Shareholder equity likely to diminish under new accounting
By Drew DeSilver, Business Reporter
Sunday, November 26, 2006
For decades, underfunded pensions, retiree health plans and
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
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
item represents shareholders' stake in the company, and how
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
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
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
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
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.
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
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.