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THE ACCOUNTING REVIEWVol. 68, No. 4October 1993pp. 703-724

he Market Valuation occounting Information

he ase o Postretirem entenefitsother than Pensions

Eli AmirColumbia University

SYNOPSIS AND INTRODUCTION: he majority f empirical egulatoryaccounting studies on financialreportinghave focused on the ex post eval-uation of accounting choices (see Lev [1979] and Barth [1991] amongothers)after an accountingmethod is adopted. There has not been muchresearch nvolving he evaluationof accounting methods ex ante because,it is argued, newly mandatedaccounting information s usually availableonly some time after the FinancialAccounting Standards Board(FASB)has required ts release.In December1990, after lengthy and controversialdeliberations, heFASB issued SFAS No. 106, Employers'Accounting for PostretirementBenefits other than Pensions (PRB) replacing he current"pay as you go"practicewith a combinationof present-valueand accrual method. Few ofthe informationtems mandated by SFAS No. 106 has yet been disclosedearlier.Consequently, his researchuses the data that were availableduringthe time of the FASB's deliberationsas an example of ex ante empiricalresearch concerning the standard-settingprocess.This study uses the PRB cash payments to retirees as disclosed byfirms in their footnotes to the financial statements under SFAS No. 81(FASB 1984)to investigatewhetherinvestorsunderestimated he full effect

This paper draws on my Ph.D. dissertation completed at University of California-Berkeley. I would like tothank Trevor Harris, Jonathan Leonard, Joshua Livnat, David Modest, Stephen Penman, Jacob Thomas,Thomas Rothenberg, Paul Ruud, anonymous referees, and seminar participants at the University of Califor-nia-Berkeley, Columbia University, University of California-Davis, Duke University, Harvard University,New York University, University of British Columbia, and Washington University for helpful comments.Baruch Lev and Brett Trueman deserve special thanks for their careful review and guidance. The financial sup-port of the Deloitte Touche Foundation is gratefully acknowledged.Submitted January 1992.Accepted March 1993.

Editor's Note: This article was awarded the AAA Competitive Manuscript Contest Award for 1992.703

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704 The Accounting Review, October1993of the PRB liabilityon firms' values. Such underestimation would occur ifinvestors are not aware of the high rate of increase in health care costs orwhen future benefits' payments to current employees are partially ignored.Additionally, this study investigates whether an estimate of the presentvalue of the PRB liabilityis value-relevant to investors. Finally, an analysisis made of the range and sensitivity of economic parameters (discount rateand health care cost trend rate) used by investors to estimate the PRBobligation.The results indicate that, during the period 1984-1986, investors, onaverage, valued each dollar of PRB cash payment in any year as a dollar;i.e., they underestimated the full consequences of firms' promise to con-tinue making such payments in the future. During the period 1987-1990, incontrast, investors translated each dollar of PRB cash payment to an aver-age of $13.75 PRB obligation. Further, estimating the present value of thePRB obligation with publicly available data shows that the present-valuemeasure is value-relevant to investors in addition to the cash paymentsdisclosed by firms.Key Words: Postretirement benefits other than pensions, FASB, Valua-tion model, Present value.Data Availability: Data used in this study were obtained from publicsources. A list of sample firms is available from theauthor upon request.

p HE remainder of this study is organized as follows: Section I provides back-ground information aboutthe issue and its importance. Thevaluation model usedin this study and the tests conducted are discussed in section II. Section IIIdescribes the sample selection and the data collection process. The results of theevaluation of the value-relevance of the PRB cash payments disclosure mandated bySFAS No. 81 are presented in section IV. Section V describes the estimation methodused to estimate the present value of the PRB obligation. Evidence on the value-relevance of the estimated PRB obligation is reported in section VI. Section VIIcontains concluding remarks.I. Accounting for PRB-Background

PreliminariesAbout 82 percent (41 percent) of U.S. companies with more (less) than 1,000employees provide nonpension postretirement benefits, such as health care and lifeinsurance, to former employees and their dependents (Foster Higgins 1988). The U.S.GeneralAccounting Office estimated the aggregateunfundedPRBobligationof privateemployers at approximately $402 billion in 1988 (GAO 1989). During the period1985-1990, the average total spending of large and mid-sized firms on retiree health

care increased by 80 percent, an average annual increase of 12.4 percent. Possiblereasons for this increase are a growing pool of elderly retirees, more cost-shiftingby thefederal government from the Medicare program to employer-providedretiree health


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Amir-Market Valuationof Accounting Information 705care plans, early retirement, longer life expectancy, and court rulings that have barredemployers from terminating postretirementhealth care plans (Geisel 1987).In November 1984, the FASB issued SFAS No. 81, Disclosure of PostretirementHealth Care and Life Insurance Benefits, which mandates disclosure of firms' annualcash payments to retirees for postretirementhealth care and life insurance benefits. InFebruary 1989, the FASB issued an Exposure Draft, Employers'Accounting for Postre-tirement Benefits other than Pensions, which proposed to end the "pay as you go"accounting practice used by firms with PRBs, and to require that they use accrualaccounting.IIn December 1990, the FASB approved SFAS No. 106. The FASB concluded thatPRBs, like pensions, are part of employees' deferred compensation, and thereforeshould be recognized on the basis of service rendered,in a mannersimilar to the provi-sions of SFAS No. 87 (FASB1985).For plans sponsored by U.S. public companies, thestandardbecame effective for fiscal years beginning afterDecember 15, 1992. For non-U.S. and small plans (fewer then 500 participants),the standardwill become effectivein fiscal year 1995.

II. Research DesignThe Valuation Model

To analyze the valuation issues discussed above, this study uses a valuation modelthat relates the value of the firm to the information provided in the income statement(earnings)and balance sheet (bookvalue of equity).The valuation model derived by Ohlson (1991)is adopted here. Unlike other valua-tion models used in the literature,this model relates equity value to both accountingearnings and book value of equity. Both are value-relevant because they assist in pre-dicting future dividends, the theoretical basis for a firm's marketprice. The model canbe written as follows:

Pt= TX +'YI+ 2d,+OoVt (1)where Pt is the marketvalue per share of the firm's common stock at time t; x, is thefirm's earnings per share over the period (t -1, t); y, is the firm'sbook value per share attime t; d, is the firm'sdividends per share at time t; V,is a vector of other value-relevantinformation;ys areparametersthat relateearnings,bookvalue, and dividends to value;O3sre parametersthat relate other information to value; and 7q,s a disturbanceterm.Substituting the "clean surplus equation," yt= y, + x, - dt, into equation (1) yieldsthe following relation:2

Pt=acoyt- +a1x,+a2y1+fOVt+7q. (2)By using the clean surplus equation,price is expressed solely as a function of account-ing earnings, book values, and other value-relevant information.

' Espahbodi et al. (1991) document a significant negative market reaction around the announcement of theExposure Draft for firms with a PRB plan. Amir and Livnat (1992) document a significant positive market reac-tion around firms' announcement of early adoption of SFAS No. 106.

2 The "clean surplus relation" is simply the accounting identity where the change in book value is equal toearnings minus dividends.


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706 The Accounting Review, October 1993A potential problem with the model, as reflected in both equations (1) and (2), isheteroscedasticity.To correct for it, equation (2) is deflatedby the book value of equityat time t-1 (yr-l). The following model is then used:

Pt__ Xt Yr VI_ao~~~~ctl~~~~~~+a2~(3)yt-i yt-1 yt-i yt-iEquation (3) represents the deflated version of Ohlson's model. Otherinformationis defined as value-relevantif it is not reflected in earnings (x) or book value (y), and

Analysis of the Valuationof PRB Cash PaymentsThis section addresses the valuation implications of the cash payments made toretirees under the PRB plan. By analyzing the valuation effects of the PRB cash pay-

ments, one can infer whether investors properly estimate the magnitude of the firm'spromise to pay PRB cash payments and, to some extent, how they translate cash pay-ments into a measureof PRBobligation.This analysis is conducted by using the follow-ing model:Pi. Ca e it ei up,-= et + a,, + Y>2r + Cit + p2t + U3t +1 (4)yir-i yir-l yrt-i Yar-1 Yit-l yir-i

where Pit is firm i's per share market price at time t; xa is firm i's earnings per shareplus the per share tax-adjusted3PRB cash payments expensed in year t, plus the persharetax-adjustedpension expense for year t; yi, is firm i's book value per share at timet; yirt- is firm i's book value per share at time t-1; cit is firm i's tax-adjustedper shareamountof cash paid by firms to their retireesduring the year (per SFAS No. 81);pex,, isfirm i's tax-adjustedpension expense per share;uplit s firm i's per share unfunded pen-sion liability, calculated as the difference between the accumulated benefit obligation(ABO)and the fair value of pension assets. The ABO measure of the pension liability isused primarily because data is available for the whole test period. Lastly, Wtl is thenormally distributederror term with a zero mean. In this model, the PRB cash payments,Cir,and the pension variablesshould be thoughtof as the "other information"variables.Firmswith higherPRBcash paymentsto retirees are expected to have largerobliga-tions. Therefore, ,B is expected to be negative because it measures the extent to whichinvestors capitalize current cash payments in determining firm value. 01 can be inter-preted as a multiplier that investors use each period to translate after-tax cash pay-ments to retirees into the tax-adjustedpresentvalue of the PRBobligation.A coefficientbelow -1 will indicate that investors regardPRB cash payments as permanent. Notethat ,B may change over time because of changes in the economic parametersaffectingthe size of the obligation (i.e., discount rate and health care cost inflation)or because ofchanges in how investors perceive the PRB cash payments (i.e., transitory or perma-nent).4 Therefore, changes in i,3 over time will yield information on how investorsupdate their estimates of these obligations over time.

3 Thetaxadjustment s made by estimatingtheeffective ax rate for each firm in each year. The effectivetaxrateis definedas income tax expense divided by pre-taxncome. This rate s bounded between zero and 40per-cent during 1984-1986 and between zero and 35 percent during 1987-1990.4 In the present context, a transitory expense/paymentis one that is not expected to repeat itselfin thefuture. A permanent expense/payment is expected to repeat itself in the future.


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Amir-Market Valuation of Accounting Information 707Analysis of the PRB Obligation

As in the case of the PRB cash method, it is important to understand how a measureof the PRB obligation is related to the firm's market value. Is the obligation used in anunbiased manner by investors in valuing firms? How sensitive is the PRB obligation tothe choice of different parameters used to estimate the obligation, and what set ofparameters is used by investors in valuing firms? The most relevant question, however,is whether a measure of the present value of the PRB obligation, based on publicly avail-able information, is value-relevant to investors in addition to the cash (pay as you go)information. To understand how investors use the present value of the PRB obligationin valuing the firm's equity, the following cross-sectional valuation model is estimatedwith 1990 data:

Pi_ ___y0 pexi,g. upli La9ao+a,- +a2 Y 90 +132 +f83904+#, (5)Yi.89 Y. 89 Yi.89 Yi.89 Y.89 Y..89

where the subscript 90 (89) refers to the 1990 (1989) fiscal year-end, Li go is the firm'sestimated PRB liability, and all other terms are as before.If investors estimate the tax-adjusted present value of the PRB liability in anunbiased manner, and if the estimate used here is an unbiased estimate, then /4 wouldbe about -1. However, since the estimated liability is sensitive to the choice of the dis-count rate and the health care inflation rate, /3 will differ from -1 according to the setof parameters used. Therefore, the size of 4 can indicate the range of parameters usedby investors in estimating the liability.The analysis is conducted in two stages. First, -a measure of the PRB liability isexamined to see if it is value-relevant in addition to the cash payments information.Second, the accounting numbers are adjusted such that earnings and book valuesinclude the estimated present values of the PRB obligation. The cash information isthen examined to see if it is value-relevant to investors in addition to the liability infor-mation.The first stage of this analysis uses the following model (which is models [41 plus[5]):

Pi ~ x0 yi __ pexi190 Ppl 90Pi O+a +a2 031 032 4+3 U +034- +. (6)Yi.8Q Yi.89 Yi.89 yi .89 Yi89 Ya8 9 Y 899If the estimated liability is value-relevant in addition to cash, then 4 will be nega-tive and significantly different from zero, which leads to the first hypothesis.Hi: The liability estimate is value-relevant in addition to cash (/34

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Amir-Market Valuation of Accounting Information 709Table 1

Sample Selection

Year 1990 1989 1988 1987 1986 1985 1984Potential sample size 556 556 556 556 556 556 556Firms with no PRB data 147 178 175 168 187 194 232Firms with insignificantPRB cash payments 82 60 60 59 57 53 53Firms for which otherCOMPUTSTAT/CRSP datais not available 9 9 15 26 19 37 24Removed as outliers 5 5 5 5 4 6 4Number of observations 313 304 301 298 289 266 243

Note: Firms with market-to-lagged-book ratios of above 15 and below 0.1 were removed as outliers.

IV. Valuation of PRB Cash PaymentsPanel A of table 2 provides some statistics on the regression variables, and panel B

presents the sample correlationmatrix. Table 3 provides the results of estimating equa-tion (4) over the period 1984-1990. As can be seen, the a1 coefficient (earnings-to-lagged-bookratio)varies between 3.37 (1985)and 7.069 (1989),which suggests that tran-sitory components in earnings change significantlyover time. The coefficient on PRBcash payments over lagged book value, O3, s negative in five of the six years presented(it is positive in 1986),and is significantly different from zero in each of 1987-1990.6 In1987-1990, fi' is below -12 and significantly different from -1. This suggests thatinvestors are discounting future cash payments because they believe them to be a per-manent commitment-obligation.The fl1 coefficient decreases (becomes more negative) almost consistently overtime. When the data are pooled, there appearsto be a change in investors' assessmentof the PRB obligation from the period 1984-1986 to 1987-1990. An F-test to detect astructuralchange (Chow test) between the two periods yields an F-statistic that is sig-nificant at the 1 percent level. A two-tailed t-test to examine the change in Al from1984-1986 to 1987-1990 indicates that the change is significant at a 1 percent level.Dummy regressorswere also used to test whether ,B in each of the years 1987-1990is significantly smaller than Al in each of the years 1984-1986. In each regression, datawere pooled from one year in 1987-1990 with data from one year in 1984-1986Intercept and slope dummies allow the regression coefficients to vary over time to testthe significance of the difference in flis over time. The t-tests showed that each of thecoefficients in the 1987-1990 period is significantly smaller than each of the coefficient

6 When the dataarepooled over the period 1987-1990, ,1 is negativeand significant.


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710 The Accounting Review, October 1993Table 2

Sample Statistics

Panel A. Descriptive Statistics, 1984-1990 (s.e. in parentheses):Pi, i,, yi, c,, pex,, upI,Y;,-l Yitl Yit-l Yir-1 yert y,,,

1990:Mean 1.79 0.13 1.06 0.009 0.010 -0.10(1.60) (0.15) (0.21) (0.010) (0.020) (0.29)1989:Mean 2.25 0.17 1.09 0.009 0.009 -0.18(1.55) (0.15) (0.29) (0.014) (0.017) (0.25)1988:

Mean 1.92 0.17 1.08 0.007 0.010 - 0.12(1.05) (0.13) (0.19) (0.011) (0.026) (0.41)1987:Mean 1.90 0.15 1.08 0.007 0.011 -0.13(1.10) (0.14) (0.17) (0.014) (0.034) (0.48)1986:Mean 1.85 0.11 1.03 0.007 0.012 - 0.14(1.07) (0.13) (0.21) (0.013) (0.027) (0.20)1985:Mean 1.59 0.11 1.04 0.005 0.016 -0.09(0.75) (0.13) (0.15) (0.006) (0.019) (0.18)1984:Mean 1.40 0.15 1.04 0.004 0.017 - 0.09(0.70) (0.11) (0.13) (0.009) (0.020) (0.17)Panel B. Full-Sample Correlation Matrix (2,014 firm/year observations):Pit/ yit,, 1.00 0.60 0.41 -0.03 0.00 -0.12x

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Regressions of PRB Model, 1984-1990(p-values for a two-tail test in parentheses)

Pit x?, Yi, C,, pexi, upli,Model: =ao,+a,, +a2, +t3 u + +(3,, +pk.yit-, yi1-% yoi,- yiW, . yet-l Yif-

Year(s) aot aI a2 (1 at 321990 0.047 6.619 0.969 - 14.580 -4.761 -0.143 0.516(n=313) (0.908) (0.000) (0.019) (0.000) (0.228) (0.596)1989 1.013 7.069 0.150 -12.680 -9.982 -0.576 0.454(n = 304) (0.001) (0.000) (0.610) (0.010) (0.047) (0.067)1988 1.191 4.454 0.042 -12.690 8.877 - 0.296 0.331(n = 301) (0.000) (0.000) (0.899) (0.026) (0.000) (0.047)1987 2.382 5.868 -1.180 -18.250 5.534 -0.221 0.371

(n = 298) (0.000) (0.000) (0.003) (0.000) (0.047) (0.144)1986 1.163 5.061 0.115 0.551 - 3.007 -0.405 0.431(n=289) (0.000) (0.000) (0.695) (0.921) (0.239) (0.113)1985 1.278 3.370 0.080 - 3.312 2.533 - 0.269 0.398

(n = 266) (0.000) (0.000) (0.812) (0.688) (0.270) (0.205)1984 1.578 4.945 -0.780 -0.412 -6.312 0.102 0.397(n= 243) (0.000) (0.000) (0.033) (0.931) (0.007) (0.675)

1987-1990 0.771 5.823 0.328 - 13.752 2.293 -0.343 0.415(n = 1,216) (0.000) (0.000) (0.055) (0.000) (0.168) (0.001)1984-1986 1.008 3.882 0.166 -0.772 -4.551 -0.323 0.341(n = 798) (0.000) (0.000) (0.404) (0.982) (0.002) (0.026)

clients in the 1984-1986 period (at a 5 percent level). This further supports theconclusion of a material change in investors' perception of the PRB obligation.7It appears that during 1984-1986, investors underestimated the present value ofcurrentand future health care for retireesand other nonpension benefits relativeto theperiod 1987-1990. During 1987-1990, investors translate $1.00 of cash payment to anaverage of $13.75 of obligation, with f,1 ranging from -12.68 to -18.25. This signifi-cant change in investors' perception could be explained by one or more of the follow-ing: (1)investors changed their assessment of the future increase in health care costs; (2)the discount rate (settlement rate) changed; (3) investors updated their assessment offuture PRB payments (scope of the plan); (4) court cases led investors to change theirbeliefs about the legal status of the PRB obligation;(5) public debate about this issuedrew more attention to it.Over the period 1985-1990, the PRBmultiplier (il) has risen from 3.31 to 14.58 inabsolute values, indicating that changes in investors' assessments of the discount rate

7 The analyses were repeated by using the Heckman (1979) procedure, which attempts to detect and correctsample selection bias. The inverse Mill's ratio was derived from a probit model that included size, industrydummies, location dummies, labor intensity, and the ratio of retirees to active employees. The results were notmaterially affected by the inclusion of the inverse Mill's ratio in the regression model.


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712 The AccountingReview,October1993or the healthcare cost trend rate areunlikelyto be the only reason for the change in thei3 coefficient.8Changesin the coverage of PRBplans also are unlikelyto have caused such signifi-cant changes in investors' assessment of the PRBliability. Overthe period 1984-1990,overall coverage had not increased and most firms were trying to contain the PRBcosts. A telephone survey of more than 200 financial officers (see Bacon et al. 1990)revealed that retirees will be paying more in the future for their own health benefits.Furthermore, n 1984, U.S. district court used the common law to mandatevestingof retiree health benefits. In 1989, the sixth U.S. CircuitCourt of Appeals ruled that "ifplan documents clearly and consistently reserved a rightto modify a plan, then modifi-cations, based on those documents, are not illegal" (Geisel 1989). This suggests thatlegal proceedings may not be responsible for investors' changing beliefs.That investors were less aware of the consequences of paying medical expenses toretireesduring the period 1984-1986, is a plausible explanation. In contrast,duringtheperiod 1989-1990, as a result of the FASB Exposure Draft,public hearings, SFAS No.106, and numerous publications in the financial press, investors could have becomemore cognizant of the size of the PRBliability.9The coefficient on the pension expense (132) variablechanged magnitude and signalmost everyyear over the 1984-1990 period,which is consistent with the results foundin Grant(1991) and Barthet al. (1992).When the data were pooled, /2 is negative andsignificant in the 1984-1986 period, and positive and insignificant for the 1987-1990period. The coefficient on the unfunded pension obligation (f3) is more stable overtime. When the data were pooled, 3% is negative and significant over 1984-1986 and1987-1990. This result is consistent with Landsman(1986). The analysis was repeatedwithout the pension variables and showed that i,3 values over 1984-1990 are notaffected by the inclusion of the pension expense and the unfunded pension liabilityasregressors.

V. Estimating the Present Value of the PRB Liabilitywith Publicly Available InformationThe method of estimating the firm-specific PRB liability (present value) withpublicly available data uses a general present-value model. Consider a firm thatsponsors a PRBplan that entitles eligible employees to full medical coveragewhen they

retirefrom the firm. The employee may retire on or afterage y,; nj denotes the numberof retirees of age j sponsoredby the firm;and mi the numberof active employees of age iworking for the firm. Expected medical costs for a retireeof age y, for the current yearare denoted by Cy,. The cost is assumed to increase with age at a rate of g1 per year.Also, because of inflation, medical costs are assumed to increase at a rate of g2 peryear.That means that a retiree of age yr today is expected to spend (and therefore be8 To get a present-valuemultiplierof 3.31, assuming a 20-yearhorizon, the combinedannual discountfactorshould be 30percent.That means that if the discount rate is9 percent,the annualhealth carecost trendrate is around -21 percent. To get a present value of 14.58 under the same assumptions, the combined

discount factor is 3.2percent,and the annualchange in healthcarecosts is around 5.8 percent.9Thereappearsto be a market nefficiencybecause the footnote informationon the size of cashpaymentsfor postretirementbenefits was available in the financial statementsduring the time when postretirementbenefits were relativelyundervaluedby investors.


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Amir-Market Valuation of Accounting Information 713reimbursed by the firm) Cy,[(l+g,)(l+g2)Jt for medical costs incurred t years fromtoday, if he or she is alive at that time. For simplicity, assume that all payments aremade atthe end of the year. The nominal interest rate,r, is assumed constant overtime.For each individual, the probabilityof living throughyear a is denoted by PL(a). Theprobabilityof staying with the firm between age a and b is denoted by PS(a, b). Theprobabilityof retiring at age p (where p is greaterthan or equal to y,) is PR(p). Underthe above assumptions, the present value of the expected obligationof the firm is givenby: 10

PV= E njCy, E( 1+ g ) k-y,(J++g2) k-i(1 +rr)jkPL (k)_J=yr kJ=

+ F miPS(iy)Cy, (1+g2)Y'-i(1 +r)iYyointo

[ PR(y, +q) (a(l+g, ) S-Or(l g2) ti( l +r)j-i-PL(k) ) (9)q=O I=jEquation (9) has two components: The first component, which represents theexpected actuarial presentvalue of paying health benefits to retirees,takes into accountthe expected increase in health care costs because of aging, g1, and inflation, g2. Thesecond component represents the present value of future PRB payments to employees,currentlyactive, and takes into account the probabilityof their being employed by thefirm until retirementage, PS(iy,) as well as the distributionof all possible retirementages, y,+q(q>O). Since data on age groups and on other parametersin the model aregenerallynot publiclyavailable, some assumptions are requiredto makethe model esti-mable.Considernow the case of an employee who becomes eligible for PRBbenefits uponreaching age 55, which most firms use as the eligibilityage in their PRBplan (see FERF1989 and Foster Higgins 1988). Assume that the firm usuallyhires new employees whenthey are 35 years old, and all employeesretire at age 62 (ages35 and 62 representaverageemployment and retirement age according to Labor Departmentstatistics). The choiceof three age groups is made mainlybecause of datalimitations. In group1, n1 retirees of

age 62 are eligible for PRB coverage; in group2, n2 employees of age 55 are fully eligiblefor PRB and will retireat age 62 if they live until that age; in group 3, n3 employees ofage 35 are not eligible for PRB.Expected medical costs for a 62-year-oldretiree forthe current year are denoted byC62.The cost is assumed to increase with age and over time in the manner describedabove. For simplicity, assume that an employee does not leave the firm before retire-ment except through death. Under the above assumptions, the present value of theexpected obligationfor the whole firm, which is the sum of the obligations for the threegroups, is:PV=S n,+n2 (1 +2) PS( 55,62) + n (1 +92) S27PS(3362 (10)1+r ler)

1? Derivation of actuarial models can be found in Ippolito (1986) and Mittelstaedt and Wharshawsky (1992).


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714 TheAccounting Review, October1993where:

S= aC62(1 +gl)j(l +g2)j(1 +r)-jPL(62 +j).j=1

The date of estimation is December 31, 1990. The variables in equation (10) thatrequire estimation are the health care cost trend rate (g2), discount rate (r), averagehealth costs per retiree (C62), he three age groups (n1, n2, n3), and the probabilitiesofstaying employed [PS( * )] and alive [PL( *Health Care Cost Trend Rate

To estimate the rate of increase in per capita health expenditures (PCHE),the fol-lowing notation will be used: GNP= gross national product (annual), PCGNP= percapita gross national product, CPI= consumer price index, MCCPI medical compo-nent of the consumer price index, HE= national health expenditure (annual), PCHE= per capita health expenditure, Q= quantity of goods produced in the economy,QH= quantityof health services produced in the economy, n= general population size.A solid dot ( * ) above a variablerepresents its percentage change over one year.Taking derivatives with respect to time:"1

G4P=CPI+Q. (11)Equation(11) means that the percentage change in the GNP is equal to the percentagechange in prices plus the percentage change in the quantity of goods produced (realgrowth). Similarly, for health services only,

HE = MCCPI + QH. (12)The per capita versions of equations (11) and (12) are:

PCGNP=CPI+Q- h, (13)PCHE = MCCPI + QH-h. (14)

Four scenarios are considered here. The first scenario (Si) is that of no real growthin per capita medical services (QH=A), that medical costs will grow at the same rateas general inflation (CPI= MCCPI).

PCHE = CPI. (15)Some believe that the minimum estimate of future change in health care costs could bebased on the general inflation rate. Proponents of this approach believe that the CPI ismore reliable than other measures (see FERF [1989, 103] for further discussion of theissue).With the second scenario (S2), real growth in per capita medical services (QH >A)is allowed, but medical costs still grow at the same rate as general inflation (CPI- MCCPI). PCHE=CPI+QH- A. (16)

"Equation (11) is derived as follows:aGNP/at a(CPI*Q)/dt a8CPI)/at aQiat

- - ~~~~+ =CPI+Q.GNP CPI*Q CPI QEquations (12) through (14) are derived similarly.

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Amir-Market Valuationof AccountingInformation 715The third scenario (S3) places no restriction on real growth or prices of medicalservices.

PCHE = MCCPI + QH-A. (17)Scenarios Si and S2 are special cases of scenario S3. Scenarios S2 and S3 are lessconservative and allow for higher forecasts of the health care cost trend rate. Becauseeconomists argue that the share of HE from the GNP cannot be higher than a certainpercentage (see GAO 1989; U.S. Department of Commerce 1989),12 a fourth scenario(S4) is added to restrict the share of HE not to exceed 15 percent of GNPin 30 years.13For PCHE to rise from 11.1 to 15 percent in 30 years, the annual increase must be

(15/11.1)1/30 or 1 percent. This yields the following equation:PCHE =PCGNP+ 1 = CPI+ Q-i + 1. (18)

The next step is to forecast PCHE according to these four scenarios. First, theannual change in the general inflation rate (CPI) must be forecast. The pattern of infla-tion has changed considerably during the last 50 years (see U.S. Departmentof Com-merce 1975, 1986, 1989). An estimate of 4.5 percent as FERF (1989) will be used.14Second, a forecast of the MCCPI is needed. The average MCCPIover the period1950-1987 was 6 percent, and the average for 1984-1987 was 6.6 percent, which isabout 2 percent over the CPI.A forecast of 6.5 percent will be used here. To forecastQH, the techniques of Box and Jenkins (1976)are used to identify and estimate the fol-lowing model over the period 1960-1987 (t-values are in parentheses):QHt= 0.496QHt l+ 0.493QHt-5. (19)(3.9) (3.8)

With this model, QH is forecast to be, on average,4 percent over the next 30 years. TheU.S. general population (i) has been growing at an average annual rate of 1.5 percent(see U.S. Departmentof Health and Human Services 1988),and this is the forecast usedhere. As for Q, I adopt the U.S. Departmentof Commerce (1986) forecast, which is 2percent on average for the next 30 years.Using the above forecasts, one can now calculate PCHE under the four scenarios.Si: PCHE = CPI=4.5 percent.S2: PCHE = CPI+ QH-A = 7.0 percent.S3: PCHE = MCCPI+ QH - n = 9.0 percent.S4: PCHE = CPI+ Q i + 1%=6.0 percent.

The forecasts result in very different estimates of the PRB obligation. Scenarios Si andS4 would be more acceptable to the GAO and the U.S. Departmentof Labor, but sce-narios S2 and S3 yield higher estimates.Discount Rate

Four possible discount rates maybe appropriatefor calculating the PRBobligation.The first nossibilitv is the settlement rate [D li. which is the rate requiredto "sell" the" For example, if PCGNP=2 percent and MCCPI-CPI=4 percent, then the share of HE from the GNPwill rise from 11.1 percent (the share of HE from the GNP in 1988) to 20.1 percent in 30 years. This isconsidered by economists to be extremely unlikely.

13 GAO (1989) uses 14.9 percent and the U.S. Department of Labor (1986) uses 12.8 percent.1 Using time-series models may give unreliable forecasts. The average CPI over the period 1950-1987was 4.25 percent, and the average over 1982-1987 was 3.8 percent. GAO (1989) uses an annual forecast of 5percent.

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716 The Accounting Review,October1993obligation to an outside party. This may be the appropriate discount rate because itmeasures the marginal interest rate that the firm pays to an independent agent to meetthe PRB obligation. The problem is that firms are currently unable to "sell" the PRBobligations. Therefore, the settlement rate may not be identifiable by the firm. Indeed,firms disclose their own calculations of the pension rates in their footnotes to theannual financial statements, and this rate is used here.The second possibility is the marginal borrowing rate of the firm (D2). Assumingthe firm has to borrow funds to pay the PRBliability, the marginal borrowing rate maybe the appropriatediscount rate. This rate is set equal to the average yield on a bondwith the same S&Prating as that of the firm. The S&Pbond ratingfor each firm is takenfrom COMPUSTAT,and the average yield on each class of bonds for the year 1989 istaken from the S&P Bond Guide. These rates are: AAA=8.70 percent, AA=8.99percent, A=9.51 percent, BBB=10.01 percent, BB=12.07 percent, and B=13.85percent. iSThe third possibility is the return on equity (D3). Employers may self-finance thePRBobligation by issuing stock. In that case, the return on equity may be the appropri-ate rateto use. To estimate the returnon equity, the market model is estimated by usingmonthly returns over the period 1984-1989.The last possibility for the discount rate is the average cost of capital of the firm(D4). The funds to pay future PRBclaims may come from both borrowing and issuingnew captial. Therefore, the appropriaterate would be the average cost of capital calcu-lated as the weighted average of D2 and D3 as follows:

(D4)= (D2)+ ME (D3), (20)BD+ME BD+MEwhere BD is the book value of the firm's debt, and ME is the market value of the firm'sequity. Book value of debt is used because the market value of debt is usually notavailable, and the book value serves as a good proxy for it. The sample averages for Dithrough D4 are 8.9, 10.3, 18.5, and 13.3 percent, respectively. The correspondingmedians are 9, 9.5, 18.2, and 13.2 percent.16Average Per Capita Health Care Costs and Demography

The average cost per retiree is calculated as:cash payments for PRB# retirees

15 If the firm'sbonds were unrated,the yield is estimatedby using the following ratio:Interest on Long-TermDebt

Long-TermDebt+CurrentPortionof Long-TermDebtThis ratiois restrictedto the interval8.7 through13.85percentto be consistent with the intervalAAAthroughBB used for ratedbonds.

16 More than 470 comment letterswere receivedby the FASB n responseto its 1989ExposureDraft.Also,five days of publichearings on this topic were held in Octoberand November1989. In a comment etter,UnocalCorp. argued that the discount rate should be the firm's cost of capital. Others, including the FinancialExecutives Institute(FEI),claimed that a normalized bond rate should be used instead. FEI, Chrysler, andothersarguedthat the CPIindex shouldbe used as the appropriatemeasure of the health care cost trendrate.TheAcademyofActuaries, GAO,andIBM,amongothers, supported he FASB'sopinion thata "best estimate"should be used. S&PCorp. arguedthat no estimatecan be reliableenough and that the presentvalue of theliabilityis too sensitive to the choice of this parameter.

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Amir-Market Valuation of Accounting Information 717Although annual cash payments to retirees are disclosed by firms in their annual finan-cial statements, firm-specific data by age group are not generally available. This studyuses the ERISA Blue Book of Pension Funds (1983, 1984-1985, 1985-1986), which isbased on form 5500 filed by each firm with the U.S. government,as a source of informa-tion for number of firm employees and retirees for some specific years. These data maybe used to estimate the number of retirees and the number of active employees age 55and older. The following notation is used throughoutthis section:

R,=the number of retirees at the end of year t;At= the number of active employees at the end of year t;R, (a, b)= the number of retirees between ages a and b at the end of year t;A,(a, b) =the number of employees between ages a and b at the end of year t;PL(a, b)= the probabilityof staying alive between age a and b.As before, assume all employees retire at age 62. Assume further that the ratio ofretirees to active employees and the number of employees age 55 and over to totalemployees remain fixed over time. Then:

R89 R84 R83 R82 (21)A89 A84 A83 A82

A89(55,62) A84(55,62) A83(55,62) A82(55,62) (22)A89 A84 A83 A82

Given these assumptions, the number of retirees in 1989 can be presented as follows:61

R89= R82o PL(62,69)+ E A82(k) oPL(k,k+ 7). (23)k=55

Because of data availabilityproblems, equation (23) is approximatedas follows:R89= R82oPL(62,69)+A82(55,62)oPL(55,62). (23)

Equation (23) approximates the numberof retirees in 1989 as the sum of two com-ponents: (1)the number of retirees in 1982 that are expected to live until 1989and (2)thenumber of active employees between age 55 and 62 who are expected to live until age62 and retire at that age. Using equations (22) and (23) and rearrangingterms:

A82(55,62)= A89R84 _R82 FPL(62,69)1 (24)A84PL(55,62) LPL(55,62)iUsing equations (22) and (24):

A89(55,62)= {89 A9R84 _ R82 PL(62,69) (25)A82 A84PL(55,62) PL(55,62)Equation (25) is an estimate of the number of employees between ages 55 and 62. Thenumberof active employees age 55 and under will be the difference between A8955,62)and A89. The number of retirees in 1989 is given by the left-handside of equation (23).Probabilitiesof Staying Employedand OtherParameters

This study assumes that the probabilityof staying with the firm depends only on theevent of death. This is a reasonableassumption for employees age 55 and over, becauseThis content downloaded from 202.43.95.117 on Mon, 4 Nov 2013 08:03:02 AM

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Estimated PRB Liability as a Percentage of Book Value

Panel A. Sample Medians:Health Inflation Rates"DiscountRate, Si S2 S3 S4

Dl 0.25 0.48 0.90 0.38D2 0.21 0.36 0.62 0.29D3 0.06 0.08 0.10 0.08D4 0.10 0.14 0.21 0.12

Panel B. Correlations Between Liability Over Lagged Book Value (Li.90/yj,,9) and Other Variables:Variables Correlation

Pi. /Y,.-1 -0.27x ,, / yi- , -0.13Yi/ yir-1 -0.20cill/yf, , 0.65pexi, / y.- l 0.17upli,/y,,, -0.14

a The discount rates are: D1= pension; D2 = bond; D3 = equity; and D4 = cost of capital.b The health inflation rates are: SI=4.5 percent; S2 = 7.0 percent; S3 = 9.0 percent; and S4 = 6.0 percent.c The variables are defined in table 2.

employees nearing retirement age are more likely to stay with the firm. For youngeremployees, this may not be a good assumption, but data on employee turnover are notavailable.Each probability of staying employed (alive) is thus calculated with actuariallife tables published by the U.S. Department of Health and Human Services (1988).It is also assumed that the level of health care expenditure does not change with theretiree age (g1=0 percent in equation [10]). This assumption is made because data onhealth care costs for different age groups were not available.By using all the data described above, the PRB liability was estimated for each firmaccording to equation (10). The estimates are calculated with each of the four discountand health inflation rate combinations. Descriptive statistics for the 231 firms in thesamplewithoutmissing dataarereported n table4. The samplemedians of the estimatedPRB liability for each pair of health care cost trend rate and discount rate (panelA) show that the liability measures are very sensitive to the choice of parameters. Theaverage correlation between the liability estimates and the other variables used in theanalysis are shown in panel B.

VI. Valuation of the Estimated PRB LiabilityAs expected, the PRB liability and annual cash payments are highly correlated.Given this high correlation, does the estimate of the PRB liability add value-relevantinformation to investors in addition to the cash payments information? The results of


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Regressions to Ascertain the Value-Relevance of PRB Obligations(1990 data, 231 observations)

pi.90 i. 90 ye. ,0 Ci.90 pexi.g up, go L 90Model: +f3+o, +CU2 + t + 2 + 3 +34 +n3.Y.89 Yi.89 yi.89 y.89 Yi.89 Yi.89 3i.89S D cOf oai a}2 i3 03 R21 1 -0.391 7.695 1.211 - 12.753 -9.253 0.179 -0.206 0.61(0.307) (0.000) (0.002) (0.198) (0.053) (0.537) (0.223)1 2 -0.402 7.705 1.211 -13.414 -9.340 0.173 -0.359 0.61(0.300) (0.000) (0.002) (0.186) (0.052) (0.542) (0.210)1 3 -0.405 7.787 1.259 1.683 - 8.767 0.141 -1.582 0.62(0.283) (0.000) (0.001) (0.853) (0.063) (0.609) (0.050)1 4 -0.413 7.688 1.305 9.919 - 7.565 0.107 - 2.224 0.62

(0.272) (0.000) (0.001) (0.550) (0.112) (0.550) (0.005)2 1 - 0.377 7.695 1.192 -12.487 -9.322 0.191 -0.123 0.61(0.327) (0.000) (0.002) (0.114) (0.051) (0.511) (0.308)2 2 - 0.386 7.711 1.181 - 13.350 -9.523 0.187 - 0.256 0.61(0-310) (0.000) (0.002) (0.191) (0.047) (0.509) (0.252)2 3 -0.422 7.761 1.274 -4.702 -8.841 0.135 -0.807 0.62(0.264) (0.000) (0.001) (0.198) (0.061) (0.625) (0.090)2 4 -0.439 7.665 1.334 1.545 - 7.652 0.093 -1.170 0.62(0.244) (0.000) (0.000) (0.867) (0.109) (0.736) (0.040)3 1 - 0.370 7.696 1.183 - 12.070 - 9.338 0.194 -0.068 0.61(0.337) (0.000) (0.002) (0.089) (0.051) (0.501) (0.288)3 2 - 0.376 7.716 1.166 -12.711 -9.594 0.193 -0.153 0.61(0.323) (0.000) (0.003) (0.067) (0.045) (0.496) (0.212)3 3 - 0.430 7.745 1.280 -6.471 - 8.889 0.132 -0.428 0.62(0.256) (0.000) (0.001) (0.343) (0.060) (0.632) (0.081)3 4 -0.451 7.657 1.345 -2.057 -7.781 0.089 - 0.622 0.62(0.232) (0.000) (0.001) (0.792) (0.103) (0.749) (0.050)4 1 - 0.382 7.695 1.199 - 12.683 -9.303 0.187 -0.158 0.61(0.321) (0.000) (0.002) (0.138) (0.051) (0.519) (0.310)4 2 -0.392 7.708 1.192 -13.547 -9.465 0.183 -0.311 0.61(0.302) (0.000) (0.002) (0.119) (0.048) (0.520) (0.275)4 3 -0.416 7.770 1.269 -3.579 -8.812 0.137 -1.077 0.62(0.271) (0.000) (0.001) (0.659) (0.062) (0.620) (0.045)4 4 -0.430 7.673 1.325 3.682 -7.600 0.097 -1.549 0.62(0.254) (0.000) (0.001) (0.718) (0.111) (0.724) (0.026)Note: The p-valuesfor a two-tail test are presentedbelow the coefficients.

to realization of the large size of the present value of the expected PRBliability during1987-1990. When the firm-specific present value of the PRBobligationis estimated andthe relation between market values and this estimate is analyzed, it is shown that theestimated PRB obligation is value-relevant to investors in addition to the cashpayments, and that cash payments are not value-relevant when the accountingnumbers are adjusted to reflect the estimated PRBobligation. This result is importantbecause it shows that even a measure of the PRBobligationbased on publicly availableinformation is more informativethan the cash information. Most firms are expected torelease their private PRB information during fiscal year 1993. This is expected to bemore informative than the PRBliability measure used here, and therefore more infor-


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Regressions to Ascertain the Superiority of Liability Information(1990 data, 231 observations)

Pi. 90 X ', 90 y .90 C i.90 pexi,9o upli,90 4Model: Y.8 = YC89-+1I y:89Y2 + +13 l +133 X.8 .S D a0 al a,2 i}1 2 33 fl31 1 0.724 7.765 - 0.023 1.945 - 5.200 - 0.414 0.68(0.011) (0.000) (0.937) (0.342) (0.051) (0.066)1 2 0.879 7.503 - 0.092 -0.852 -4.784 - 0.245 0.58(0.002) (0.000) (0.746) (0.746) (0.067) (0.313)1 3 0.893 7.427 -0.045 -3.548 -4.625 -0.079 0.55(0.002) (0.000) (0.879) (0.266) (0.073) (0.756)1 4 0.868 7.398 -0.040 - 2.272 -4.627 - 0.131 0.56

(0.003) (0.000) (0.892) (0.431) (0.073) (0.604)2 1 0.233 7.482 - 0.050 3.203 - 7.869 -0.080 0.70(0.327) (0.000) (0.788) (0.070) (0.007) (0.578)2 2 0.902 7.691 - 0.163 0.624 - 5.150 - 0.381 0.64(0.002) (0.000) (0.576) (0.792) (0.051) (0.096)2 3 0.894 7.445 - 0.050 - 3.586 -4.603 - 0.090 0.56(0.002) (0.000) (0.867) (0.252) (0.075) (0.725)2 4 0.847 7.420 -0.033 - 1.663 -4.671 -0.167 0.57(0.003) (0.000) (0.909) (0.543) (0.071) (0.500)3 1 0.974 7.536 - 0.322 2.712 -4.912 - 0.755 0.74(0.001) (0.000) (0.246) (0.229) (0.076) (0.001)3 2 1.005 8.098 - 0.343 2.556 - 6.191 - 0.581 0.76(0.000) (0.000) (0.219) (0.213) (0.021) (0.004)3 3 0.925 7.458 -0.076 -4.182 -4.388 -0.093 0.57(0.001) (0.000) (0.796) (0.167) (0.089) (0.716)3 4 0.814 7.482 -0.019 - 0.990 -4.761 -0.210 0.59(0.005) (0.000) (0.949) (0.700) (0.067) (0.386)4 1 0.445 8.450 0.156 3.147 - 6.259 -0.436 0.73(0.106) (0.000) (0.587) (0.080) (0.023) (0.030)4 2 0.887 7.591 -0.124 -0.056 -4.947 -0.315 0.61(0.002) (0.000) (0.671) (0.982) (0.060) (0.182)4 3 0.893 7.436 - 0.047 - 3.545 -4.619 - 0.856 0.56(0.002) (0.000) (0.874) (0.261) (0.073) (0.738)4 4 0.857 7.407 - 0.037 - 1.933 -4.648 -0.151 0.56

(0-003) (0.000) (0.900) (0.490) (0.072) (0.546)Note: The letter 1above a variable in the model indicates adjustment for the PRB liability. The p-values for atwo-tail test are given below the coefficients.

mative than the cash measure. These findings support the motivation behind theFASB's decision to adopt SFAS No. 106.It appears that the PRB liability is highly sensitive to the choice of param-eters-health care cost trend rate and discount rate-used to calculate it. The FASBtried to mitigate this problem by requiringsome disclosure aboutthe sensitivity of thePRB obligation and annual cost to the choice of the health care cost trend rate (SFASNo. 106, par. 74). A similar requirement for the discount rate used to calculate theobligation may be helpful to financial statement users. In addition, the results suggestthat the marketuses a measure of the health care cost trend rate close to the generalinflation rate to estimate the obligation. It is also suggested that, unlike the discount


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Amir-Market Valuationof Accounting Information 723rate suggested by the FASBin its Exposure Draft, a firm-specific measure of the returnon equity or the cost of capital is used by investors to estimate the present value of thePRB obligation.This research is limited by the fact that the estimate of the PRBliability cannot befully validated.To date, no firm-specific demographic data are availableto researchers,and only a small numberof firms have adopted SFAS No. 106. When auditedestimatesare reported by firms in their financial statements, it will be possible to examinewhether the actual reported iability is incrementallyinformative over the estimatedlia-bility used in this reserch. It would also be interesting to examine managers' choice ofparameters to calculate the PRB obligation.

ReferencesAmir, E., and J.Livnat. 1992. Recognition vs. disclosure: Does it make a difference? A study of otherpostretirement benefits. Working paper, Columbia University, New York.Bacon, P., J. Kasper, G. De Lissovoy, S. Dicarlo, and J. Gabel. 1990. The employer response to theFASB proposal of accruing postretirement health benefits. Benefits Quarterly 6: 48-50.Barth, M. E. 1991. Relative measurement errors among alternative pension asset and liability mea-sures. The Accounting Review 66 (July):433-63., W. H. Beaver, and W. R. Landsman. 1992. The market valuation implication of net periodicpension cost components. Journal of Accounting & Economics 15 (March): 27-62.Belsley, D. A., E. Kuh, and R. E. Welsch. 1980. Regression Diagnostics. New York: McGraw-Hill.Blue Book of Pension Funds. 1983, 1984-1985, 1985-1986, ERISA Benefits Funds, Inc., Washing-ton, D.C.Box, G. E. P., and G. M. Jenkins. 1976. Time Series Analysis: Forecasting and Control. San Francisco:Holden-Day.Espahbodi, H., E. Strock, and H. Tehranian. 1991. Impact on equity prices of pronouncements related

to nonpension postretirement benefits. Journal of Accounting & Economics 14 (December):323-46.Financial Accounting Standards Board. 1984. Statement of Financial Accounting Standard No. 81:Disclosure of Post Retirement Health Care and Life Insurance Benefits. Stamford, CT: FASB.. 1985. Statement of Financial Accounting Standard No. 87: Employers' Accounting for Pen-sions. Stamford, CT: FASB.. 1990. Statement of Financial Accounting Standard No. 106: Employers' Accounting for Post-Retirement Benefits other than Pensions. Norwalk, CT: FASB.Financial Executives Research Foundation. 1989. Retiree Health Benefits: Field Test of the FASBProposal. Morristown, NJ:FERF.Foster Higgins. 1988. ThirdAnnual Health Care Benefits Survey. New York:A. Foster Higgins & Co.Inc.Geisel, J.1987. Court says firm can alter retiree health plan benefits. Business Insurance 21 (April):6.. 1989. Burden of retiree health benefits growing. Business Insurance 23 (January): 2, 7.General Accounting Office. 1989. Report to Congressional Requesters. Employee Benefits. Wash-ington, D.C.: GAO.Grant, J.1991. Liabilities for non-pension retirement benefits-Valuation impact of expenditure dis-closures. Working paper, Case Western Reserve University, Cleveland, OH.Heckman, J.1979. Sample selection bias as a specification error. Econometrica 47 (January):153-61.Ippolito, R. A. 1986. Pensions, Economics and Public Policy. Homewood, IL: Dow Jones-Irwin.Landsman, W. 1986. An empirical investigation of pension fund property rights. The AccountingReview 61 (October): 662-91.Lev, B. 1979. The impact of accounting regulation on the stock market: The case of oil and gas com-panies. The Accounting Review 54 (July):485-503.Mittelstaedt, F., and M. Wharshawsky. 1992. The impact of liabilities for retiree health benefits onshare prices. Working paper, University of Notre Dame, Notre Dame, IN.Ohlson, J.1991. Earnings, book values, and dividends in security valuation. Working paper, Colum-bia University, New York.


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724 The Accounting Review, October 1993U.S. Department of Commerce, Bureau of the Census. 1975. Historical Statistics of the United States-Colonial Time to 1970. Washington, D.C.: Government Printing Office.--. 1986. Money and Income of Households, Families and Persons in the United States, Series P-G0.Washington, D.C.: Government Printing Office.. 1989. Statistical Abstract of the United States, 109th ed. Washington, D.C.: Government Print-

ing Office.U.S. Department of Health and Human Services. 1988. Vital Statistics of the United States 1986.Hyattsville, MD: Government Printing Office.U.S. Department of Labor. Pension and Welfare Benefits Administration. 1986.Employer-SponsoredRetiree Health Insurance. Washington, D.C.: Government Printing Office.

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