How Will FASB’s Accounting Changes Affect Shareholders’ Equity and Credit Ratings?

On September 29, 2006, the Financial Accounting Standards Board (FASB) released its Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (SFAS 158).

SFAS 158 requires firms to put the net financial status of their postretirement plans on their balance sheet, and eliminates all smoothing of actuarial gains and losses in the funding position that flows into the other comprehensive income section in shareholders’ equity. Under the new rules, a pension’s current financial health will be reflected in its sponsor’s book value. In the past, companies could show an underfunded pension plan as an asset on the balance sheet. SFAS 158 also requires sponsors to measure plan funding and expenses as of fiscal year-end rather than allowing an optional earlier measurement date.

Earlier this year, Watson Wyatt projected the effects of disclosing the funded status of postretirement benefit obligations on corporate balance sheets for the FORTUNE 1000 (see Watson Wyatt Insider, February 2006). That earlier analysis assumed the changes were in place for fiscal year 2004. To get a more current snapshot, this analysis looks at the pension finances of the FORTUNE 1000 for fiscal 2005.

The Fiscal 2005 Analysis

As in the previous study, we measured difference between a plan’s funding position — calculated as the projected benefit obligation (PBO) (or APBO for non-pension plans) the market value of assets — and the net recognized on the balance sheet. To estimate the after-tax effect, we assumed a 35 percent tax-rate effect on the difference between PBO underfunding and the net amount recognized on the balance sheet (Table 1).

Table 1 | Estimated Impact of SFAS 158 on Shareholders’ Equity for the FORTUNE 1000 ($ billions)

According to these projections, recognizing the funded status of their postretirement plans will significantly reduce shareholders’ equity in FORTUNE 1000 companies. The aggregate decrease in shareholders’ equity is 8.7 percent — $318 billion. The 2005 snapshot actually depicts a smaller total decrease in shareholders’ equity than the 2004 snapshot, which projected a 9.54 percent decrease. The median decrease in shareholders’ equity is 4.69 percent.

But while the overall effect of SFAS 158 is significant, the results vary widely by industry. Table 2 shows the effect of SFAS 158 at an industry level.

Echoing previous studies, the durable manufacturing sector will take the biggest hit to shareholders’ equity, primarily due to its retiree health obligations. In stark contrast, the new accounting rules should have a minimal effect on shareholders’ equity in the finance industry. Those companies typically sponsor well-funded plans, and, for the most part, their balance sheets already accurately reflect their plans’ funded status.

Will Lower Shareholders’ Equity Affect Share Price?

The implementation of the FASB’s accounting changes has prompted concern about how lower shareholders’ equity will affect a company’s share price. Only time will tell for sure, but many analysts expect the effects to be minimal.

The funded status of pension and retiree health plans was already available in the footnotes to companies’ financial statements, so equity analysts and investors have long had access to the information and methodologies for analyzing its effects. One could say that the FASB has essentially aligned its accounting measurements with current market practices.

Table 2 | Total Changes in Shareholders’ Equity by Industry ($ millions)

*PBO underfunding as a percentage of shareholders’ equity was actually positive for the service industry due to overfunding in large pensions sponsored by a few companies.

What About the Effect on Credit Ratings?

Another concern is whether lower shareholders’ equity will affect companies’ credit ratings. Similar to the effect on share prices, however, credit analysts have been fully aware of pension deficits from the pension footnotes. An earlier Watson Wyatt analysis found “a notable positive relationship between higher pension deficits and lower credit ratings” (see Watson Wyatt Insider, October 2005).

Table 3 depicts the change in shareholders’ equity due to SFAS 158 for the FORTUNE 1000 based on Standard & Poor’s debt ratings. Credit ratings of BBB and higher are considered investment-grade, while ratings below BBB are non-investment-grade or “junk” status.

Table 3 | Estimated Impact of SFAS 158 on Reported Shareholders ’ Equity of FORTUNE 1000 Firms ($ billions) Based on Investment Grades

SFAS 158 will have much less effect on shareholders’ equity in firms rated AA and higher than in firms with lower investment grades. Table 3 suggests that credit analysts may already recognize and react to pension deficits — whether they appear in the footnotes or on the balance sheet.

Elimination of Early Measurement Dates

Before SFAS 158, companies could measure plan funding up to three months before their fiscal year-end. SFAS 158 closes the three-month window, and starting December 31, 2008, plan sponsors must measure their assets and liabilities as of the end of their fiscal year. The FASB wants to ensure that companies record events in the same year they occur. Thirty percent of FORTUNE 1000 defined benefit plan sponsors currently use a measurement date other than their fiscal year-end and will have to change their practices to comply with SFAS 158. This may create some data collection and timing challenges.

Looking Ahead

The balance sheet changes took effect December 15, 2006, for public companies, and will be tougher on some companies and industries than on others. Some firms will have to change their measurement practices to meet the new requirements.

After roughly a year of rising interest rates and decent market returns, plan funding ratios for 2006 are expected to improve significantly, which should reduce the hit to shareholders’ equity for many firms. However, many companies’ 2006 balance sheets will now reflect higher pension deficits and lower shareholders’ equity, and the immediate recognition of gains and losses will create significant balance sheet volatility. However, the financial impact on the corporate cost of capital from changes in share prices and credit ratings may not be significant.

The Pension Protection Act of 2006 (PPA) should gradually improve the financial health of postretirement benefit plans, which might smooth out some of this balance sheet volatility in the future. Watson Wyatt believes that companies may react to the PPA and the new accounting rules by adopting investment approaches that better hedge their long-term pension liabilities. The shift is part of a global trend to more closely match pension investments with plan liabilities, rather than focus only on the amount of plan assets.