Thursday, January 21, 2010

Pension Accounting

Bonjour! Dear Friend

Prior to initiating the discussion on the subject matter for the day, I want to make some confessions. Pension Accounting was a thorny topic for me and it took me some time to imbibe it. Whilst I am going to write about it, makes me feel perturbed, yet I want to share my learning with you. At work, a project director taught me a mantra once “keep things simple, keep things stupid” and they are easy to manage. I tried applying the same mantra here and it least I was able to answer the multiple choice questions expected on the exam. Knowing that this was not a very heavily tested area, I took some risk and kept my fingers crossed of not running over a simulation on the D-day! I was glad, I could sail through a few multiple choices slickly on the test.

Lets begin with looking at the applicable authoritative pronouncements. The new Codification Topic 715 covers all of the following FASB statements under its various subtopics:-

1)FAS 87 and FAS 88, Employer's Accounting for Pensions,

2)FAS 132R, Employers Disclosures about Pensions and Other Post  Retirement Benefits,

3)FAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans amending  FAS 87 and FAS 88 and

4)FAS 106, Employers' Accounting for Post Retirement Benefits other than Pension.

Defined Benefit Pension Plan (FAS 87) is crucial from the exam perspective. It is a plan that defines an amount an employer commits to pay to its employee, called pension benefit, for life beginning at retirement. It is a function of age, number of years of service and compensation. The objective is:-
a) to provide a measure of pension expense reflecting the terms of underlying plan and
b) recognize the pension expense of an employee over his/her approximate service period.

Knowing the Pension Expense components or Net Periodic Pension Cost 
Net Periodic Pension Cost is the amount recognized in employer's financial statement as the cost of pension plan for the period. Please ensure to take a look at the key terms laid out in FAS 87 for a better understanding.

1)Service Cost (cost - addition to pension expense) - It is the discounted PV of benefits earned by an employee during the current period.

2)Interest Cost (cost - an addition to pension expense) - Causes an increase in Projected Benefit Obligation (PBO) due to passage of time. It is calculated as interest rate * beginning PBO, where interest rate is the assumed discount rate at which the pension benefit could be effectively settled.

3)Actual Return on Plan Assets (return - decreases the pension expense) - It is calculated as FV of plan assets at the end less FV of plan assets in the beginning plus Benefits paid during the year less contributions made during the year.

4)Prior Service Cost amortization - It is the cost of retroactive benefits granted in a plan amendment. Retroactively increasing benefits increases the PBO and prior service cost at the date of amendment and vice-versa. The increased or decreased cost is amortized as a component of net periodic pension cost. Amortization can be done on Straight Line basis that amortizes cost over the average remaining service life of the active employee.

5)Actuarial gains/losses - It occurs due to changes in actuarial assumptions. Gains decrease and losses increase the penion cost. There are 2 components of gains/losses - a) Current period difference being the difference between actual and expected return (expected rate of return on plan assets * market related value of plan assets) and b) Amortization of the unrecognized gain/loss for previous periods.

6)Amortization of Transition Asset (decrease) or Liability (increase) to penion expense, a FAS 87 adjustment. This indicates the funded status of the plan when FAS 87 was adopted. The employer records the amortization over average remaining service of plan employees or over 15 year year period, if the service period is below 15 years.
Note - Under FAS 106, the amortization period is 20 years instead of 15 years.

I have tried to exemplify the expense elements in the file linked below.

Post Retirement Benefits other than pension (FAS 106) is very much similar to FAS 87 except that it talks about plan for fringe benefits to retired employees. They both allocate benefit costs based on years-of-service. Since the expense elements are same as explained above, I would now like to talk about FAS 158.

Recognition of Liability or asset - FAS 158 amended FAS 87 and FAS 106 requiring companies to report their plans’ funded status as either an asset or a liability on their balance sheets. This has been well explained in an article below by Kenneth W. Shaw.

There is another article on FAS 158 explaining how FAS 87 and 106 have been amended and gives a bird's eye view in a tabular form on the pension expense elements and the related journal entries. I highly suggest you to go through Figure 1 and 2 in it.

With this, I conclude the topic on Pension Accounting. Speaking candidly, this topic was hard for me to write on and is still giving me butterflies.  I sincerely hope that I was able to justify the topic. Would love to see your comments on this one for sure!



  1. Thank you so much for your crash course in pension accounting!! I'm a staff auditor that has just started working on pension testing, and this helped provide a quick background on key terms - thank you! :)

  2. thank you for your short and concise summary...
    However im having some trouble with your 3 step Actual gains and losses...
    We learned that we need to use the expected rate of return and then see if we must factor in the actual unrecognised gains or loses.... using the corridor or threshold method....

  3. I have to say, you totally nailed it, my friend. I think you have made and provided a clear summary of all the important information about pension accounting. This should be an imperative to all our employers as it deals with the benefits that they can gain upon post retirement. You certainly are going to help the elderly and their employers to understand the bearing of this ‘thorny’ topic, as you say. Kudos!

    Jeanie Yearsley

  4. Based on how long you have been working and how hard you worked, then you will have a bigger pension. I have seen people retire in their 50's and set off for the world living off a really good pension. What if you don’t have that? What if you are paying off some debt? It would be good to circulate the money, like investing on Forex. Once you are earning and receiving a stipend, you can use that to pay off your debt until you are free. Then you will be able to live the rest of your life free from debt and enjoying your life with your pension.

    Wystan Dale

  5. This is indeed very helpful in understanding many things about pensions. The key terms in here are helpful for older people because key terms like "Actuarial gains/losses", which is the gain and loss arising from different estimates and what the company actually experiences with the pension plan; and "Amortization of Transition Asset or Liability" can be difficult to understand. And also to people working in a related field as for people like Tiffani.

    Clemencia Summers

  6. I notice FAS 87 entries, and pension expense recognition on the employee benefit obligations liability. What is the difference between the two?

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