Preparing for CFA?

Practice tests, mock exams and readings with performance analytics. More Info

Home
AlphaBetaPrep.com
Sign In

Accounting for defined contribution and defined benefit plans

Accounting for pension plans depends on the type of plan. There are two main types of plans: a defined contribution plan and a defined benefit plan.

Defined contribution plans

Under a defined contribution plan, a company contributes an agreed-upon amount to the plan (which it recognizes as pension expense and as an operating cash flow) and it has no obligation related to performance of the pension plan assets after the contribution has been made. Any asset or liability is limited only to the extent of any contribution payable.

Defined benefit plans

Under a defined benefit plan, a company makes promises of future benefits to be paid to employees. Hence, it retains obligations and risks related to performance of the pension plan. Uncertainty arises, both from estimation of future pension benefits to be paid (because they depend on future salary levels, employee turnover, employee age, etc.) and from performance of the pension plan assets. A company’s pension obligation equals the present value of the estimated future benefits to be paid.

Companies typically create a separate legal entity to which they make payments which are invested by the fund. These are called plan assets. If the fair value of fund assets is higher (lower) than a company’s pension obligation, a company reflects a net pension asset (liability). Any change in net pension asset or liability is recognized in either profit and loss or other comprehensive income.

IFRS accounting for defined benefit plans

Under IFRS, a change in net pension asset or liability has three components: service costs, net interest expense or income, and remeasurements. Service costs and net interest expense or income are recognized in profit and loss.

Service costs represent the present value of the increase in pension obligation arising from one additional year of service provided by employees. It also includes any past service costs arising from any changes in the plan.

Net interest expense or income represents the change in value of the net pension asset or liability and is calculated by applying the discount rate used to calculate pension liability to the net pension asset or liability.

Remeasurement arises from actuarial gains and losses (which depends on changes in assumptions) and any difference between the actual return on plan assets and any return included in the net interest expense or income. Remeasurements are reflected directly in equity through other comprehensive income.

US GAAP accounting for defined benefit plans

Under US GAAP, the change in net pension asset or liability has five components: (a) service costs for the period, (b) interest expense on opening pension obligation less (c) expected return on plan assets, (d) past service costs, and (e) actuarial gains and losses. The first three items are recognized in profit and loss and the last two in other comprehensive income and allowed to be amortized to profit and loss over future periods. US GAAP also permits companies to immediately recognize actuarial gains and losses in profit and loss.

Since companies capitalize employee compensation as part of inventories and expense it through COGS and charge employee benefits of non-production employees directly to the income statement, analysts need to look at the extensive disclosures given in notes to obtain information about a company’s pension expense and assets and liabilities.

by Obaidullah Jan, ACA, CFA on Sat Apr 25 2020

This article can help you prepare for Reading 28 LOSh.

Access complete notes and question bank   Login with Google Login with Facebook


More Articles

Initial recognition and subsequent measurement of bonds Effective interest method of bond amortization Lease accounting from lessee perspective Lease accounting from lessor perspective Accounting for defined contribution and defined benefit plans