Pension Asset or Liability
A corporation reports a pension asset on its balance sheet when the fair value of its plan assets is higher than the present value of its pension benefits, the projected benefit obligation (PBO). It reports a pension liability when the PBO is higher than the fair value of plan assets.
In case of a defined contribution plan, a pension plan in which the employer is only obligated to make contributions but it is not responsible for plan assets performance, a pension asset arises when contribution made is higher than the required contribution and a pension liability occurs when the contribution made is lower than the contribution required.
Let us say that your company runs a defined contribution plan to which it is required to make $20 million contribution during the current financial year, but it contributes of $22 million. You will record this using the following journal entry:
Alternatively, if the required contribution is $24 million and your company pays $20 million only, the journal entry would be:
Measures of pension obligation
A defined benefit plan is a pension plan in which the employer guarantees benefits such that any plan assets under-performance or over-performance accrues to it. It must determine the present value of pension benefits it must pay its employees. There are three ways in which the present value of pension benefits can be defined: vested benefit obligation, accumulated benefit obligation and projected benefit obligation.
Vested benefit obligation
The vested benefit obligation (VBO) is the present value of pension benefits which have already accrued to the employee determined at current salary levels.
Let us say your company has three employees each earning $5,000 per month. The pension benefits accrue when employee completes 5 years of service. If two of the employees have completed 5-years of service, the company will define its pension obligation by finding the present value of pension benefits expected to be paid to the two employees at the current salary level. This definition of pension liability is called vested benefit obligation.
Accumulated benefit obligation
The accumulated benefit obligation (ABO) represents the present value of both vested and non-vested benefits determined at the current salary levels.
Continuing the example above, if the employer defines its pension liability as the present value of actual benefits to be paid to two employees who have vested benefits and also incorporates an expectation that the third employee will complete the vesting period and hence will be entitled to the benefits, all valued at current salary level, the present value of benefits is called accumulated benefit obligation.
Projected benefit obligation
The projected benefit obligation (PBO) is the present value of both vested and non-vested benefits at the future salary level. The projected benefit obligation is the most comprehensive definition of pension liability and accounting standards require companies to value its pension liabilities by their projected benefit obligations.
Considering the example above, the projected benefit obligation equals the present value of two employees with vested benefits determined at the future salary level plus the present value of expected value of benefits to be paid to the third employee also valued at future salary level.
Let’s consider two scenarios: (a) a company’s defined benefit has plan assets of $100 million and PBO of $110 million, it has a net pension liability of $10 million, (b) a company has fair value of plan assets of $220 million and PBO of $190 million
|Pension liability or assets||Scenario A||Scenario B|
|Projected benefit obligation||$110 million||$190 million|
|Fair value of plan assets||($100 million)||($220 million)|
|Pension liability (assets)||$10 million||($30 million)|
In case of Scenario A, we have a net plan liability of $10 million and in case of Scenario B, we have a (net) pension asset of $30 million.
by Obaidullah Jan, ACA, CFA and last modified on