Canadian and international accounting regulators are working on a major overhaul of the way financial statements are presented that will move pension plan reporting out of the fine print of the footnotes and put it front and centre in financial results.
The reforms -- which are still in the drafting stage -- will require companies with defined benefit pension plans to report any surplus or deficit in their plans on a redesigned income statement. They will also be compelled to clearly show the impact that income or losses from their pension plans had on their results.
"We want to make things much more transparent so people don't have to dig around in the footnotes to figure out what is going on," says Tricia O'Malley, Canada's representative on the International Accounting Standards Board.
The proposed changes, which the international regulator would like to put in place in 2004, are sure to push the issue of pension accounting even further up the business agenda in the coming year.
"This will be a big accounting issue for 2003," predicts Christine Wiedman, an accounting professor at the University of Western Ontario who is doing research on pension funds in Canada.
Prof. Wiedman says the topic likely will gain more attention as companies disclose growing funding deficits for plans in their 2002 results and those liabilities begin to affect their credit ratings and their ability to borrow. That is what has already happened at major U.S. companies such as General Motors Corp. and Ford Motor Co., which had their credit ratings lowered by Standard & Poor's partly over concerns about their pension funds.
The issue of pension accounting has become a flash-point over the past year, largely because of the dramatic reversal in fortune many plans have faced as both equity markets and interest rates went into freefall.
Hefty surpluses have evaporated and companies that for years had the luxury of using income from their pension plans to boost their bottom line are now faced with growing pension costs.
To make matters worse, the field of pension accounting is awash with rules that often make it difficult for investors to figure out just how bad -- or even how good -- things are.
"What we have now is some weird debit or credit on the balance sheet that in no stretch of the imagination could ever be described as an asset or a liability that anyone could understand," Ms. O'Malley says. "It produces some bizarre stuff."
Part of the difficulty is that under current rules, companies are allowed to delay recognizing changes in the value of their plans and can spread the reporting of those changes over several years -- a practice known as smoothing.
While markets were on a tear, nobody paid much attention to this fact -- or to the fact that profit figures in some cases included sizable pension income components.
Once markets tanked, it became a whole different story as analysts and investors began to recognize that large liabilities were building at some firms and rules were enabling companies to keep those losses off the balance sheet.
In the post-Enron era, any off-balance sheet debt is sure to draw attention, and given the poor performance of most funds, those debt numbers are likely to increase.
Prof. Wiedman is currently looking at the funding status of 100 of the country's largest defined benefit funds. (A defined benefit plan is one where employees are guaranteed a pension income based on their service and salary level.) Her findings -- to be published early next year -- show that 42 per cent of those plans showed a surplus at the end of 2001, down from 77 per cent in 2000. She predicts that number will run between 17 and 22 per cent this year.
As well, her research shows the large gap between what gets reported on the balance sheet and fund performance. In all, she found, the 100 plans were underfunded by a total of $1.8-billion in 2001, but showed $6.7-billion in assets on their balance sheets. What that means, she says, is that there was about $8.5-billion in debt kept off the balance sheet among these firms.
"You can see that the financial statements do not reflect the economic status of plans," she says.
This year, analysts and investors -- including Warren Buffett -- also began to question the rosy assumptions some companies were making about the returns they expected to generate from their pension funds.
Those assumptions are key because they directly affect the pension costs of a firm. A revision of just 1 per cent in a pension fund's expected return on investments on average shaves close to 7 per cent off operating profit, according to a study by Prof. Wiedman of 27 Canadian plans this year. At firms with large, mature funds, the change can be much higher.
Now international regulators want to change all that, and Canadian standard setters say they will likely follow their lead.
"If you are going to make significant changes in anything as big as pensions, we do not want individual countries going off and doing their own thing," says Paul Cherry, chairman of the Accounting Standards Board of the Canadian Institute of Chartered Accountants. "We are hoping if the international board looks at it, we will be able to piggyback on some of their work."
The changes proposed by the international board are designed to go hand in hand with the remodelling of the income statement and would end smoothing altogether. They would also end the debate about estimated returns because returns would be reported as they actually took place.
"The number doesn't get buried or smoothed. You would report value changes as they happened," Ms. O'Malley says.
That's a change that accounting experts say will lead to more uncertainty in corporate earnings.
"If smoothing mechanisms are no longer available it will introduce further volatility in corporate earnings," says Ashley Witts, a pension expert at Towers Perrin in Vancouver.
Indeed, standard changes introduced in Britain this year that require companies to review their plan's assets and liabilities annually and declare the results in their annual statements provoked an outcry. Several employers, including Marks & Spencer and British Airways, have closed their defined benefit plans to new employees. In the end, British regulators suspended the new rules and said they would wait for the international standard.
But Ms. O'Malley says the design of the new income statement should solve some of those problems.
Yes, the elimination of smoothing will mean more volatility, she says, but investors will be able to clearly see that the changes (good and bad) are caused by changes in the pension fund -- not a company's main business.
"What we are trying to do is find a way to report what is going on in the plan without distorting the reporting of the business operations," she says.
"We are saying we will report volatility and report it when it does happen, but display it in such a way that people can identify it for what it is and make their own judgments about what that should do in terms for their valuation of the firm."
In order to do that, the international body is proposing that the current pension number be broken up and that its various components be reported in the appropriate place on the newly designed income statement. Income from the plan, for example, would be shown for what it is -- investment income -- and service costs would be shown as a business expense.
Ms. O'Malley says firms already have to make these calculations. The new standard would simply require them to show this work.
Mr. Cherry at the CICA thinks this is a sensible way to go.
"People really need to be aware of the significant components that affect the single number that is currently being reported as pension expense or pension income," he says. "I think we have to move to the point where we don't report a single number."
He also sees problems with the whole practice of smoothing.
"Definitely, this smoothing approach that brings things in over a number of years is opaque," he says. "It doesn't mean anything. It is just a mathematical calculation. That's a significant issue."
Even without changes in regulations, pension consultants say their clients currently involved in preparing 2002 financial statements are spending more time on the issue of pensions and are planning to step up their disclosure in response to investor concerns.
Mr. Witts at Towers Perrin says many clients are receptive to providing more information, and he predicts that generally, disclosure about the level of uncertainty surrounding pension plans will increase this year.
As for those estimates of expected return on plan assets, Mr. Witts says that in his experience, companies are spending more time on that number this year.
He does not expect to see many large drops in the expected return, but he does predict plenty of modest revisions down one-quarter or one-half a percentage point.
Those changes, he says, reflect the fact that the expected return is a long-term forecast designed to predict returns over 10 to 15 years.
All this will have analysts and investors watching pension numbers this year as never before.
"Definitely, I think there is momentum on this issue," Prof. Wiedman says. "Corporate financial reporting policies are more important today than two years ago.
© The Globe and Mail
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