These lectures cover CPA practice questions cover projected benefit obligation, pension expense, plan funded status, plan assets and pension plan.
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Fundamentals of Pension Plan Accounting
Pension plan is an arrangement whereby an employer provides benefits (payments) to employees after they retire for services they provided while they were working. In accounting for a pension plan, consideration must be given to accounting for the employer and accounting for the pension plan itself. A pension plan is said to be funded when the employer sets funds aside for future pension benefits by making payments to a funding agency that is responsible for accumulating the assets of the pension fund and for making payment to the recipients as the benefits come due. In an insured plan, the funding agency is an insurance company; in a trust fund plan, the funding agency is a trustee.
Types of Pension Plans
The most common types of pension arrangements are defined contribution plans and defined benefit plans. In a defined contribution plan, the employer agrees to contribute a certain sum each period based on a formula. The employees bear part of the cost of the stated benefits or voluntarily make payments to increase their benefits. The formula might consider such factors as age, length of service, employer’s profits, and compensation level. Accounting for a defined contribution plan is straightforward. The employer’s responsibility is simply to make a contribution each year based on the formula established in the plan. Thus, the employer’s annual cost is the amount it is obligated to contribute to the pension trust. If the contribution is made in full each year, no pension asset or liability is reported on the employer’s balance sheet.
A defined benefit plan defines the benefits that the employee will receive at the time of retirement. The employer bears the entire cost. The formula that is typically used provides for the benefits to be a function of the level of compensation near retirement and of the number of years of service. The accounting for a defined benefit plan is complex. Because the benefits are defined in terms of uncertain future variables, an appropriate funding pattern must be established to insure that enough monies will be available at retirement to meet the benefits promised.
Most accountants agree that an employer’s pension obligation is the deferred compensation obligation it has to its employees for their services under the terms of the pension plan. However, there are three ways to measure this liability. One approach is to base the obligation on the vested benefits to which current employees are entitled. The vested benefits pension obligation is computed using current salary levels and includes only vested benefits.
A second approach to the measurement of the pension obligation is to base the computation on all years of service performed by employees under the plan—both vested and nonvested¾using current salary levels. This measurement of the pension obligation is called the accumulated benefit obligation. A third measurement technique bases the computation on both vested and nonvested service using future salaries. Because future salaries are expected to be higher than current salaries, this approach, known as the projected benefit obligation, results in the largest measurement of the pension obligation