Introduction to pension accounting

In addition to salaries, many companies offer other benefits to their employees such as pensions plans, health insurance, stock option benefits, fitness memberships, or life insurance plans.

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 accounting guide

 

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How a pension works

Pension plans are best summarized by 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.

 

pension accounting diagram

 

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.

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Two Types of Pensions

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:

Below is a tabular comparison between the two:

 

Defined Contribution PlanDefined 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.
Journal Entry:

DR Pension Expense

CR Cash

Journal Entry: More complicated. Explained below.

 

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Defined Benefits Plan

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 the 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:

  1. To determine the fair value of the assets and liabilities of the pension plan at the end of the year
  2. To determine the amount of pension expense for the year to be reported on the income statement
  3. 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 at $10 million.  Let’s see how the pension accounting works.

 

To record company contribution to pension

DR Defined Benefit Pension Liability             5,000,000

CR Cash                                                               5,000,000

 

To record pension expense

DR pension expense                                       10,000,000

CR Defined Benefit Pension Liability            10,000,000

 

To adjust pension liability to fair value

DR Other comprehensive income (OCI)        1,000,000

CR Net defined benefit liability                       1,000,000

 

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Determining Pension Expense in pension accounting

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 health care services may change drastically over time and the use of these services are 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.

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Additional accounting resources

This guide to pension accounting is a primer on some of the nuances handling pensions and other benefits as an accountant.  In order to help advance your career, we recommend these additional helpful resources: