Pension Cost

Pension cost represents the amounts recognized in a company's financial statements on account of the cost of its post-employment benefit plans. In a defined contribution plan, pension cost equals the contributions due, and in a defined benefit plan, it comprises service costs, interest cost (net of expected return on plan asset), and amortization of actuarial gains or losses.

In US GAAP, pension cost of a defined benefit plan is referred to as net periodic benefit cost, and in IFRS, it is termed as defined benefit cost.

Components of defined benefit cost

Under US GAAP, net periodic benefit cost comprises service cost, interest cost on the projected benefit obligation, expected return on plan assets, amortization of prior service cost, and amortization of gains or losses recognized in the other comprehensive income previously.

Service cost is considered operating in nature while the other components are treated as non-operating. Under IFRS, pension cost includes service costs, net interest on pension asset or liability, and remeasurement of net defined benefit liability (asset).

Service costs

Service costs represent the increase in defined benefit obligation that results from one additional year of service provided by employees. Service cost calculations take into account the plan benefit formula, vesting conditions, future compensation levels, etc.

Under IFRS, service cost includes any past service costs and any settlement gains or losses.

Interest cost

Interest on projected benefit obligation arises due to passage of time. Since the obligation is a discounted value, it increases as we approach one period closer to the benefit payments.

Under IFRS, pension cost includes a net interest component, i.e. the interest on the defined benefit obligation and expected return on plan assets are netted off.

Expected return on plan assets

Expected return on plan assets represents the increase in plan assets expected over the period from investment returns. It is based on long-term expectation of future investment performance.

Under IFRS, expected return on plan assets is part of the net interest component.

Amortization of gains or losses

Gains or losses arise during annual remeasurement of pension plan, for example, from difference between actual return and expected return, and/or the difference between initial estimate of projected benefit obligation and revised estimate. Under US GAAP, unless an employer adopts a policy of immediate recognition, such gains and losses are reflected in the other comprehensive income and amortized to profit or loss.

Under IFRS, gains and losses are termed as ‘remeasurements of pension liability (asset)’, and are initially recognized in other comprehensive income.

Amortization of past service cost

When a plan is amended, there is often a change in the projected benefit obligation. Under US GAAP, such change is deferred and recognized initially in other comprehensive income, and charged in the income statement (usually) over the remaining years of service of the employees. This component is referred to as amortization of past service cost.

Under IFRS, past service costs are included in current service costs.

Pension cost of a defined contribution plan

In a defined contribution plan, only the contributions due in respect a period are recognized in profit and loss (or capitalized where allowed) and there are no associated interest costs or actuarial gains or losses.

Example

CPE Ltd. has a defined contribution plan to which it is obligated to contribute an amount of $20 million each year. In the financial year 20Y1, the company paid $25 million to the fund while in financial year 20Y2, contributions amounted to $15 million.

The company will recognize a pension expense of $20 million each in 20Y1 and 20Y2. The first year payment will result in $5 prepayment of contribution which will be expensed in 20Y2.

Pension cost vs pension expense

While the pension cost represents the total cost of an employee benefit plan to a company, it is often different from the pension expense reported in an income statement. It is because US GAAP allows service cost to be capitalized as part of cost of inventories or fixed assets, while IFRS allows capitalization of all components of pension cost.

If the service cost component is not eligible for capitalization, it is included in operating expenses, and other components are presented as non-operating.

by Obaidullah Jan, ACA, CFA and last modified on
Studying for CFA® Program? Access notes and question bank for CFA® Level 1 authored by me at AlphaBetaPrep.com

XPLAIND.com is a free educational website; of students, by students, and for students. You are welcome to learn a range of topics from accounting, economics, finance and more. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect!

Copyright © 2010-2020 XPLAIND.com