How does the market price pension accruals

We use a cross-sectional valuation model that distinguishes between the operating and financial activities of the firm to examine the repercussions of three main alternative measures of pension expense. The GAAP Method recognizes a smoothed net pension expense, the NETCOST Method includes the excess of interest cost over the actual return on pension plan assets, if and only if this number is positive, and the FV Method substitutes the fair value in place of the smoothed pension expense. Three alternative fair value estimates of pension expense are examined: the first includes the expected return on plan assets and fair value other costs; the second includes the actual return on plan assets and net fair value other costs; the third includes the expected and the unexpected return on plan assets, along with net fair value other costs. Results from OLS regressions are consistent with the GAAP Method being relevant while the market appears to value the unexpected return included in the FV Method. Additional analyses from jack-knife (out-of-sample) regressions confirm the OLS findings. Further, we show that the multiples assigned to the alternative measures of pension expense differ based on the funding status of pension plans. The results are robust to various sensitivity checks.

Introduction
SFAS Nos. 87 and 132, the pension accounting standards governing the measurement, recognition and disclosure requirements during the time period of this study, incorporate a number of smoothing provisions to negate the earnings volatility that would otherwise arise. When characterizing the cost of sponsoring defined benefit pension plans to capital markets, SFAS Nos. 87 and 132 allow firms to use an expected rather than the actual return on pension plan assets in measuring net pension cost. Differences between expected and actual returns, as well as discrepancies originating from the actuarial assumptions employed and actual experience, are amortized over long time horizons (White et al., 2003; Revsine et al., 2005; Chadwick, 1986; Gerson Lehrman, 2006; Schultz and Francis, 2003; Henry, 2001; Henry et al., 2002; Norris, 2001; Jones and Walker, 2003). Over the years, various commentators have expressed concerns regarding the smoothing mechanisms embedded in SFAS Nos. 87 and 132 and suggested alternative ways of accounting for pensions. For example, S&P introduced its S&P Core Earnings concept in May 2002. This involves an alternative way of measuring pension expense that includes service cost and the excess of interest cost over the actual return on pension plan assets, but excludes pension earnings and other pension costs. Additionally, the FASB is currently reassessing the smoothing provisions inherent in SFAS Nos. 87 and 132. The above demonstrate that pension cost computation is important to the FASB’s agenda, as well as to that of other constituents.

Author: Paraskevi Kiosse, Martien Lubberink and Ken Peasnell

Source: Lancaster University Management School

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