Pension Plans
I. Overview – A pension plan is an agreement in which the employer provides employees with
defined or estimated benefits in exchange for current or past services. Pension benefits are not
paid currently; rather, they are a form of deferred compensation and are paid to retired
employees, usually on a periodic basis. It is a guide for pension plan expense shown on the
income statement and the presentation of the related pension liability or asset on the balance
sheet of the sponsor company.
It is not concerned with amounts to be funded (paid) to the pension trust during the year. It is
concerned with amounts accrued and expensed by the employer company. It is based on accrual
accounting. The accounting problems are caused by necessary use of estimates and assumptions,
which affect the timing and measurement of pension costs (expense), gains and losses from
investments of plan assets, and liabilities.
In a DEFINED BENEFIT PLAN, the benefits that the employee receives at retirement are
determined by formula. It is the sponsor company’s responsibility to ensure that contributions to
the plan are sufficient to pay benefits as they come due.
In a DEFINED CONTRIUTION PLAN, the contributions that the sponsor company makes to
the plan are determined by formula. The employees’ retirement benefits are based on the amount
of funds in the plan.
Accounting for defined contribution plans is very simple, whereas accounting for defined benefit
plans is complex. For a defined contribution plan, the sponsor company makes just one journal
entry and, for defined benefit plans, the sponsor company makes multiple journal entries.
It is very important to note that a pension plan and the sponsoring company are two separate
legal entities. The pension plan accounting covered below is not concerned with the pension
plan’s accounting. Rather, it is concerned with how the sponsor company accounts for the plan.
a. Characteristics - a pension plan can be:
i. Written or Implied – a plan’s provisions must be applied to both written plans
and those plans whose existence may be implied from a well-defined, although
perhaps unwritten, practice of paying postretirement benefits.
ii. Contributory or Noncontributory – Employees are required to contribute to the
plan if it contributory; only the employer contributes to the plan if it is
noncontributory.
iii. Funded or Non-funded
1. The employer makes cash contributions to the plan if it is funded. The
amount funded does not have to equal the pension plan expense for the
period.
2. For a non-funded plan, the employer makes entries on the books to reflect
the pension plan liability.
3. Pension plans are accounted for on the accrual basis; any difference
between the net periodic pension cost charged against income and the
amount funded is recorded as accrued or prepaid pension cost.
iv. Overfunded vs. Underfuned—applies to defined benefit plans only; an overfunded
plan has assets in excess of liabilities, whereas an underfunded plan has liabilities
in excess of its assets.
b. Types of Plans
i. Non-GAAP Methods
1. “Pay-as-you-go” – A cash basis method of expensing pension plan
payments after someone has retired. Because it is a cash basis method, it
is not GAAP.
2. Terminal Funding – A company pays an entire pension plan liability
upon retirement of an employee, generally by purchasing an annuity-type
insurance policy. Terminal funding is also a cash basis method and is not
GAAP.
ii. GAAP Methods
1. Defined Contribution Plan – This type of plan specifies the periodic
amount of contribution to the plan and the way that the contributions
should be allocated to employees. Factors to consider when calculating
contributions to the plan include the employee’s length of service and
compensation amounts.
2. Defined Benefit Plan – This type of plan defines the benefits to be paid to
employees at retirement. Contributions are computed using actuarial
estimates of future benefit payments based on factors such as the
employee’s compensation levels at or near retirement and the number of
years of employee service.
c. Definitions
i. Prior Service Cost – The cost of retroactive benefits granted, past service cost at
initiation of a new plan, or subsequent plan amendment reflecting new or
increased benefits. Prior service cost should be amortized over future periods
benefited.
ii. Service Cost – The present value of benefits attributed by the pension benefit
formula to current services rendered by employees (and is provided by the
actuary). The service cost component is a portion of the projected benefit
obligation and is unaffected by the funded status of the plan.
iii. Interest Cost – The increase in projected benefit obligation (PBO) due to passage
of time. Measuring the PBO as a present value requires accrual of an interest cost
on the projected benefit obligation, at rates equal to the assumed discount rates.
iv. Actual Return on Plan Assets – Determined based on the fair value of plan
assets at the beginning and ending of the period, adjusted for contributions and
benefit payments (a squeeze).
v. Prepaid Pension Cost – An asset is the cumulative employer contributions in
excess of cumulative accrued net pension cost.
vi. Accrued Pension Liability – The unfunded accrued pension cost is the
cumulative accrued net pension cost in excess of cumulative employer
contributions.
vii. Projected Benefit Obligation (PBO) – The actuarial present value of all benefits
attributed by the plan’s benefit formula to employee service rendered prior to that
date. PBO may use an assumption as to future compensation levels.
viii. Accumulated Benefit Obligation (ABO) – The actuarial present value of
benefits attributed by a formula bas on current and past compensation levels. An
ix.
x.
xi.
xii.
ABO differs from a PBO in that the ABO includes no assumption about future
compensation levels (use current salaries).
Vested Benefits – Pension plan benefits that already belong (vest) to employees
who have earned their benefits by reason of having reached retirement age and/or
who otherwise meet unique pension plan requirements. The benefits are vested
whether or not that person has actually retired, and they are not contingent on
remaining in the service of the employer. Generally, pension plan documents
require money to be left in the plan until retirement.
Actuarial Gains and Losses—Adjustments to the PBO that arise when the
actuary changes one or more of the assumptions used to calculate the PBO. Gains
decrease the PBO; losses increase the PBO.
Benefit Payments—Payments to the participant after retirement. The payment of
benefits reduces the PBO and reduces Plan Assets.
Plan Assets—Assets, generally stock, bonds, etc., set aside to provide for pension
benefits. They are reported at FV. Plan assets increase each period by
contributions to the pension plan (funding) and by the return on assets. Plan
assets decrease each period by the amount of benefits paid to retired employees.
II. Income Statement Accounting for the Employer’s Net Periodic Pension Cost
a. Income Statement (Expense) Formula
Current Service Cost
Interest Cost
(Actual Return)
Amortization of Prior Service Cost
(Gains) Losses
Amortization of Existing Net Obligation or Net Asset
Net Pension Expense
b. Journal Entries
i. To record net pension expense for period
Net pension expense
Current pension liability
ii. To record payment of cash to pension plan trustee
Current pension liability
Cash
c. Components of “Net Periodic Pension Expense”
i. Current Service Cost – Increase in the PBO (Projected Benefit Obligation)
resulting from employee services this period. The pension benefit formula is
applied to compute a present value.
ii. Interest Cost – The increase in the projected benefit obligation during the current
period that is (PBO) due to the passage of time.
1. PBO X Settlement Rate = Interest Cost
iii. (Return on Plan Assets) – Accounting standards allow companies to offset
pension expense by either the actual return on plan assets or the expected return
on plan assets
1. Actual Return on Plan Assets: Based upon fair value of plan assets at the
beginning and end of the period, adjusted for contributions and benefit
payments.
Beginning fair value of plan assets Plus Contributions Minus Benefit
Payments = Estimated Fair Value of Plan Assets Minus Actual fair value
of plan assets = Actual return on plan assets
2. Expected Return on Plan Assets: Companies use the expected return on
plan assets in the computation of pension expense in order to smooth
earnings. The expected return on plan assets is calculated as follows:
Beginning FV of plan assets X expected rate of return on plan assets =
expected return on plan assets.
When companies use the expected return on plan assets to calculate
pension expense, the difference between actual and expected return must
be recognized in other comprehensive income each period and then
amortized to pension expense over time with any actuarial gains or losses.
iv. Amortization of Unrecognized Prior Service Cost – In the period that a pension
plan is initiated or amended, the resulting prior service cost increases the PBO and
is recorded as unrecognized prior service cost in other comprehensive income.
The unrecognized prior service cost in accumulated other comprehensive income
is amortized to pension expense over the plan participant’s remaining years of
service. The amortization is calculated using the unrecognized prior service cost
balance at the beginning of the period.
v. (Gains) or Losses (Unrecognized) – Gains and losses arise from two sources:
1. The difference between the expected and actual return on plan assets when
the expected return on plan assets is used to calculate pension expense,
and
2. Changes in actuarial assumptions.
3. Accounting—two choices
a. Recognize gains and losses on the income statement in the period
incurred, OR
b. Recognize the gains and losses in other comprehensive income in
the period incurred and then amortize the unrecognized gains and
losses to pension expense over time using the corridor approach—
an entity’s net unrecognized gain or loss is amortized over the
employees’ average remaining service period, if as of the
beginning of the year, this amount exceeds 10% of the greater of
the beginning of the year balances of:
i. Market related value of plan assets = Assets
ii. Projected benefit obligation = Liabilities
vi. Amortization of Existing Net Obligation or Net Asset at Implementation
1. Projected Benefit Obligation Minus Fair market value plan assets = Initial
unfunded obligation / 15 years or average employee job life (greater) =
minimum amortization
III. Balance Sheet Accounting for Pension Plans
a. Pension Plan Contributions—A company’s contribution to its defined benefit pension
plan(s) increases the pension plan asset (overfunded pension plans) or decreases the
pension plan liability (underfunded pension plans).
Journal Entry:
Pension benefit asset/liability
xxx
Cash
xxx
b. Funded Status—Companies must report the funded status of their pension plans on the
B/S as an asset or liability or both. The funded status of a pension plan is calculated
using the following formula:
FV of plan assets – PBO = Funded Status.
If a company has multiple defined benefit pension plans, the funded status of each plan is
calculated separately.
i. Pension Plan Asset (noncurrent): A positive funded status indicates that the
pension is overfunded. All overfunded pension plans are aggregated and reported in
total as a noncurrent asset.
ii. Pension Plan Liability (current, noncurrent, or both): A negative funded status
indicates that the pension is underfunded. All underfunded pension plans are aggregated
and reported as a current liability, noncurrent liability, or both.
c. Accumulated Other Comprehensive Income: Changes in the funded status of a
pension plan due to prior service cost and pension gains and losses must be reported in
other comprehensive income in the period incurred, unless the company chooses to
recognize the pension gains and losses immediately on the income statement. Prior
service cost and pension gains and losses remain in accumulated other comprehensive
income until amortized to net periodic pension cost. Any remaining unrecognized
transition obligation or asset is also reported in accumulated other comprehensive
income, net of tax, until amortized to the net periodic pension cost.
i. Prior Service Cost and Pension Loss
1. Recognition in Period Incurred: Prior service cost and pension losses
decrease the funded status of the pension plan and are recorded with the
following journal entry in the period incurred:
Other Comprehensive Income
xxx
Pension benefit asset/liability
xxx
A deferred tax asset must also be recognized because prior service cost
and pension losses increase the benefits that will be paid to retired
employees in the future. When these benefits are paid, the company will
take a tax deduction for the benefit payments, decreasing future taxes.
The related deferred tax benefit must be recognized in OCI as an offset to
the unrecognized prior service cost or pension loss. All elements of AOCI
are reported net of tax.
Deferred tax asset xxx
Deferred tax benefit—OCI xxx
2.
Amortization to Pension Expense—When prior service cost, net losses,
and any remaining transition obligation are amortized, they are reclassified
out of accumulated other comprehensive income and recognized as a
component of pension expense.
Net periodic pension cost xxx
Other comprehensive income
xxx
The related deferred tax benefit must also be removed from accumulated
other comprehensive income and recorded on the income statement.
Deferred tax benefit—OCI xxx
Deferred tax benefit—I/S xxx
ii. Pension Gains
1. Recognition in Period Incurred—Pension gains increase the funded
status of the pension plan and are recorded with the following entry in the
period incurred?
Pension benefit asset/liability
xxx
Other comprehensive income
xxx
A deferred tax liability must also be recognized because pension gains
decrease the benefits that will be paid to retired employees in the future
and thereby decrease the tax deduction for the benefit payments,
increasing future taxes. The related deferred tax expense must be
recognized in OCI as an offset to unrecognized pension gain. All
elements of AOCI are reported net of tax.
Deferred tax expense—OCI
Deferred tax liability
2.
xxx
xxx
Amortization to Pension Expense—When pension gains and any
remaining net transition assets are recognized in net periodic pension cost
through the amortization process, the following reclassification adjustment
is recorded.
Other comprehensive income
Net periodic pension cost
xxx
xxx
The related deferred tax expense must also be removed from accumulated
other comprehensive income and recorded on the income statement.
Deferred tax expense—I/S
xxx
Deferred tax expense—OCI
xxx
IV. Pension Settlement and Curtailment and Termination Benefits
a. Settlements – Settlements occur when the pension plan assets increase in value to the
point that sale of the pension plan assets allows a company to purchase annuity contracts
to satisfy pension obligations. Remaining funds from the sale of assets may, with
restrictions, be used by the corporation.
b. Curtailment – Curtailments are events that reduce the expected remaining years of
service for present employees or eliminate accrual of defined benefits for future services
of a significant number of employees.
c. Termination – Termination benefits arise when employees are paid to terminate their
rights to future pension payments.
i. Formula
Lump sum payments Plus P.V. Termination Benefit = Special Term Benefit
ii. Journal Entry
Special term benefit expense
Special term benefit liability