ASC 715: Accounting for Retirement Benefits

Accounting for retirement benefits is governed by standards that ensure financial statements accurately reflect a company’s obligations. The primary guidance in the United States is Accounting Standards Codification (ASC) 715, Compensation—Retirement Benefits. This standard dictates how companies must measure, recognize, and disclose the costs and liabilities associated with their pension and other postretirement benefit plans. Its objective is to ensure that the cost of these benefits is recognized over the employees’ service period.

By standardizing accounting methods, ASC 715 allows for better comparability between different companies’ financial health. The standard addresses both the expense recorded on the income statement and the liability shown on the balance sheet, which involves detailed calculations based on numerous assumptions.

Scope and Applicability of ASC 715

The applicability of ASC 715 hinges on the type of retirement plan a company offers. The standard primarily focuses on defined benefit (DB) plans, where the employer promises a specific benefit amount to employees upon retirement. This benefit is often calculated using a formula based on factors like an employee’s salary, age, and years of service. The employer bears the investment risk; if the plan’s investments perform poorly, the employer is still responsible for funding the promised benefits.

In contrast, defined contribution (DC) plans, such as a 401(k), have simpler accounting. For DC plans, the employer’s obligation is limited to contributing a specified amount to an employee’s account. The employee bears all investment risk, and the future benefit depends on contributions and investment returns.

Beyond traditional pensions, ASC 715 also governs the accounting for Other Postemployment Benefits (OPEB). These are non-pension benefits provided to retirees, with the most common example being retiree health insurance. OPEB plans are accounted for as defined benefit plans because the employer promises to provide a benefit whose ultimate cost is unknown and depends on future events like healthcare inflation and retiree longevity.

Core Components of Benefit Obligation and Plan Assets

The primary measure of a company’s liability is the Projected Benefit Obligation (PBO). The PBO is the actuarial present value of all benefits attributed to employee service up to the measurement date, calculated using assumptions about future compensation levels. This forward-looking measure considers expected future salary increases for pay-related plans, providing a realistic estimate of the eventual obligation.

A related measure is the Accumulated Benefit Obligation (ABO). The ABO is also an actuarial present value of benefits earned to date, but it is based on current and past compensation levels, without any assumption about future salary growth. For plans where benefits are not tied to pay, the ABO and PBO will be the same.

On the other side of the equation are the Plan Assets. These are the funds, such as stocks and bonds, that a company has set aside in a trust to meet its future benefit payments. These assets must be segregated and restricted for the sole purpose of providing benefits and are measured at their fair value. The difference between the PBO and the fair value of plan assets determines the plan’s funded status.

These calculations rely on actuarial assumptions, which are estimates about uncertain future events set at the measurement date. Key assumptions include the discount rate, used to calculate the present value of future obligations, and the expected rate of compensation increase for pay-related plans.

Calculating Net Periodic Benefit Cost

The expense recognized on a company’s income statement for a defined benefit plan is the Net Periodic Benefit Cost. This is a calculated amount comprising several components that reflect different aspects of the plan’s financial activity. The calculation follows a general formula of Service Cost plus Interest Cost, minus the Expected Return on Plan Assets, plus or minus certain amortization amounts.

Service Cost represents the value of benefits earned by employees for their work during the current period. It is the actuarial present value of benefits attributed to one year of service and is reported in the same line item as other compensation costs, such as salaries.

Interest Cost reflects the increase in the Projected Benefit Obligation due to the passage of time. Because the PBO is a present value figure, it grows each year as the future benefit payment dates get closer. The interest cost is calculated by multiplying the PBO at the beginning of the year by the discount rate.

The Expected Return on Plan Assets reduces the overall benefit cost. This component is an estimate of the earnings generated by the plan’s investments and is calculated by multiplying the expected long-term rate of return on assets by the plan’s market-related value, which is a smoothed value of plan assets designed to reduce volatility. Any difference between this expected return and the actual investment return is deferred and recognized over time.

The final pieces are the amortization components. One is the Amortization of Prior Service Cost, which arises when a company amends a plan to grant employees additional benefits for past service. This cost is deferred and recognized over the remaining service lives of the affected employees. The other is the Amortization of Net Gains or Losses, which accounts for differences between actuarial assumptions and actual experience. These gains and losses are also deferred and amortized over time.

Balance Sheet Recognition and Other Comprehensive Income

A company must recognize the funded status of its retirement plans on the balance sheet. If the fair value of plan assets is less than the PBO, the plan is underfunded, and the company records a net pension liability. Conversely, if plan assets exceed the PBO, the plan is overfunded, and the company records a net pension asset. Companies with multiple plans must aggregate all overfunded plans into a single noncurrent asset and all underfunded plans into a single liability.

A mechanism for balance sheet recognition under ASC 715 is the use of Other Comprehensive Income (OCI). OCI acts as a holding account within equity for certain gains and losses that are not immediately recognized in the income statement, thereby reducing earnings volatility. Unrecognized prior service costs from plan amendments and actuarial gains and losses are initially recorded in OCI, bypassing net income.

These amounts are then systematically reclassified out of Accumulated Other Comprehensive Income (AOCI), the cumulative balance of OCI, and into the income statement over time as components of the net periodic benefit cost. This process ensures that while the balance sheet reflects the plan’s true funded status, the income statement impact is smoothed over several periods.

Financial Statement Disclosure Requirements

ASC 715 mandates extensive disclosures in the footnotes to the financial statements to provide a transparent look into the company’s commitment to its retirement plans. A central disclosure is a full reconciliation of the beginning and ending balances of both the benefit obligation and the fair value of plan assets. This table shows all major activities during the year, such as service and interest costs, contributions, benefits paid, and actuarial gains or losses.

Companies must also disclose the funded status of their plans and the net asset or liability amounts recognized on the balance sheet. The disclosure must break down the components of the net periodic benefit cost for the year, showing each element like service cost, interest cost, and expected return on assets separately.

A significant portion of the disclosure requirements centers on the assumptions and investment strategies. Companies must disclose:

• The key actuarial assumptions used, such as the discount rate, the expected long-term rate of return on assets, and the rate of compensation increase.
• A narrative description of their investment policies and target asset allocations for different classes of assets like equity securities, debt securities, and real estate.
• The fair value of plan assets by category.