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

There are two types of pension plans

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.
Journal Entry: DR Pension Expense CR Cash	Journal Entry: More complicated. Explained below.

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 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. Determine the fair value of the assets and liabilities of the pension plan at the end of the year
2. Determine the amount of pension expense for the year to be reported on the income statement
3. 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.

2) There are four components

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

3) Accounting for defined benefit pension plans has long been a major issue in accounting. Standard‐setters are grappling with revisions to pension accounting standards, and much change has already occurred in the United Kingdom. Key issues concern how to report the impact of changes in assumptions, how to recognize pension costs on the balance sheet and income statement, and how to reconcile the differences between accountants' and actuaries' approaches to pensions. Current standards assume that accounting estimates are independent of actuarial assumptions, and yet require a direct comparison of the accounting liability with the pension plan assets, when in fact they are incompatible measures based on differing assumptions and differing methodologies.