FAS 87: Employers’ Accounting for Pensions

Statement of Financial Accounting Standards No. 87 (FAS 87) was issued in 1985 to standardize how companies accounted for their defined benefit pension plans. Before its release, companies used various methods to calculate pension expenses, making it difficult for investors to compare the financial obligations of different firms. FAS 87 introduced a uniform methodology based on accrual accounting, which recognizes costs over the service periods of employees rather than only when cash contributions are made. This approach ensures a company’s financial statements reflect the deferred compensation employees earn throughout their careers. While its specific rules have been updated, the foundational concepts are preserved within the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC).

Core Components of Pension Status

A pension plan’s financial position is determined by two primary elements: the obligation to employees and the assets set aside to meet that obligation. The key measure of the company’s liability is the Projected Benefit Obligation (PBO). This figure represents the present value of all future pension payments that employees are expected to receive, based on their service to date but calculated using estimated future salary levels. The PBO is an actuarial estimate, relying on assumptions about employee turnover, mortality rates, the discount rate, and projected compensation increases.

To fund these future obligations, companies contribute assets to a separate pension trust. These plan assets typically consist of a diversified portfolio of stocks, bonds, real estate, and other investments. For financial reporting, these assets are measured at their fair value at the reporting date. The value of these investments will fluctuate with market conditions, directly impacting the financial health of the pension plan.

The relationship between these two components determines the plan’s funded status, which is the most direct indicator of its financial health. The funded status is calculated by subtracting the Projected Benefit Obligation from the fair value of the plan assets. If the plan assets exceed the PBO, the plan is considered overfunded, resulting in a net pension asset on the company’s balance sheet. Conversely, if the PBO is greater than the plan assets, the plan is underfunded, creating a net pension liability.

Calculating Net Periodic Pension Cost

The net periodic pension cost is the amount of pension expense recognized on a company’s income statement during a specific accounting period. It is a more complex figure than the funded status and is composed of several distinct components that are netted together:

• Service cost: Represents the value of pension benefits earned by employees for their work during the current year. This can be thought of as a form of deferred compensation, reflecting the increase in the pension obligation due to another year of employee service.
• Interest cost: Represents the increase in the Projected Benefit Obligation that occurs simply because the future benefit payments are one year closer to being made. It is calculated by multiplying the PBO at the beginning of the year by the discount rate.
• Expected return on plan assets: This component reduces the overall pension expense and is based on the anticipated earnings from the pension plan’s investments. It is an estimate, not the actual return, which helps to smooth the volatility of market fluctuations in the expense calculation.
• Amortization of prior service cost: Arises when a company amends its pension plan to grant employees additional benefits for past service. This cost is deferred and then gradually recognized as an expense over the remaining service lives of the affected employees.
• Amortization of gains and losses: Smooths the impact of unexpected changes, such as when the actual return on plan assets is different from the expected return or when actuarial assumptions for the PBO change. These gains and losses are also deferred and amortized over time.

Financial Statement Reporting and Disclosures

The outputs of the pension accounting calculations are reflected in a company’s primary financial statements and detailed in the accompanying footnotes. On the balance sheet, the funded status of the pension plan is reported directly. An overfunded plan is shown as a noncurrent asset, while an underfunded plan is reported as a liability, often split between current and noncurrent portions depending on the expected timing of future contributions.

The net periodic pension cost is reported on the income statement, but its components are presented in different sections. The service cost component is included in operating income, often alongside other employee compensation expenses. The other components—interest cost, expected return on assets, and amortization amounts—are required to be presented separately from service cost and outside of operating income.

To provide users with a deeper understanding of the pension plan, extensive disclosures in the footnotes are required. These disclosures provide a reconciliation of the funded status, showing the changes in both the PBO and plan assets from the beginning to the end of the year. Companies must also disclose the key actuarial assumptions used, such as the discount rate and rate of future compensation increases. Furthermore, the footnotes must show a detailed breakdown of the components that make up the net periodic pension cost.

Transition to Current Standards

The foundational principles of FAS 87 have been carried forward and integrated into the FASB’s modern accounting framework. The guidance for employers’ accounting for pensions is now located within ASC 715, Compensation—Retirement Benefits. This codification consolidated numerous accounting pronouncements, including FAS 87, into a single source. While the core calculation methods remain largely intact, the way these items are presented on the financial statements has evolved.

The most substantial change in pension accounting since FAS 87 came with FAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, which was later incorporated into ASC 715. This standard mandated that companies must recognize the funded status of their pension plans—the net difference between plan assets and the PBO—directly on the balance sheet.

Before this change, the full underfunded or overfunded status was often not immediately visible on the balance sheet due to complex smoothing and deferral mechanisms permitted by the original FAS 87. The move to require the direct recognition of the net funded status provided investors with a much clearer view of the true financial impact of a company’s pension promises.