Liability for Postretirement Benefits

Question: According to the information provided at the beginning of this chapter, Alcoa reported a $2.6 billion liability at the end of 2010 for accrued postretirement benefits. What constitutes a postretirement benefit?

Answer: In a note to the 2010 financial statements, Alcoa explains part of this liability as follows:

“Alcoa also maintains health care and life insurance benefit plans covering eligible U.S. retired employees and certain retirees from foreign locations. Generally, the medical plans pay a percentage of medical expenses, reduced by deductibles and other coverages. These plans are generally unfunded, except for certain benefits funded through a trust. Life benefits are generally provided by insurance contracts. Alcoa retains the right, subject to existing agreements, to change or eliminate these benefits.”

Postretirement benefits cover a broad array of promises that companies make to their employees to boost morale and keep them from seeking other jobs. According to this note disclosure, Alcoa provides two of the most common: health care insurance and life insurance. Based on stipulations as to eligibility, Alcoa helps its employees by paying a portion of these insurance costs even after they have retired. Alcoa apparently continues to provide these payments as a reward for years of employee service.

Determining a Liability for Postretirement Benefits

Question: Assume that one of the employees for the Michigan Company is currently thirty-four years old and is entitled to certain postretirement benefits starting at the age of sixty-five. The company has promised to continue paying health care and life insurance premiums for all retirees as long as they live.Health care and life insurance benefits paid by an employer while an employee is still working do not pose an accounting issue. The costs are known and can be expensed as incurred. These expenses are matched with the revenues being generated by the employees at the current time. For this employee, no postretirement benefits will be paid for the next thirty-one years (65 less 34). After that, an unknown payment amount will begin and continue for an unknown period of time. In one of the opening chapters of this book, the challenge presented to accountants as a result of future uncertainty was discussed. Probably no better example of uncertainty can be found than postretirement benefits. Payments may continue for decades and neither their amount nor their duration is more than a guess.

The employee is helping the company generate revenues currently so that, as always, the related expense should be recognized now according to the matching principle. Although this obligation might not be paid for many years, both the expense and related liability are recorded when the person is actually working for the company and earning these benefits.

How is the amount of this liability possibly determined? An employee might retire at sixty-five and then die at sixty-six or live to be ninety-nine. Plus, estimating the cost of insurance (especially medical insurance) over several decades into the future seems to be a virtually impossible challenge. The skyrocketing cost of health care is difficult to anticipate months in advance, let alone decades. The dollar amount of the company’s obligation for these future costs appears to be a nebulous figure at best. In this textbook, previous liabilities have been contractual or at least subject to a reasonable estimation prior to recognition. How is the liability calculated that will be reported by a company for the postretirement benefits promised to its employees?

Answer: As shown by the Alcoa example, postretirement benefits are estimated and reported according to U.S. GAAP while employees work. Because of the length of time involved and the large number of variables (some of which, such as future health care costs, are quite volatile), a precise determination of this liability is impossible. In fact, this liability might be the most uncertain number found on any set of financial statements. Apparently, reporting a dollar amount for postretirement benefits, despite its inexactness, is more helpful than omitting the expense and liability entirely. However, decision makers need to understand that these reported balances are no more than approximations.

The actual computation and reporting of postretirement benefits is more complicated than can be covered adequately in an introductory financial accounting textbook. An overview of the basic steps, though, is useful in helping decision makers understand the information that is provided.

To arrive at the liability to be reported for postretirement benefits that are earned now but only paid after retirement, the Michigan Company takes two primary steps. First, an actuaryAn individual who mathematically computes the likelihood of future events. calculates an estimation of the cash amounts that will eventually have to be paid as a result of the terms promised to employees. “An actuary is a business professional who analyzes the financial consequences of risk. Actuaries use mathematics, statistics, and financial theory to study uncertain future events, especially those of concern to insurance and pension programs.”http://www.math.purdue.edu/academic/actuary/what.php?p=what. In simpler terms, an actuary is a mathematical expert who computes the likelihood of future events.

To make a reasonable guess at the amount of postretirement benefits, the actuary has to make a number of difficult estimations such as the average length of time employees will live and the future costs of health care and life insurance (and any other benefits provided to retirees). For example, an actuary’s calculations might indicate that these costs will average $10,000 per year for the twenty years that an employee is expected to live following retirement.

The future payments to be made by the company are estimated by an actuary, but they are projected decades into the future. Thus, as the second step in this process, the present value of these amounts is calculated to derive the figure to be reported currently on the balance sheet. Once again, as in previous chapters, interest for this period of time is determined mathematically and removed to leave just the principal of the obligation as of the balance sheet date. That is the amount reported by the employer within noncurrent liabilities.

The Consequences of Having to Report a Liability

Question: Alcoa recognizes an accrued postretirement benefit liability on its balance sheet of $2.6 billion. This number is the present value of the estimated amounts that the company will have to pay starting when each employee retires. Except for the inherent level of uncertainty, this accounting seems reasonable. At one time decades ago, companies were not required to recognize this obligation. The liability was ignored and costs were simply expensed as paid. Only after advanced computer technology and sophisticated mathematical formulas became available was the reporting of this liability mandated. What is the impact of reporting postretirement benefits if the numbers can only be approximated?

Answer: Organizations typically prefer not to report balances that appear to weaken the portrait of their economic health and vitality. However, better decisions are made by all parties when relevant information is readily available. Transparency is a primary goal of financial accounting. Arguments can be made that some part of the problems that many businesses currently face are the result of promises that were made over past decades where the eventual costs were not properly understood.

As the result of the evolution of U.S. GAAP, decision makers (both inside and outside the company) can now better see the costs associated with postretirement benefits. Not surprisingly, once disclosed, some companies opted to cut back on the amounts promised to retirees. The note disclosure quoted previously for Alcoa goes on further to say, “All U.S. salaried and certain hourly employees hired after January 1, 2002 are not eligible for postretirement health care benefits. All U.S. salaried and certain hourly employees that retire on or after April 1, 2008 are not eligible for postretirement life insurance benefits” (emphasis added).

For the employees directly impacted, these decisions may have been understandably alarming. However, by forcing the company to recognize this liability, U.S. GAAP has helped draw attention to the costs of making such promises.

Vital Signs Studied in Connection with Liabilities

Question: In previous chapters, various vital signs have been examined—numbers, ratios, and the like—that assist decision makers in evaluating an entity’s financial condition and future prospects. In connection with liabilities, do specific vital signs exist that are frequently relied on to help assess the economic health of a business or other organization?

Answer: One vital sign that is often studied by decision makers is the debt-to-equity ratioA measure of a company’s use of debt for financing purposes; it is computed by dividing total liabilities by total stockholders’ equity.. This figure is simply the total liabilities reported by a company divided by total stockholders’ equity. The resulting number indicates whether most of a company’s assets have come from borrowing and other debt or from its own operations and owners. A high debt-to-equity ratio indicates that a company is highly leveraged. As discussed previously, that raises the level of risk but also increases the possible profits earned by stockholders. Relying on debt financing makes a company more vulnerable to bankruptcy and other financial problems but also provides owners with the chance for higher financial rewards.

Recent debt-to-equity ratios presented in Figure 15.12 "Recent Debt-to-Equity Ratios for Several Prominent Companies" for several prominent companies show a wide range of results. No single financing strategy is evident here. The debt-to-equity ratio indicates a company’s policy toward debt, but other factors are involved. For example, in some industries, debt levels tend to be higher than in others. Also, individual responses to the recent economic recession might have impacted some companies more than others.

Figure 15.12 Recent Debt-to-Equity Ratios for Several Prominent Companies

Another method to evaluate the potential problem posed by a company’s debts is to compute the times interest earned (TIE)A measure of a company’s ability to meet obligations as they come due; it is computed by taking EBIT (earnings before interest and taxes) and dividing that number by interest expense for the period. ratio. Normally, debt only becomes a risk if interest cannot be paid when due. This calculation helps measure how easily a company has been able to meet its interest obligations through current operations.

Times interest earned begins with the company’s net income before both interest expense and income taxes are removed (a number commonly referred to as “EBIT” or “earnings before interest and taxes”). Interest expense for the period is then divided into this income figure. For example, if EBIT is $500,000 and interest expense is $100,000, the reporting company earned enough during the year to cover the required interest obligations five times.

Figure 15.13 Recent Times Interest Earned for Several Prominent Companies