Early SFAS 106 adopters provide revealing healthcare data - Statement of Financial Accounting Standards No. 106

Healthcare Financial Management, June, 1993 by Bruce A. Leauby, Joseph Y. Ugras, Mary Jeanne Welsh

ACCOUNTING

Healthcare executives should have a strong interest in the recently released Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits other than Pensions (SFAS 106). The requirements of SFAS 106 focus heavily on estimating the healthcare benefits of retirees and forces corporations to project the magnitude of expected increases in healthcare costs. Estimates for recording these retiree healthcare benefits for all U.S. companies range from $200 billion to $400 billion, imposing significant financial statement implications for all firms that provide healthcare benefits to retirees. The requirements of SFAS 106 will also have an impact on the way corporations design and implement healthcare cost controls, which may directly affect many healthcare entities. Understanding SFAS 106, and the reactions of firms to this standard, will allow healthcare executives to better manage their organizations to take advantage of new opportunities and meet new challenges that may arise.

In December 1990 the Financial Accounting Standards Board (FASB) released SFAS 106, which is generally effective for fiscal years beginning after Dec. 15, 1992. SFAS 106 is a dramatic change in how companies measure the cost of providing other postretirement benefits (OPEBs). Companies must change from pay-as-you go (cash-basis) to an accrual method that is similar to that applied to pension expense measurement.

The new standard has received a great deal of attention from the financial community because of the expected negative effect the accounting change will have on corporate earnings. Concerns have been raised about the ability of companies to reliably estimate OPEB costs, which under SFAS 106 require a number of calculations and projections that companies previously did not make. There also have been predictions that companies would curtail OPEBs in an effort to reduce the effect of the adoption of SFAS 106. Some organizations have already altered their plans to the detriment of retirees, and many of these changes are now being contested in the courts.

Because SFAS 106 is so different in its measurement of OPEB costs, an accurate prediction of its impact on corporate reports prior to actual implementation was not possible. However, a number of companies adopted the standard for their 1990 and 1991 annual reports, and their experiences provide a basis for determining the magnitude of the change.

SFAS 106 provisions

SFAS 106 covers all types of OPEBs, but focuses on healthcare costs because they are the major cost component under most plans. Under SFAS 106, companies must accrue the costs of OPEBs over the period in which employees earn benefits, rather than account for the expense when benefits are actually paid to or for retirees. The change from a cash basis to an accrual basis of accounting shifts OPEB cost recognition from the future to current periods, significantly increasing annual OPEB expense. The components of OPEB costs are analogous to those set up for defined benefit plans in Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions (SFAS 87)--service cost, interest cost, the actual return on plan assets, amortization of unrecognized prior service cost, and amortization of the transition obligation and gain or loss component.(a) Many companies found that when they adopted SFAS 87, reported pension costs decreased, and some companies even reported pension income because earnings on pension plan assets more than offset cost components such as service and interest cost.(b)

A similar effect, however, is not expected when companies adopt SFAS 106. SFAS 106 also offsets OPEB cost components with earnings on plan assets, but few companies prefund the benefits. Unlike pension plans, there are very limited tax-preferred arrangements available for funding, and there is no government regulation comparable to ERISA that mandates prefunding.(c)

Although accounting for OPEBs is similar to accounting to pensions, there are some unique elements. The first element is the expected postretirement benefit obligation (EPBO), which is the actuarial present value of the OPEB at the measurement date that is expected to be paid to or for the employee and any beneficiaries or covered dependents. The EPBO includes benefits that are expected to be paid in the future, regardless of whether the employee has attained full eligibility for the benefits at the measurement date. The EPBO does not have to be disclosed in the financial statements, but it is the basis for service cost measurement.

The second element is the accumulated postretirement benefit obligation (APBO). The APBO is the actuarial present value of all future benefits attributed to an employee's service rendered as of the measurement date. Unlike the EPBO, the APBO only includes those benefits for which employees are fully eligible at the measurement date.(d) The APBO is the basis for determining the employer's balance sheet obligation. The APBO is also used in calculating OPEB costs because the interest cost component is measured as the increase in the APBO due to the passage of time.