SOME CALL FOR CHANGE IN RULE INCLUDING PENSION DATA ON BOTTON LINE: COUNTING INVESTMENT GAINS SEEN MISLEADING POTENTIAL INBVESTORS

Securities regulators are concerned that companies are using hefty pension surpluses to boost their bottom line, thus misleading investors.

With the booming stock market helping to fatten pension fund coffers, these companies are reporting higher earnings – not because of higher profits from their operations, but because accounting rules require them to show their pension expenses or earnings in their financial statements.

Under Financial Accounting Standard 87, the accounting rule for pensions, companies report their pension liabilities or assets in their annual reports only as footnotes to their main statements; a part of any pension surplus may be recognized as income.

Now, some Securities and Exchange Commission officials are wondering if that information could be better presented to investors.

“The agency is looking at it,” says Brian J. Lane, director of the SEC’s division of corporation finance.

Although FAS 87 permits pension earnings to end up on the bottom line, “the question becomes, ‘Is there sufficient disclosure for investors to see what part of the earnings are attributable to pension earnings,’ ” says Mr. Lane.

The SEC has received telephone calls from lawmakers wondering the same thing.

Although the Financial Accounting Standards Board, an independent organization, usually writes accounting rules, the SEC can develop its own rules, as it sometimes has in the past.

A spokeswoman for Sen. Phil Gramm, R-Texas, chairman of the Senate Banking Committee, with jurisdiction over securities matters, says the issue is not on his radar screen.

But Rep. Earl Pomeroy, D-N.D., who is involved in pension issues, says FAS 87 is worth re-examining to see if corporations should be “allowed to mask or shade the public appearance of corporate performance using an unrelated income source such as income on a pension fund.”

He plans to visit members of the FASB to get a better understanding of the technicalities. “It is a ruling of FASB which is now demonstrating some important policy ramifications. It is only appropriate Congress and the administration look at the policy impact of FAS 87 and draw conclusions whether or not we are comfortable with the result.”

Patricia McConnell, an accounting expert at Bear Stearns Cos. Inc. in New York, concludes that companies should not be able to count investment gains by their pension funds in their operating earnings. Ms. McConnell conducted an in-depth study of the influence of pension fund earnings on corporate earnings after institutional investors asked her how to calculate companies’ earnings without factoring in the pension surplus.

FAS 87, which was issued in December 1985, needs fine-tuning, she says. After all, investment earnings by a company pension fund are essentially no different from earnings from other investments, and should be treated as such, Ms. McConnell says.

Investors typically treat earnings from investments and the sale of businesses, for example, as unsustainable, “low-quality” earnings, which they tend to discount when valuing a company.

Of the three components of a company’s pension cost – the cost of benefits earned by workers in the current year, the interest expense on deferred benefits and returns on pension fund investments – Ms. McConnell believes that only the service cost or the cost of current benefits earned should be part of a company’s operating costs or earnings.

The accounting rule presents a further problem. When it was being developed, there was concern it would cause huge swings in corporate earnings. The final rule allows the spreading out of pension earnings or liabilities over many years.

Moreover, the rule requires companies to use their assumed rates of return instead of actual returns in computations. This could give companies wiggle room to massage their earnings by using inordinately high rates of return.

Jeremy Gold, an actuary and former principal at Morgan Stanley & Co. who commented extensively on FAS 87 when it was issued, says the rule needs to change so that a pension fund’s true earnings or liabilities are not averaged out over time.

“far too smooth”

“FAS 87 provides expenses or earnings that are far too smooth to be of really good help to financial analysts,” says Mr. Gold, now a doctoral student in finance at the University of Pennsylvania’s Wharton School of Business, Philadelphia.

To him, pension funds should be viewed no differently than mutual funds or securities firms. “We would be really surprised if mutual funds averaged their returns and that is what they credited to your accounts,” he observes.

Says Peter Knutson, associate professor emeritus of accounting at Wharton: “If the return

on pension assets should be shown as investment income rather than a reduction in pension expense, it would be far more revealing.”

Mr. Knutson would go one step further and not allow companies to include in their operating earnings the effect of a change in assumed rates of return, or the difference between the returns they earned and what they assumed.

But, he says, it is “politically impossible” to change the accounting rule. “Companies are very sensitive about that pension disclosure, and particularly when something that makes them look better is involved.”

Moreover, he says the Financial Accounting Standards Board made changes last year in the way companies report pension fund data in their financial statements.

Pension consultants say companies should be able to continue including pension income in their operating income.

“Just because they are low-quality earnings doesn’t mean they shouldn’t be (considered) earnings at all,” says Eric P. Lofgren, director of the benefits consulting group in the Philadelphia office of Watson Wyatt Worldwide.

“a long shot”

Adds Michael Johnston, an actuary and consultant with Hewitt Associates, Lincolnshire, Ill.: “If underfunding produces a cost, then overfunding should produce a profit.”

Ms. McConnell could get her way, however, if the accounting standards board examines the issue as part of a bigger project on corporate income statements.

But Timothy S. Lucas, the board’s director of research and technical activities, warns that the project is “a long shot.”

Mr. Lucas, who was in charge of developing the pension accounting rule in the mid-1980s, says the accounting body anticipated there would be times when companies could benefit from how well their pension funds invested their assets. But, he says, the rule gives investors “what we thought was the relevant information.”

Crain News Service