Net pension expense

2nd September 2021 0 By indiafreenotes

Net periodic pension cost is the cost of a pension plan for a reporting period, as stated in an employer’s financial statements. This cost includes the following components:

  • Amortization of prior service cost or credit.
  • Actual return on plan assets.
  • Interest cost
  • Service cost
  • Gain or loss

Pension expense is the amount that a business charges to expense in relation to its liabilities for pensions payable to employees. The amount of this expense varies, depending upon whether the underlying pension is a defined benefit plan or a defined contribution plan. The characteristics of these plan types are as follows:

  • Defined contribution plan. Under this plan, the employer’s entire obligation is complete once it has made a contribution payment into the plan, as long as no associated costs are being deferred for recognition in later periods. Thus, the employer commits to pay a specific amount of funds into a plan, but does not commit to the number of benefits subsequently distributed by that plan. The accounting for a defined contribution plan is to charge its contributions to expense as incurred.
  • Defined benefit plan. Under this plan, the employer provides a predetermined periodic payment to employees after they retire. The amount of this future payment depends upon a number of future events, such as estimates of employee lifespan, how long current employees will continue to work for the company, and the pay level of employees just prior to their retirement. In essence, the accounting for defined benefit plans revolves around the estimation of the future payments to be made, and recognizing the related expense in the periods in which employees are rendering the services that qualify them to receive payments in the future under the terms of the plan.

Components of Company Pension Expense

  1. Current Service Cost = amount by which a company’s defined benefit obligation increases as a result of employee service during the accounting period. The current service cost is fully and immediately recognized for the accounting period.
  2. Interest Cost (same as the discount rate discussed later) = amount by which a company’s existing defined benefit obligation increases as a result of the passage of time. The interest cost is fully and immediately recognized for the accounting period.
  3. Return on Plan Assets = Amount of returns generated by plan assets during the accounting period. Typically, companies apply EXPECTED return on plan assets when calculating pension expense. Long-term expected return will better reflect the plan’s investment strategy and reduce year to year volatility in the pension expense. The use of expected returns is allowed by GAAP and IFRS.  Since this is an asset return, the return on plan assets component acts as a contra expense, offsetting other costs.
  4. Amortization of Past Service Cost = the difference in the DBO after a plan amendment has been adopted and the DBO before the plan amendment. The plan amendment could reduce costs, creating a benefit that reduces the pension expense.
  • GAAP: this is recorded as a direct to equity adjustment outside of net income, as part of other comprehensive income for the accounting period in which the amendment took place. A periodic past service cost expense is then amortized to the pension expense over the remaining service lives of the employees covered by the amendment.
  • IFRS: if the amendment affects any vested obligations, then the vested percentage of the past service cost is incorporated into the pension expense for the accounting period of the amendment and the remaining past service cost for unvested obligations is amortized to future pension expense calculations over the course of the related vesting period.
  1. Amortization of Actuarial Gains and Losses.

Actuarial gains and losses arise from:

  • Differences between expected plan returns and actual plan returns (see #2 of 5).
  • Changes in actuarial assumptions that impact the current service cost (see #1 of 5). Examples: employee life expectancy, salary growth forecasts, interest cost component assumptions, retirement dates, etc.
  • GAAP: actuarial gains and losses are recognized as part of other comprehensive income during the period of gain or loss, on the company’s statement of changes in shareholder’s equity.
  • IFRS: actuarial gains and losses do not flow to equity, but are applied to assets or liabilities and are incorporated in the calculation of a net asset or liability on the balance sheet. A net pension asset is reported as pre-paid pension expense; a net liability is accrued pension expense.
  • 10% Amortization Expense “Rule” companies will not begin to incorporate an amortization gain/loss into its calculation of pension expense until the gain/loss from asset return differences or the benefit/cost from changes to the plan exceeds the greater of 10% of the value of plan assets or 10% of the DBO.