Audit and Enterprise Risk Services
Pension Accounting Considerations Related to Changes in Amortization Policy for Gains and Losses and in the Market-Related Value of Plan Assets
Financial Reporting Alert 11-2
Over the past few months, several companies have announced plans to change their method of accounting for returns on plan assets and amortization of actuarial gains and losses in net periodic pension expense. For example, companies have decided to move to a mark-to-market (MTM) approach in which they immediately recognize actuarial gains and losses outside the "corridor" as a component of net periodic pension cost. In an effort to accelerate the recognition of gains and losses in the income statement, companies have also changed from using a calculated value to using fair value in determining the market-related value of plan assets for the expected return calculation. In accordance with ASC 250,1 such companies have retrospectively applied these changes in accounting principles to their financial statements. The purpose of this alert is to highlight some of the significant implications and other considerations related to such accounting changes.
Accelerated Amortization of Gains and Losses
Under ASC 715-30-35-18, "a gain or loss results from a change in the [measured] value of either the projected benefit obligation or the plan assets resulting from experience different from that assumed or from a change in an actuarial assumption." ASC 715 does not require immediate recognition of such gains and losses as components of net periodic pension cost in the period in which they arise (commonly referred to as "smoothing" of gains and losses). ASC 715-30-35-21 indicates that "[g]ains and losses that are not recognized immediately as a component of net periodic pension cost shall be recognized as increases or decreases in other comprehensive income" (OCI). Under ASC 715-30-35-23, the "amount recognized in accumulated [OCI] affects future net periodic pension cost through subsequent amortization . . . of the net gain or loss." ASC 715-30-35-24 describes the minimum amount of such gains and losses that must be recognized each year (commonly referred to as the "corridor approach") as follows:
As a minimum, amortization of a net gain or loss included in accumulated [OCI] (excluding asset gains and losses not yet reflected in market-related value) shall be included as a component of net pension cost for a year if, as of the beginning of the year, that net gain or loss exceeds 10 percent of the greater of the projected benefit obligation or the market-related value of plan assets.
Alternatively, ASC 715-30 allows for any systematic and rational recognition of gains and losses as a component of net periodic pension cost if that method (1) results in recognition of at least the minimum amortization amount required by the guidance, (2) is applied consistently, and (3) is applied to all gains and losses on both plan assets and projected benefit obligations. Any method of amortization that accelerates recognition of gains and losses in net income is generally preferable because it accelerates the recognition in earnings of events that have already occurred.
Change From Calculated Value to Fair Value of Plan Assets
Asset gains and losses are differences between the actual return and expected return on plan assets and include both changes reflected in the market-related value of plan assets and changes not yet reflected in the market-related value. The "market-related value of plan assets" is used to calculate the expected return on plan assets. ASC 715-30-20 indicates that this value can either be "fair value or a calculated value that recognizes the changes in fair value in a systematic and rational manner over not more than five years." The method used to calculate the market-related value must also be applied consistently from year to year for each asset class.
When a company changes from using a calculated value to using fair value in determining expected return on plan assets, the changes in the expected return will more closely align with changes in the actual return on plan assets. These changes will be recognized in the net periodic benefit cost in the period of change and could possibly result in more volatility in earnings. Generally, a change from the use of a calculated value to fair value is a change to a preferable method because it accelerates the recognition in earnings of events that have already occurred.
Change in Accounting Principle
When companies elect to change their accounting method for the amortization of gains and losses through net periodic benefit cost, or to change the market-related value of plan assets, such election should be accounted for as a change in accounting principle in accordance with ASC 250. Generally, a change in amortization method related to gains and losses or to market-related value of plan assets should be applied consistently in all pension plans, as required by ASC 715-30-35-25.
ASC 250-10-45-2 states that a "reporting entity shall change an accounting principle [only if the change] is required by a newly issued Codification update [or if] the entity can justify the use of an allowable alternative accounting principle on the basis that it is preferable." ASC 250-10-45-5 states:
An entity shall report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Retrospective application requires all of the following:
a. The cumulative effect of the change to the new accounting principle on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
b. An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
c. Financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new accounting principle.
In changing to an accelerated method of recognizing pension gains and losses or to fair value for the market-related value of plan assets, companies need to consider the effects on net periodic pension cost in all prior periods presented in the financial statements. To account for the retroactive application as if the principle had always been used, the cumulative-effect change to periods before those presented should be reflected in beginning retained earnings of the earliest period presented (cumulative change to net periodic pension cost) and in accumulated OCI (cumulative gains and losses now recognized in profit and loss). See below for consideration of income taxes resulting from this change in amortization method for gains and losses.
Financial Reporting Considerations
Presentation - Components of Net Periodic Pension Expense
ASC 330-10-55-6 states that "[i]n the aggregate, net periodic pension . . . cost is viewed as an element of employee compensation." In addition, ASC 715-30-35-3 refers to net periodic pension cost as a "homogeneous amount." Although the components of net periodic pension cost are measured separately, they should be reported together as a single net periodic pension expense on the face of the financial statements. Accordingly, it would not be appropriate to disaggregate the individual components of the pension cost (e.g., service, cost, interest cost, amortization of net gains and losses) and report them separately in the statement of profit and loss. However, disclosure of the separate components is required in the notes to the financial statements. Because an accelerated recognition approach may result in more volatility in earnings, companies should also consider including in MD&A a discussion of material gains and losses included in net periodic pension expense.
ASC 250-10-45-8 states that "[r]etrospective application [of a change in accounting principle] shall include only the direct effects of a change in accounting principle, including any related income tax effects." ASC 740-20-45-11 indicates that adjustments of the opening balance of retained earnings for certain changes in accounting principles "shall be charged or credited directly to [OCI] or to related components of shareholders' equity."
As a result of the change in accounting principle discussed above, the tax effects of items adjusted in the individual prior periods presented in the financial statements are also adjusted to reflect the period-specific tax effects of applying the new accounting principle. The amounts of items previously recorded in OCI generally resulted in the establishment of a deferred tax asset or liability. Because the change addressed in this Alert does not affect the tax treatment of pension liabilities or the measurement of pension assets or liabilities, the current deferred tax asset or liability will continue to exist after the adoption of the changes in accounting policies discussed above. However, the amounts recorded in OCI representing the tax effects under a company's previous policy would be retrospectively reflected in retained earnings (or the income tax expense (benefit) line in an individual prior period presented) upon the change in accounting policy discussed above.
Financial Statement Impact
A change in pension accounting for plan assets and actuarial gains and losses may significantly affect the company's balance sheet (e.g., retained earnings and accumulated OCI); companies should therefore consider the effect this change may have on certain covenants in legal contracts (e.g., debt agreements) and financial ratios (e.g., debt/equity ratio). In addition, because it is common for companies to capitalize compensation cost (including net periodic pension expense), companies need to consider the effects on the related balance sheet items (e.g., inventory, fixed assets) when making a change to an accelerated recognition approach. Because both the timing and amount of certain components of net periodic pension expense will change, companies must ensure that their capitalization policy and related systems are updated accordingly.
In addition, companies should be aware that using an accelerated amortization approach or fair value instead of calculated value for the market-related value of plan assets could potentially result in prospective earnings volatility due to the elimination of the smoothing of gains and losses. Earnings volatility would also result from a remeasurement (because of a plan amendment, curtailment, or settlement), since the gain or loss on remeasurement would affect earnings immediately under a MTM approach. Further, in the current economic environment, retrospective application of such an accounting changes may result in the recognition of significant losses in prior periods presented.
For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte's "Titles of Topics and Subtopics in the FASB Accounting Standards Codification."