Prior service cost definition
/What is Prior Service Cost?
Prior service cost refers to the expenses incurred when an employer amends a pension plan to grant additional benefits to employees for services they provided in previous periods. These amendments may include improvements in pension formulas, retroactive benefit increases, or adjustments to vesting schedules, often as part of labor negotiations or workforce retention strategies.
Accounting for Prior Service Costs
Since prior service costs relate to past employee service, the cost is not recognized immediately but instead is amortized over future periods, typically following the plan’s vesting or service period guidelines. This accounting treatment ensures that financial statements reflect the cost impact gradually, aligning with the long-term nature of pension obligations. Prior service costs are recorded as a component of other comprehensive income (OCI) and systematically allocated to pension expense over time, helping organizations manage their financial obligations while maintaining fair and competitive retirement benefits for employees.
Example of Prior Service Cost
Owl Corporation has a defined benefit pension plan. In the current year, it increases the benefit that the plan participants will receive, which also expands the benefits associated with prior service years. This represents a $100,000 prior service cost, which the company initially recognizes in other comprehensive income, and gradually shifts into its net periodic pension cost over the remaining service period of the affected employees.
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FAQs
Can prior service cost be negative?
Yes, prior service cost can be negative when a pension plan amendment reduces previously promised benefits for employee service already rendered. In this case, the negative amount is referred to as a prior service credit and is initially recognized in other comprehensive income. The credit is then amortized over future periods, reducing net periodic pension cost.