Increasing attention to the use of accounting gimmicks to boost profits has rekindled a nine-year-old controversy involving Financial Accounting Standards Board Statement No. 106. In recent months, critics have renewed charges that some companies are using FAS 106 — the standard that since 1993 has governed accounting for postretirement health-care benefits — as part of a strategy to reduce retiree medical coverage, then reflect the lower reserve amounts in operating earnings. While there is evidence to support the suggestion in some cases, the issue is far more complex.
The FAS 106 issue mirrors criticism of FAS 87, which funnels surplus pension assets through corporate income statements as a credit to pension expenses. Some companies, critics charge, then slash their pension benefits to help keep the surpluses pumped up.
“The mechanics of FAS 87 and FAS 106 are almost identical,” says J. Richard Hogue, an actuary specializing in FAS 106 valuations. That’s because both standards were designed to ensure that companies record liabilities for retirement benefits in the years employees were working to earn those benefits, according to “the key principle of accrual accounting: to match revenues and expenses,” notes Julia D’Souza, assistant professor of accounting at Cornell University’s Johnson Graduate School of Management. D’Souza argues that FAS 106 “offers a relatively cost-free means for managers to achieve desired financial reporting objectives.”
Here’s how the technique supposedly works: Under FAS 106, companies record their accrued liability for postretirement health benefits and other nonpension benefits, after making a series of assumptions about health-care cost trends, inflation, retirement age, mortality rates, employee turnover, and other variables. “The accounting rules require companies to disclose the principal underlying assumptions” so that investors “can assess the accuracy of the estimated liability,” says Eli Amir, a U.S. and international accounting standards scholar who now heads Israel’s accounting standards board. Still, the wide range of variables can allow a company to tweak its expectations any number of ways, and affect earnings favorably.
The APBO Election
When FAS 106 was adopted, it gave companies a choice. They could record their unfunded, previously unrecognized accumulated postretirement benefit obligation (APBO) as a single, one-time nonrecurring charge, or they could record it through smaller charges taken over as many as 20 years. (Companies formed since 1993 account for postretirement benefits on an accrual basis.) Accounting rules require that if a company adjusts its estimated liability downward after taking a one-time APBO hit, the difference must be amortized as a credit that flows through to the bottom line. “At the time, it was posited that some companies would recognize the APBO in one fell swoop, and then, through a series of negative plan amendments, bring the already-recognized obligation into earnings over time,” says Jane Adams, an accounting and tax analyst in Credit Suisse First Boston’s equity research group.
Indeed, this is what happened in the three years between approval of FAS 106 and its effective date. Some corporations recognized the entire accumulated liability and then dramatically reduced retiree health-care benefits, citing the standard’s impact on their financial statements. McDonnell Douglas Corp., for one, terminated health-care benefits for its nonunion employees as of January 1993 — just after its 1992 recognition of an accumulated liability of $2.48 billion. (McDonnell Douglas is now a part of Boeing Co.)