Corporations are required to recognize pension expense on the income statement and their pension asset/liability, which equals the difference between projected benefit obligation and plan assets, on the balance sheet. IAS 11 under the IFRS and ASC 715 under the US GAAP offer accounting guidance for pensions.
Many corporations offer pensions plans which to their employees to which they contribute funds. A pension plan is a trust whose ultimate beneficiaries are the employees.
Types of pension plans
Pension plans are predominantly of two types: defined contribution plans and defined benefit plans.
Defined contribution plan
A defined contribution plan is a fund to which a corporation is obligated to make a certain contribution each period, and this discharges its obligation in relation to pensions. The corporation is not affected by the actual return of the contributions made. The employees have a range of investment choices which ultimately decide their accumulated sum at the time of their retirement and their eventual benefits payout during retirement.
Accounting for defined contribution plan
Accounting for a defined contribution plan is easiest. Corporation just needs to recognize the contribution it is obligated to make each period as the pension expense. If its contribution is higher than the contribution required, it results in a pension asset on the balance sheet and if the contribution made is lower than the contribution required, it is reported as a pension liability on the balance sheet.
Defined benefit plan
A defined benefit plan is a plan in which the corporation guarantees the ultimate benefit payout. They are ultimately responsible for the pension liability. In a funded plan, they contribute an amount each period just like in a defined contribution fund. The company is responsible for investment of the plan assets such that if the plan assets underperform, the company must plug the deficit and if the plan assets underperform, the corporation can curtail its contributions.
Accounting for a defined benefit plan
Accounting for defined contribution plan is complex because it is affected by changes in the present value of the pension benefits that must be paid, changes in the fair value of plan assets, changes in pension policies, etc. Pension expense is reported on the income statement, net pension asset or liability is reported on the income statement, some gains and losses are reported in other comprehensive income and many other disclosures must be made in the notes to the financial statements.
Balance sheet: projected benefit obligation and plan assets
Projected benefit obligation
Accounting standards require corporations to record a pension liability for an amount representing benefits which are already earned plus benefits which are expected to be earned valued based on salaries that are expected to prevail in future. The present value of all such vested and non-vested benefits at future salaries is called the projected benefit obligation.
The projected benefit obligation increases over a period due to two factors: (a) due to increase in benefits because employees earned one additional year of benefits (this is called service cost) and (b) due to unwinding of interest (called interest cost). It decreases by a factor of benefits actually paid out to employees. The balance in projected benefit obligation also changes (increases or decreases) due to changes in actuarial assumptions i.e. changes in employee turnover, mortality rate, inflation, etc.
$$ Closing\ PBO=Opening\ PBO+S+I\ -\ B\pm\ A $$
Where S is service cost, I is interest cost, B is benefits paid and A is changes in actuarial assumptions.
Many companies set aside some money for the pension plan which is invested. These investments earmarked to meet the pension liabilities are called plan assets. The value of plan assets increases due to investment return i.e. dividends and changes in fair value. It also increases when in response to increase in projected benefit obligation, corporations make periodic payments called contributions. The plan assets value decreases when benefits are paid out to employees as and when they are due.
$$ Closing\ Plan\ Assets=Opening\ Plan\ Assets+R+C\ -\ B $$
Where R is the actual return on the plan assets, C is the contributions made and B is benefits paid.
When the projected benefit obligation is higher (lower) than the closing fair value of the plan assets, the difference is recognized as a pension liability (asset) on the balance sheet.
$$ Pension\ liability\ (asset)=Plan\ Assets\ -\ PBO $$
Income statement: pension expense
Pension expense reported on income statement equals the (a) service cost i.e. the increase in PBO attributable to one additional year of service, plus interest cost resulting from unwinding of interest minus actual return on plan assets plus/minus any amortization of prior service cost plus/minus changes in actuarial assumptions.
$$ PE\ =\ S\ +\ I\ - R± PS ± C $$
Where PE is the pension expense for the period, I is the interest cost, R is the return on plan assets, PS is the amortization of prior years-service cost and C is gains and losses.
Written by Obaidullah Jan, ACA, CFA and last modified on