Question

Now let's have a close look over the three most important components of the pension expense. The treatment of expected and actual return on plan assets, particularly when the actual return is greater than the expected, the amortization of prior service cost and the unexpected gain/ loss. Discuss the accounting treatment of these items with suitable examples.

Answer 1

1. Expected and Actual Return on Plan Assets:

At the start of the year, companies will multiply the fair market value of the assets held in their pension funds by an estimate of the long-term rate of return on these investments. This will be called as Expected Return on Plan Assets. The difference between the fair values of beginning and ending plan assets, adjusted for contributions and benefit payments is the Actual Return on Plan Assets.

Example:-

Company A's long-term rate of return on their pension plan assets was found to be 7.2%. At the start of the year, Company A had $100,000,000 in pension assets. The expected rate of return on these assets was calculated as:

= $100,000,000 x 0.072, or $7,200,000

At year end, Company A's accounting team determined the pension fund's actual return was $9,000,000, or 9.0%. Since the actual return was greater than the expected return, Company A would report an unrealized gain on plan assets of $9,000,000 - $7,200,000, or $1,800,000.

2. Amortization of Prior Service Cost:

When an employer issues a plan amendment, it may contain increases in benefits that are based on services rendered by employees in prior periods. If so, the cost of these additional benefits is amortized over the future periods in which those employees active on the amendment date are expected to receive benefits.

Example:-

Company A recently amended their pension plan. The change in rule increased Company A's projected benefit obligation by $300,000. The amendment to the plan affected 100 of Company A's employees, and the average time until retirement for this group was ten years.

Accounting rules dictate Company A amortize this pension cost of $300,000 over ten years; thereby increasing its pension expense by $300,000 / 10 years, or $30,000 per year for the next ten years.

3. Unexpected Gain/Loss:

This is the gain or loss resulting from a change in the value of a projected benefit obligation from changes in assumptions, or changes in the value of plan assets. Such gain/loss is amortized in the period after they are created.