Wednesday, September 24, 2008

Pension Accounting Made Easier

As of September, 2006, U.S GAAP implemented SFAS 158, which requires companies to now fully recognize on the balance sheet, the over-funded or under-funded status of their pension plans and other post-retirement benefit plans.

There are direct implications of this accounting change on performing ratio and trend analysis. Under the new rules, if a company previously had an under-funded pension liability that was not fully reflected on the balance sheet, the balance sheet items will now be affected by typically increasing pension liabilities, decreasing shareholders' equity (net of tax) and increasing deferred tax assets.

This pension accounting rule change will not affect net income. However, under the under-funded off-balance sheet pension plan scenario, even if net income were to stay the same year over year, with this new standard, shareholders' equity would decrease and thus for non-economic reasons, the ROE would increase! In the same way, if long-term debt levels stay the same, a decreased shareholders' equity would act to increase the debt/capital ratio. If you include pension liabilities as part of long term debt, it exacerbates the situation by increasing the debt/capital ratio even further. So be careful if you are doing ratio and trend analysis before and after 2006 on companies that file under U.S. GAAP.

The other impact of this new accounting standard, is in valuing companies' intrinsic values. Prior to SFAS 158, value investors may have been doing their own calculation of the after-tax impact of off-balance sheet pension assets or liabilities. Now, the pension asset or liability is fully reflected on the balance sheet, so calculations to bring it on-balance sheet are no longer necessary. In fact, continuing to do these off-balance sheet calculations could lead to faulty analysis if all the existing balance sheet items are not fully accounted for.

Analysis of pension and other post retirement plans is still prudent, since there are many management estimates used in constructing both the value of the plan assets and obligations. Identification of overly aggressive or conservative management estimates can be a useful indicator for investors, in order to gauge management's disposition in producing the financial reports.

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