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Introduction to Pension Accounting
In addition to salaries, many companies offer other benefits to their employees such as pension plans, health insurance, stock option benefits, fitness memberships, or life insurance plans. There are very specific requirements around pension accounting, which will be outlined in this article.
For regular benefits, the accounting is relatively simple – the employer records an expense for the amount of the benefits employees earn in a year.
However, the accounting treatment becomes more complicated when employees earn the rights to the benefits NOW but receive those benefits later, in the FUTURE. A clear example of such a benefit is the pension.
Pension plans are best summarized in a diagram. The following diagram shows three major players: the employer, the employee, and the pension trust.
A pension trust is a legal entity that holds the pension investments and disburses the funds later, when necessary.
Trusts are managed by trustees, who are independent of the company. We can examine several relationships below.
Relationship 1: Employees provide services to the employer and, in return, they receive wages.
Relationship 2: Employers make contributions to the pension trust.
Relationship 3: Funds are used from the pension trust to pay the employee in the future and, sometimes, employees can also make contributions to the trust.
There are two kinds of pensions available today. One is the defined contribution plan and the other is the defined benefits plan. Below is a tabular comparison between the two:
Defined Contribution Plan
Defined Benefits Plan
This plan specifies how much money the employer needs to contribute to the pension plan.
This plan specifies how much employees will receive in payments during their retirement.
Investment risk is on the employees.
Investment risk is on the employer. Outflows from the pension trust to employees are pre-specified.
Under the defined benefits plan, the employee is guaranteed a certain amount of benefits/payments in the future. Because pension payments are usually made much later in the future, there is a clear time difference between when employees receive future payments and when employees actually earn those benefits. Because of this difference, companies must use the accrual basis of accounting instead of when cash changes hand.
The pensions accounting treatment for defined benefit plans requires:
Determine the fair value of the assets and liabilities of the pension plan at the end of the year
Determine the amount of pension expense for the year to be reported on the income statement
Value the net asset or liability position of the pension plan on a fair value basis
Pension expense is an expected value and when the actual value of the pension differs, those deviations are recorded through other comprehensive income (OCI) under IFRS. For Canadian private companies that adhere to ASPE, there is no such OCI account.
Pension Accounting Example
XYZ Company has a defined benefit pension plan. At the end of 2015, the fair value of the assets and liabilities in the pension amounted to $6 million. In 2016, the pension expense was $10 million and the company contributed $5 million to the pension plan. At the end of 2016, the fair value of the pension assets and liabilities was $10 million. Let’s see how pension accounting works.
There are four important components that must be considered when determining pension expense:
Current Service Cost: The increase in the present value of the pension obligation that results from the employees’ current services
Past Service Cost: These costs arise from plan initiations, plan amendments, and reductions in the number of employees under pension plans
Interest Cost: The increase in the overall pension obligation due to the passage of time
Expected Income from Plan Assets: Income expected from assets in the pension plan, including investment income from interest, dividends, and capital gains
Accounting for Other Benefits
In addition to pension accounting, companies also have to provide other benefits that are treated similarly to pensions from an accounting perspective.
For example, some companies continue to pay for medical services used by former employees who have retired. This is seen in several companies in the United States.
Similar to pension benefits, companies will accrue an expense for benefits earned by employees in that year and create a liability provision for those benefits that are to be provided in the future.
Although the general idea may seem straightforward, there are several other factors that must be considered.
For example, dissimilar to pension payments, the costs of healthcare services may change drastically over time and the use of these services is irregular compared to annuity payments like pensions.
Therefore, when accounting for other employee-related benefits, some may require proper professional and subjective judgment depending on the situation.
This guide to pension accounting is a primer on some of the nuances of handling pensions and other benefits as an accountant. In order to help advance your career, we recommend these additional helpful CFI resources:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
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A well rounded financial analyst possesses all of the above skills!
Additional Questions & Answers
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