Isn't it great when you can sneak one past folks? I believe that's probably what management teams at AT&T (NYSE: T), Verizon (NYSE: VZ), and Honeywell (NYSE: HON) were thinking when they recently decided to change their pension accounting practices. Problem is, they're trying to sneak a big one past investors.

Odds are, they'll succeed.

If accounting can put most people to sleep, pension accounting could put them into a coma. Investors tend to look the other way rather than digging in -- which makes it easy for companies to sweep dirt under the rug. 

If you aren't interested in the accounting magic these companies are up to, at least realize that they're probably hoping you won't notice that they've pulled the wool over your eyes. Is that the kind of management with whom you'd want to invest your hard-earned money?

Smooth accounting
A pension is a promise to provide retirement income to employees. By law, companies are required to save as they go, setting aside a certain amount of money for each employee every year. Companies invest those savings -- much like you invest your 401(k) -- and hope that good investment returns will reduce the amount of savings required.

Like most 401(k)s, corporate pension savings took a beating in 2008. For companies, increases and decreases in pension values affect earnings. If the pension plan makes money, it boosts earnings. If the pension loses money, it reduces earnings. Companies have a choice between recording pension gains and losses on an annual basis or, in a process known as "smoothing," spreading gains and losses over several years.

Many companies choose smoothing, if only to reduce the year-to-year swings in earnings. In particular, when markets fall, smoothing helps reduce the immediate earnings hit. But recently, AT&T, Verizon and Honeywell decided to quit smoothing and start recording pension gains and losses on an as-you-go basis -- purportedly to make earnings more transparent.

What's wrong with that? Well, for starters:

  • As-you-go accounting benefits from rising interest rates. I'll skip the boring details and just note that rising interest rates typically make pension plans look healthier. Companies using smoothed accounting have to average those gains in over a period of years, whereas as-you-go accounting lets you grab all the goodies right away. Nice timing, and a savvy maneuver if you're a management team scrambling to figure out how to boost EPS growth.
  • As the table below shows, AT&T, Verizon, and Honeywell have huge unrecognized pension losses. Instead of smoothing those losses into future earnings, they are retroactively charging the bulk of those losses against 2008 earnings. In other words, they're largely sweeping them under the 2008 rug -- maybe hoping that nobody will be looking at or care about it in 2011? That maneuver will reduce 2008 earnings and boost future earnings. Both should do wonders for near-term earnings growth.


Unrecognized Pension Losses as of Dec. 31, 2009


$23.0 billion


$12.2 billion


$7.8 billion

Sources: The Wall Street Journal, company reports.

Does it matter? You bet. For AT&T, the maneuver reduced 2008 earnings from a profit of $12.9 billion to a loss of $2.6 billion. That would really hurt -- if anyone were looking.

Such moves are all perfectly legal, but there are more investor-friendly ways to improve earnings transparency. A great example is IBM's (NYSE: IBM) recent decision to provide additional earnings data that excludes some pension gains and losses. This improves transparency by making it easier for investors to see the company's operating fundamentals. Then again, IBM has a credible plan to deliver double-digit EPS growth through 2015 -- without resorting to accounting maneuvers.

General Electric (NYSE: GE) is making changes similar to IBM's. Unlike AT&T, Verizon and Honeywell, IBM and GE aren't sweeping losses under the 2008 rug. The approach IBM and GE are using deserves respect and trust. The approach AT&T, Verizon, and Honeywell are using does not.

The tip of the iceberg?
Conditions are ripe for more companies to follow in the footsteps of AT&T, Verizon, and Honeywell. Interest rates are expected to start rising in the near future, and many companies have big pension losses from the last few years that they're still smoothing into earnings. For about 15% of S&P 500 companies with underfunded pension plans -- meaning they hadn't saved nearly enough -- those unrecognized losses amounted to half or more of pension assets at the end of 2009. While that figure likely improved somewhat in 2010, don't be surprised if AT&T, Verizon, and Honeywell are not alone. The Wall Street Journal speculates that noteworthy candidates with potential to follow them include DuPont (NYSE: DD) and Goodyear Tire & Rubber (NYSE: GT).

Foolish takeaway
I think companies that implement pension accounting changes along the lines of the three I focused on are taking advantage of accounting-rule flexibility to make earnings look better than they really are. Investors should consider that when evaluating earnings growth -- and figure out what else management is trying to sneak past them.

Want to keep your eyes on these companies? Add AT&T, Verizon, and Honeywell to your watchlist.

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