The Association of U S West Retirees



Shareholder equity likely to diminish under new accounting
By Drew DeSilver, Business Reporter
Seattle Times
Sunday, November 26, 2006

For decades, underfunded pensions, retiree health plans and other post-retirement employee benefits have been the hidden shame of American business exiled to little-read footnotes far away from the balance sheets, where their dodgy accounting couldn't embarrass their corporate sponsors.

Starting next month, however, new accounting rules will drag those plans into the daylight. And when they land on corporate balance sheets, billions of dollars in shareholder equity are likely to evaporate.

Weaker balance sheets could make it harder, or at least more expensive, for companies to borrow. Their stock could suddenly appear overpriced. In extreme cases, dividend payments could be endangered.

On the other hand, potential investors can more easily assess the risk to tomorrow's profits from yesteryear's pension promises.

A Seattle Times analysis of 31 Northwest companies with pension plans estimated that, had the rules been in effect last year, nearly 15 percent of the combined shareholder equity would have disappeared.

Boeing, which runs by far the largest pension and retiree-health plans in the Northwest, would have taken the largest hit losing $8.7 billion, or 78 percent, of its shareholder equity. At other companies, the impact varies from substantial to negligible.

Boeing and other Northwest companies say the change won't have much real-world impact on their operations or profits. But analysts who've been tracking the reforms say they could have dramatic impacts on investor and corporate behavior.

What is "shareholder equity"?

A company's total assets minus its total liabilities. This balance-sheet
item represents shareholders' stake in the company, and how much they
theoretically would receive if the company were liquidated. Take away all
intangible items from shareholders' equity, and you have book value, a
closely related concept that many investors use to decide if a stock is
overpriced or underpriced.

Drew DeSilver


Long-term assessment

The new rules will force companies to include their pensions and other post-retirement obligations on their balance sheets, along with the actual value of the assets set aside to pay for those promises. Up to now, those numbers have been disclosed only in easy-to-overlook footnotes and weren't reflected on the balance sheet.

While the rules won't affect reported profits or cash flows, analysts say they will paint a much more accurate picture of companies' long-term financial commitments and, more importantly, the ability to pay for them.

"For some of the companies that make these promises [to workers and retirees], these are very large obligations, and the assets in the pension plan could be their most significant asset," said David Zion, an accounting analyst at Credit Suisse in New York.

"If you're not factoring those in, I would argue you have a hole in your analysis," he said.

Many revisions ahead

The vast majority of public companies will have to revise their balance sheets when they report their fiscal 2006 results. Gordon Latter, a pensions analyst for Merrill Lynch, estimates the Standard & Poor's 500 companies will lose an aggregate $217 billion in equity about 6 percent of total equity.

A big unknown is how Wall Street will react. By reducing equity, companies' debt-to-equity ratios a common measure of leverage, and hence of risk will rise.

Consider Boeing. As of the end of 2005, its pension plans and retiree health benefits together were underfunded by about $9.7 billion. But current accounting rules allowed Boeing to show combined post-retirement assets of $3.7 billion on its balance sheet.

The company estimates that the new rule will cut its shareholder equity by $7 billion, or nearly two-thirds, for fiscal 2006 (an improvement over fiscal 2005 largely because of gains in the pension plans' investment portfolios).

As a result, Boeing debt-to-equity ratio would rise from 4.4 to around 20.5.

Boeing spokesman Todd Blecher said the company doesn't expect much market reaction. The equity reduction won't affect any of the company's loan covenants, and both Moody's and Standard & Poor's have raised their ratings on Boeing this year, he said.

"The folks in the market who've been watching us have been able to calculate this since, well, forever, because all the information has been in the footnotes," Blecher said.

Alaska Air Group controller Brandon Pedersen called the new rules "a non-event," even though Alaska expects its fiscal 2006 equity to be reduced by $75 million to $100 million, close to 10 percent.

Alaska's debt-to-capital ratio, a gauge of its leverage, likely will rise a few percentage points, but as Pedersen pointed out, the ratio already stands at around 75 percent.

"The good news/bad news is that we're an airline, and we're already highly leveraged," he said. "A lot of industries would cringe at that kind of number, but for the airline business we think it's all right."

But Merrill Lynch's Latter questioned whether all companies, or their investors, would be so unruffled. He compared the footnote disclosures to the fine print in a condo agreement or on a medicine label.

"Disclosure and transparency aren't the same thing," he said. "Do you as an investor go into the footnotes and back all this out? I certainly don't."

For more than two decades, the Financial Accounting Standards Board (FASB) has let companies put pension numbers on their books that were at best incomplete and at worst nearly meaningless.

A plan's obligation was measured as if it were about to be shut down, rather than assuming it would continue into the foreseeable future. Changes in the market value of a plan's assets, variations in interest rates and employee turnover, and other factors were "smoothed" out over several years, rather than recorded right away.

The idea was to reduce volatility; fluctuating pension assets and obligations could make financial statements yo-yo unpredictably.

But in valuing stability over accuracy, FASB's old rules allowed corporate pension accounting to drift further and further from reality.

Few worried much about this in the go-go 1990s, when the soaring stock market gave most corporate pension plans the appearance of robust health.

Flaws revealed

But the steep market declines earlier this decade revealed just how precarious many plans were. Zion said the pension plans in the S&P 500 were $240 billion in the black in 1999, but three years later fell $203 billion into the red.

Several high-profile instances of companies dumping pensions onto federal insurers underlined the importance of knowing just how healthy corporate plans are, or aren't.

The new rule is the first step in FASB's effort to clean up pension accounting. In the second phase, still several years off, FASB intends to completely overhaul the way plan assets and obligations are calculated.

For corporate managers, who loathe volatility in their financials, the accounting reforms will be an added incentive to keep down the costs of the benefit plans, Zion said.

That's likely to accelerate current trends such as making retirees pay more for health care, freezing pension plans or closing them to new workers, or shutting the plans completely, he said.

Drew DeSilver: 206-464-3145 or