FAS Pension Accounting for Financial Statements
Gain insight into how a company's defined benefit pension plan is valued for financial reporting and the significant role management's estimates play in the process.
Pension accounting under the Financial Accounting Standards Board (FASB) establishes the rules for how a company reports the financial position of its defined benefit pension plans. These standards, found within Accounting Standards Codification (ASC) Topic 715, were developed to provide a more complete and understandable picture of a company’s obligations. The guidance requires companies to report the funded status of their pension plans directly on their financial statements. This involves a complex set of calculations and disclosures that reflect the plan’s assets, liabilities, and annual cost, allowing for better comparability between different companies.
Pension Impact on the Balance Sheet
A company’s balance sheet reflects the net financial position of its defined benefit pension plan, a figure referred to as the funded status. This status represents the difference between what a company has promised its employees in future retirement payments and the funds it has set aside to meet those promises.
The first element is the Pension Benefit Obligation (PBO), an actuarial measurement of the total benefits that employees are entitled to receive in the future. This calculation is based on their service performed to date and incorporates projections of future salary increases. Because these payments will be made years or even decades in the future, the PBO is expressed in today’s dollars by discounting the future estimated payments to their present value.
The second component is the Fair Value of Plan Assets. These are the investments, such as stocks and bonds, that a company has contributed to a separate pension trust. The assets are earmarked to fund the pension obligations and are reported at their current market value.
If the Pension Benefit Obligation is greater than the fair value of the plan assets, the plan is considered underfunded, and the company must report a net pension liability. Conversely, if the plan assets exceed the PBO, the plan is overfunded, and the company reports a net pension asset.
Calculating Net Periodic Pension Cost
The pension expense recorded on a company’s income statement, known as Net Periodic Pension Cost (NPPC), is an aggregate of several components calculated according to ASC Topic 715. This figure represents the total cost attributed to the pension plan for a specific accounting period.
One component is service cost, which is the value of pension benefits earned by employees for their work during the current year. Another component is interest cost, the increase in the Pension Benefit Obligation that occurs as future benefit payments get one year closer.
Offsetting these costs is the expected return on plan assets. This component reduces the total pension expense and is based on the anticipated long-term earnings from investments in the pension trust. This is an estimate, not the actual return, which helps smooth market volatility.
Two other components involve the gradual recognition of past events. The amortization of prior service cost arises when a company amends its plan to grant additional benefits for past service. The amortization of actuarial gains and losses allows for smoothing differences that occur when actual results deviate from actuarial assumptions.
The Role of Actuarial Assumptions
The calculations for a company’s pension obligations and costs depend on a series of estimates known as actuarial assumptions. Management’s judgment in setting these assumptions can have a substantial effect on the reported pension liability and expense.
One assumption is the discount rate, the interest rate used to determine the present value of the Pension Benefit Obligation (PBO). A lower discount rate results in a higher PBO, requiring a larger principal amount today to meet future payments. A decrease in the discount rate leads to an increase in both the pension liability and the annual pension expense.
Another assumption is the expected rate of return on plan assets. This figure represents the company’s long-term forecast for investment earnings on the assets held in the pension fund. A higher expected rate of return will lower the Net Periodic Pension Cost.
Finally, the rate of compensation increase projects the average annual growth in employee salaries. Since the pension benefit for many employees is based on their final or average pay, this assumption directly affects the size of the future obligation. A higher assumed rate of salary growth will lead to a larger projected benefit obligation.