Companies must account for pension funds established on the behalf of their employees. One aspect of a pension fund is accounting for pension expense, which includes the cost to run the pension, and is reported on the income statement. The components that make up pension expense under the generally accepted accounting principles (GAAP) include service cost, interest cost, expected return on plan assets, prior service cost and effects of gains and losses. Companies should understand the components to accurately account for pension expense.
Service cost, the first component of pension expense, increases the total amount of pension expense. The service cost component is the same service cost used to calculate the pension benefit obligation. It represents the amount of cost added to the pension benefit plan due to employees’ service contributions for the year. The projected benefit obligation takes into account the present value of the estimated amount of employees’ pensions. Pension benefit obligation equals the sum of service cost, interest cost, actuarial gains or losses, plan amendment gains and losses and benefits paid. The future salary levels of employees is taken into consideration when determining service cost. The calculation for service cost assumes that employees plan to remain with the company.
Interest cost relates to the amount of interest accrued on the project benefit obligation for a certain period of time. Interest cost causes the pension expense total to increase. Interest cost is calculated by multiplying the discount rate by the beginning balance of projected benefit obligation for the year. In most cases, the discount rate used by companies reflects the current market rate used on high-quality bonds or the rate of return on retirement annuities.
Expected Return on Plan Assets
Pension plan managers invest in various assets, which usually consist of stocks, bonds and other assets. The expected rate of return on the pension plan’s assets is what the company anticipates as the return on investment. When a company realizes a positive return on their investments, pension expense declines. In contrast, a negative return on plan assets results in an increase in pension expense. To calculate the expected return, you must take the fair value of the assets at the beginning of the period and multiply it by the long-term rate of return on the assets.
Prior Service Cost
Some companies make changes to pension plans or adopt new pension plans. Prior cost recognizes employee service contributions made prior to changes to an existing pension plan or contributions to a new plan. The amount expensed is amortized over the service life of employees included in the calculation of prior service cost. Most companies determine the number of years to amortize by averaging the service years of all included employees. Prior service cost increases the overall pension expense for the year.
Effects of Gains or Losses
The last component of pension expense is the effects of gains or losses on the pension benefit obligation. Several factors are considered when determining gains and losses. The first factor includes the difference between the actual return on assets and the expected return on assets. If the actual returns are greater than the expected returns, the company realizes a gain. if the actual returns are less than the expected returns, the company realizes a loss. A gain or a loss can also result from changes in the actuarial assumptions used to calculate the projected benefit obligation.
- American Academy of Actuaries: Fundamentals of Current Pension Funding and Accounting
- Millsaps College: Intermediate Accounting II: Accounting for Pensions
- The University of Texas at El Paso: Determining Pension Expense
- New York State Society of CPAs: New Pension Accounting Rules: Defusing the Retirement Time Bomb
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