Dow Chemical mini-case

(pension accounting)

Reporting requirements for postretirement benefits (pensions and other post-retirement benefits or OPEBs) are specified under SFAS 132. This standard prescribes similar disclosure formats for both OPEBs and pension benefits. While companies rarely separately report either the current or accrued benefit cost (pension or OPEB) in the financial statements, the standard mandates extensive note disclosure. This includes details about both economic and reported amounts relating to liabilities, assets, and costs of postretirement benefits—separately for both OPEBs and pensions. The notes also must give details about actuarial assumptions and, in the case of OPEBs, the effect of changes in these assumptions on both the income statement and balance sheet.

In its simplest form, companies report the net pension liability on their balance sheets. This is the difference between the fair market value of the pension assets and the present value of the pension obligation (PBO). The PBO is, essentially, the expected future payments to retirees discounted to the present at the discount or settlement rate. Reporting the net, rather than the gross amounts, was important to companies as they sought to minimize the balance sheet impact of the new pension standard.

Also, in its simplest form, pension expense is equal to the following:

Service cost / The increase in the pension liability due to employees working another year for the company
+ Interest cost / The accrual of interest on the pension liability
- Expected return on plan assets / Note: this is an expected long-run return and not the actual return realized for the year

The service cost component is provided by actuaries hired by the company. The interest cost is the beginning-of-year PBO multiplied by the discount or settlement rate. This is the same accrual we would make to a discount bond to accrue interest (remember, the PBO is recorded at present value).

The first thing to notice is that pension expense is based on expected returns, not actual (realized) returns. This is computed as the beginning-of-year fair market value of the pension investments multiplied by an assumed long-run expected return. Also, and this is important, the difference between the expected and actual (realized) returns is deferred and is not recognized on-balance sheet unless they exceed prescribed levels (10% of the larger of the fair market value of plan assets or the PBO). As a result, a significant amount of real effects are not recognized on-balance sheet. This deferral was an important part of the pension discussion when the standard was drafted. Companies sought to smooth their earnings by eliminating fluctuations due to swings in market rates of return or fluctuations in the PBO due to plan amendments or changes in the discount rate.

Dow Chemical provides the following footnote in its 2002 annual report relating to its pension plans:

  1. How much pension expense (revenue) does Dow report in its 2002 income statement?
  2. Dow reports a $1,105 million expected return on plan assets as an offset to 2002 pension expense. Approximately, how is this amount computed? What is the actual gain or loss realized on 2002 plan assets? What is the purpose of using this estimated amount instead of the actual gain or loss?
  3. What factors affected its 2002 pension liability? What factors affected its 2002 plan assets?
  4. What does the term ‘funded status’ mean? What is the funded status of the 2002 Dow retirement plans? What amount of asset or liability does Dow report on its 2002 balance sheet relating to its retirement plans? What factors account for the difference between these two amounts?
  5. Dow reduced its discount rate from 7% to 6.75% in 2002. What effect(s) does this reduction have on its balance sheet and its income statement?
  6. Dow increased its estimate of expected returns on plan assets from 9.18% to 9.25% in 2002. What effect(s) does this increase have on its financial statements? In general, does such an action increase or decrease income?