Although there’s nothing new
in our proposal that isn’t already
in GAAP, we encourage FASB to issue rules that will force managers
to report everything clearly and
completely.
3. Funding. By contract or law,
corporations earmark assets as
collateral against their benefit obligations. Rather than either buying
insurance to pay the debt or constructing a portfolio that would
hedge the liability and mitigate real
volatility, managers create high-risk equity portfolios to minimize
current cash outflows and boost expected yields, hoping they’ll grow
to provide cash when the debts
come due. This strategy creates
additional risk that spawns more,
not less, year-to-year income vari-
Spirit
Our
solution
would
penetrate
the fog
around
pension
and other
benefit
plans.
the liability should be credited with
an equal debit reported among
the year’s expenses as a current
cost of doing business, instead of
speciously spreading it over the
future as additional labor cost. If
an amendment produces smaller
future cash outflows, the liability
should be debited with an equal
credit reported as an immediate
financing gain from debt forgiveness, instead of mindlessly spreading these savings over future years
as a reduction in labor cost.
A NEW VIEW
Sample data from 2011 annual reports (in billions)
ExxonMobil
AT&T
IBM
Total liabilities — GAAP
$170
$599
$96
Total liabilities — modified
198
650
180
Debt-to-equity — GAAP
1. 1
5. 1
4. 8
FOR EXAMPLE
To show how GAAP produces misleading outcomes, we analyzed
data from the most recent annual
reports for ExxonMobil, AT& T and
IBM. The accompanying table (at
right) shows the results.
The first two lines of the table
show amounts for total liabilities, first under GAAP and then as
modified to eliminate asset offsets.
It then shows debt-to-equity ratios
calculated using both the nominal
GAAP numbers and modified debt
measures (assuming unchanged
equity). In these cases, the ratio increased by approximately 20 percent, 10 percent and 85 percent,
revealing risk that was partially
concealed. The results also show
that GAAP inhibits comparability
between companies.
The next two lines in the table
illustrate how smoothing misrepresents annual reported pension
costs. The modified cost equals
service cost plus interest less actual return plus/minus actuarial liability changes, plan amendments,
and other real events.
The last three lines report the
measurement error equal to the difference between the reported and
modified costs. The relative size of
the error compared to the GAAP
cost ranged from very large (
approximately 120 percent) to huge
(approximately 270 percent) to astronomical (approximately 1,400
percent). We also scaled this error
against the companies’ reported
pretax income. For ExxonMobil,
the error was material at 6 percent;
for AT&T, it was 55 percent (which
means modified income was less
than half the reported amount);
and for IBM, the error was slightly
higher than 20 percent.
The non-comparability of uniformly applying GAAP is manifested twice, first in the significant
Debt-to-equity — modified
1. 3
5. 6
8. 9
Annual benefits cost — GAAP
$4.0
$4.1
$0.3
Annual benefits cost — modified
8. 7
15.0
4. 7
Measurement error
4. 7
10. 9
4. 4
Error as percent of GAAP cost
117%
266%
1,377%
Error as percent of GAAP pre-tax income
6%
55%
21%
impact for each company, and second in varied degrees of distortion
across companies.
This analysis clearly suggests
that GAAP suppresses useful information about risk by smothering facts about the real costs and
volatility of benefit plans. This
situation should be intolerable to
absolutely everyone. That includes
management because the capital
markets’ uncertainty about the real
effects surely causes them to impose higher capital costs and bid
stock prices lower.
Our efforts also reminded us that
current footnotes are frustratingly
difficult to decipher, primarily because managers prefer obfuscation
over illumination.
3. Put fund investments with the
assets on the balance sheet and continuously mark them to market;
4. Report all gains and losses
on the income statement without
deferring, offsetting, aggregating,
smoothing or surreptitiously slip-
ping them directly into equity; and,
5. Mandate clear footnotes.
OUR PRESCRIPTION
As everywhere else, reporting plain
and simple truths will always produce more useful information.
GAAP for pension and other benefits falls atrociously short of plain
truth and comes nowhere close to
simple.
What, then, should FASB do?
Here’s our prescription:
1. Report service cost as the only
current labor cost, interest as a financing cost, and fund returns as
investing income;
2. Put the full benefit liability
among the debts on the balance
sheet and continuously mark it to
market;
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