is less than 20 years, the employer may elect a 20-year amortization period. If almost all participants are inactive, an amortization period equal to the average remaining life expectancy of inactive plan participants is used instead of an amortization period tied to the expected remaining service lives of the active participants.
In addition to the disclosure of EPBO liabilities, the accrual of APBO liabilities on the balance sheet, and the income statement recognition of the amortization of those liabilities, SFAS No. 106 calls for the footnote disclosure of a lengthy list of items:
1. Nature of the plan, which includes:
* A description of basic plan provisions
* An explanation of substantive
(recent and expected future)
modifications of the plan.
* The extent of any contractual
increases in benefits.
* Employee groups covered.
* Types of benefits provided.
* Employer's funding policy.
* Types of assets held for funding
* Nature and effect of any matters
affecting year-to-year financial
2. Net periodic cost for the current
period, which includes:
* Service cost.
* Interest cost.
* Current return on plan assets.
* Amortization of unrecognized
prior service cost.
* The net effect of plan asset gains
* The cost of providing special or
contractual termination benefits
(and a description of the nature
of such events).
* The amount of gains or losses
arising from a settlement or curtailment
(including a description
of the nature for such
3. Financial condition of plan, which
* Fair value of plan assets.
* All accumulated Other Postemployment
Benefit (OPEB) obligations
(showing separately the
portion or portions attributable
to retirees, other fully eligible
plan participants, and other active
* Prior service costs.
* Potential gains and losses on
plan assets not yet recognized.
Amounts and types of employer
securities included in plan assets.
* Extent of insurance coverage of
future OPEB obligations (including
separate disclosure of
insurance issued by the employer
or related parties).
* The outstanding balance of any
4. Assumptions used, which include:
* Health care cost trend rates (including
a description of the direction,
timing, and pattern of
change in assumed future rates).
* Rates of increase in projected
* Discount rates used to measure
* Alternative accelerated amortization
* Expected rates of return on plan
assets (net of tax effect, if any).
5. The one percent rule, requiring a
disclosure of the effect of a one
percentage point increase in the assumed
health care cost trend rate
on the measurement of APBO (including
the related aggregate of the
service and interest cost components
of net periodic cost), holding
all other assumptions constant.
Coping with SFAS No. 106
It will be necessary for bankers and other financial statement analysts to determine the extent to which a particular company has implemented SFAS No. 106. They will also be required to determine whether the cumulative effect of the accrual is being accounted for as a one-time accounting change or, using the SFAS No. 106 transition approach, over a period of time. In many situations, it will also be helpful to "back out" the accrual of OPEB to compare current financial statements with older historical information.
Managers will be expected to deal with the implications of SFAS No. 106, including such cash flow issues as:
1. The effect on the debt-to-equity ratio
of the enterprise and the ability
to raise capital from investors and
lenders in view of that effect.
2. The lack of tax deductibility for the
prepayment of OPEB obligations.
3. The necessity of taking into account
the new financial statement
ramifications of providing postemployment
health care benefits to
employees and the consequences
of collective bargaining, negotiations
of executive compensation,
and the restructuring of benefits
within the organization.
4. The opportunity for companies
with overfunded pension plans to
transfer OPEB obligations to the
pension plan, thereby absorbing
the over funding rather than
allowing excess pension assets to
revert to the employer.
Preparers and Users
Financial statement preparers and users must also recognize that expected postemployment benefit obligation information, reported or disclosed as a result of SFAS No. 106, is not necessarily reliable for these reasons:
1. Historical data have often not been
accumulated by employers in a
manner sufficient to make statistically
reliable estimates of future
2. Abrupt individual changes within
an employer's work force (such as
marriages of employees to spouses
considerably younger or older than
themselves, sudden changes in the
health conditions of one or more
employees, and similar events) can
have a significant impact on OPEB
3. The expected future trends of medical
costs are highly uncertain;
therefore, any disclosed amount
should be viewed cautiously.
4. Accountants and actuaries have
not had much experience in estimating
the variables that enter into
SFAS No. 106 computations.
SFAS No. 106 represents the accounting profession's attempt to deal with a serious problem: escalating health care costs. To the extent that bankers and other financial statement users have better information regarding the effect of these costs on the economic well-being of employers, SFAS No. 106 will serve these users well.
Company managers are more aware of the current economic effect of agreements to provide postemployment benefits. They are, moreover, better prepared to fund or otherwise prepare for the inevitability of these costs. Therefore, both employers and employees will benefit. (1) For companies with 500 or more employees, SFAS No. 106 is effective for fiscal years beginning after December 15, 1992. For other companies, it applies to fiscal years beginning after December 15, 1994. (2) Financial Accounting Standards Board, Statement of Financial Accounting Standard No. 106, "Emplo Accounting for Postemployment Benefits Other than Pensions," 1990. (3) Data taken from corporate annual reports, as reported by Light, Treece and Driscoll, "Now That Wasn't So Bad...Was It?" Business Week, December 2, 1991, p. 123. (4) Colleen Johnson, "Employers Expect FASB Rule to Cost Dearly," Benefits Administration, April 1, (5) S.H Altman and M.A. Rodwin, "Halfway Competitive Markets and Ineffective Regulation: The American Health Care System," Journal of Health, Politics, Policy and Law, 1988: Vol. 13, pp. 323-339. (6) I.R. Levit, M.S. Freeland, and D.R. Waldo, "National Health Care Spending Trends: 1988," Health Affairs, 1990: Vol. 9, pp. 171-184. (7) G. Spencer, "Projections of the Population of the United States by Age, Sex and Race: 1988 to 2080," Current Population Reports, Bureau of the Census, Series P-25, No. 1,018, 1989. (8) E.L. Schneider and J.M. Gualnik, "The Aging of America: Impact on Health Care Costs," Journal of the American Medical Association, May 2, 1990: Vol. 263, pp. 2,335-2,340. (9) Ibid. (10) Financial Accounting Standards Board, Statement of Financial Accounting Standard No. 106, "Empl Accounting for Postemployment Benefits Other than Pensions," 1990.…
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Publication information: Article title: Sorting through the Dramatic New Retiree Health Care Accounting Rules. Contributors: Spalding, Albert - Author, Reinstein, Alan - Author, Gray, Peter C. - Author. Magazine title: Journal of Commercial Lending. Volume: 74. Issue: 11 Publication date: July 1992. Page number: 36+. © 1992 The Risk Management Association. COPYRIGHT 1992 Gale Group.
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