Accounting and Reality

I never understand articles that begin with headlines this one: "GM Faces a New Threat to Its Books: Shareholder Equity Stands To Vanish if Pensions Become Liability via Proposed Rule." GM's shareholder equity has already vanished in the sense that if GM were to liquidate tomorrow and pay off its bondholders and pension obligations, there would be nothing left. GM has a positive stock price because people think the company will--or, rather, might--make enough profits as a going concern that there will be something left after bondholders, pensioners and health plans are satisfied. In what way is making the accounting numbers reflect the financial reality a "threat"?

WSJ.com - Tracking the Numbers: GM Faces a New Threat to Its Books: Shareholder Equity Stands To Vanish if Pensions Become Liability via Proposed Rule By MICHAEL RAPOPORT: A review of General Motors Corp.'s 2005 would include billions of dollars in losses, tepid sales and high costs. A fresh year may bring fresh financial woes: If accounting rule makers proceed with a plan to compel companies to account for their pension plans on their balance sheets, GM might suffer more than any other firm. Such a change may even wipe out most or all of the auto maker's shareholder equity, which is another way of saying that when all of GM's liabilities are subtracted from its total assets, little or nothing may be left.

Current rules let companies overstate the value of their pension plans. Even companies with plans that face major shortfalls can show a net asset, thanks to assumptions behind pension accounting. Sometime next year, the Financial Accounting Standards Board, which sets U.S. accounting rules, aims to make a change to require many companies to show a liability from pensions instead of a net asset. GM's shareholder equity might tumble by more than $24 billion, analysts' calculations show.

"In terms of absolute dollars, [GM's] balance sheet would get hit hardest," says David Zion, an accounting analyst at Credit Suisse First Boston. Should GM's already hurting shareholders, who have watched their stock fall in value to 20-year lows, care about what happens to a financial metric such as shareholder equity? In theory, shareholder equity is the value left for investors if a company were to liquidate itself and pay off all of its creditors. No one has said GM is going to do that, but some on Wall Street (and some credit-derivative traders) have bet on a bankruptcy filing. GM says it won't file for protection from creditors, but were it do so, shareholder equity would be more than theoretically important....

Right now companies reflect pensions on their balance sheets essentially by counting the difference between the total contributions they have made to their pension plans and the total pension costs they have had to recognize. This approach doesn't include a variety of negative items, especially losses incurred by pension-plan assets that companies haven't had to recognize as part of earnings but are real nonetheless.... GM shows a net asset of $30.2 billion from its pension plans on its year-end 2004 balance sheet, even though the plans were actually underfunded by about $7.5 billion at that point. FASB's plan would essentially take the positive $30.2 billion figure off GM's balance sheet and replace it with the negative $7.5 billion.

That is a swing of about $37.7 billion, on a pretax basis. Assume the standard 35% corporate-tax rate, the analysts say, and the deficit would become $24.5 billion, the estimated amount by which FASB's new approach would reduce GM's shareholder equity. As of the end of 2004, GM's equity was $27.7 billion, so this approach would have slashed the equity as of that point to $3.2 billion. As of GM's latest balance sheet, on Sept. 30, equity had dropped even lower, to $22.4 billion, so it is possible that the new accounting might send GM's equity into the red....

While the numbers at issue are huge for GM, the company is far from alone: Mr. Zion says the companies in the Standard & Poor's 500-stock index carried a combined $99 billion net pension asset in 2004, even though their plans were underfunded by $165 billion. That is a $264 billion disconnect that FASB's likely new approach would address.

Comments

[hedged]

This sort of thing is even more silly when you consider that actual financial analysts, as opposed to the media, rarely look at accounting book value anymore.

Then again, an entire industry based in California has spent millions of dollars lobbying against options accounting changes which would have zero effect on cash flows. So some people obviously care about accounting...usually for various reasons of self-interest, not logic.

[save_the_rustbelt]

As I used to teach, accounting is part art and part science.

The Financial Accounting Standards Board should have stepped up on this issue long ago.

During the 90s many companies used absurd investment return numbers so every plan looked health. Now reality sets in.

The market already knows about GM's pension problems and should have already discounted for same (although perhaps not enough).

Defined benefit plans shouold be accounted for as a "trust fund" and removed altogether from a corporate balance sheet. The corporation should show 1) a liability to be currently funded, and 2) any liability from underfunding. Both are claims on cash flow. The pension assets are not available to the general fund of the company.

Many companies won't like this idea even a little.

Confused yet?

[Arun Khanna]

"In what way is making the accounting numbers reflect the financial reality a threat?"
Broadly speaking I agree with your point that finance numbers already reflect reality so accounting numbers are secondary. However in this particular case, GM's (or any publicly listed firm) negative book value of equity will trigger bond covenants and potentially lead to further credit rating downgrades which could have a major adverse impact on GM's chances of recovery.
Having said that, I don't have much sympathy for GM management given their sustained poor performance so perhaps the earlier the company goes under the better it is.

[Gwailo]

GM's 2004 balance sheet shows a $9bb pension liability (mostly unfunded non-US pensions) and $28bb for "postretirement benefits other than pensions" i.e health care. (Shareholders' equity is $27bb, almost all in the finance arm as opposed to manufacturing. Total liabilities are $153bb for manufacturing and $300bb for GMAC.)

http://www.gm.com/company/investor_information/sec/

If one reverse-engineers Note 16 to the financials, (p. II-57) it looks like the *big* problem is not with the pension liabilities but is the presence of an *additional* $33bb of unfunded health care etc. benefit obligations that haven't yet been "recognized" i.e. haven't yet hit the balance sheet. According to GM, a 1% change in the assumed rate of future health care cost inflation means a $7bb-$8bb swing in postretirement benefit costs.

GM stock looks like a fairly shakey call on some kind of universal federalized health insurance plan being enacted in the relatively near future.

[trotsky]

On a similar note, I've read many stories about how the GASB standards requiring cities and states to account for the future cost of retiree health care will cause a "crisis" of municipal finance.

[dsquared]

likely to cause them to breach banking covenants which are usually not drawn up with sufficient "get-out" clauses for accounting restatements.

[Adrian]

Dsquared--I'm not giving you a get-out for accounting restatements unless you let me ignore artificial "equity" now.

[Andy Lang]

I'm a retired pension and health actuary and I have been working pro bono to fix private pension, private health care, Social Security and medical care for a decade now.

Believe it or not they are, for the most part, mostly inexpensive when done right--less than 5% of pay for Social Security for example and less than 4% for most DB pension plans.

I googled the GM story so I could download it--my neighbor gets the WSJ and gives them to me (I refuse to have to put up with their op-ed pages just to read their otherwise good journalists) and found you guys.

The DB pension industry is nearly dead, even though such plans when done right are one of mankind's greatest inventions.

But I just wrote a post in the Discussion forum of Society of actuaries website, Pensions--www.soa.org--which you might be interested in. (enter as a Guest)

It was not about GM per se but how the rules set by Congress--and yes accountants too--are so screwed up that a thousand Solomon's would have difficulty straighening them all out.(you might also find other posts of mine helpful too.)

Some actuaries have not exactly been helpful, alas, alack.

Ergo, the book I am writing: Saving Capitalism & Democracy...by Fixing Social Security & Medical Care.

And I am not at all kidding on that title.

[Andy Lang]

BTW--one of the major reasons why the pension accounting rules are so messed up in FAS 87 is that accountants have never really come to grips with the two different kinds of fundamental GAAP sets of rules,

1.Termination of company accounting and

2. Ongoing company accounting.

They produce widely differing results--as I found out way back in the 60's and early 70's when I did some annual statements and reviewed many others from other insurance companies, when my employer was actively seeking companies to purchase.

So--any thoughts as to why accountants have not dealt with this better and how to deal with it for all readers of financial statements?