Describe the accounting for employer sponsored defined benefit pension plans

Answer 1

EMPLOYER (SPONSOR) ACCOUNTING FOR A DEFINED BENEFIT PENSION PLAN

The funded status of a defined benefit pension plan on the employer's balance sheet mirrors the overfunded or underfunded status on the books of the pension plan on each balance sheet date. Differences between pension assets and pension liabilities relate to funding policies of the employer, investment performance, changes in actuarial assumption, and changes in the pension benefit formula. Pension plans measure and report pension assets at fair values and measure and report pension liabilities using a current market interest rate for high-quality, fixed-income investments. Thus, the amounts reported on the balance sheet of the employer and of the pension fund reflect value changes as they occur.

U.S. GAAP and IFRS do not require the employer to recognize the value changes in measuring net income as the value changes occur. Instead, employers include unamortized performance and actuarial gains and losses and unamortized prior service cost in Other Comprehensive Income. When firms amortize these items and include them in Pension Expense (or less commonly Pension Credit), they eliminate the amounts previously recorded in Other Comprehensive Income.

Reporting the Funded Status on the Balance Sheet

Both U.S. GAAP and IFRS require employers to recognize the funded status of a defined benefit pension plan as either an asset (pension plan is overfunded) or as a liability (pension plan is underfunded). A firm with multiple plans for different groups of employees nets the pension assets and pension liabilities for each pension plan and may further combine all plans that are overfunded and, separately, all plans that are underfunded. A firm with both net underfunded plans and net overfunded plans would show both an asset (for the net overfunded plans) and a liability (for the net underfunded plans). Applying U.S. GAAP, the firm debits or credits Other Comprehensive Income, a shareholders' equity account that is not part of net income, for the offsetting amount. Applying IFRS, the firm has several options for Many entries in Other Comprehensive Income represent changes in fair value, in this case in the pension plan, that receive delayed recognition in net income.

Under both U.S. GAAP and IFRS, the following formula calculates the Net Pension Expense (or Credit) for a defined benefit pension plan,:

Interest Cost (the increase in the obligation because of the passage of time)
+ Service Cost (the increase in the obligation because of an additional year of employee service)
- Expected Return on Pension Investments
+/- Amortization of Performance and Actuarial Gains and Losses
+/- Amortization of Prior Service Cost

Including interest cost as a positive amount and the expected return on pension investments as a negative amount illustrates the extent to which expected earnings from pension investments cover the increase in the pension liability caused by the passage of time. If the expected return is large enough, the firm will report a pension credit to income, as opposed to an expense. When pension assets equal pension liabilities and the expected rate of return on pension investments equals the discount rate used to compute the projected benefit obligation, then the amounts on these two lines offset each other. Such an outcome is unlikely. When the interest cost exceeds the expected return on pension investments, either employer contributions or future earnings on pension plan investments must make up the difference. Computing pension expense (or credit) using the expected return (not the actual return) rests on the view that pension plans should take a long-term perspective and generate earnings from investments based on a long-term expected rate of return. Annual deviations from this long-run expected rate should not flow through to net income as they occur. Finally, including service cost as a positive amount (that is, as an increase in the expense) parallels inclusion of wage and salary costs as an expense.

One of the principles underlying the accounting for pensions and other postretirement benefits is deferred recognition of the effects of deviations of actual from expected investment performance, actuarial gains and losses, and changes in prior service cost. U.S. GAAP and IFRS require firms to include these effects in Other Comprehensive Income as they occur and amortize them into net income over time. The rules for amortization of these amounts under U.S. GAAP and IFRS are complex.