Magazine article Journal of Commercial Lending

Sorting through the Dramatic New Retiree Health Care Accounting Rules

Magazine article Journal of Commercial Lending

Sorting through the Dramatic New Retiree Health Care Accounting Rules

Article excerpt

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%. …

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