[Senate Hearing 109-1047]
[From the U.S. Government Publishing Office]
S. Hrg. 109-1047
FASB'S PROPOSED STANDARD ON
``EMPLOYERS' ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER POST-
RETIREMENT PLANS''
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
ON
EXAMINING A FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) PROPOSAL THAT
WILL PROVIDE ENHANCED TRANSPARENCY OF CORPORATE ACCOUNTING FOR DEFINED
BENEFIT PENSION AND OTHER POST-RETIREMENT PLANS
__________
JUNE 14, 2006
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate/
senate05sh.html
----------
U.S. GOVERNMENT PRINTING OFFICE
48-080 PDF WASHINGTON : 2009
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800;
DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC,
Washington, DC 20402-0001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Justin Daly, Counsel
Stephen R. Kroll, Democratic Special Counsel
Dean V. Shahinian, Democratic Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
C O N T E N T S
----------
WEDNESDAY, JUNE 14, 2006
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbannes............................................ 2
Senator Allard............................................... 2
Senator Enzi................................................. 3
WITNESSES
Robert H. Herz, Chairman, Financial Accounting Standards Board... 5
Prepared statement........................................... 22
Response to written questions of:
Senator Enzi............................................. 48
Senator Bunning.......................................... 51
Sir David Tweedie, Chairman, International Accounting Standards
Board.......................................................... 7
Prepared statement........................................... 36
Response to written questions of:
Senator Enzi............................................. 54
Senator Bunning.......................................... 56
Additional Material Supplied for the Record
FASB's Proposed Standard on ``Employers' Accounting for Defined
Benefit Pension and Other Post-Retirement Plans''.............. *
* Retained in Committee files
(iii)
FASB'S PROPOSED STANDARD ON
``EMPLOYERS' ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER
POST-RETIREMENT PLANS''
----------
WEDNESDAY, JUNE 14, 2006
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met, pursuant to notice, at 10:29 a.m., in
room SD-538, Dirksen Senate Office Building, Senator Richard
Shelby (Chairman of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD SHELBY
Chairman Shelby. Today, the Banking Committee will examine
a Financial Accounting Standards Board (FASB) proposal that
will provide enhanced transparency of corporate accounting for
defined benefit pension and other post-retirement plans. Sound
and transparent accounting standards are the lifeblood of the
capital markets. Financial reporting must reflect economic
reality. If it does not, investors will lose confidence in the
integrity of our markets. It is that simple.
To establish high-quality accounting standards, the
standard setter must have an open process to consider the views
of all interested parties, and it must possess unquestioned
independence. The FASB proposal, the first phase of a two-phase
project, would require employers to recognize on their balance
sheets the overfunded or underfunded status of their single
employer benefit pension plans and other post-retirement
benefits. This accounting change would make financial
statements more accurate, complete, and reliable.
I applaud FASB for embarking on this important project and
offer my continued support for their independent judgment. The
effort to bring transparency to pension accounting is part of a
larger effort to not only harmonize global accounting
standards, but also to improve their quality. The Securities
and Exchange Commission, the FASB, and the International
Accounting Standards Board, IASB, are working together on this
important endeavor.
This morning, we will hear testimony from two witnesses.
Neither one is a stranger to the Committee. Mr. Robert Herz is
Chairman of the FASB, and Sir David Tweedie is Chairman of the
IASB. I welcome both of them back to the Committee and look
forward to their statements.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL SARBANES
Senator Sarbanes. Well, Mr. Chairman, I want to commend you
for your continued attention to the importance of the work of
the Financial Accounting Standards Board and the International
Accounting Standards Board. Of course, Bob Herz and Sir David
Tweedie are no strangers to this Committee, and I am pleased to
join with you in welcoming them back this morning.
The statements of both of our witnesses outline potential
problems with the present accounting rules for defined benefit
pension plans. Some of those potential problems are perhaps
inherent in the nature of defined benefit pension plans
themselves, especially the possibility that assets will shift
in value or will not be adequately matched to the maturity of
pension obligations.
Others may reflect difficulties of predicting future
employment and industry health, difficulties not foreseen
several decades ago, and others may reflect inconsistencies or
loopholes in the statutes governing pension funding. But both
organizations, as I understand it, have undertaken a serious
reexamination of these issues, and that is now underway.
There is, of course, debate over implementation costs, when
to measure benefit obligations and associated assets,
appropriate effective dates, transition periods, and whether
special rules are needed for nonpublic companies, nonprofit
organizations, and cooperatives. Some have expressed concern
about the impact immediate balance sheet disclosure could have
on companies and, hence, their ability to continue to fund the
benefit plans. Others, of course, have emphasized that an
accounting system for public companies that does not adequately
disclose the size and impact of obligations of this nature can
hardly be called transparent. So I join with you in looking
forward to learning more about these issues today, and I join
with you, as always, in welcoming Sir David and Bob Herz back
before the Committee.
Chairman Shelby. Thank you, Senator Sarbanes.
Senator Allard.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Well, Mr. Chairman, again, I would like to
thank you for holding this hearing. This is a major proposal
that will have significant implications for business, so I
appreciate the opportunity to learn more about what FASB is
doing. As part of this debate, we cannot lose sight of the
voluntary nature of the current retirement benefit systems.
Certainly it is important to have fair, consistent, accurate,
and transparent reporting. However, we must also be cognizant
of the potential to disincentivize employers from providing
benefits. As with all important regulatory decisions, I hope
that FASB is taking an appropriate amount of time and giving
adequate consideration to the comments it receives. Such
expansive decisions are better done right than done fast.
I look forward to the testimony of our witnesses, and it
will be most helpful as we continue to monitor progress on this
issue.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Enzi.
STATEMENT OF SENATOR MIKE ENZI
Senator Enzi. Thank you, Mr. Chairman, and I really
appreciate your holding this hearing today on revising our
Nation's accounting standards for pension plans and retirement
health benefits and their convergence with the international
accounting standards. This hearing could not be timelier as we
approach the retirement of the baby-boom generation. Day after
day, the newspaper headlines are filled with stories of large
and small companies struggling with legacy costs, especially in
the retirement benefits area.
After his last appearance before the Banking Committee a
couple years ago, Sir David Tweedie and I had the opportunity
to meet in the Committee's anteroom. The original topic of
discussion was intended to be about the use of stock options
grants in the United States and in Europe; however, the topic
quickly changed to a discussion on accounting standards for
retirement benefits. At that time both of us had agreed that
accounting for retirement benefits was one of the bigger
challenges for the accounting industry. We both thought the
issue dwarfed the issue of stock options.
Sir David spoke of his experience with companies in legacy
industries and the U.K.'s pension turmoil. We both recognized
that the problem was looming over the horizon in the United
States. Little did we know how correct that would be.
Mr. Chairman, as you know, last year I took over the
chairmanship of the Committee on Health, Education, Labor, and
Pensions. One of my first orders of business was to begin
drafting legislation to revise our pension laws under ERISA to
ensure that defined benefit pension plans are fully funded and
do not become a burden on the Pension Benefit Guaranty
Corporation, PBGC. Currently, we have convened a conference
committee with the House to resolve the difference between the
House and Senate bills. I have got to say this would be a whole
lot easier if we were just initiating the policy for pensions
to start, but they have been in effect for years and years, and
any change that we make affects past actions as well as future
actions. It is complicated because the plans already exist, so
our option is not to start over. Our option is to transition so
that we make sure that people that worked hard for years and
years with the anticipation of retirement can retire and that
the funds are made strong and complete.
Now, while pension accounting, pursuant to the funding
rules for ERISA and the Tax Code, are much different than
generally accepted accounting practices, there are vital
lessons to be learned. FASB is making the right decision to
update retirement benefits accounting standards at this time.
The current standards do not accurately tell the story of the
true cost of liability a company may owe for future
obligations. The first stage may appear to be a modest change,
but even a modest change in this volatile area can be
significant, particularly when you take into consideration the
changes that the pensions bill are going to be making at the
same time. These are not being done in opposition to each
other. They are being done in conjunction with each other. But
it is important that there be a lot of communication so that
one is not undoing the process of strengthening that the other
is doing.
The real work will come when FASB engages in Phase 2 of its
initiative to look at the methodologies behind the numbers.
Today we are on the verge of an evolution in our pension and
retirement health care system. Companies are making the
decision to no longer provide defined benefit plans and
retirement health care due to escalating costs. In addition,
study after study shows that Americans in general do not have
enough money to live through their golden years.
Now, as FASB and the International Accounting Standards
Board consider changes to accounting rules, I would offer them
guidance to do so in a manner that would not cause companies to
immediately stop retirement benefits. Any significant change
must be done with sufficient transition periods in place and
time for companies to adjust and to plan ahead. Our employees'
retirement benefits are too important not to take the time to
get this right the first time.
I have commended FASB before for having a Small Business
Advisory Committee, and I think that has helped with some
significant decisions. Perhaps there could be a temporary
committee that would also work on the retirement benefit thing
to bring in the expertise of people that have been working in
that for years to make sure that what we are doing on pensions
legislation and what you are doing on standards will be
conjunctive rather than opposing.
Mr. Chairman, as this is a hearing on accounting standards,
I would also like to add a comment on the recent revelations on
the manipulation in the marketplace on stock options. If there
can be good news out of this, it appears that the backdating
scandal appears to have happened before the implementation of
Sarbanes-Oxley. Thankfully, provisions in the act require much
faster disclosure of executives who exercise stock options
rights. This and vigilant oversight by the SEC should put an
end to it. However, I am very disturbed by the Enron-type
shenanigans that appear to have gone on with stock option
backdating. This is just another lessons that the manipulation
of accounting standards is wrong. It is criminal, and those who
are manipulating the markets must be punished.
Now, when we discussed stock options and accounting a
couple of years ago, the discussion I brought to the table was
about entrepreneurship and broad-based employee stock option
plans. I still believe that companies should have these tools
available to them. Legislation introduced would have
immediately expensed and disclosed executive stock options.
Executives should not be permitted to manipulate executive
stock options to the detriment of employees and shareholders. I
fully support Chairman Cox and the SEC Enforcement Division to
crack down on that abusive practice.
Mr. Chairman, I thank you for holding this hearing.
Chairman Shelby. Senator Bunning.
Senator Bunning. No opening statement. Thank you.
Chairman Shelby. I want to welcome again both of you to the
Committee. Sir David, I know you travel a lot. We are glad to
have you here. Thank you. Your written testimony will be made
part of the record. Bob, we will start with you.
STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING
STANDARDS BOARD
Mr. Herz. Thank you, Chairman Shelby and Ranking Member
Sarbanes, and other Members of the Committee. I am here on
behalf of the Financial Accounting Standards Board, and I want
to thank you for this opportunity to discuss our current
project to improve the employers' accounting for defined
benefit pension plans and other post-retirement benefits.
Our ultimate goal in that project is to develop, in
cooperation with the IASB, a high-quality principles-based
global standard for accounting for these obligations. I am
therefore very pleased that Sir David is also here with me
today.
As you probably know, we are working very closely with our
international colleagues on a number of key projects, including
the development of a common conceptual framework, topics like
accounting for business combinations, financial instruments,
financial statement presentation, revenue recognition, and a
number of other projects designed to reduce the differences
between U.S. GAAP and international financial reporting
standards, and in the process to improve both of our respective
standards. Sir David will elaborate further on these efforts to
bring about high-quality global accounting standards.
With regard to the post-retirement benefit project, we have
undertaken that project because current accounting standards do
not provide complete and transparent information about
employers' obligations and costs relating to these benefit
promises. Our proposed changes in the first phase of our two-
phase project would require employers to recognize the over or
underfunded status of their defined benefit pension plans and
other post-retirement benefit plans on their balance sheets. We
believe these changes would more faithfully report the
underlying economic effects of those plans and increase the
transparency, completeness, and usefulness of financial
statements for shareholders, creditors, employees, retirees,
and others.
The second broader phase of the project, which will begin
after completing the first phase, will address a broad range of
accounting and reporting issues in the area of post-retirement
benefits. Before discussing further details about this project,
I would like to provide you with a little bit of background on
the FASB.
We are, of course, an independent, private-sector
organization. Our independence from enterprises, auditors, and
others is fundamental to achieving our mission to establish and
improve standards of financial accounting and reporting for
both public and private enterprises. Through the FASB,
accounting standards are set by an independent group of experts
who carefully develop proposed rules through an open, public
deliberative process which contributes to overall confidence in
the capital markets.
Financial reporting is meant to tell it like it is and not
to allow distortions or the skewing of information that favors
particular companies or industries, particular types of
transactions, or particular political, social, or economic
goals other than that of sound reporting.
While bending standards to favor or retain a particular
outcome may seem attractive to some, in the long run, biased
accounting standards can lead to mistakes in private and public
investment decisions.
Because our actions affect so many organizations, our
decision process must be open, thorough, and as objective as
possible. So our rules of procedure require an extensive and
thorough public due process. It involves public meetings,
public roundtables, meetings with many interested parties, and
exposure of our proposed standards to external scrutiny and
public comment, and in making our judgments we must balance the
often-conflicting perspectives of various interested parties in
order to make independent, objective decisions guided by
fundamental concepts and key qualitative characteristics of
financial reporting.
In November of 2005, our Board unanimously decided to add a
comprehensive project to our agenda to reconsider the existing
accounting guidance for defined benefit pension plans and other
post-retirement benefits. That decision responded to many
requests from users of financial statements, preparers and
auditors, our advisory committees, the staff of the Securities
and Exchange Commission, the Pension Benefit Guaranty
Corporation, and many others, to remedy deficient rules that
have resulted in unclear and misleading financial reporting for
defined benefit plans and other post-retirement benefits.
What are the key concerns? First, the current standards
permit an employer sponsoring such plans to delay recognition
through a complex series of smoothing mechanisms of the
economic events that result in great distortions of the costs
and obligations that are reported. Current requirements also
relegate important information about the benefit plans and
their status to the notes in the financial statements.
Additionally, the existing reporting of benefit costs obscures
the employers' reported results of operations by combining the
effects of compensation, investing, and financing activities.
We decided to conduct our project in two phases. The first
phase of the project focuses on recognizing on the employers'
balance sheet the overfunded or underfunded status of its post-
retirement benefit plans. The second, broader phase of the
project will address other more complex issues, including how
best to recognize and display in reported earnings or other
comprehensive income, the various elements that affect the cost
of providing post-retirement benefits. A key issue to be
explored there will be whether and to what extent should the
current smoothing mechanisms relating to pension costs and
other post-retirement benefit costs be allowed to continue, or
should it be eliminated or at least simplified.
We will also examine issues such as how best to measure the
obligations, in particular, obligations under plans with lump
sum benefit features, cash balance plans and multi-employer
plans, and whether more or different guidance should be
provided regarding measurement assumptions.
Since our November 2005 decision, the Board and staff have
held three public meetings to discuss the Phase 1 project. We
have discussed it at meetings with our advisory committees and
with other interested groups. We have also discussed it at
numerous venues across the country.
So after about 4 months of public due process, in March of
this year we unanimously agreed to issue the Phase 1 proposal
for public comment. The Phase 1 proposal would require
employers to recognize the overfunded or underfunded status of
their post-retirement benefit plans on their balance sheets.
For example, for defined benefit pension plans, the amount of
what is called the projected benefit obligation would be
compared to the value of the related plan assets. If the
projected benefit obligation exceeds the plan assets, the
difference would be reported as a liability on the employers'
balance sheet, that is, it is in an underfunded position with a
corresponding decrease net of any tax effects to the employers'
reported equity. Conversely, if the value of the plan assets
exceeds the projected benefit obligation, the difference would
be reported as an asset with a corresponding increase net of
any tax effects in the employers' reported equity.
The Phase 1 proposal would also require that employers
measure the plan assets and obligations as of the date of their
financial statements. In contrast, current accounting standards
permit them to be measured at dates up to 3 months earlier. The
proposed changes would require recognition of the overfunded or
underfunded status by the end of this fiscal year for calendar
year-end companies. For public companies, the change in the
measurement dates to bring it to the fiscal year end would be
delayed for another year to 2007, and for private companies,
they would be given another year, to 2008.
The comment period for the Phase 1 proposal ended on May
31. The Board plans to hold public roundtable meetings later
this month on the proposal to ensure that we understand the
views and positions of interested parties. While our staff is
currently analyzing and summarizing the over 200 comment
letters we have received, from my own reading of the letters,
some of the key issues and concerns raised by respondents focus
on the measurement of the underfunded or overfunded status, the
proposed effective dates, and the proposed requirement to
measure plan assets and liabilities as of the employers' fiscal
year end.
After the roundtable meetings, the Board will then begin
public redeliberations on the Phase 1 proposal. Our
redeliberations will focus on the key issues raised by
constituents, and only after carefully evaluating the input
received will the Board consider whether to issue a final
standard on Phase 1, which, of course, requires approval by a
majority of our Board. Once we do that, assuming we do it, the
Board will begin Phase 2 of the project.
Chairman Shelby, before handing over to Sir David, I would
like to take this opportunity to thank you and Senator Sarbanes
and other Members of the Committee for all your efforts in
recent years to improve the integrity of financial reporting,
and for your support of our work. Many thanks.
Chairman Shelby. Sir David.
STATEMENT OF SIR DAVID TWEEDIE, CHAIRMAN, INTERNATIONAL
ACCOUNTING STANDARDS BOARD
Mr. Tweedie. Thank you very much, Mr. Chairman, Ranking
Member Sarbanes, Members of the Committee. May I say, as ever,
it is a great pleasure to be here in the United States, the
finest country that anyone ever stole.
[Laughter.]
Mr. Tweedie. I must say that it is a great opportunity to
discuss a topic that I care deeply about, as Senator Enzi
reminds me. I am a baby boomer, and this is an issue--I may not
look it--but this is an issue that does start to creep up on
you.
I think the real area though is the fact that between the
FASB and the IASB, we could make real progress in changing
accounting systems that are deficient, distort behavior, have
intergenerational consequences, and could lead to great cost,
as Senator Enzi emphasized, to taxpayers.
We are in the process now of adding a project onto our
active agenda. We intend to work very closely, as Bob said,
with the FASB, and I am delighted that Bob is here with me
today. He has been a great advocate of international standards,
and has provided essential leadership in our convergence
program with the United States'.
Perhaps before I turn to post-retirement benefits, I could
put IASB's work into context. The FASB and the SEC helped form
our constitution, which makes it quite clear that our objective
is to come up with one single set of high-quality global
standards. Since I first appeared before this Committee in
February of 2002, 100 countries now allow or require
international standards to be used, including the European
Union, which requires them for consolidated accounts of listed
companies. This also includes Australasia and South Africa.
China is starting next year. Canada is going to shift in a few
years time. Japan, we have a major convergence program with.
Israel is coming in in 2008, and Chile the following year.
In all of this, the cooperation of the FASB has been
essential, and our major objective now is to converge with the
United States so we do indeed have one single set of standards
and not two, as we have at present. The idea is, companies
worldwide want access to markets on both sides of the Atlantic,
and the convergence program is a major way of getting there.
Shortly after Bob became Chairman, we signed the Norwalk
Agreement with the FASB, whereby we were trying to remove the
differences in our various standards. By 2010, 1,000 companies
using international standards will be registered with the SEC,
and we see that number growing. It was taking too long,
however, to get rid of these differences, and with the help of
Bob and the SEC, we produced what is known as the Roadmap, a
way in which we can get rid of these differences rather faster,
and a method by which we can remove the reconciliation required
when you list in the U.S. markets, using standards from another
jurisdiction, and that has become a source of major contention
among companies worldwide, and probably stopping several of
them coming to the United States. We hope we can get rid of the
need for reconciliation in the next 2 to 3 years.
The program is split into two parts. First there is a
short-term phase, whereby we look at differences we know we can
get rid of quite quickly, and we will just make a few changes
to paragraphs in standards. FASB are doing some and we are
doing some. Others, where the standards are perhaps outdated or
too complicated, while we could converge them, we think that
would be a waste of resources, and we intend to write jointly a
new standard. These cover various issues including financial
instruments. If you have read the International Financial
Instrument Standard, if you understand it, you have not read it
properly. These are the sort of situations that affect, I
think, probably the U.S. standard too, and what we want to do
is write a new one. Post-retirement benefits fit into this
class as well.
Bob and I often hear that accounting should not affect
behavior, but the trouble is poor accounting masks the problem
and leads to bad behavior. The overall deficit about a year
ago, and the European Union companies in the Dow Jones Stoxx
Index was $146 billion at today's exchange rates. The U.K. FTSE
Index, the top 100 U.K. companies, showed deficits of $68
billion this time last year. The trouble is the international
standard and present U.S. GAAP obscures the issue. To put it
very simply, if we had a pension fund which had assets of $40
million and liabilities of $40 million, and the assets fell by
$10 million, you would have a deficit of $10 million. That is
not how they are generally shown.
What happens is we have smoothing mechanisms. The first
comes in to say, well, some of that deficit will be market
noise, we measure that at 10 percent or whatever is the higher,
the liabilities or assets. The liabilities are the higher at
40. We take $4 million off the deficit of 10. We then spread
that deficit of $10 million over the active working lives of
the employees, say 10 years, and you end up with a deficit
shown in the accounts of $600,000.
Now, as I have often said, explain that one to your
grandmother. You may as well take the $10 million and divide it
by the cube root of the number of miles to the moon and
multiply it by your shoe size.
[Laughter.]
Mr. Tweedie. It really does not mean a thing. Nor
disclosure, as we have discovered, in the case of share auction
option accounting does not help. It really is not taken
seriously enough, and that is why in the United Kingdom, one of
the last things I did while I was Chairman of the U.K.
Standards Board was introduce a new standard on pensions, FRS
17 which actually shows a whole deficit on balance sheet, and
this is very similar to what Bob and the FASB are doing just
now.
I thought it might be helpful to the Committee to explain
what happened when we did that. When we first announced it,
British companies split 50/50 for and against. The main
argument was this was just a snapshot and could be distorted.
We also required though that the trend is shown, so this
deficit or surplus over the last 5 years is shown, and that
very quickly showed that the deficits were getting worse. The
problem exposed was we launched at not an ideal time. We
launched at the beginning of the bear markets, so asset values
fell. But what people did not realize was the effect on
liabilities.
The first thing that happened, people have developed a very
bad habit of living longer, and it has just got to stop.
[Laughter.]
Mr. Tweedie. The second factor was that interest rates
fell. Now, that is normally a good thing, but the trouble was
so did annuity rates. So if you promise someone a pension of
10,000 and annuity rates are at 10 percent, that will be a
capital sum required of 100,000. If they fall to 5 percent, you
need 200,000. So what happened was assets fell and liabilities
rose in the funds at the same time, and it was not noticed.
The interesting thing, 2 or 3 years after we introduced the
standard, the atmosphere had completely changed. As several
senior executives said to me, pensions are now being discussed
in the board room, it is no longer a hidden matter which was
never revealed in the accounts.
We decided, when we became the IASB, to amend our pension
standard to allow the U.K. proposal to be one of the options.
Interestingly enough, 15 major U.K. companies wrote in, all of
them suggesting that we do allow the FRS 17 approach, and two
of the major business groups, the Association of British
Insurers and the Confederation of British Industry, also
supported it. That is quite a change from a few years earlier.
Companies now see what they can promise.
This, as I know you are aware, is a huge issue. Our job is
to make sure that people can make informed decisions, the
question of the risk to the company, the question of the risk
to the individual, and if the company cannot make the promises,
the risk to the taxpayer.
FRS 17, like the FASB's first stage, was an incremental
change. There are still defects that are in Phase 2 of Bob's
project in which we hope to join in. We still allow an assumed
return on assets for the future, and some of these assumed
returns have been heroic. Now we need to look at the issue in a
more comprehensive manner. We intend to add to the agenda, and
again, like Bob, we intend to try and do it in two phases.
We will join in, I suspect, and do something very similar
to that Bob has already proposed. We also intend that while the
timing of our first phase and some of the things that we deal
with may differ slightly from Bob's, we will still end up with
a common standard. It is just a case of the movement toward it.
We are intending to look at not only the smoothing mechanisms,
but can we do something on the gains and assets, the
curtailments, the presentations, the disclosures?
FASB is leapfrogging us at the moment, and we will catch up
with our first phase, and then we will end up with the same
standard. The work that we do will help FASB. The work FASB
does will help us.
Retirement income depends on state-provided pensions,
private savings and company schemes. Our job is to make sure
that companies' schemes are on the same basis, and if they are
not, people at least are aware of that. Good accounting will
not solve the problem, but it makes the issues transparent. It
helps the company. It means that they have to manage it. The
problem is obvious. It is not an instant liability as a payable
on inventory would be. It is simply something that has to be
met. It helps investors because they see the cash-flow
implications. It helps employees because they now understand
the risk, and it helps public officials because they now
realize what the problem really is.
Interestingly, we are finding British companies are now
explaining the problem quite clearly. We are getting
disclosures something like, ``We have a deficit of 50 million.
We intend to put an extra 5 million a year into the fund. We
intend to change the fund slightly. We expect the return on the
existing assets to be in the region of 4 percent. If that all
happens, we will be back in equilibrium in 2010. The effect on
profits, assuming they are maintained at current levels, will
be 1.3 percent, and the problem is starting to disappear and be
managed.''
It will not be easy. I always liken standard setting to
American football. To an outsider American football is really
just a big committee meeting, punctuated by extreme moments of
violence----
[Laughter.]
Mr. Tweedie. And I expect that this process may be
something similar.
It is important very much to get all views. As Bob said, we
have major due process, but this--and I very much agree with
Senator Enzi--is one of the major issues facing us, not only in
accounting, but in public policy too.
Thank you, sir.
Chairman Shelby. Thank you both. Harmonizing international
accounting standards is an important project and has been given
added importance recently by the cross-border consolidation
exchanges. We will start with you, Sir David. Would you just
touch again on the major accounting issues that you see that
are likely to present the most difficult challenges with
respect to convergence in that context?
Mr. Tweedie. I do not see them being a challenge to
convergence because I think both boards are very keen that we
do converge, and we have had nothing but cooperation, but I
think the issues that are going to be controversial are
certainly out there. We know, for example, leases is one where
again we are thinking of putting that on our agenda right now.
Chairman Shelby. Leases?
Mr. Tweedie. Leases, yes. One of my big ambitions is
actually flying an aircraft that is on an airline's balance
sheet before I die.
[Laughter.]
Mr. Tweedie. Basically, the leasing standards worldwide are
harmonized, but none of them work. There are massive off-
balance sheet amounts that are reflected both in the rights to
the asset on the asset side, but also liabilities that
companies cannot escape from. These are missing.
Financial instruments is going to be a challenge. It took
our predecessors 12 years to come up with our present
controversial standard. That is another one we are working
actively with the FASB to look at.
Consolidations, the question of special purpose vehicles,
we too are looking at what is being done in the United States
and seeing if that is the answer internationally, whether we
can improve upon it, if we can. We will obviously be back
discussing it with the FASB. The whole question of
consolidation here is, when should you bring a company in as a
subsidiary. Is it when you have 50 percent plus one of the
equity or is it when you control it? And these are issues, big,
deep, philosophical issues that we have to resolve.
Chairman Shelby. Bob, you want to comment on that?
Mr. Herz. Yes, I would add just one or two other issues
that I think are important. One is the whole area of
intangibles. We are doing a lot of projects on the--I call it
the liability side of the balance sheet, so to speak, but on
the asset side the area of intangibles is one where accounting
right now does not capture the value drivers of many businesses
in the modern era, and so figuring out whether or not financial
statements can better capture that, or is there other
information that can be provided, I think----
Chairman Shelby. How substantial is this?
Mr. Herz. Well, since it is very hard to measure, what we
do know, rightly or wrongly, is that the difference between the
market value of many companies and their book value, there is a
big gap there. Some of that goes up and down with the stock
market, but there is often a big gap that remains. It depends
on what type of company, but certainly we also know that when
one company buys another company or when people are analyzing a
company seriously to make major investments in it, they look at
all these kinds of things, really, what are the value drivers
of the business, the know-how, the people assets, the customer
loyalty and retention, those kinds of things. In U.S.
accounting, those are only generally captured when they are
either purchased or there is a business combination. If they
are internally generated, there is no accounting for that
asset, whereas, actually in the international standards,
sometimes there is some accounting where there is ability to
demonstrate that it is likely to prove to be beneficial with
some degree of certainty. I think that is a real important
area.
I think the area of fair value also, and to what degree
beyond where you have established markets should that be used
versus historical cost notions, is a very important one and one
that we are going to be taking up starting later this year in
our joint project to relook and merge our respective conceptual
frameworks.
Chairman Shelby. Bob, I have another question. Mr.
Chairman, I should say. The comment period for your proposal
ended a couple of weeks ago. FASB has received more than 200
comment letters, I understand. Could you describe somewhat to
the Committee what some of the more common reactions have been?
Mr. Herz. Yes. And, again, this is from my own reading. I
read the letters as they come in. Our staff then produces a
very comprehensive analysis of the comment letters, which they
are in the process of doing right now. But from my own reading,
some of the issues that commentators have focused on--well,
first of all, I think most people agree that the current
accounting model needs fixing.
One of the issues in Phase 1 that they focused on is
whether the measurement of the underfunded or overfunded status
should be what is called the projected benefit obligation, or
what is called the accumulated benefit obligation. The
projected benefit obligation includes what is called a salary
progression assumption for future increases in salary that
would then, in effect, determine what the benefits--the value
of the benefits that you have earned today by current service.
The accumulated benefit obligation excludes those future salary
potential increases.
I think a number of companies have focused also on the
issue of what we propose that for a calendar year-end company,
that they put these liabilities, or in some cases, assets on
their balance sheet by the end of this fiscal reporting year,
so 12/31. Some companies said they do not know if they have
enough time to do that. I do not think it is the issue of
making the calculations because the calculations are already
made and disclosed in the footnotes, so all that is available,
but it is the issue of things like they may have loan covenant
issues, other plans, internal compensation plans that may work
on book value numbers, for example. This will obviously change
book values. That is another comment.
A third set of comments relates to our proposal that the
measurements be done as of the end of the company's fiscal year
end. Right now the rules allow companies to do those
measurements up to 3 months before the fiscal year end, and
people are saying that with tighter reporting deadlines that
have been put in place in the last few years, that just adds an
extra degree of burden. So those are all comments, and many
other comments that we will carefully consider.
Chairman Shelby. Sir David, would you just briefly describe
for the Committee for the record, you have the role of the
Securities and Exchange Commission and the Roadmap, which aims
to eliminate by 2009 the reconciliation requirements for
foreign companies listed in the United States. We have talked
about this before I think in London one time.
Mr. Tweedie. Indeed, sir. The SEC has played a major role,
along with the FASB. It has become quite clear that as we move
on convergence, companies outside the United States are really
saying, well, where is the reward for this? If we are doing
this, do we still have to keep reconciling to U.S. standards?
Do we have to wait until they are identical? We think probably
by about 2011 we will be getting pretty well the same answers,
whether it is international or U.S. standards. That is now
leading I think to political pressure in some countries,
leading to the threat that, well, if we have to reconcile, why
shouldn't U.S. companies across here, which may have debt
borrowings or whatever, why should they not have to reconcile
as well? That is a waste of resource and something that should
not really be resorted to.
So I think the SEC is helping us by trying to set out this
Roadmap, things we can do quickly and are pretty confident we
can do that, and also they have helped us set out the agenda of
the issues they think are really important to them. What they
are really saying is we know you do not have to complete these
when we consider whether or not to remove the reconciliation,
but provided the program is continuing and it is quite clear
there is going to be a convergence toward the end, then we are
willing to consider that, probably in a couple of years time.
I think that has assuaged a lot of the concern.
Internationally it has been a very constructive move and we are
very grateful to them for bringing forward the idea.
Chairman Shelby. Thank you.
Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman. I want
to welcome both of our witnesses again before the Committee. It
is very helpful to have their testimony.
First of all, I take it there is complete agreement that
the objective here is to develop a single set of international
accounting standards that will be used worldwide? Is that
correct?
Mr. Tweedie. It is indeed. We, for example, think with the
post-retirement standard, we will end up with an almost
identical standard. The idea is we can get it in identical
words. Americans have a congenital inability to spell properly,
but apart from that, we want them to be exactly the same there.
[Laughter.]
Senator Sarbanes. What is your time frame for achieving
this objective?
Mr. Herz. I will hazard a kind of a speculated, somewhat
educated prognostication.
Senator Sarbanes. Well, you have got it obfuscated pretty
well already.
[Laughter.]
Mr. Herz. Yes, thank you. As Sir David said, I think that
around the rest of the world, good parts of the world are
adopting international financial reporting standards and
continue to do that. You then look at which of the major
markets that have not done that and what is going on. One of
them is clearly us. We have our program of closely working with
Sir David. Another one is Japan, where we have actually started
to almost triangulate the effort. Their standards have
historically been patterned more on ours, but they also want to
move toward international standards.
The third major market is Canada, and they have announced
that within 5 or so years they will try and move from their
standards, which again are very similar to U.S. standards, to
international standards.
So the real key has become us and Japan, I think, in terms
of at least major global capital markets. I could foresee one
chain of events being--and, again, this is just one
possibility, but certainly one genuine possibility--that we
continue our efforts; other things that are going on, including
the SEC, will start to review the filings of international
financial reporting standards filers that are coming into the
United States now. They are going to embark on a program to
look at those carefully over the next years to understand
whether there seems to be consistency or not in their
application. You know, are they applied relatively consistently
in Greece versus in Australia, which I would suspect the first
time around for people who have adopted whole new standards, is
quite a challenge, and you cannot expect perfection to begin
with. But I think effort at continuous improvement over the
next few years would enable the SEC to consider and probably
lifting that reconciliation requirement.
If that happens, I think there will probably be some U.S.
filers that in certain industries where a lot of their
competitors are using international standards, who will say,
well, why cannot we also use those standards? I think that will
probably be studied, and then sometime, given that we are
continuing to make them more and more similar and common, the
SEC will say, OK, for U.S. domestic filers, you can also use
the international standards. After a couple years of that maybe
people will say, gee, they seem like you have made enough
progress on convergence to say why are we maintaining two sets
of standards at this point? The differences are not significant
enough any more. I think that will be the point at which we
have essentially met this objective.
I think it is still a 8- to 10-year process in my own view,
even being optimistic.
Senator Sarbanes. Want to add anything to that, Sir David?
Mr. Tweedie. I think to finalize it, looking even at this
project, the FASB has projected an 8-year period to finally
finish the pensions project. We can do a lot in the meantime. I
think probably in 5 years time, the differences will be pretty
small, we will be really getting very close. There will still
be a few, but we will be working on those, and I see it in
about an 8-year time frame if I had to say when.
Senator Sarbanes. I wanted to just follow up on that, and
as something that Bob Herz sort of mentioned in the course of
his answer just now. It is one thing to get convergence on the
standards, it seems to me another thing to get convergence or
acceptability on the implementation of the standards. What is
your view on that part of the question?
Mr. Herz. Well, I think probably Sir David is better at
answering that. I think the issue is, the one that I mentioned,
is that to what extent and over what period will there be
consistent application in different jurisdictions around the
world where they are coming from? They are used to their old
standards and the different cultural differences.
Senator Sarbanes. Do you use standards that have been
adopted, which are the international standards, as I understand
it, are they being--the International Financial Reporting
Standards, are they being enforced or monitored by a EU
organization or by separate national organizations in each of
the EU countries?
Mr. Tweedie. It is a mixture of the two, Senator. What is
happening in Europe, there is a committee of the securities
regulators called CESRFin, and it is really trying to pool
together the national regulators who in fact they have a common
enforcement mechanism, and there is a lot of peer review going
in, views about decisions taken, interpretations and so on. So
they are trying to coordinate on a European wide basis.
I think, as Bob was hinting at--and the SEC has been very
clear about it--that the standard setters can only provide one
leg of this stool. We also need good auditing, because if the
standards are not audited properly, then it will not work, as
we have seen from the past in your work, sir on the Sarbanes-
Oxley Act. We need corporate governance to make sure that their
decisions are taken in the atmosphere of trying to produce a
fair presentation, and the forfeit is enforcement. So all of
these are going to come together. I suspect the SEC may well be
selective, saying, well, this part of the world is doing it
properly, this part is not, and we do not trust it in the
meantime. And they may well decide to break on these bases.
Even though the standards are being used, we are not quite sure
how well they are being used, and that is what the SEC is going
to check.
Senator Sarbanes. If I could put one final question.
Chairman Shelby. Go ahead.
Senator Sarbanes. Senator Enzi raised this, and I think
Senator Allard also alluded to it. In considering the pension
issue, which is now under examination, as I understand it, how
much attention is being paid to the fact that these business
enterprises were allowed to proceed in a certain way in dealing
with a pension issue. It is now being proposed, well, those
standards are inadequate and they do not provide an accurate
reflection, and therefore, they should be changed. Senator
Enzi, I think, said something about, well, you know, there is
not much problem if it had been that way from the very
beginning, but it has not been that way. So we are confronted,
I guess, to some extent with a transition problem, or
alternatively, what the impact would be of requiring an
immediate change on these defined benefit retirement plans,
which are under attack for other reasons as well at the moment.
So it does raise some difficult questions about what the
impact would be on retirement plans that have been in effect
for a substantial period of time, that people, in effect, have
done all their planning in relation to and relied upon, and
some are even saying that an immediate change, that some of
these enterprises would go under. They would be catapulted into
the red in a substantial manner. Now, that only to some extent
underscores the nature of the problem that you are seeking to
correct, but it does confront you with an important transition
problem it seems to me. What is the thinking on that?
Mr. Herz. Well, I think the thinking in our Phase 1
proposal was limited to the balance sheet and to put that
right, so to speak. Most of the comments we got in leading up
to that was that more of the controversy and the notion that
this will be the final straw that will abandon the plan, freeze
the benefits. More of the commentary came around Phase 2. What
are you going to do with reported earnings, which are not
affected in Phase 1?
I would also say that it is very hard to predict these
kinds of things. What we do now is that there has been a
pronounced flight away already over the last 20 years or so
from defined benefit plans. I think statistics I saw from the
Department of Labor were that over the last 20 or so years, the
number of defined benefit plans has gone down by something like
80 percent, and that is long before we talked about doing
anything in terms of the accounting.
We also hear that the reactions of some companies will be,
well, in order--if I have to present the liability, maybe I
ought to do some more funding in order to reduce the liability
or get on a program to reduce it, a la what Sir David described
as some of the U.K. reaction. Some of it has also been that
whether it is real or speculation, that there may be a move by
some companies to change the way they invest the plan assets,
to more closely match fund the obligation. Therefore, they
might switch from less equities to more bonds in their
portfolio.
Again, as a layman, that seems to me that increasing the
funding and better matching the obligation would seem to better
secure the benefits. I think part of the problem is that the
existing accounting has gotten us to this point of masking some
of the issues, and that may have led to over promising of
benefits, and certainly some of the accounting mechanics Sir
David talked about, the assumed rate of return assumption, have
in many minds led to very undesirable behaviors as far as the
investment profile of the pension plan assets.
A wise man told me once in this whole area--which I am sure
you all know public policy very much--but certainly in
accounting, that when you make changes, things will change,
behavior will change, but it is not like a basketball, it does
not bounce straight up and down. It is kind of like a football,
it bounces side to side and hard to predict.
Senator Sarbanes. Did you have to deal with that problem?
Mr. Tweedie. No, and I think the interesting thing, looking
at the U.K. position--and there are others more expert than I
that could give you details on this--but since we produced the
pension standard, there has been a marked change in the debate.
The national financial papers are full of pension issues, and
many companies, I think, have now realized for the first time--
and so have their employees. British Airways, for example, a
couple of years ago I think its deficit was somewhere in the
region of, if it was in dollars, it would be something like
$2.4 billion, which is about 44 percent of its market
capitalization at the time. That was a huge deficit. And they
have been in discussions with their employees. They have
stopped paying dividends because they feel they have to fill
this hole. They have put more money into the fund. They are now
suggesting that their employees are going to have to work
longer and perhaps some of the benefits might have to change,
but they have made promises that it is very difficult to keep I
think. So they are looking at it very carefully, how they can
manage their way out of it.
The advantage, I think, of showing the numbers is that we
are talking about a long-term issue, it does not have to be
funded tomorrow. So the question is how do they do it over the
period in which they have to meet the commitments? And I think
a lot of companies are doing it very seriously. They are taking
the details and the problems of the schemes into account. They
are trying to do it over a long term, but they have actually
got a serious debate going now, and they are planning their way
through it, whereas, the danger was that suddenly they realized
they could not possibly meet this under any circumstances, and
then bankruptcies follow and the pension falls to pieces. It
has now become a big issue in the United Kingdom in takeovers,
where the pension regulator is demanding money is put into
funds to hold the deficits rather than just be distributed to
shareholders and so on.
So there is a lot of behavioral change which has actually
safeguarded pensions.
Chairman Shelby. Senator Allard.
Senator Allard. Thank you, Mr. Chairman. I found this
hearing enlightening, and thank you for holding it.
Senator Enzi, who had to leave here earlier, has asked me
to make sure that we protected his ability to be able to submit
questions.
Chairman Shelby. We will leave the record open. He is very
interested in this issue and is a very good member of this
Committee. We will leave the record open for his questions.
Senator Allard. Yes, for his questions, if you would,
please.
I have a question to Mr. Herz to start with. You said that
you had an opportunity to look at a lot of the responses that
were coming in. Were you able to assess a difference between
the responses from large companies as opposed to medium and
small companies? Was there any differential that you could pick
up in their response?
Mr. Herz. I guess the one thing that I recall from some of
the letters is that when you are dealing with smaller
companies, particularly private companies, they have a lot more
arrangements related to their book value. They have the book
value stock plans, for example. Their loan covenants may be
crafted differently, as well in some public companies. So any
time you do something that will affect their stockholders
equity, those things become a matter of discussion.
Other than that, I think there were some--there are the
issues of resource availability to change the measurement date,
and I think we took that into account by giving the private
companies a 2-year window in order to get--recognizes there may
be only so many actuaries to go around at a point in time.
Senator Allard. This is for Sir David. You have co-ops in
the United Kingdom like we have co-ops here. My understanding
is that with the post-retirement kind of proposal we have here,
you had some problems with that in the United Kingdom in the
fact that some of those co-ops were closing; is that correct?
Mr. Tweedie. Not so much because of the pension schemes. I
think there were other reasons for that. But certainly----
Senator Allard. Go into that detail for me, how that is----
Mr. Tweedie. I would have to come back to you, Senator,
really on the detail of that, because it did not become a huge
issue when we did it with the co-ops, frankly. This may have
emerged later, but--and I am not so familiar with the United
Kingdom as I used to be--basically, the issue, a lot of the
companies had actually defined contribution schemes, so they
were not caught up in the benefit issue. And a lot of our
smaller companies have those too. This may be something that I
will have to ask the U.K. Standards Board to see what problems
they have. They are coming to see us next week to deal with
leasing and pensions, so it will be well worthwhile having a
discussion with them, and I will raise that point and get back
to you if I may.
Senator Allard. I would appreciate that very much. I think
it would be very helpful in our deliberations here.
Mr. Herz, have you given us a time frame in which you
intend to complete this project on pension funds?
Mr. Herz. Well, right now, we, for Phase 1, our current
plan would be to begin redeliberations based upon the input we
get through that over the summer, and finish probably by the
end of the third quarter on Phase 1. Phase 2, I think, our
staff has not drawn up a detailed project plan yet, but I think
it will be a more than 1-year and probably 2- or 3-year
exercise because there are a number of very complicated issues.
Senator Allard. Then once you have put things into place,
then there is going to be an implementation period after that.
Mr. Herz. Right.
Senator Allard. I gather from your comments, this is going
to be a phased-in implementation process?
Mr. Herz. Well, for Phase 1, the putting of the assets and
liabilities on the employers' balance sheets, we are proposing
that to be done at the end of the companies' fiscal year ends
that end starting with the December 31 fiscal year end reports.
The measurement dates, change in the measurement date to bring
it to year end, rather than 3 months before. By the way, a lot
of companies already do it as of year end. It is probably 50/50
as to whether people avail themselves of that lag option. That
is phased in. For public companies it would be phased in in
2007, or for private companies 2008.
As to once we look at Phase 2 and whatever we come up with,
whether there will be a phase-in period for that, certainly
there will be a gap between when we finalize any Phase 2
standard and when it would have to be implemented.
Senator Allard. So you will be talking about everybody
being on the same fiscal year; is that what you are----
Mr. Herz. Not the same fiscal years. They will have to
measure the plan assets and liabilities as of their fiscal year
end.
Senator Allard. I see, OK. That is going to take us a while
to get all through this process.
Mr. Herz. I think by the time we have a comprehensive,
reworked global standard--because we are going to be working
very closely with the IASB on that--in place, it may be 3 or
more years is my best guess.
Senator Allard. I would like to have you just kind of go
over some of the issues that you saw that sort of spurred you
to move forward to address pension and other post-retirement
benefit accounting, and also, when was the last time that we
really addressed this issue?
Mr. Herz. Well, going to the second part of your question,
the existing standard for defined benefit pension plans was
issued I think in 1985. The existing standard for other post-
retirement benefits, which are primarily retiree health care
coverage, was issued I think in 1990 or 1991. There have been
some tweaks since then. There has been enhanced footnote
disclosures put in since then as well, but not a comprehensive
relook at it.
I think the issue started to really come to light at the
turn of this century, at the turn of the Millennium with what
people called the perfect storm of pensions. The equity values
went way down because the stock market bubble, the value of the
liabilities, as Sir David gave in his example, went up because
of decreasing interest rates, and so the degree of underfunding
became more and more pronounced, and, of course, in some cases
was almost all the companies could take in certain industries.
I think that coupled with that, there began to become a
realization that the mechanics of the existing accounting,
which borrow a lot from some of the actuarial approaches,
particularly this assumed rate of return assumption that Sir
David mentioned. And just to kind of give you a simple example
of how this kind of works, if you had a billion dollars in
value in a pension plan, big company, the current accounting
says assume a long-term rate of return, and that depends on
your asset mix. The typical asset mix in a pension plan might
be 60 percent equities and 40 percent bonds, for example, and
so people would assume a long-term rate of return of, say, 8
percent. The current accounting says take that 8 percent on the
billion dollars, and assume that you are going to make $80
million this year, and you do not only assume it but you
actually credit, you report of $80 million for that year. Let's
say the pension assets actually tumble by $200 million, as they
did in 2001-2002. That difference of $280 million, first what
you assume versus what actually happened, gets spread over very
long periods of time. It could be 20 or more years.
So you are reporting $80 million in earnings, and you are
taking the $280 million deficit and spreading it over, say, 20
years, which would be a $14 million number if I am doing my
math right. And so you would net report pension income that
year of $66 million, even though your pension plan went down by
$200 million. A lot of people--Sir David said, ``How can this
be?'' The answer was, traditionally, the idea was that over a
long period of time things would even out. But of course, what
we found was that in a number of companies and industries it
did not even out. They went over the cliff.
Senator Allard. Thank you.
Thank you, Mr. Chairman.
Chairman Shelby. Basically, what you are trying to do, as I
understand it, with accounting, pension accounting reform, is
get to the truth of the matter. That is what accounting is
about, is it not? I know Senator Sarbanes has been very active
in this whole area, as we all know, of corporate governance and
accounting standards and seeking the truth and the value of
something. So this puts a value on a company. I know we,
Senator Sarbanes and I, worked together on making sure they did
not politically try to change the way stock options were valued
because they did have a value or they did not. You know the
deal there. You are working on it still. Well, at this time, is
your plan to give companies an opportunity to grow out of their
dilemma, out of their problems, but to realistically point out
they have got a real problem, as some of them do?
Mr. Herz. Yes. I think, as with the analogy with the United
Kingdom example, our plan is by----
Chairman Shelby. Sir David pointed out British Airways.
Mr. Herz [continuing]. ----Phase 1 to highlight the issue
by putting the issue on the balance sheet which I think there
puts it front and square. As I said, the issue of broader
controversy is then how then you report the earnings, should
there be any smoothing or not? I think people think the assumed
rate of return thing that I just described needs to go, but the
debate over whether you should continue any smoothing or not is
a genuine debate. And I could say----
Chairman Shelby. How prevalent is the smoothing today going
on in corporate pension accounting, or has been?
Mr. Herz. Everybody does it. They do not have to do it but
there is an election to do basically ongoing mark to market
accounting in full. They do not have to avail themselves of all
these smoothing mechanisms, but everybody does.
Chairman Shelby. But if you keep doing this, you are going
to suffer under the illusion of problems, you maybe brush them
aside, you ignore them, and this and that, and then the workers
who are depending on this are going to be holding the bag, will
they not, Sir David?
Mr. Tweedie. That is exactly the problem. What the FASB is
doing now and what happened in the United Kingdom will
highlight the issue. The other bits, if you like, are
refinements. We are not saying that we have got the measurement
exactly right. We know that there is quite a lot of controversy
by the interest rates, whether, as Bob said, it is a projected
measure of an accrued measure. All of this is up for discussion
in the long-term project, but the fact is, they are not in
equilibrium, these schemes, and they are showing these
deficits. And what it has done, I think, as you put it quite
rightly, Mr. Chairman, is given the company the opportunity to
say, well, we do not have to pay all this out for 20-30 years,
but we had better start working on how we fund it because at
the moment we are not funded. That is what I think it has done,
it has given them a breathing space.
I think this reform that Bob is bringing in will save a lot
of companies that otherwise might have just gone straight into
the mountainside. They would not realize until too late they
could not climb high enough.
Chairman Shelby. It seems to me that a lot of pension
accounting that I understand has been a joke in a sense, not
really counting, no transparency, interest rates, you know, the
returns what they say they are and all this kind of stuff. Is
that not a real problem for you, Mr. Herz?
Mr. Herz. Yes. That is exactly why we are taking up this
project.
Chairman Shelby. Thank you for doing it. There will be
opposition in America and probably across the water to doing
this, but ultimately, accuracy of accounting and the truth of a
situation is what it is all about, is it not?
Mr. Herz. Absolutely, and that is why again I wanted to
take this opportunity to thank the both of you for all your
efforts in that regard and for the strong message in that
regard.
Chairman Shelby. I think you have no other alternative but
do it and do it right.
We appreciate both of you appearing here today, and your
input. Sir David, we are going to continue to work together on
convergence and a lot of other things that come together
because of Sarbanes-Oxley and my colleague's legislation.
Mr. Tweedie. Thank you, sir. Can I echo what Bob has said?
It is a great pleasure to come here and to discuss things with
yourself and Senator Sarbanes. We do very much appreciate that
your idea is the same as ours, transparency and helping the
economies, and that is exactly what we are after. Thank you for
your support, sir.
Chairman Shelby. Senator Sarbanes, you have any comments?
None?
Thank you very much. The Committee is adjourned.
[Whereupon, at 11:41 a.m., the Committee was adjourned.]
[Prepared statements, response to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF ROBERT H. HERZ
Chairman, Financial Accounting Standards Board
June 14, 2006
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
______
PREPARED STATEMENT OF SIR DAVID TWEEDIE
Chairman, International Accounting Standards Board
June 14, 2006
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
______
RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI FROM ROBERT H.
HERZ
Q.1. A recently released study of 100 large corporations with
defined benefit pension plans found that 97 of those
corporations would suffer a significant reduction in equity if
FASB implements Phase 1 of the pension accounting project to
move the footnote disclosure onto the balance sheet. Some
analysts say that market researchers and analysts already take
into account the footnote disclosure when making a
recommendation on a company's stock. I am very concerned about
this. While it appears to be a relatively minor change, the
additional red ink on many companies' bottom line will be
significant. Since our defined benefit system is a voluntary
system, one could see where companies in the red would file
bankruptcy to get rid of their pension plans.
Has FASB looked at any additional studies to see whether
this might be a possibility?
A.1. The objective of Phase 1 of the FASB's project on pensions
and other post-retirement benefits is to improve the
completeness, transparency, and understandability of a
sponsoring employer's reported obligations related to post-
retirement benefits. At present, important information about
the financial status of a company's post-retirement benefit
plans is reported in the footnotes, and not recognized in the
basic financial statements. That makes it more difficult for
users of financial information to assess an employer's
financial position as well as its ability to carry out the
obligations of its plans. So while sophisticated investment
analysts and users of financial statements may use the footnote
disclosures to prepare pro forma financial information that
more properly reflects the employer's obligations related to
post-retirement benefits, recognizing the funded status of the
plans in the sponsor's financial statements will make it easier
for investors, employees, and others to understand and assess a
company's financial position, as well as its ability to carry
out the obligations of its post-retirement benefit plans,
including pensions.
The FASB has long believed that disclosure is not an
adequate substitute for recognition--a belief that is supported
by studies and years of experience. Many investors focus on the
primary financial statements rather than the footnotes.
During the course of our work on this project, we reviewed
various studies quantifying the extent and magnitude of
unrecognized liabilities for defined benefit pension and other
post-retirement benefit plans. Commentators have expressed
various views on possible actions of employers if and when such
liabilities are recorded on the employers' balance sheets. For
example, some believe that certain companies, following the
already well established trend away from defined benefit
pension plans, may choose to migrate to defined contribution
plans. Others contend that recognizing the liability for
defined benefit pension and other post-retirement benefit plans
will promote greater security of the promised benefits by
increasing the incentive for companies to more fully fund such
obligations and, as discussed in the response to Question 2
below from Senator Bunning, to adopt more sound investment
policies related to plan assets, which might also reduce the
volatility of a plan's funded status.
As I noted in my testimony at the June 14, 2006, hearing,
predicting such behavioral impacts is difficult at best. In any
event, our mission is to establish unbiased accounting
standards in order to enable the users of financial statements
to better assess the financial condition and performance of
enterprises. The accounting standards we establish should not
be deliberately skewed or biased toward favoring particular
transactions or types of arrangements or toward achieving
particular social, political, or economic objectives other than
sound and transparent reporting to investors and other users.
In that regard, the proposed requirement to recognize the plan
surplus or deficit on the employer's balance sheet does not
alter the underlying economic position, but merely reflects
that position in the financial statements.
Q.2. As Chairman of the HELP Committee, we have been working on
pension reform since the beginning of last year. It is quite
apparent that accounting for pension plans is quite unique in
that accountants and auditors must rely heavily on third
parties, such as actuaries, in order to put together the
accounting statements. As part of Phase 2 of the FASB
initiative, you will be looking at how the pension and
retirement health benefits are calculated.
How will FASB include the actuaries in the process of the
development of the Statement? Would FASB consider establishing
a new, perhaps ad hoc, Advisory Board just to gain the
expertise of the actuaries and other third parties?
You established a Small Business Advisory Committee, which
I applaud you for doing. It appears quite effective. A new
temporary Committee for the pension accounting initiative could
prove just as productive.
A.2. The FASB establishes project resource groups to provide
information and practical insights from knowledgeable parties
on all our major projects. The FASB seeks information and views
from project resource group members as needed throughout the
life of a project, for example, to identify issues to be
addressed as well as to analyze possible alternative
approaches. Resource group members also perform reviews of
Exposure Drafts and final Statements prior to finalization.
A typical project resource group comprises constituents
from a variety of backgrounds--preparers, auditors, users of
financial information, subject-matter experts, and
representatives of the nonpublic, small business sectors (also
mutual enterprises and not-for-profit sectors when
appropriate). With regard to our pensions and other post-
retirement benefits project, we intend to form a project
resource group for Phase 2 of the project. Given the importance
of actuarial information and calculations in this area, the
project resource group will certainly include actuaries.
Moreover, we have already and will continue an active dialogue
with the actuarial community regarding the project. During
Phase 1 of the project, we have sought and received significant
input from actuaries through comment letters, at our public
roundtables, and through various other discussions.
Q.3. The debate has been going on for years among the banking
and securities industries as to whether there should be a
difference in accounting for the bottom line as to which assets
should be tracked on a mark-to-market basis or whether they
should be tracked based upon a long-term investment strategy.
With respect to pension accounting, some have believed that
pension plan sponsors are trying to build up the portfolio for
the longer term investment and that the accounting standards
should reflect that.
As you move into Phase 2 of the FASB project, what criteria
should be considered to determine whether mark-to-market
accounting is appropriate? In addition, what additional costs
will companies incur to implement mark-to-market accounting?
Will FASB be doing a cost-benefit analysis on this?
A.3. The FASB decided to conduct the pensions and other post-
retirement benefits project in phases so that issues such as
those related to measurement of benefit obligations and mark-
to-market accounting could be addressed by leveraging the
FASB's projects on the conceptual framework and on financial
statement presentation, which are presently ongoing. The
conceptual framework establishes the foundation, principles,
and definitions on which accounting standards rely. The
conceptual framework, therefore, is essential in analyzing
economic transactions in order to identify the assets,
liabilities, gains, and losses that should be represented in
the financial statements. The financial statement presentation
project will establish the reporting format for reporting those
gains and losses.
Phase 2 of the FASB's pensions and other post-retirement
benefits project has no predetermined conclusions. The FASB
will research, analyze, and carefully consider the timing of
recognition of gains and losses (i.e., what some refer to as
mark-to-market) but has not prejudged the outcome, which will
be based on a thorough analysis of the issues. As with all FASB
decisions, the Board will consider the costs of implementing
accounting standards compared to the benefits to be derived by
the improvement in accounting and reporting.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM ROBERT H.
HERZ
Q.1. I would like to ask Mr. Herz about an issue that came up
in the Finance Committee yesterday that involves FASB. Very
quickly, Mr. Herz, there was discussion yesterday in the
Finance Committee about the fact that international accounting
standards generally do not recognize the LIFO method. I
understand that FASB and the IASB are involved in discussions
about the possible convergence of U.S. and international
accounting standards. However, I understand that the issue of
inventory accounting generally, and LIFO in particular, is NOT
on any current agenda. Could you please confirm this for me?
A.1. Your understanding is correct. The issue of inventory
accounting in general is not on any current agenda for the
FASB. In 2002, when the IASB decided not to permit the use of
LIFO internationally, we considered whether to propose
eliminating its use under U.S. GAAP. We decided against this,
noting that tax conformity rules would make LIFO elimination
more difficult in the United States and that companies
reporting using international financial reporting standards
(IFRS) that file financial statements in the United States
could avoid the need to report reconciling items relating to
inventory accounting by using methods such as FIFO or average
cost that are acceptable under both U.S. GAAP and IFRS.
Q.2. Your written testimony indicates that some feel that the
current accounting treatment provides an incentive for
companies to invest more aggressively than might be appropriate
for their pension plans. Do you feel this is a real concern?
A.2. A number of knowledgeable commentators have expressed
these concerns. Current accounting standards permit an employer
that sponsors defined benefit post-retirement plans to
recognize investment income based on what management assumes it
will earn on dedicated plan assets over a long period of time,
not what it actually earns each year. The period over which
that assumed investment return is based is the period over
which the plan assets will be used to pay benefits. That could
span 30 or more years. Actual investment gains or losses need
not be recognized as those gains or losses are incurred.
Some believe that use of this accounting method leads plan
sponsors to invest in higher risk securities. They therefore
contend that the present accounting has a bias toward investing
in higher risk investments that has jeopardized the security of
promised defined benefits. Accordingly, they advocate that the
present accounting be eliminated by requiring immediate
recognition of actual market gains and losses as those gains
and losses are incurred; potentially causing employers to
reallocate their plan portfolios away from equity securities
toward more fixed income securities.
Q.3. What kind of feedback did you get during the open comment
period? Are there any common concerns you have heard?
A.3. We received approximately 240 comment letters and hosted 2
public roundtable meetings. Most of the respondents agreed with
the goal of making financial statements more complete,
transparent, and understandable. Most auditors, investors, and
many investment and credit analysts generally agreed with the
Board's proposal to use the projected benefit obligation (PBO).
On the other hand, actuaries and plan sponsors generally
disagreed with the way pension benefit obligations are proposed
to be measured. They advocated measuring those obligations as
the accumulated benefit obligation (ABO) versus the PBO. The
difference between the two measures is that the PBO includes
the effect of assumed future salary increases on the obligation
for salary-based promised benefits while the ABO does not. As
with each of the major components of the proposal, the Board
carefully deliberated this issue before reaching a final
consensus to use the PBO.
Respondents made numerous other comments, including those
related to retrospective application of the proposed changes
and other features of the proposed Statement that the FASB is
carefully redeliberating.
Q.4. and Q.5. The Projected Benefit Obligation used in the
proposed standard requires accounting for assumed future salary
increases even though these increases are not owed under any
contract between employer and employee. Do you think it is
misleading to reflect such a liability as it is not yet an
obligation of the employer?
I am sure you are aware of discussions in the business
community about the use of Accrued Benefit Obligation as the
appropriate measure for the balance sheet instead of the
Projected Benefit Obligation. Do you agree and why or why not?
A.4. and A.5. The determination of future cash flows used to
develop measures of pension obligations makes a variety of
assumptions about the future based on the existing agreement
between the employer and the employee. Examples include
assumptions about obligations that will vest in the future,
assumptions about future growth of cash balance and other lump-
sum benefits, assumptions about early retirement benefits that
are not fully actuarially reduced, and assumptions about
employee turnover, retirement, and life expectancy, as well as
assumptions about future inflation and about increases in
compensation for plans that base the pension benefit on final
or career average pay.
As discussed in the response to Question 3, the difference
between the PBO and the ABO is that the PBO includes the effect
of assumed future salary increases in the calculation of
benefits payable for service to date, while the ABO does not
factor this into the determination of the obligation.
As described below, when the Board issued Statement 87, it
concluded that the PBO was the most relevant measure of the
pension obligation. Some have suggested that because employers
have discretion to grant or not to grant increases in
compensation, the measure of a company's pension obligation
should ignore the effect of future salary increases on benefits
earned to date.
The FASB's conceptual framework does not limit liabilities
to those that are legally enforceable. Liabilities include
constructive, equitable, and moral obligations. Furthermore,
the definition of a liability encompasses the duty or
responsibility that entails settlement by probable future
transfer or use of assets and the duty or responsibility
obligates a particular entity, leaving it little or no
discretion to avoid the future sacrifice. Current accounting
standards, as well as the Board's proposal, require employers
to assume future increases in compensation that they expect to
grant as they affect the benefits promised for current or past
service. This is consistent with the way many other long-term
liabilities are currently recognized in financial statements.
The issue is whether and, if so, how to include the effects
of future increases in compensation when a defined benefit
plan's formula incorporates compensation in determining the
pension benefit. Some of the factors for measuring the pension
obligation as the PBO include:
a. The Board concluded in Statement 87 that the PBO is the
most relevant measure of the benefit obligation after extensive
debate of the issue. The Board's current decision to retain
that conclusion in Phase 1 of the project, therefore, is
consistent with that prior conclusion.
b. Most users of financial statements believe the PBO
better reflects the employer's economic obligation and the
terms of the substantive plan.
c. Using a measure of the obligation other than the PBO
might necessitate changing how other assumptions are
determined, specifically the discount rate, which implicitly
includes the impact of expected inflation. Views on that issue
are described in paragraphs 140-142 of Statement 87's basis for
conclusions.
d. Further, as noted in paragraph 139 of Statement 87's
basis for conclusions:
Among those respondents who argued that obligations dependent
on future compensation increases are excluded by the definition
of a liability, very few were prepared to accept a measure of
net periodic pension cost that was based only on compensation
to date. The Board notes that under the double entry accounting
system, recognition of an accrued cost as a charge against
operations requires recognition of a liability for that accrued
cost. Thus, excluding future compensation from the liability
and including it in net periodic pension cost are conflicting
positions.
e. For most plans that provide post-retirement benefits
other than pensions, there is no measure of the obligation that
is analogous to the ABO in a pension plan. Therefore, if the
Board was to require that the ABO be used to measure the
pension obligation, the Board also would have to determine the
equivalent measure for other post-retirement benefits. Thus,
the issue is broader than pension plans alone.
f. Including assumed future increases in compensation in
the benefit obligation reflects the different employer
commitment and employee expectation between a flat benefit plan
and a final pay or career average pay plan.
Some also have suggested that the ABO is the amount at
which the obligation could be settled, assuming the employer
terminates or freezes the plan. In considering this issue, we
have noted that the ABO does not necessarily represent the
amount at which the obligation could be settled in an arm's-
length transaction with an independent third party. That
settlement amount would likely be affected by factors not
presently reflected, or measured differently from those
included, in the ABO as presently measured. The result could be
a settlement amount that could be higher or lower than the ABO.
Further, we do not believe that the accounting for a presently
ongoing arrangement between the employer and the employee
should assume a different arrangement than what is presently
understood between the employer and the employee. Any future
event or transaction that alters that arrangement should be
recognized when that event or transaction takes place. Phase 2
of our project will include a comprehensive examination of
alternative measurement approaches.
The Board is currently redeliberating the Phase 1 Proposal.
In our redeliberations, we are addressing many key issues
raised by constituents during the comment phase of the project.
We expect to complete redeliberations soon and issue a final
standard for Phase 1 shortly thereafter. Once the final
Statement on Phase 1 is issued, the Board will begin Phase 2 of
the project.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI FROM SIR DAVID
TWEEDIE
Q.1. Recently, the United Kingdom has been undertaking pension
reform. When we met a couple of years ago, accounting reform
for pension plans was high on your list due to the trouble of
companies in legacy industries.
Could you provide us with greater detail of the U.K.
experience of having to deal with the accounting for old-line
companies as compared to companies without legacy burdens?
A.1. By legacy industries and old-line companies we assume that
you are referring to industries with substantial union labor
such as steel, mining, heavy industry, and airlines. Such
companies will tend to have mature pension plans that are large
compared to the company itself. For example, in the United
Kingdom, the 2005 Lane Clark and Peacock survey reported the
following figures for 2004:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Under FRS 17, the United Kingdom accounting standard, the
accounting for pension plans in such companies reflects the
economic reality that the pension plans are large compared with
the size of the company. However, to prevent the balance sheet
of the entity from being overshadowed by the pension deficit,
FRS 17 requires the pension deficit to be presented separately
after all other net assets. Similarly, the retained earnings of
the entity are presented both before and after the impact of
the pension deficit.
A further concern was expressed that the recognition of a
deficit in full on the balance sheet would reduce retained
earnings to a level such that it would not be possible, under
company law, to pay dividends. However, under U.K. company law,
the availability of retained earnings for the payment of
dividends is assessed by reference to the separate financial
statements of the parent, not the consolidated financial
statements. FRS 17 does not require recognition of group plans
in the separate financial statements of the parent or the
individual financial statements of the subsidiaries in the
group if the individual companies cannot identify their share
of the plan assets and liabilities.
The international standard on pensions, IAS 19, permits the
use of FRS 17 accounting as one of the permitted options.
Q.2. The debate has been going on for years among the banking
and securities industries as to whether there should be a
difference in accounting for the bottom line as to which assets
should be tracked on a mark to market basis or whether they
should be tracked based upon a long term investment strategy.
With respect to pension accounting, some have believed that
pension plan sponsors are trying to build up the portfolio for
the longer term investment and that the accounting standards
should reflect that.
As you move into Phase 2 of the FASB project, what criteria
should be considered to determine whether mark to market
accounting is appropriate? In addition, what additional costs
will companies incur to implement a mark to market accounting?
Will FASB be doing a cost benefit analysis on this?
A.2. While the Senator's question is directed to the Phase 2 of
the FASB project, it is applies equally to the IASB's work on
pension accounting. FASB Statement 87 (issued in 1985) requires
that the assets of a pension plan be measured at fair value. In
1993, revisions to IAS 19, the international standard, required
plan assets to be measured at fair value. The U.K.'s most
recent standard, FRS 17, continued this well-established
practice. The question, then, is not whether accounting
standards should change to mandate fair value in this case,
they already do. The question is whether the accounting
standards should include devices designed to smooth the income-
statement effect of changes in plan assets. Those same devices
have been widely criticized as masking economic reality. On
balance, I agree with many of those criticisms.
Critics often complain that fair value is a ``snapshot''
and assert that they are investing pension assets ``for the
long term.'' I certainly heard those criticisms at the U.K.
Accounting Standards Board. Rather than introducing arbitrary
smoothing mechanisms, FRS 17 requires that companies disclose 4
years of trend information. Financial statement users can form
their judgements from 4 years of real information, rather than
having to untangle 4 years of smoothed information.
The Senator also asks about the costs companies will incur
to implement fair value measurement of plan assets. As noted
above, there is no incremental cost, nor can I see any savings
from failing to measure plan assets at fair value. Indeed, the
cost of implementing and tracking the various smoothing
mechanisms, and of preparing the disclosures needed to explain
their effects, far outweighs the cost of measuring fair value.
We should also note that financial statement users--including
analysts, shareholders, lenders, regulators, unions, suppliers,
and others--incur significant costs in attempting to understand
the effects of the smoothing mechanisms inherent in FASB
Statement 87, IAS 19, and to a lesser degree, FRS 17.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM SIR DAVID
TWEEDIE
Q.1. In some cases it is appropriate for companies to close
defined benefit plans when they become a potential liability
for the taxpayer. In your testimony, you cite such closings in
the United Kingdom as a positive occurrence under the same
reasoning. Do you think that companies with otherwise viable
defined benefit programs are choosing to close these programs
as a result of the pension accounting standard being
implemented by the U.K. Accounting Standards Board?
A.1. We have anecdotal evidence that the accounting under FRS
17 raised the profile of pension plans with Boards of
directors. I would argue that FRS 17 resulted in companies
becoming more aware of the liabilities arising from the pension
plan and the associated risks. This, together with changes in
the regulatory environment, may have led to companies to
conclude that their pension plans were no longer an
economically viable method of providing employee compensation.
I do not think that companies that regard defined benefit plans
as an economically appropriate method of providing employee
compensation have closed their plans just because of the
accounting required under FRS 17. FRS 17 simply provides
transparent and objective information about the cost and risks
of providing a defined benefit pension.
Q.2. Is there an alternative accounting standard that could
provide accountability and transparency, but not unnecessarily
force employers out of pension programs?
A.2. Standard setters often hear that accounting standards will
change behavior. Yet, if the standard reveals information to
the capital markets, and market participants find the
information useful, why should accounting standards withhold
that information? There may be implications. Management may
change its behavior. But the role of the accounting standards,
as I see it, is to provide the capital markets with the most
useful and neutral information possible.