Question

According to the textbook, the defined contribution plan and defined benefit plan are the most popular pension plans used by employers. Employers have changed from traditionally defined benefit plans to defined contribution plans with no major company establishing a traditional pension plan in the past decade. Differentiate between the defined contribution pension plan and the defined benefit plan. What are the major differences in accounting for defined contribution plans and defined benefit plans? Assess the most likely reasons this trend has occurred and the future impact on accounting for pensions. Extra Credit Explain how cash-basis accounting for pension plans differs from accrual-basis accounting for pension plans. (EC)Why is cash-basis accounting generally considered unacceptable for pension plan accounting?

Answer 1

Differentiate between the defined contribution pension plan and the defined benefit plan-

Employer-sponsored retirement plans are divided into two major categories: defined-benefit plans and defined-contribution plans. As the names imply, a defined-benefit plan—also commonly known as a traditional pension plan—provides a specified payment amount in retirement. A defined-contribution plan allows employees and employers (if they choose) to contribute and invest funds over time to save for retirement.

These key differences determine which party—the employer or employee—bears the investment risks and affects the cost of administration for each plan. Both types of retirement accounts are also known as superannuations.

Accounting for defined contribution plans

In a defined contribution plan, the amount of contribution (or the contribution rate) by the employer is usually determined at the discretion of the employer, by contractual agreement, or both. Upon retirement and when the participant withdraws from the plan, the amount allocated to the participant's account represents the participant's accumulated benefits. This may then be paid to the retiring employee or used to purchase retirement annuity, as defined by the plan agreement.

Accounting for defined benefit plans

In regard to defined benefit plans. In this type of plan, the employer provides a predetermined periodic payment to employees after they retire. The amount of this future payment depends upon a number of future events, such as estimates of employee lifespan, how long current employees will continue to work for the company, and the pay level of employees just prior to their retirement. In essence, the accounting for defined benefit plans revolves around the estimation of the future payments to be made, and recognizing the related expense in the periods in which employees are rendering the services that qualify them to receive payments in the future under the terms of the plan.

Cash Basis Accounting-

1. Determine the fair value of the assets and liabilities of the pension plan at the end of the year.
2. Determine the amount of pension expense for the year to be reported on the income statement.
3. Value the net asset or liability position of the pension plan on a fair value basis.

Defined Contribution Plan	Defined Benefits Plan
This plan specifies how much money the employer needs to contribute to the pension plan.	This plan specifies how much employees will receive in payments during their retirement.
Investment risk is on the employees.	Investment risk is on the employer. Outflows from the pension trust to employees are pre-specified.
Journal Entry: DR Pension Expense CR Cash	Journal Entry: DR Defined Benefit Pension Liability CR Cash

The accrued or prepaid pension cost is the amount on a company's balance sheet that is equal to the accumulated difference between past net periodic pension costs and past plan contributions (for unfunded plans, such as for executives, substitute “benefit payments” for “plan contributions”)

Accrued pension benefits represent the total amount of money that has been saved up for your retirement. When you retire, you employer will distribute these funds using a variety of investment or insurance products, but generally an annuity is used.

Cash-balance plans are like traditional defined-benefit pension plans with a 401(k) twist. As in a traditional pension plan, investments are professionally managed and participants are promised a certain benefit at retirement. But that promised benefit is stated as a 401(k)-style account balance, rather than as a monthly income stream.