According to the ancient legend of the Gordian Knot, whoever could untangle its complicated strands would rule the world.
Tradition says that a bold sword stroke by Alexander the Great sliced open the vexing knot, followed by his conquest of everything between Greece and India. We think this fable provides a fine metaphor for defined-benefit pension accounting and makes us wonder whether any standard-setters have the courage to untangle this mess by wielding useful truth as their sword.
When the Financial Accounting Standards Board issued SFAS 158 in 2006, it seemed to be laying a sharp edge on the knot, but its current rush to complete the convergence project has figuratively put the pension sword back in the scabbard without a date for bringing it back out. Our hopes were raised in May when the International Accounting Standards Board announced its exposure draft on pension accounting; alas, the details show that its sword is clearly too dull to penetrate even the outer layer of the knot, much less to cut to the chase and unleash useful information for everyone's benefit. If only either or both boards would just see the value in reporting the truth.
THE KNOTTY PROBLEMS
To explain just how bad pension accounting really is, we published "Pensions and OPEB: Bass-O-Matic Accounting" (Dec. 19, 2005) to describe the impenetrable practices foisted on the capital markets.
One flaw is blending together the following three distinct annual factors into one lump-sum labor-based cost, which is then capitalized or expensed, depending on what employees specifically work on: service cost, the only true labor cost for pensions; interest, a financing cost that has nothing to do with labor and everything to do with being in debt; and asset return, the product of investing that also has nothing whatsoever to do with labor and everything to do with risk exposure.
Another flaw is disguising the employers' risks by artificially stabilizing reported annual cost and earnings per share, instead of revealing the volatility that would clearly signal the existence and extent of those risks. To placate apprehensive managers (while stifling the flow of useful information to capital markets), both FASB and the IASB endorse five smoothing techniques: expected asset returns are used to find annual cost, instead of actual observed results; unexpected asset returns/losses are deferred and offset against future unexpected amounts; unexpected changes in the pension obligation's value are also deferred; a very small portion of the combined deferred amount is recognized under only the most extreme circumstances; and changes in the obligation created by amending the plan (both up and down) are deferred and amortized.
We note that suppressing volatility has deferred more than $22 billion of losses for AT&T as of December 2009 (its reported earnings for 2009 were only $12.5 billion). The resulting ugly mess defies rational explanation and produces useless information.
SFAS 158 perpetuated a third flaw while trying to correct an even worse one. The balance sheet now reports market-based amounts for pensions, but the obligation and plan asset amounts continue to be offset. This net number can be terribly misleading and distortive. For example, consider AT&T as of the end of 2009: Its pretax ROA apparently was 7.1 percent but falls by 230 basis points to only 5.8 percent when this offsetting is undone. Its debt/equity ratio was apparently 1.27 but climbs by 45 percent to 1.84 after eliminating the offset.
WHY THE KNOT?
All in all, terrible standards that deviate from the truth have produced this severely tangled nonsense. Briefly, this knotty problem arose in the 1980s when FASB lacked strong support from the Securities and Exchange Commission and was still dependent on corporate contributions. Being afraid to stand up to bullying by statement preparers, the board kowtowed and created a mess.
The International Accounting Standards Committee went along later and incorporated essentially the same unprincipled rules in its standards. As a result, the truth is suppressed and otherwise withheld from capital markets all over the world.
FASB'S FEEBLE SWIPE
As mentioned, FASB gave a half-hearted try with its sword when it issued SFAS 158. However, all it accomplished was recognizing the net difference between the plan assets and benefit obligation on the employer's balance sheet. Ironically, the original board said in 1985 that it wished it could have required this treatment. In other words, all we got out of this feeble swipe was implementing a 20-year-old preference that did nothing to eliminate income statement smoothing.
FASB promised that "Phase 2" of the project would tackle and truly fix that part of the knot. However, in the ensuing three-plus years, the board has not done anything about it. Instead, FASB has pushed pensions aside in favor of a lengthy list of convergence projects.
Bottom line, FASB's blade barely dented the knot, leaving fiction, myth and legend in financial statements, not cold, hard economic truth.e_SClBTHE IASB'S TURN
IAS 19 mimics the same volatilaphobic approach created by SFAS 87, with a few minor differences. However, the IASB did not choose to implement the changes created by SFAS 158 at the time it was issued. Accordingly, it's not surprising that the IASB has felt pressured to freshen up and converge its pension accounting rules. The important question was whether the IASB's latest efforts would push IFRS beyond FASB's modest improvements and untangle the Gordian knot, once and for all.
We were optimistic when we began reading the IASB's exposure draft, but its contents soon destroyed that bit of hopefulness. The draft standard would mark both pension assets and benefit obligations to their fair values and offset them on the balance sheet, just like SFAS 158. Because offsetting understates the debt-equity ratio while overstating ROA, managers will mistakenly think they're reaping a double benefit when, of course, all they will achieve is presenting false and misleading numbers. And if we can figure out this shortcoming, so also can the capital markets, with the sure result of lower stock prices, not higher ones.
The exposure draft actually adds to the Gordian Knot by taking offsetting where no one has gone before. Specifically, the IASB conjures make-believe economics by proposing that the same actuarial discount rate used to estimate the pension liability's fair value also be used to determine the plan assets' expected return. The outcome is even more smoothing than under GAAP. Just like the un-principled FASB standard, this proposal banishes unwanted volatility to other comprehensive income on the balance sheet, making a complete end run around earnings. This wasn't done to put unvarnished truth in the financial statements; rather, it was a balm intended to assuage management's severe volatilaphobia, but only by sacrificing useful truth on the altar of winning favor from corporate constituents.
That dull "thunk" you just heard was the sound of the IASB's pathetic slash with its very dull sword. If the members are going to make managers report fair values of the assets and liability, then why not use those numbers to determine the real interest cost and the real return on the assets?
We can't move on without pointing out that this proposal deflates the IASB's oft-trumpeted claim that IFRS is more principles-based than GAAP. Absolutely no worthwhile principles support these practices.
UNDOING THE GORDIAN KNOT
Nothing will fix the Gordian Knot more completely and quickly than a dual commitment from both boards to tell the truth, the whole truth, and nothing but the truth in a straightforward and understandable manner. This approach would obviously help statement users comprehend risks produced by pensions. Importantly, it will also hold management far more accountable. Finally, it would help regulators of all kinds get a handle on the health of the private pension system.
Here's the sword of truth we would apply:
*Plan assets (at market value) should be reported among investments on employers' balance sheets.
*Plan liabilities (at market value) should be reported among other short- and long-term debts.
*Service cost is compensation and should be capitalized or expensed as appropriate.
*Interest is a financing cost and belongs with all other interest charges on the income statement.
*Return on plan assets is investment income and the full actual amount (whether realized or unrealized) should flow through income statements.
*Prior service costs from increases in obligations or prior service benefits from decreases in obligations should be reported in full as additional compensation or savings when the amendment occurs.
*Changes in obligation values should be reported in full as gains or losses on income statements in the year they are observed.
*Pension footnotes should be clear and unambiguous.
Once this fundamental simplicity of pension arrangements is reflected in financial statements, all sorts of behaviors will change. There is not now, never has been, and never will be any legitimate justification for the obfuscation that characterizes existing GAAP and the proposed international standard.
Just how hard could it be to pull this change off? It simply requires straightforward truth-telling. For both boards, the obstacle is managers' adamant lunacy that accounting creates volatility. The fact that the IASB is still funded in part by corporate contributions means it will get more pushback in the form of threats to withhold contributions.
Nevertheless, simple truth-telling with forthrightness will reveal the Gordian Knot is nothing but a simple slip knot. All a truth-loving board would have to do is just tug on one of the loose ends with a truthful standard, and it would disappear forever.
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