Implications of pension and other post retirement benefit (OPRB) recognition biases on leverage ratio components

Abstract

Leverage ratios, the ratio of a firm’s debt to equity or assets, is a frequently used measure of firm risk, utilized by firms, analysts, and investors. However, pension and other post-retirement benefits (OPRB) are largely ignored in determining a firm’s total liabilities. Similarly, pension and OPRB assets are not accurately incorporated into a firm’s total assets listed on the balance sheets. This is largely due to intricacies in pension fund accounting under Statement of Financial Accounting Standards (SFAS) No. 87 that can cause the true pension and OPRB liabilities and assets to be masked from the financial statements. I propose two new, innovative methods to correct for this bias by adjusting “Total Assets” and “Total Liabilities” to properly incorporate pension and OPRB data. As a result, I find that the measurement error between leverage ratios ignoring these elements and those including them is significant. I then apply the corrected values for total assets and total liabilities after incorporating pensions and OPRB to a bankruptcy prediction model, modeled after the Altman Z-score and ZetaTM models (1968, 1977, 2000). I find that, contrary to my original hypothesis, the modified variables do not increase the models’ explanatory power in predicting corporate distress over the original, unadjusted models.