Past Service Cost
Past service cost, also known as prior service cost, refers to the change in the present value of a company’s defined benefit pension plan obligation due to a plan amendment or changes that impact the benefits earned by employees for their service in prior periods.
In other words, if a company changes its pension plan in a way that either increases or decreases the benefits attributed to employees’ past service, the resulting change in the company’s obligation is known as the past service cost.
For example, a company might decide to improve its pension plan by granting its employees more generous benefits for the years they have already worked. This would increase the company’s pension obligation, and the increase would be recorded as a past service cost.
In the context of accounting for pensions under International Financial Reporting Standards (IFRS), past service costs should be recognized in profit or loss in the period of the plan amendment. Under US GAAP, the treatment can be more complex, and these costs might be initially recognized in other comprehensive income and then gradually amortized to profit or loss over the remaining service years of the affected employees. As always, specific accounting treatment can depend on the details of the situation and the applicable accounting standards.
Example of Past Service Cost
Let’s say ABC Company has a defined benefit pension plan for its employees. As per the original plan, an employee would receive annual pension benefits equal to 2% of their final salary multiplied by the number of years they have worked for the company.
In 2023, ABC Company decides to amend the plan to make it more generous for its employees. Now, the annual pension benefit would be equal to 2.5% of the employee’s final salary multiplied by their years of service. This amendment is applied retroactively, meaning it covers all past years of service of the employees.
As a result of this amendment, the present value of ABC Company’s pension obligation increases by $500,000. This increase is due to the improved benefits for employees’ past years of service, so it’s considered a past service cost.
Under International Financial Reporting Standards (IFRS), ABC Company would recognize this $500,000 as an expense in its income statement for 2023, the period in which the plan amendment occurred.
Please note that the specifics of pension accounting can be quite complex, and the exact accounting treatment can vary depending on the details of the pension plan amendment and the applicable accounting standards. In real-life scenarios, companies often engage actuarial experts to calculate the impacts of such amendments and accountants to determine the correct accounting treatment.