Describe the accounting for pension plan benefits

Answer 1

RETIREMENT BENEFITS

Many employers provide retirement benefits to their employees, including pensions, health insurance, and life insurance. U.S. GAAP and IFRS have similar provisions, although both standard-setting bodies currently have projects underway to make changes in the required accounting.

RECOGNITION OF PENSION EXPENSE

The employer must recognize the cost of pension plans as an expense in some period. An important conceptual question is whether the employer should recognize this cost as an expense:

1 . During the years while employees render services, or

2 . Later, when retired employees receive benefits during retirement.

The first approach records the cost of pension benefits as an expense in the period when a firm receives employee services, so the accounting for this type of deferred compensation is similar to the accounting for current compensation (that is, salaries and wages). Employees agree to render services currently for a package of compensation, some of which they receive immediately and some of which they receive later. The second approach records the cost of pension benefits as an expense long after the firm has received employee services. Typically accounting records a cost as an expense when a firm receives services (in this case, when employees earn pension benefits in return for working) regardless of when a firm actually pays cash to settle the obligation (in this case, when the employees receive the benefits). Both

U.S. GAAP and IFRS require firms to recognize the cost of pension plans as an expense during the years when employees render services.

PENSION PLAN STRUCTURE AND DEFINITIONS

The structure of a typical pension plan is as follows:

The employer sets up a pension plan that is legally separate from the employer. The pension plan specifies the eligibility of employees, the types of promises to employees, the method of funding, and the pension plan administrator. Some employers promise to contribute a certain amount to the pension plan each period for each employee (usually based on an employee's salary), without specifying the benefits the employee will receive during retirement. The amounts employees eventually receive depend on the investment performance of the pension plan. Common terminology refers to such plans as defined contribution pension plans. In most defined contribution plans, employees have a say regarding how the administrator invests the amounts contributed on their behalf. Other employers specify the benefit that employees will receive during retirement. Employer contributions plus earnings from investments made with those contributions pay the specified benefit. Common terminology refers to such plans as defined benefit pension plans. The assets in a defined benefit pension plan will usually not equal the liabilities of the plan, resulting in an overfunded or underfunded plan.

2 . Each period the employer transfers cash to the pension plan, which is usually organized as a trust. The plan administrator serves in a fiduciary capacity for the benefit of employees. The employer cannot access assets in the pension plan except under specific conditions that vary, as a matter of pension law, by jurisdiction. Under current accounting guidance, the employer does not consolidate the assets and liabilities of the pension plan with its own assets and liabilities. The total amount of cash that the employer contributes to the pension plan over time is the total amount of pension expense that the employer must recognize in measuring net income. The pension expense for a particular period is the amount of the cash contribution for defined contribution pension plans. For defined benefit pension plans, the cash contribution rarely equals pension expense.

3 . The pension plan receives cash each period from the employer and invests the cash in bonds, common stock, real estate, and other investments. The plan pays cash to retired employees each period. The assets in the pension plan usually change each period. U.S. GAAP and IFRS require firms to report pension plan assets at fair value. Thus, actual earnings from pension plan investments include not only interest and dividends but also realized and unrealized changes in the fair value of plan investments.

4 . The pension plan computes the amount of the pension liability each period. The pension liability for a defined contribution plan equals the assets in the pension plan. The computation of the pension liability for a defined benefit plan uses the pension benefit formula underlying the pension plan and requires management to estimate employee turnover, mortality, interest rates, and other factors, commonly referred to collectively as actuarial estimates or actuarial assumptions. The liability of the pension plan equals the present value of the expected amounts payable to employees (that is, the employees' expected benefits). The discount rate that firms use in measuring the liability is the rate of return on high-quality fixed-income investments with a maturity approximately equal to the period to maturity of the pension benefits.

The typical benefit formula for a defined benefit plan takes into account both the employee's length of service and salary. For example, the employer might promise to pay an employee during retirement an annual pension equal to a stated percentage (say, 2%) of the average annual salary during the employee's five highest-paid working years. In this example, an employee with 40 years of service receives an annual pension equal to 80% of that employee's average salary during the five highest-paid working years.

U.S. GAAP defines the primary measurement of the pension liability of the pension plan as the projected benefit obligation (PBO)—the present value of the amount the pension plan expects to pay to employees during retirement based on accumulated service but using the level of salary expected to serve as a basis for computing pension benefits. IFRS uses similar measurement methods and terminology.

A related measure of the pension obligation, found in U.S. GAAP, is the accumulated benefit obligation (ABO)—the present value of amounts the pension plan expects to pay to employees during retirement based on accumulated service and current salary at the time of measuring the pension liability. The difference between the PBO and the ABO relates to future salary increases, which the PBO incorporates but the ABO does not include.

U.S. GAAP and IFRS require firms to base both pension expense and funded status on the PBO. The liability of the pension plan usually changes each period as follows:

Projected Benefit Obligation (PBO) at Beginning of the Period
+ Increase in PBO for Interest
+ Increase in PBO for Current Employee Service (service cost)
+/- Actuarial Gains and Losses
- Payments to Retirees
= Projected Benefit Obligation (PBO) at End of the Period

The projected benefit obligation changes during a period for several reasons:
1 . Like other long-term liabilities, it increases each period because interest accrues as the payment dates approach (that is, the payments are one year nearer to becoming cash outflows).

2 . It increases because employees work another period and earn rights to a larger pension.
It changes because of changes in assumptions about employee turnover, mortality, inter-est (discount) rates, and similar factors.