Many of us still face doubt or even no idea in computing and recording pension transaction [so do I]. It is not because of we are dumb and lazy, no, of course we are not. We just need some information [tutorial will be perfect] to answer our questions: What is pension? How to calculate (compute) it and how do pension transactions recorded in the book [what entry should be made]? This “accounting for pension” post series tries to answer those basic questions.
The basic purpose of all pension plans is the same—to provide benefits to employees upon retirement. In effect, companies as employer, total pay for a period consists of current pay, plus the right to receive additional pay upon retirement. In 1987, the FASB issued Statement No. 87, “Employer’s Accounting for Pensions”.
There are two types of pension plans: “defined contribution plans” and “defined benefit plans“.
- Defined Contribution Plans – Periodic defined contributions are made by the employer into a trust fund administered by a third-party trustee. When an employee retires, the accumulated value in the fund determines how much is to be paid to the employee. If the fund has been invested wisely, the employee will receive a greater payout than if it was invested poorly. Thus the benefit to the employee is undefined and the employer’s obligation extends only to making the specified defined contribution.
- Defined Benefit Plans – Defined benefit plans guarantee the employee a specified retirement income related to the employee’s average salary. The periodic contribution to the fund is based upon the expected future benefits to be paid. Thus the benefit is defined, while the contributions are undefined, and the employer is responsible to make sure the employee receives the defined benefits as specified in the plan.
Because the accounting for defined contribution plans is relatively easy [the periodic contribution is simply debited to Pension Expense], Statement No. 87 focuses on defined benefit plans. We will do the same in this post.
In the U.S.; in order to make sure that the pension fund will contain enough money at retirement to pay the employees their defined benefits, Congress passed a law in 1974 known as the “Employee Retirement Income Security Act (ERISA)“. This law requires companies to fund their pension plans in an orderly manner so that the employees are protected at retirement. The periodic amounts to be contributed to the fund are directly related to the future benefits expected to be paid. Most plans require contributions that will accumulate to the balance needed to pay the agreed-upon benefits at retirement. The contribution amounts are determined by actuaries and must be adjusted as estimates and assumptions are revised to reflect changing conditions.
In most cases, the employer contributes annually an amount equal to the present value of future benefits attributed to current services. If the employer contributes less than this amount, the plan is said to be “under-funded“; if the employer contributes more, the plan is “over-funded“.
The Projected Benefit Obligation (PBO) and Its Calculations
The projected benefit obligation (PBO) is the present value of the future benefits expected to be paid to employees based on their employment to date and taking into consideration expected increases in salaries that would affect their benefits.
This measurement is based upon actuarial assumptions of: employee turnover, life expectancy, and interest rates.
The PBO is increased and decreased by several items, thus leading to the following relationship:
PBO, beginning year
(+) Service cost
(+) Interest cost
(?) Benefits paid
(±) Changes in actuarial assumptions
(=) PBO, year-end
EXAMPLE: Company A had a beginning PBO of $100,000, service cost and interest cost were $10,000 and $9,000 respectively, changes in assumptions were ?$4,000, and the ending PBO is $95,000. Using the above formula, benefits paid would be $20,000, determined as follows:
$100,000 + $10,000 + $9,000 ? X ? $4,000 = $95,000
X = $20,000
The Pension Fund
In the U.S. [as mentioned at the beginning of this post]; under ERISA, companies must make periodic contributions to the pension fund, which is usually administered by an independent trustee. The trustee then invests these monies in stocks or interest-bearing securities. Thus, the fund will increase through the earning of dividends and interest, or as a result of increases in the market value of these securities. Conversely, the fund will decrease if the market value of the securities falls.
The relationship between the beginning fair value of the pension fund and its ending fair value may be expressed as follows:
Pension fund value, beginning of year
(+) Employer contributions
(+) Actual return on fund assets
(?) Benefits paid (by the employer)
(=) Pension fund value, year-end
EXAMPLE: Company B had a beginning-of-year pension fund value of $200,000, and an end-of-year value of $300,000. This year its contributions to the fund were $150,000, while the fund paid benefits of $25,000. The actual return must have been a negative $25,000, calculated as follows:
$200,000 + $150,000 + X ? $25,000 = $300,000
X = ?$25,000
Basic Journal Entries For Pension Expense
A company’s annual pension expense may consist of as many as five components. These components are:
- Service cost
- Interest cost
- Expected return on pension fund
- Amortization of unrecognized prior service cost
- Amortization of unrecognized gains and losses
The third item, expected return on the pension fund, would generally decrease rather than increase pension expense. These five components are combined and their total is debited to Pension Expense. The actual contribution to the pension fund [which may or may not be exactly equal to this total] is credited to Cash. If the expense is greater than the contribution, the difference is a liability; if it is less, the excess contribution is an asset.
EXAMPLE: Company A has pension expense of $10,000 and contributes $10,000 to the pension fund. Company B also has pension expense of $10,000 but contributes only $8,000. Company C has pension expense of $10,000 and contributes $13,000.
The entries for these companies are as follows:
[Debit]. Pension Expense = $10,000
[Credit]. Cash = $10,000
[Debit]. Pension Expense = $10,000
[Credit]. Cash = $8,000
[Credit]. Accrued Pension Liability = $2,000
[Debit]. Pension Expense = $10,000
[Credit]. Prepaid Pension = $3,000
[Credit]. Cash = $13,000
Let’s construct another variation case example: Company D had service cost, interest cost, and amortization of unrecognized prior service costs in the amounts of $20,000, $5,000, and $2,000, respectively. Its return on the pension fund was a positive $3,000 and it had no other elements of pension expense.
The total pension expense is: $20,000 + $5,000 + $2,000 ? $3,000 = $24,000.
If company D makes a $20,000 contribution to the pension fund, its entry is:
[Debit]. Pension Expense = $24,000
[Credit]. Cash = $20,000
[Credit]. Accrued Pension Liability = $ 4,000
Note: on the above last example, we found company D had service cost. We will discuss further in details about the “service cost”, “Interest Cost”, and “Return on Plan Asset” on my next post as a part of this post series.