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Pensions

There are various types of pension plans including single-employer defined benefit plans, multiemployer plans and defined contribution plans. Single-employer defined benefit plans are the most controversial in accounting. This is because the accounting for pension plans often made it difficult to compare the financial statements of one business to the financial statements of another. Significant pension related obligations were often not recognized in the financial statements.1

Defined benefit plans include a promise to compensate employees with a specified amount of pension benefits. These benefits are commonly calculated based on the employee's length of service with the company and their salary at the time of retirement. While both employers and employees typically contribute to the pension fund, the employer bears the investment risk since it must make up the difference between the value of the fund and the defined benefit obligation if there is a shortage. 

Pension plan accounting is very complex, and only the basics will be discussed here. The main purpose of accounting for pension plans is to recognize the compensation cost of an employee's pension benefits over the course of the employee's career with the business. As a result, accrual accounting is a fundamental element of pension accounting. This means that a business's pension expense each year is not limited to its cash contributions to the pension fund, but must reflect the present value of the estimated cost of the pension compensation that each employee has become entitled to as a result of their service over the year. 

The second purpose of accounting for pension plans is to recognize that any difference between the amount of money available in the pension fund and the amount of the company's future pension obligations is a liability for the company.



We can calculate the present value of the company's plan assets (its investment in the pension fund) and its ABO (which is an estimate of the present value of its future benefit obligation) below. ABO assumes that a company's current salaries do not rise. As a result, it typically understates the projected benefit obligation (PBO) which assumes salaries will rise; and overstates the vested benefit obligation (VBO) because it only counts service already performed. FASB Statement no. 87 requires accountants to measure the funded status of the plan using ABO. 



The service cost estimate is the additional liability created because benefit obligations have accrued to each current employee for working another year. As well, because the company is now one year closer to having to pay its obligations, the present value of the obligation increases by the amount of one year's interest (ie. one year's discount must be added back). For example, if I owed you $110 next year, and the interest rate was 10%, I would record the present value of the liability as $100. After a year has passed, the present value of my obligation would be $110 to you. I would record a $10 interest expense and increase the liability account by $10 accordingly.


References:
1. FASB: Summary of Statement No. 87: Employers' Accounting for Pensions (Issued 12/85) <http://www.fasb.org/summary/stsum87.shtml>

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