Question

On 1/1/20 Company ABC started a defined benefit pension plan. On that date, the company granted retroactive benefits to its 170 employees. The actuaries estimated the cost of these benefits to be $ 105,000. Management is trying to select a method to amortize prior period service cost (PSC).

The first option (Option A), favored by the FASB, is the “years of service” method. This method provides a total of 510 years of service. The second option (Option B) is to use straight line depreciation based on the average number of years of employee service.

a. Option A

b. Option B

c. The method selected never affects the computation of net income.

d. Both options will generate the same net income.

Answer 1

Prior Service Cost (PSC) should be recognized by employers as a pension expense over the remaining service lives of the employees who are expected to benefit from this defined benefit pension plan.
Journal entry on initial recognition:
Other Comprehensive Income	DR
Pension Liability (Defined Benefit Obligation)		CR
(Being initial recognition of past service cost on 01.01.2020)
Journal entry for amortization of PSC:
P&L	DR
Other Comprehensive Income		CR
(Being past service cost amortized to pension expense for the year)
Option A
The "Years of service method" requires Prior Service Costs (PSC) to be amortized by allocating equal amounts to each employee's remaining service years.
Cost per service year = Total PSC/Total Service Years	=$105000/510	= $205.88 per service year
Annual amortization of PSC = Cost per service year * Total number of service years for that year
In the absence of further information regarding the number of employees expected to retire each year, the exact annual amortization of PSC under this method cannot be computed. It may be assumed that none of the 170 employees are retiring in 2020 and that some employees would retire in each subsequent year. Following this assumption, the annual amortization for each year would depend on the number of service years of the employees left that year, which may not be a static amount.
Thus, the annual amortization impact to P&L would differ each year, although the total PSC of $105000 would ultimately be charged to P&L over the total service years of the employees.
Option B
Under the straight line method, PSC can be amortized over the remaining service life on a straight-line basis.
Average Remaining service life of employees	=Total service years/Number of employees
	=510/170	=3 years
PSC amortization per year	=$105000/3	=$35000
Thus under the straight line method, an amortization of $35000 would be charged to P&L each year over a period of 3 years, thereby charging the total PSC of $105000 to P&L.
So we see that both options do impact the computation of net income as the amortization amount is charged to P&L from OCI each year. Thus Option C is not suitable.
Further, although the total amount being amortized is ofcourse the same, the amortization charge each year differs based on the method chosen and is not the same, thus annual net income is not the same under both methods. Hence Option D is not suitable.

Considering that the amortization of PSC to pension cost in P&L is expected to reflect the benefit basis the number of employees remaining and their remaining service life, Option A would be a suitable approach giving a clearer view, unless the management is looking to smoothen the annual P&L impact by following a straight line method under Option B.