Accounting for pensions and other postretirement benefit plans and the use of accounting estimates and changes in estimates: an ethical perspective.

James, Marianne L.

CASE DESCRIPTION

The primary subject matter of this case concerns ethical dilemmas accountants and other executives may face when selecting required estimates in accounting for and reporting of defined benefit pensions and other postretirement benefit plans and complying with the requirements of Statement of Financial Accounting Standards No. 158, the new accounting standard. Accountants' professional and ethical responsibilities and resolutions of the ethical dilemmas are explored. Secondary, yet important issues are the effects of the choice of estimates on financial statement results and on the usefulness and integrity of the financial statements. This case has a difficulty level of three to four and can be taught in about 45 minutes. Approximately two hours of outside preparation is necessary to fully address the issues and concepts. This case can be utilized in intermediate accounting as part of the coverage of pensions, or in a more advanced graduate class focusing more extensively on underlying conceptual issues and the research components of this case. The case has ethical, conceptual, analytical, and research components. Utilizing this case can enhance students' oral and written communication skills.

This is an illustrative case. Any similarities with real companies, individuals, and situations are solely coincidental.

CASE SYNOPSIS

Examples of unethical behavior by financial executives and accounting frauds, such as those at Enron, WorldCom, and Adelphia Cable have renewed the public's as well as the business community's attention on the importance of truthful and ethical financial reporting. Legislation, particularly the Sarbanes-Oxley Act of 2002 has supported this renewed emphasis.

Ethical financial reporting not only requires the absence of fraudulent behavior but also that entities and their accountants choose estimates that best reflect the underlying economic events. When accounting issues involve extensive estimates over a long time horizon, ethical dilemmas may arise if individuals with competing interests attempt to influence the estimates chosen. Accounting for pensions and other postretirement benefit plans requires extensive estimates over a long time horizon.

The Financial Accounting Standards Board (FASB) recently issued Statement of Financial Accounting Standards No. 158 "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans," which requires that companies with underfunded plans recognize the underfunded portion on their balance sheets (FASB, 2006). For some entities the effect of this provision is quite significant. Estimates chosen for the plans' discount rates and rates of return on plan assets can significantly affect the funding status and can be used to manage financial statement results.

The primary focus of this case is to examine the ethical dilemmas accountants may face when executives utilize estimates to manipulate financial statements. The case explores the effects on financial statements and their causes, effects on stakeholders, motivation of key personnel, professional and ethical responsibilities of accountants, and potential resolutions to the ethical dilemmas. The case can be taught at the same time that retirement benefits are covered in an intermediate accounting class, or in an advanced accounting class focusing primarily on underlying concepts and the case's research components. The case has ethical, analytical, conceptual, communication, and research components.

INTRODUCTION

The primary purpose of financial accounting and reporting is to provide information that is useful to decision makers (FASB, 1978). Information is considered useful if it is reliable, relevant, consistent, and comparable (FASB, 1980). Generally Accepted Accounting Principles (GAAP) provide guidance and rules for accounting for economic events and transactions to help entities achieve this purpose. Ethical behavior by accountants and financial executives is essential to preserving the usefulness of financial reporting and to support the purpose of new and existing accounting standards.

Because of the complexity of financial transactions, inherent uncertainties, and the need for extensive estimates, financial information may be manipulated or "managed," thus decreasing its usefulness. Accounting standards and rules which intent to enhance the reliability, relevance, and comparability of financial statements are not static. New standards are issued to meet changes in the business and financial environment and to further enhance the usefulness of financial statements. Accounting for defined benefit pensions and other postretirement plans is complex, involves long-term horizons with inherent uncertainties, and requires extensive estimates and assumptions, such as estimates of employee turn over rates, longevity, health care and salary trends, and discount and plan asset return rates.

Historically, defined benefit pensions, which promise employees a specific amount of retirement income, represented the most common employer-sponsored plans. Although this is changing, with some major companies (e.g., IBM and Verizon) discontinuing defined benefit pension plans, they still play an important role for many employees, comprising about 38% of employer-sponsored plans (Clements, 2006).

Accounting for pensions and other postretirement benefit plans has evolved over time. On September 29, 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans" (FASB, 2006). This standard amends but does not supercede SFAS No. 87, "Employers' Accounting for Defined Benefit Pensions," and SFAS 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" (FASB, 1985, 1990). SFAS 158 represents phase one of FASB's ongoing comprehensive pension and other postretirement benefit project. Additional changes, which may include changes in the calculation of expense are expected as FASB continues to examine accounting and disclosure for these defined benefit plans.

One of the major provisions of this new standard affects the methods in which pension and other postretirement liabilities are calculated and recognized on sponsoring entities' balance sheets. SFAS 158 requires that entities accrue a liability to the extent that their pension and other postretirement obligations exceed the plan assets (FASB, 2006).

The provisions of SFAS 158, which was effective for fiscal periods ending after December 15, 2006 most significantly affect companies with underfunded pension and other postretirement benefit plans. A recent estimate (prior to the issuance of SFAS 158) suggests that large companies carried approximately 300 billion dollars in pension and other postretirement obligations off their balance sheets (Byrnes & Welch, 2006). Companies may influence the funding status of the benefit plans and thus the amount recognized on their balance sheets through their choice of the discount rate. This potential tool for manipulation may create ethical dilemmas for those involved in the financial reporting process.

ILLUSTRATIVE EXAMPLE

Katie Schmaltz, CPA, CIA, has just been promoted to assistant controller of Mottins Corporation, a publically traded company that manufactures component parts for consumer electronics. For the past four years, she worked for Mottins as their internal auditor. She enjoyed her work as internal auditor, but she is excited about becoming the company's assistant controller. Katie is very proud of being an accounting professional and believes that professional ethics are of paramount importance. She considers Cynthia Cooper, the internal audit director who together with two colleagues discovered and the reported the WorldCom fraud, a role model. The company recently and unexpectedly lost its controller to early retirement. The new controller, Jim Kariton, will be joining the company in a few days. Meanwhile, Katie familiarizes herself with the financial reporting process, the general ledger, and the most recent financial statements.

Mottins Corporation has been growing and prospering during the past five years. As part of its growth and expansion project, the company recently purchased the patent for a new innovative parts manufacturing process that the company hopes will increase its sales by 100 percent over the next five years.

Mottins Corporation sponsors a defined benefit pension plan, as well as a postretirement health care plan. Virtually all of the company's employees are covered by these plans. Both plans are underfunded; the pension plan is slightly underfunded, while the other postretirement benefit plan is significantly underfunded. Consistent with the requirements of SFAS 87 and SFAS 106, no liability had to be accrued on the company's 2005 balance sheet for its retirement benefit plans.

Katie reviews the note disclosures for the defined benefit pension and retiree health care plans and notices that for the fiscal year ended December 31, 2006, the company properly adopted SFAS 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans," which amends both SFAS 87 and SFAS 106. The following are selected disclosures from the Mottins Corporation's 2006 financial statements.

SELECTED INFORMATION FROM THE 2006 FINANCIAL STATEMENT NOTES

Financial Statement Note No. 9: Retirement Plans

Effective fiscal year 2006, the Company properly adopted Statement of Financial Accounting Standards No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans." Consistent with the requirements of SFAS 158, the funding statuses of the Company's defined benefit retirement plans must be disclosed and are as follows:

Funding Status of Defined Benefit              December 31, 2006
Pension Plan                                    (in thousands)

Projected benefit obligation                       $  6,855
Plan assets at fair market value                     6,790
Funding Status                                      $  (65)
  Items not yet recognized as components
  of net periodic pension cost (expense)
Prior service cost                                   $  39
Unrecognized net loss                                 26

Funding Status of Retiree                      December 31, 2006
Health Care Plan                                (in thousands)

Accumulated benefit obligation                     $  1,010
Plan assets at fair market value                      852
Funding Status                                     $  (158)
  Items not yet recognized as components
  of net periodic health care cost (expense)
Transition Obligation                                $  40
Prior service cost                                    100
Unrecognized net loss                                 18

The Company utilized the following rate assumption in accounting for its defined benefit retirement plans:

Rate Assumptions--Pension Plan         2006           2005
                                   (in percent)   (in percent)

Discount rate                           6             5.5
Return on plan assets                   9              9
Salary trend rate                       3              3

Rate Assumptions--Retiree Health       2006           2005
  Care Plan                        (in percent)   (in percent)

Discount rate                           6             5.5
Return on plan assets                   9              9
Health care trend rate                  7              7

While reviewing the financial statement disclosures, Katie notices that Mottins recognized $223,000 in long-term pension and other postretirement benefit liabilities. Katie, who had read in the financial press that some companies that sponsored underfunded employee retirement plans were quite adversely affected by the provisions of the new standards, is pleased to learn of this relatively small impact of SFAS 158 on her company's financial statements.

Upon further review of the financial statement notes regarding the pension and postretirement health care plans, she notices that the company increased its discount rate assumptions from 5.5 percent to 6 percent for the year 2006. She recalculates the projected pension and accumulated postretirement benefit obligations utilizing the 2005 discount rate assumptions and realizes that the total effect of the 0.5 percent increase in the discount rate was a reduction of $846,000 in total liabilities. She calls the actuary who provides actuarial assumptions and estimates for the company's plans and learns that the change was within reasonable limits and had been specifically requested by the former controller.

Two weeks later, Jim Kariton, the new controller discusses a number of forthcoming financial reporting issues with Katie. Katie is pleasantly impressed by the new controller's qualifications, personality, and interpersonal skills. She is looking forward to a collegial and rewarding professional relationship with her new superior.

At the end of their conversation, Jim instructs Katie to contact the company's actuary and request his support for increasing the discount rate by 0.25 percent in 2007 and the long-term expected rate of return on plan assets by 0.25 percent for both the pension and retiree health care plans. Katie states that she noticed that the discount rate had already been increased by 0.5 percent for 2006. Jim indicates that a further increase is warranted by overall increases in interest rates, and that the long-term expected rate of return on plan assets should be increased to 9.25 percent due to an enhanced outlook for the plans' investments. Katie can't help wondering about the motivation for this newest increase.

A week later, while visiting Chief Financial Officer (CFO) Mike Johans' office to drop off a report, she overhears him speaking with the pension fund manager, asking for a change in the investment mix to increase the percentage of higher-yield, lower-rated securities in the plan assets. During the phone conversation, he impresses on the fund manager that the equity markets are expected to flourish. Katie has heard that the fund manager is a good friend of the CFO and that they play golf together on a weekly basis.

Katie talks to her friend in Human Resources and learns that the CFO has apprised the Director of Human Resources about a potential change in the retirement plan to a 401(k) plan for new employees and the elimination of the retirement health care plan. Katie, who also is covered under the current plans, is concerned for her and her colleagues' welfare.

Katie is unaware that meanwhile, the Chief Executive Officer (CEO), John Ballon, has been meeting with individual board members for lunch and other outside activities, utilizing the opportunity to encourage them to vote for a curtailment of employee retirement benefit plans. John Ballon knows that the company will need to decrease its expenses to continue meeting or beating its earnings trends and targets. John's and other executives' bonuses are directly contingent on meeting earnings forecasts. In addition, John holds a large number of stock options, currently valued at 1.4 million dollars. He plans to meet earnings forecasts for each year until his planned retirement in three years.

A few weeks later, one of Katie's colleagues casually mentions that her boss, CEO John Ballon has been meeting with several board members, some of whom are also on the company's audit committee. She also mentions that she overheard a reference to employee retirement plans. After considering this new information, Katie begins to suspect that the CEO may be trying to influence board members' votes regarding the retirement plans.

Later that day, Jim Kariton asks Katie to review the financial statement notes and disclosures relating to the company's property, plant, equipment, and intangible assets. Katie notices that the notes describe the useful life of the patent as 17 years. She asks Jim Kariton whether this represents an appropriate estimate given the rapid change in technology. He immediately responds with the statement that "This is not a concern; we are amortizing the cost over the legal protection of the patent remaining at time of purchase." Katie doubts that this technology really will be useful for 17 years and offers to ask the engineering department to provide an updated estimate of the usefulness of the patent. Jim Kariton states that this not necessary and that any change in the useful life likely would be immaterial.

Katie decides to again mention her concerns regarding the planned increases in the discount rate and rate of return assumptions for the retirement benefit plans; the controller states that the increases are justified and that the CFO recommended them. Katie asks him whether the company is planning any future changes in the retirement plans. The controller indicates that he knows of no such plans and again asks her not to concern herself about these issues. He also hints that if financial results are favorable for the company he will recommend that she receive a bonus for all her hard work.

Katie decides to call the company's former controller at home to inform him of her promotion to assistant controller and perhaps gain some insights into the prior year discount rate change. After a few minutes of pleasant conversation, she asks him about the increase in the discount rate for 2006. The former controller tells her that "top management requested the change." He also says that he is enjoying retirement and his part-time teaching position at the State University. At the end of the conversation he advises her to be diligent about her new position and to always remember what the "CPA" and "CIA" certifications stand for. Katie feels that she has been subtlety warned. Katie is uncertain about what she should do.

REQUIRED

Answer the questions listed in the Assignments/Questions section of this case as assigned by your instructor. Provide concise answers and support all your statements.

ASSIGNMENTS/QUESTIONS:

Company-Case Specific Questions:

1. SFAS 158 changed how liabilities for pensions and other postretirement benefits must be calculated; as a result, some entities--including Mottins--that did not have to recognize related liabilities on their balance sheets under SFAS 87 and SFAS 106 must now do so under SFAS 158. What factor(s) account(s) for this difference?

2. How are underfunded pensions and other postretirement benefit obligations recognized on the balance sheet after adoption of SFAS 158? What was the effect on Mottins' balance sheet?

3. Why would increasing the discount rate assumptions affect the pension plan and health care plan liabilities recognized on the balance sheet? How would the planned increase in the rate of return on plan assets likely affect Mottins' financial statements? Do you believe that the changes in the rates requested by the controller and CFO are reasonable?

4. If Mottins Corporation had not increased its discount rate during 2006, how would its financial statements have differed? How did the change affect the company's stakeholders?

5. Review the authoritative literature regarding accounting changes and relate it to the discount rate and rate of return changes for pensions and other postretirement benefits. Under what circumstances are changes in estimates justifiable? Does the situation in this case meet the criteria?

6. Review the authoritative guidance regarding the amortization of intangible assets. What are the criteria for selecting the useful life of an intangible asset, such as a patent? Do you agree with Mottins' accounting treatment for its patent?

7. Evaluate the behavior of the individuals involved in this case from an ethical perspective. What are their ethical and professional responsibilities? What may be the motivation for their behavior?

8. Katie apparently feels uncomfortable with some of the accounting estimates and changes in estimates. What options does she have to address these issues and potentially solve her dilemma? What are Katie's professional responsibilities in this case?

9. What would you do if you were in Katie's position?

Researchable Questions:

1. Identify a large company that has been affected significantly by the implementation of SFAS 158. Briefly summarize the effect on the company's balance sheet.

2. What changes are expected under phase two of FASB's pension and other postretirement benefit project? How would these potential changes affect entities' financial statements?

3. What types of disclosures have to be made by the company regarding its benefit plans. List and briefly describe the types of disclosures required under SFAS 158, SFAS 106, and SFAS 87. Do you believe that these disclosures enhance the usefulness of the financial statements?

4. Can an error or "inaccurate" accounting estimate be ignored if the amount or change in the amount are immaterial? Refer to the authoritative guidance in your answer. Also relate your findings to Mottins' estimates.

REFERENCES

Byres N. & D. Welch. (2006, January 30). Retiree Accounting: More Than Meets the Eye. Business Week, 3969, 84.

Clements, J. (2006, March 8). The debt Bubble Threatens to Derail Many Baby Boomers' Retirement Plans. The Wall Street Journal. (March 8), D1.

Financial Accounting Standards Board. (1978, November). Statement of Financial Accounting Concepts No. 1. Objectives of Financial Reporting of Business Enterprises. Stamford, CT.

Financial Accounting Standards Board. (1980, May). Statement of Financial Accounting Concepts No. 2. Qualitative Characteristics of Accounting Information. Stamford, CT.

Financial Accounting Standards Board (1985, December). Statement of Financial Accounting Standards No. 87. Employers' Accounting for Defined Benefit Pensions. Stamford, CT.

Financial Accounting Standards Board (1990, December). Statement of Financial Accounting Standards No. 106. Employers' Accounting for Postretirement Benefits Other Than Pensions. Norwalk, CT.

Financial Accounting Standards Board. (2006, September). Statement of Financial Accounting Standards No. 158. Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans--an amendment of FASB Statement No. 87, 88, 106, and 132 R. Retrieved on October 12, 2006 from www.fasb.org.

U.S. Congress. (2002). One Hundred Seventh Congress of the United States of America at the second Session. Sarbanes-Oxley Act of 2002. H.R. 3763.

Marianne L. James, California State University, Los Angeles