Accounting for pensions

The accounting for pensions can be quite complex, especially in regard to defined benefit plans. In this type of plan, the employer provides a pre-determined periodic payment to employees after they retire. The amount of this future payment depends upon a number of future events, such as estimates of employee lifespan, how long current employees will continue to work for the company, and the pay level of employees just prior to their retirement. In essence, the accounting for defined benefit plans revolves around the estimation of the future payments to be made, and recognizing the related expense in the periods in which employees are rendering the services that qualify them to receive payments in the future under the terms of the plan.

There are a number of costs associated with defined benefit plans that may at first appear arcane. Here is a summary of the relevant costs, which sum to the net periodic pension cost that is recognized in each accounting period:

Cost

Explanation

+ Service cost

This is the actuarial present value of benefits related to services rendered during the current reporting period. The cost includes an estimate of the future compensation levels of employees from which benefit payments will be derived.

+ Interest cost

This is the interest on the projected benefit obligation. It is a financial item, rather than a cost related to employee compensation.

+ Actual return on plan assets

This is the difference between the fair values of beginning and ending plan assets, adjusted for contributions and benefit payments. It is a financial item, rather than a cost related to employee compensation.

+ Amortization of prior service costs

When an employer issues a plan amendment, it may contain increases in benefits that are based on services rendered by employees in prior periods. If so, the cost of these additional benefits is amortized over the future periods in which those employees active on the amendment date are expected to receive benefits.

+ Gain or loss

This is the gain or loss resulting from a change in the value of a projected benefit obligation from changes in assumptions, or changes in the value of plan assets.

= Net periodic pension cost

 

The accounting for the relevant defined benefit plan costs is as follows:

  • Service cost. The amount of service cost recognized in earnings in each period is the incremental change in the actuarial present value of benefits related to services rendered during the current reporting period.
  • Interest cost. The interest cost associated with the projected benefit obligation is recognized as incurred.
  • Amortization of prior service costs. These costs are charged to other comprehensive income on the date of the amendment, and then amortized to earnings over time. The amount to be amortized is derived by assigning an equal amount of expense to each future period of service for each employee who is expected to receive benefits. If most of the employees are inactive, the amortization period is instead the remaining life expectancy of the employees.
  • Prior service credits. If a plan amendment reduces plan benefits, record it in other comprehensive income on the date of the amendment. This amount is then offset against any prior service cost remaining in accumulated other comprehensive income. Any residual amount of the credit is then amortized using the same methodology just noted for prior service costs.
  • Gains and losses. Gains and losses can be recognized immediately if the method is applied consistently. If you do not elect to recognize them immediately, it is also possible to account for them as changes in other comprehensive income as they occur. If there is a gain or loss on the difference between the expected and actual amount of return on plan assets, recognize the difference in other comprehensive income in the period in which it occurs, and amortize it to earnings using the following calculation:
    1. Include the gain or loss in net pension cost for a year in which, as of the beginning of that year, the gain or loss is greater than 10% of the greater of the projected benefit obligation or the market-related value of plan assets.
    2. If this test is positive, amortize the excess just noted over the average remaining service period of those active employees who are expected to receive benefits. If most of the plan participants are inactive, amortize the excess over their remaining life expectancy.