In several sports, especially golf, tennis and baseball, a player occasionally makes contact with the ball in the exact right place on the club, racket or bat.Hitting it on the "sweet spot" brings about the maximum transfer of energy under full control. Last June's report out of the Securities and Exchange Commission on off-balance-sheet financing really hit a sweet spot by pointing out several areas for improvement in financial reporting practice.
And the structure of the human eye is amazing. Its ability to convert light into intelligible nerve impulses is astounding, but fragile and limited. One of those limits is a place on the retina in which there are no receptor cells. The consequence is that each of us has a normally unnoticed "blind spot" that literally makes it impossible for us to see in that particular place in our field of vision.
Well, the SEC's sweet spot report also managed to hit us in a blind spot.
We're sheepish that we had never made the observation on pension accounting that appears in the SEC report, with this title that leaves us breathless: "Report and Recommendations Pursuant to Section 401* of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance-Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers."
Specifically, the report - produced jointly by the Office of the Chief Accountant, the Office of Economic Analysis and the Division of Corporation Finance - looks at several deficiencies in financial reporting practice. One is accounting for defined-benefit pension plans and other post-retirement benefits, or OPEB.
Our regular readers know that SFAS 87 - and SFAS 106 - have been the target of our criticism for years. We have attacked the Financial Accounting Standards Board's approach for its dependence on expectations in lieu of observations. We have also criticized its many devices that remove volatility from the reported numbers and thereby obscure the truth. And we have rebuked the board for falling short of its objective of providing clear and complete information.
Like a large wooden mallet, the SEC report has hit us so hard that we're seeing pension plans in a completely different light. The report questions why the assets and liabilities of these plans are not consolidated with the parent's other assets and liabilities.
In other words, the staff members suggest that the pension trust is not separate, but only an artifice that is essentially a 100 percent controlled special purpose entity. The clear implication is that much more useful information will be reported if the parent's statements include the pension (and OPEB) assets and liabilities, instead of a net amount, especially one that is so mangled by the smoothing processes applied under generally accepted accounting principles.
Quality Financial Reporting
We were also gratified by a brief discussion in the report of another point. In commenting on the need for transparency, the report states, "The staff believes that many issuers interpret financial reporting narrowly, and regard technical compliance with the requirements as satisfactory. However, if investors and other users are misled or have insufficient information to understand the activities of the issuer, such 'compliance' does not serve the purpose of financial disclosure. Moreover, such a mindset puts the burden on regulators and standard-setters to drive all improvements in reporting. The staff believes that if issuers focus on clear and transparent communication with investors in preparing financial statements, both accounting and disclosures will improve."
We interpret this comment as a clarion call not just for consolidating pension entities, but also for a completely new attitude, in which managers take the initiative for improving financial reports. In effect, the SEC staff is saying that it's about time that statement preparers woke up and started doing good things without being forced to.
Our long-time readers will recognize the similarity of this view to our favored paradigm that we call Quality Financial Reporting. Through the QFR lens, the goal is meeting user information needs - not trudging the well-worn path of unquestioning compliance with arcane rules.
In the pension area, quality reporting will not come from minimum effort in complying with GAAP. Instead, QFR is doing the very best you can to communicate with financial statement users, period, whether in the financial statements or the footnotes.
Beyond the warm and fuzzy reward of knowing that you are doing your best to tell the truth, the Quality Financial Reporting strategy promises the payoff of lower capital costs by reducing users' uncertainty and risk.
A light in the darkness
This paradigm leads us to wholeheartedly embrace the report's suggestion that an employer's future cash flows can be more usefully assessed if its balance sheet includes all its assets and liabilities. The current practice of netting pension (and OPEB) assets against the obligations hides some of that useful information.
Suppose that a company has a net liability of $100 million. While informative, that single fact masks the risk by not revealing whether the gross liability is $150 million or $2 billion. This masking is why GAAP generally does not embrace offsetting; nonetheless, pension plans have long been given a free pass. Why? We think the reason was a conceptual blind spot, aggravated by political fear that constituents would howl over having to put the full liability on their balance sheets.
Whatever the reason for its acceptability, we hope that offsetting for pension assets and liabilities will now be seriously challenged, so that employers' financial statements can be made more useful through consolidation. We see two areas that could be improved.
First, the credibility of financial statements would be boosted if they told more of the story behind these benefits. After all, funding the pension plan with marketable securities diverts resources away from strategic investments that produce future operating profits and cash flows, thus exposing shareholders to much different sets of risks and rewards. It also involves entering into precarious long-term financial commitments, in which employers agree to pay unknown amounts to unknown individuals for unknown periods. The risk is enormous, and the balance sheet is incomplete without this debt.
Second, piercing the veil surrounding these plans would more fully expose the deficiencies in today's methods of determining annual expense. With the assets and liabilities on the balance sheet, the expense is much more straightforward: When liabilities get bigger, there is an expense, and when assets get bigger, there is income. It's as simple as that.
We think explicit reporting would have two highly positive effects. The obvious one is that financial statement users will be able to assess the future cash flows, as well as management's past decisions. The less obvious but more significant effect is that managers would start to actually manage the assets and the liability.
We are convinced that the complexity of pension and OPEB accounting is so daunting that more than 99 percent of managers actually believe the GAAP numbers and are not paying any attention to the need to mitigate the real risks. That is, they consider market and actuarial gains and losses to be unimportant because they don't appear in the financial statements. If these results were to be brought onto the statements, managers would be confronted with their riskiness and would be compelled to try to bring them under control.
Any reform that would bring about those results has to be good. Will it happen soon through changes in GAAP? We don't think so, but we are optimistic that somewhere out there are a few wise managers who will also be hit in a blind spot and come to understand the advantage of clearly reflecting the real economics behind the promises made to employees. In our recently completed series of columns, we have been making the point that GAAP isn't good enough. Add nonconsolidation of pensions as another issue to this massive pile.
In closing, we want to apologize to the SEC. On occasion, we have written disparagingly of the regulatory system's inability to produce innovative solutions, and have accused them of applying old answers to new questions. But in this case, they have come up with a new answer to an old problem. We're glad that they have proved us wrong, and we hope the future will bring about more reform than even we have imagined.
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