Question

According to U.S. GAAP, how should pension plans be accounted for?

What are the components of a current year's pension plan expense? Discuss each of these components.

Why are pension plans problematic to account for?

Answer 1

Part 1

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 comparison between the two:

Defined Contribution Plan

This plan specifies how much money the employer needs to contribute to the pension plan. Investment risk is on the employees.

Journal Entry:

DR Pension Expense

CR Cash

Defined Benefits Plan

This plan specifies how much employees will receive in payments during their retirement.Investment risk is on the employer. Outflows from the pension trust to employees are pre-specified.

Journal Entry: More complicated. Explained below.

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 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

Part 2

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

Part 3

The real cost of pensions can't be measured in cash flow terms: how much is being paid out this year, as opposed to the contributions being put in. ... That is because pensions are a debt which must be paid. The problem is that low bond yields have forced up the present value of future benefits and widened deficits.

In the U.S. the Financial Accounting Standards Board (FASB) has established the FASB 87 Employer Accounting for Pensions guidelines as part of the Generally Accepted Accounting Principles (GAAP).

FASB 87 allows the off-balance-sheet accounting of pension assets and liability amounts. Subsequently, when the PBO is estimated for a company’s DB plan and plan contributions are made, the PBO is not recorded as a liability on the company’s balance sheet, and plan contributions are not recorded as an asset. Instead, the plan assets and the PBO are netted, and the net amount is reported on the company’s balance sheet as a net pension liability.

This type of accounting flexibility creates many significant problems for both companies and investors. As previously stated, the estimated PBO and plan assets are large in relation to the debt and equity capitalization of a company. In turn, this means that the financial condition of a company is not accurately captured on the company’s balance sheet unless these amounts are included in the financials.

As a result, important financial ratios are distorted, and many corporate executives as well as investors may reach erroneous conclusions about the financial condition of a company.