What is Prior Service Cost?

Prior Service Cost

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Prior Service Cost

Prior Service Cost, also known as Past Service Cost, is a term used in pension accounting that refers to the cost of providing retroactive benefits to employees. This cost arises when a company changes its pension plan benefits.

For example, if a company decides to improve its pension plan benefits, it might grant all current employees (and perhaps some former employees) additional pension benefits for service already rendered. This retroactive enhancement to benefits increases the pension plan’s obligation, which is then recognized as a Prior Service Cost.

According to U.S. Generally Accepted Accounting Principles (GAAP), Prior Service Cost is recognized in other comprehensive income when it’s incurred, then gradually reclassified into net periodic pension cost over the employees’ remaining service period until retirement.

Under International Financial Reporting Standards (IFRS), Past Service Cost is recognized immediately in the profit or loss for the period.

The specific accounting for Prior Service Cost can be complex and is subject to various rules and conditions, so companies typically rely on actuaries and accounting professionals to calculate and record these amounts.

Example of Prior Service Cost

Suppose ABC Corporation has a defined benefit pension plan for its employees. In 2023, ABC Corporation decides to improve its pension benefits by increasing the retirement benefits its employees will receive. This change is not just for future service by the employees, but it also increases the benefits for past years of service.

The actuary calculates that this change increases the present value of the company’s pension obligation by $500,000 due to the additional benefits for service already rendered by employees (prior service). This increase is the Prior Service Cost.

Under U.S. GAAP, ABC Corporation would initially recognize this $500,000 Prior Service Cost in other comprehensive income in its 2023 financial statements. It would then gradually reclassify this amount into net periodic pension cost over the remaining service period of the affected employees.

Let’s say the average remaining service period of these employees is 10 years. The corporation would then reclassify $50,000 ($500,000 / 10 years) from other comprehensive income to net periodic pension cost each year for the next 10 years.

Under IFRS, however, ABC Corporation would recognize the full $500,000 Past Service Cost in profit or loss in its 2023 financial statements.

It’s important to note that this is a simplified example and the actual calculation of Prior Service Cost can involve a number of complex factors, including assumptions about future salary levels, employee turnover, and discount rates. Therefore, companies usually rely on actuaries to compute these amounts.

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