A Comparative Study of Pension Accounting in Australia and the USA: Applying the "Economic Substance Over Legal Form" Principle

Isabel Gordon

This thesis compares the genesis, social context and institutional rules for pensions in Australia with that of the USA, and investigates how this links to the development of accounting regulations in both jurisdictions. The social and institutional contexts vary between Australia and the USA, implying differences with respect to the interplay between the defined benefit plan (DBP) and the sponsoring employer, and suggesting that accounting treatments for pensions in the sponsoring employer's books vary between the two countries. The development of accounting regulations in the USA and Australia is traced using a duality viewpoint: 'the economic entity substance' and 'the legal entity form' views (Miller, 1987a). The legal entity form view considers that the DBP is a separate legal entity distinct from the sponsoring employer, and so the pension obligation is discharged by funding the pension plan. The economic entity substance view considers the DBP a part of the economic entity of the sponsor, resulting in the sponsor recognising the net pension asset/liability on the sponsor's balance sheet with the year-to-year difference shown in the sponsor's profit and loss.

The Australian accounting profession has been strongly influenced by pension accounting developments in the USA, although the contextual and institutional frameworks vary between the USA and Australia. Currently, most pension accounting standards aspire to the economic entity substance view evident in the USA, Australia and the international pension accounting standard. This study also compares current pension accounting standards in Australia, the USA and the international pension accounting standard using a theoretical benchmark that adapts Barth and Clinch's (1996) use of Ohlson's (1989) 'clean-surplus' model, and offers an alternative to the comparability construct used in accounting.

Prior to the convergence of Australian accounting standards with International Financial Reporting Standards on 1 January 2005, there was an absence of measurement rules for setting the contribution expense to the DBP. This study empirically investigates whether Australian sponsors of DBP take advantage of the absence of these measurement rules and set the contribution expense according to firm circumstances (the economic entity substance view) or fund circumstances (the legal entity form view). Given the problems with the total accrual models documented in the earnings management literature, this study follows the suggestions of Bernard and Skinner (1996) and McNichols (2000) and models a single item, the contribution expense to the DBP.

Using sponsor firms of DBP in Australia from 1995 to 1999, the contribution expense to the DBP is modelled to investigate whether the economic entity substance view or the legal entity form view dominates the setting of the contribution expense. If the legal entity form view is dominant, the contribution expense is expected to decrease/increase as the funding ratio and fund performance increases/decreases; and a low/high contribution expense is expected to be associated with the presence/absence of a hybrid fund and use of the accrued benefit/projected benefit actuarial methods. If the economic entity substance view prevails, then management is expected to minimise the contribution expense in times of ailing profits; take fewer cash expenses when internally generated funds are low; reduce the contribution expense as the debt ratio increases; and increase the contribution expense as the firm's average rate of tax increases. To address the role of individual firm performance and permit the partitioning of firms according to performance, firm variables are industry-adjusted. In addition, this thesis isolates the contribution holiday event as a specific setting to see if sponsors reduce the contribution expense to zero for earnings management reasons.

The evidence reveals that the legal entity form view dominates the determination of the contribution expense by sponsors of DBP. There is limited empirical support for the economic entity substance view that sponsor firms are setting the DBP contribution expense to achieve firm reporting objectives. When firms are partitioned on the basis of performance, and firms with a return on assets industry-adjusted less than zero are selected, the results do not vary substantially. Similarly, contribution holiday firms are not taking a contribution holiday as a result of ailing profit and cash flow, or mounting debt or to take advantage of taxation opportunities. When sponsor firms eligible to take a contribution holiday are isolated, it is found that presence of a hybrid fund is significantly associated with the contribution holiday. This suggests that firms are maximising the benefits of the contribution holiday (the hybrid plan permits a contribution holiday for both the defined benefit and defined contribution sections) and depleting surplus.

The empirical results of this study which support the legal entity form view are consistent with the social context and institutional framework for superannuation in Australia that the DBP is an entity separate from the sponsor. But the empirical results are inconsistent with the accounting regulations in Australia (which support the economic entity substance view) after convergence to international financial reporting standards. Thus, it is concluded that there is a dislocation between the institutional and accounting regulations for pensions in Australia as the institutional regulations do not impose a liability upon the sponsor to make good the deficit of the DBP while the accounting regulations require the recognition of the deficit in the sponsor's balance sheet. The implication for standard-setters, therefore, is that entrenched institutional features should not be assumed away by the accounting profession in the rush for convergence. This underscores the issue that the process of convergence is more than 'rubber-stamping' as witnessed by the re-emergence of the pension accounting debate in the financial media.

This thesis concludes that knowledge of the institutional regulations is important for earnings management studies as firm reporting objectives may be subjugated in the first instance by regulatory opportunities such as the contribution holiday. The empirical findings of this study that support the legal entity form view complement the analysis of the social and institutional contexts of superannuation in Australia as being congruent with the legal entity form view. By contrast, as a result of convergence to international financial reporting standards, current Australian accounting regulations support the economic entity substance view. The instance of pension accounting highlights that regulators, in the pursuit of convergence to international financial reporting standards, should consider the relationship between the institutional factors and the accounting rules in the standard-setting process.

Professor James Guthrie