Motives Behind DB Sponsors’ Move to Mark-to-Market Accounting

A study suggests that defined benefit plans’ move to mark-to-market accounting may be less driven by transparency motives and more driven by executive compensation motives.

Since December 2010, companies like Honeywell, AT&T, Verizon Communications, UPS and others announced they would use mark-to-market recognition in corporate earnings statements of defined benefit (DB) plan gains and losses.

This move to mark-to-market accounting, an alternative to amortizing gains and losses over many years, resulted in large reported losses for many. The Boeing Company, AT&T, UPS, Windstream Corp. and FirstEnergy Corp. all announced that lower discount rates and a change to practices around recognizing pension gains and losses in the year in which they occur—rather than amortizing them over time—resulted in a charge for pensions. For example, AT&T ended 2011 on a down note, posting a $6.7 billion loss in the fourth quarter due largely to a change in how it accounts for its employee pension benefits and the breakup fee it was required to pay after scrapping its bid to buy T-Mobile USA.

In many announcements, the companies stated they were changing accounting methods to increase transparency. Companies say this is a more accurate measure of a DB plan sponsor’s financials. In addition, removing amortization removes long-term market fluctuations and when DB plan sponsors use this accounting to project into the future, it improves their ability to budget for the plan, she adds.

Other than for financial reasons, Willis Towers Watson has seen clients move to mark-to-market accounting to align with international accounting standards or to align their measures with their competitors’.

However, Professor Jaewoo Kim, and others from the University of Rochester, Simon Business School, note in a research report that the possibility that company managers were incented to change accounting methods to report higher future profits and extract higher compensation was not unnoticed by financial analysts and commentators in the financial press. Kim and his fellow researchers call this motivation “managerial opportunism.”

NEXT: Some support for the transparency motive

Kim tells PLANSPONSOR that when he read about firms’ mark-to-market adoption, it struck him that some firms voluntarily chose to use fair value accounting. “When they moved from amortization, they gave up smoothing. The mark-to-market adoption is a puzzle because such decision likely increases future earnings volatility due to changes in market factors such as interest rates,” he says. “The presumption in the accounting literature is that firms prefer smooth and not volatile earnings. The move was counterintuitive to me.”

Kim notes that there has been debate about the benefits and costs of fair value accounting, and in surveys, CFOs say they generally do not support it. So, the question is, why would firms voluntarily move to mark-to-market accounting?

First, the researchers used a logistic regression model to identify the economic factors that explain firms’ adoption of mark-to-market (MTM) pension accounting. Second, to explicitly test the opportunistic explanation, they analyzed the relation between CEO cash compensation and pre-adoption period pension expense, and post-adoption period MTM pension adjustments. Finally, to test the transparency explanation they compared the firms’ earnings response coefficients (ERCs) before and after adoption of MTM reporting.

At a general level, the results reveal that both the transparency and opportunistic explanations are useful in explaining cross-sectional variation in MTM adoption decisions. On balance, however, the weight of the evidence tends to favor the “managerial opportunism” hypothesis.

The transparency hypothesis is supported by the results of the logistic regression tests where the researchers found that firms with a low level of transparency (i.e., low pre-adoption earnings response coefficients, ERCs) are more likely to adopt MTM accounting. Additional support for the transparency hypothesis comes from the analysis of ERCs before and after MTM adoption where they found that MTM adopting firms experience an increase in ERC (i.e., an increase in earnings informativeness, hence an increase in transparency) from the pre- to post-adoption period relative to matched control firms.

NEXT: ‘Managerial opportunism’ a more likely motive

On the other hand, the logistic regression results also support the opportunistic explanation for MTM adoption because such tests document that the likelihood of MTM adoption is higher when analysts have lowered expectations about a firm’s future performance. A decline in a firm’s expected future earnings performance is a determinant of managers’ opportunistic adoption of MTM because MTM adoption enables managers with large accumulated and unrecognized actuarial losses (that would otherwise have had to hit future income statements in the form of amortization expense) to instead be opportunistically written off as a one-time adjustment to Retained Earnings in the adoption year. Simply put, managers opportunistically use MTM adoption to take a “big bath” to get bad news/large accumulated pension actuarial losses behind them.

Additional evidence in favor of the opportunistic explanation comes from tests of the relation between CEO cash compensation and: 1) the amortization of actuarial losses and gains over years prior to MTM adoption and 2) reported MTM pension adjustments in years after MTM adoption. With regard to the latter the study found that after MTM adoption, the CEO cash compensation of adopting firms is insensitive to the firms’ actual reported MTM pension adjustments. When coupled with the fact that the balance sheets of almost all adopting firms showed large accumulated losses that had not yet been amortized into income (but which would otherwise have had to be amortized into income in the coming years), collectively the results of the two sets of CEO compensation tests suggest that managers of MTM adopters had an incentive to adopt MTM for pensions to shield future cash compensation from future amortization expense.

Kim explains that when company boards make CEO compensation decisions, they make many adjustments. “When we think about nature of MTM accounting, the gains or losses are affected by market factors such as stock market performance, interest rates and mortality tables. It is relatively easy for CEOs to argue that they do not have control over these things,” he says. “So these amounts would be taken out of consideration for a CEO’s compensation.”

He adds, “I’m conjecturing here, but it seems it is relatively more difficult to take an amortized amount out of CEO compensation. There is some debate over whether gains or losses reflect the true nature of operating expenses. It may be true that entire gains or losses are heavily affected by market factors, but when amortizing, you are trying to match the expense to the period in which the expense is incurred.”

Kim says, as a researcher, he is very cautious to draw any policy conclusions. He notes that only about three dozen companies adopted MTM out of all pension plan sponsors. “We just try to understand and explain decisions based on economic theories,” he says.