Employers usually provide certain incentives to their employees to boost morale and workplace engagement. One such incentive is the pension benefit, which sets up employees for financial stability post-retirement. To calculate the pension expense payable to employees, employers must have good accounting knowledge of the pension expense components that are part of the income statement.
What is the Pension Expense?
The pension expense is the employer’s liability expense on pensions payable to employees for the time period indicated on the income statement. The amount of pension expense is usually determined by the type of pension plan, whether it’s a defined benefit plan or a defined contribution plan.
To calculate the net pension expense for a defined benefit plan, the interest and service costs and the amortization of prior service costs are summed up, and the expected return on plan assets is deducted from the total sum.
Here’s the mathematical formula for calculating a company’s net pension expense:
Net pension expense = service cost + interest cost – expected return on plan assets + amortization of prior service costs + (or -) amortization of actuarial gains or losses.
Note: Expected return on plan assets is a gain and lowers the net pension expense, while the other components are losses that lead to an increase in the net pension expense. When calculating pension expenses, gains are deducted while losses are added.
Components of pension expenses that are reported in an income statement?
The pension expenses reported in an income statement include service cost, the interest cost, return on plan assets, amortization of prior service cost, and gains and losses.
Service cost
The current service cost is the most fundamental component of pension expense. The employer’s liability expense is for every full year of employee service. Basically, the service cost refers to the current value of estimated retirement benefits accrued by employees under the pension cover plan in the current year.
It can also be defined as the amount an employer must set aside annually to cover employees’ retirement pension benefits. This amount is influenced by factors like salary increases, job promotions, and early retirement.
Note: service cost is the current service cost and doesn’t include prior service cost incurred when providing retroactive pension benefits.
Interest cost
Interest cost refers to the interest accumulated yearly on the starting balance of the projected benefit obligation (PBO). The PBO is the present value of all employee benefits during employment.
Return on plan assets
Plan assets typically comprise bonds, stocks, and investments like real estate and mutual funds. Therefore, the return on plan assets accounts for the income on invested plan assets for the current year. To calculate the value of this pension expense component, the employer projects the rate of return of the pension plan assets in the long term, then multiplies this value by the fair value of the assets at the beginning of the year.
Note: The fair value is the present selling price of an asset in the current market.
Amortization of prior service cost
Amortization of prior service cost refers to an employer’s liability expense on pensions payable to employees for credit received before implementing changes/modifications to the company’s pension plan. This cost is usually covered over the outstanding period of the employee’s service.
Note: amortization of prior service cost can also be defined as the cost of providing retroactive pension benefits.
Gains and losses
Market instability and the subsequent need to periodically reassess the assumptions used when computing the projected benefit obligation and Pension expenses are usually influenced by market instability. The rise or drop in the estimated PBO due to this reevaluation is defined as the amortization of actuarial gains or losses. It causes either an increase or decrease in pension expense.
Changes in the market cause changes in the value of plan assets, consequently affecting pension expenses. For instance, while the rate of return on plan assets usually lowers the pension expense, it could cause an increase in pension expense if the plan assets incur a loss due to market instability.
Is pension expense included in the income statement?
The pension expense is usually included in the income statement. The components of the pension statement usually included in the income statement include service cost, the interest cost, return on plan assets, amortization of prior service cost, and amortization of gains and losses.
However, according to the 10% amortization expense rule, companies should only include gains and losses in the income statement under the following conditions:
i. If the gain/loss from asset return differences is more than 10% of the value of the plan assets/DBO.
ii. If the benefit/cost from the amendments to the pension plan is more than 10% of the value of the plan assets/DBO.
Pension service cost formula
To determine the current service cost, employers must determine the amount by which the company’s defined benefit liability increases due to employee service for the accounting period.
References
i. University of Oregon: Accounting for Pensions
ii. Nir Yehuda- Accounting Clinic VII: Accounting for Pensions
