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Accounting for Pensions

Accounting for Pensions

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Accounting for Pensions

Accounting for pensions involves the identification, recognition, measurement, and disclosure of a company’s obligations and expenses related to its pension plans in its financial statements. A pension plan is a retirement benefit offered by employers to provide income to their employees after they retire. There are two main types of pension plans: defined benefit plans and defined contribution plans.

Under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), pension accounting is primarily governed by FASB’s ASC Topic 715 and IAS 19, respectively.

Here are the key aspects of accounting for pensions:

  • Identification: Determine whether the company has pension plans and classify them as either defined benefit or defined contribution plans.
  • Defined benefit plans: In a defined benefit plan, the employer promises to provide a specified level of retirement benefits based on a formula that usually considers factors like years of service and salary levels. The employer bears the risk of the pension plan’s investment performance and bears the obligation to provide the promised benefits.
    • Measurement: Actuarial valuation techniques are used to estimate the present value of the defined benefit obligation (DBO) and the fair value of plan assets. The difference between the DBO and the fair value of plan assets is the net defined benefit liability or asset.
    • Expense recognition: The components of the pension expense for a defined benefit plan include service cost, interest cost, expected return on plan assets, actuarial gains and losses, and any past service costs or curtailments.
    • Disclosure: Disclose information about the pension plan, the actuarial assumptions, the fair value of plan assets, the defined benefit obligation, the pension expense, and any risks and uncertainties related to the plan.
  • Defined contribution plans: In a defined contribution plan, the employer contributes a specified amount to the plan, and the employee’s retirement benefits depend on the investment performance of the plan assets. The employer does not bear the obligation to provide a specific level of retirement benefits.
    • Expense recognition: The pension expense for a defined contribution plan is the employer’s contributions to the plan during the period.
    • Disclosure: Disclose information about the pension plan, the employer’s contributions, and any risks and uncertainties related to the plan.

By properly accounting for pensions, a company provides users of its financial statements with an accurate representation of its financial position and performance, considering its pension obligations, related expenses, and any associated risks and uncertainties.

Example of Accounting for Pensions

Let’s consider an example of a company accounting for a defined benefit pension plan.

Example: Company XYZ sponsors a defined benefit pension plan for its employees. At the end of the year, the company receives the following information from its actuary:

  • Defined benefit obligation (DBO): $2,000,000
  • Fair value of plan assets: $1,800,000
  • Service cost: $150,000
  • Interest cost: $100,000
  • Expected return on plan assets: $90,000

Here’s how Company XYZ would account for its defined benefit pension plan:

Step 1:

Measurement: Calculate the net defined benefit liability by comparing the DBO with the fair value of plan assets.

Defined benefit obligation: $2,000,000
Less: Fair value of plan assets:$1,800,000
Net defined benefit liability:$200,000

Step 2:

Expense recognition: Calculate the components of the pension expense for the defined benefit plan.

  • Service cost: $150,000
  • Interest cost: $100,000
  • Expected return on plan assets: $90,000

The total pension expense is:

Service cost: $150,000
Plus: Interest cost: $100,000
Less: Expected return on plan assets:$90,000
Pension expense: $160,000

Step 3:

Financial statement impact:

  • The pension expense of $160,000 is recognized in the income statement, which reduces the company’s net income.
  • The net defined benefit liability of $200,000 is reported as a liability in the balance sheet.

Step 4:

Disclosure: Company XYZ would disclose information about its defined benefit pension plan, the actuarial assumptions, the fair value of plan assets, the defined benefit obligation, the pension expense, and any risks and uncertainties related to the plan in the notes to the financial statements.

By properly accounting for its defined benefit pension plan, Company XYZ provides users of its financial statements with an accurate representation of its financial position and performance, considering its pension obligations, related expenses, and any associated risks and uncertainties.

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