JP Morgan sent around a report on a change in pension accounting at Honeywell last November.  Honeywell had been following the traditional procedure of amortizing any accumulated pension gains or losses that lay outside of the corridor over the average remaining service life of employees.  The company decided to stop amortizing – any gain or loss outside of the corridor would be expensed immediately.

This is a great example for intermediate II or a professional research class. For example, you can ask the students to (a) check the codification to see if this change is acceptable, (b) prepare the debits/credits needed to make the change, or (c) consider what issues the external auditor might consider in preparing its letter regarding the acceptability of the change. It also challenges some widely held notions among researchers/instructors.

First, I generally suggest to students that companies do all they can to avoid earnings volatility.  Honeywell’s action is almost guaranteed to increase volatility in future earnings, which is hard for me to reconcile with my prior beliefs.

Second, because Honeywell at the time had losses in excess of the corridor, the cumulative effect on prior year’s incomes was negative.  Thus at first glance, this appears to be an income decreasing voluntary accounting change, something that again goes counter to the conventional wisdom.  However…

Third, a few years ago, the FASB mandated retroactive restatement for voluntary accounting changes.  As such, the losses that Honeywell would have recognized during prior years under a non-amortization approach go directly to retained earnings when the change is implemented.  As such, reported current-period income is unaffected by the change.

Fourth, because the past losses go to retained earnings, future earnings will almost certainly be higher.  It is akin to writing goodwill off to retained earnings at acquisition rather than capitalizing and amortizing.  Thus what initially looks like an income decreasing accounting change may really be a (future)  income increasing accounting change.

Finally, I use a number of class examples that demonstrate over the life of a transaction, reported earnings and net cash flow will be equal.  We all know that OCI items and stock option expenses derail this “clean surplus.”  But I do not think academics are as aware that the retroactive restating of voluntary accounting changes also breaks the long run articulation between cumulative reported earnings and net cash flows.