March 3, 2008

Warren Buffett on “Juicing” Earnings: Pension Plan Assumptions

This year, Warren Buffett’s always entertaining 21-page letter to Berkshire Hathaway shareholders does not address one topic that Buffett has been focused on for several years now – runaway executive compensation.

Instead, Buffett has shifted his attention to the latest means for corporate America to report ever-higher earnings – the seemingly innocuous area of pension plan investment-return assumptions. He notes that for the 363 companies in the S&P 500 that have pension plans, the assumption they used in 2006 to calculate their pension expense averaged 8%. Buffett points out, however, that these investment-return estimates appear way too high, when judged against both past and reasonably expected future investment experience. He sums this assessment up by saying that the “helpers” who are advising companies on these matters must be “direct descendants of the queen in Alice in Wonderland, who said: ‘Why sometimes I’ve believed as many as six impossible things before breakfast.’”

Buffett notes that there is no puzzle as to why managers go with a high investment-return assumption – they can of course report higher earnings that way. And if their assumption is wrong, then fortunately for them “the chickens won’t come home to roost until long after they retire.” He indicates that after decades of pushing the envelope (or worse) on reporting earnings, it is time for Corporate America to “ease up.”

It should be noted that the optimism embodied in certain pension plan assumptions has been of concern to the SEC Staff over the past few years as well, as noted in this 2004 speech from an SEC Staffer and in Section II.J.1. of the most recent Corp Fin “Current Accounting and Disclosure Issues” outline. In the outline, the Staff stated:

The staff expects registrants with material defined benefit plans to include clear disclosure of how it determines its assumed discount rate, either in the financial statement footnotes or in the critical accounting policies section of MD&A. That disclosure should include the specific source data used to support the discount rate. If the registrant benchmarks its assumption off of published long- term bond indices, it should explain how it determined that the timing and amount of cash outflows related to the bonds included in the indices matches its estimated defined benefit payments. If there are differences between the terms of the bonds and the terms of the defined benefit obligations (for example if the bonds are callable), the registrant should explain how it adjusts for the difference. Increases to the benchmark rates should not be made unless the registrant has detailed analysis that supports the specific amount of the increase.

The Staff has also sought through the comment process more detailed discussion of the estimates of discount rates and long-term rates of return on plan assets in the MD&A – through its critical accounting policies and estimates interpretations – including the sensitivity of assumptions to changes in investment returns. Now that Buffett has weighed in, there is no doubt that efforts will remain focused on this area.

For more on the interesting topics covered in Warren Buffett’s letter (as well as the topics that were conspicuously not covered), take a look at Kevin LaCroix’s The D&O Diary blog.

A Smaller FASB on the Horizon

It is not too often that you see a regulatory (or quasi-regulatory) body shrinking, but that is just what is happening at the Financial Accounting Standards Board. Last week, the Financial Accounting Foundation (FAF) – the body that governs the FASB and the GASB – announced the approval of a number of governance, structural and operational changes that include reducing the number of FASB board members from seven to five.

These changes came out of a FAF committee established last summer to examine the “structure, effectiveness and efficiency of the governance processes of the FAF, FASB and GASB.”

In addition to the reduction in the size of the FASB, the FAF approved a by-law change broadening a requirement that FASB members possess “investment” experience, and it changed the FASB’s agenda-setting process to a “leadership” approach – vesting more authority in the FASB chair over project plans, the agenda and priorities. The FAF decided to retain the FASB’s simple majority voting requirement.

For some commentators, it looks like “the fix is in” with these latest FASB changes. As noted in this recent blog from The Accounting Onion, these changes appear geared toward “quick and dirty convergence” with international financial reporting standards.

March E-Minders is Up!

We have posted the March issue of our monthly email newsletter.

– Dave Lynn