Definition
The term amortization of prior service cost refers to the systematic recognition of a pension expense in future periods resulting from a retroactive change to the plan's benefit formula. When a company modifies or amends their pension plan, accounting rules require the calculated prior service obligation to be amortized over the average remaining years of service for the plan's participants affected by the change.
Explanation
Companies provide employees with a pension plan as part of a larger array of employment benefits. The FASB Statement of Financial Accounting Standards No. 87 requires firms to measure and disclose pension obligations as well as the performance and financial condition of their plans at the end of each accounting period.
When a company makes a change to their pension plan that affects a participant's future retirement benefit, it must recalculate the obligation earned by plan participants in prior years. This is referred to as a prior service cost.
Accounting rules require companies to amortize this increase in the pension obligation to pension expense. The amortization should occur over a future time span that aligns with the average remaining future service of the plan's participants that benefited from the amendments to the pension's formula.
In addition to prior service cost, the overall level of pension funding depends on variables such as the return on plan assets, interest costs, service costs, changes to the plan's formula, and the plan's gains and losses.
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.
Related Terms
- The term pension plan refers to an arrangement whereby an employer agrees to provide employees with a stream of income payments after they retire. Pension plans are typically divided into two broad categories: defined benefits plans and defined contribution plans.
Moneyzine EditorSeptember 26th, 2023 - The term defined benefits plan refers to a pension plan whereby an employer provides employees with a known stream of income payments after they retire. With a defined benefits plan, the employer assumes all of the risk associated with the performance of the investments in the company's pension fund.Moneyzine EditorSeptember 26th, 2023
- The term defined contributions plan refers to a pension plan consisting of a predetermined schedule of fixed employer contributions to an employee's fund. With a defined contributions plan, the employer contributions are known ahead of time, and the exact retirement income benefit will depend on the performance of the investments in the employee's fund.Moneyzine EditorSeptember 26th, 2023
- The term pension obligation can refer to one of three different ways to measure the future expenses or liabilities associated with a pension plan. Generally, pension obligations can be stated in terms of accumulated, vested, and projected benefits.Moneyzine EditorSeptember 20th, 2023
The term accumulated benefit obligation refers to the present value of retirement benefits earned by employees using current compensation levels. A company's accumulated benefit obligation (ABO) is one of three ways to calculate expenses or liabilities associated with pension plans. The other measures include vested benefit obligations (VBO) and projected benefit obligations (PBO).Moneyzine EditorJanuary 4th, 2024- The term vested benefit obligation refers to the portion of the accumulated benefit obligation that employees will receive regardless of their continued participation in the company's pension plan. A company's vested benefit obligation (VBO) is one of three ways to calculate expenses or liabilities associated with pension plans. The other measures include accumulated benefit obligations (ABO) and projected benefit obligations (PBO).Moneyzine EditorSeptember 21st, 2023
- The term projected benefit obligation refers to the present value of the retirement benefits earned by employees, using an estimate of future compensation levels. A company's projected benefit obligation (PBO) is one of three ways to calculate expenses or liabilities associated with pension plans. The other measures include accumulated benefit obligations (ABO) and vested benefit obligations (VBO).Moneyzine EditorSeptember 21st, 2023
- The term pension service cost refers to the present value of the projected retirement benefits earned by plan participants in the current period. Generally, a company's pension service cost is the amount it must set aside in the current period to match the retirement benefits accrued by plan participants.Moneyzine EditorSeptember 20th, 2023
- The term pension interest cost refers to the annual interest accrued on the beginning balance of the projected benefit obligation. Since the company's projected benefit obligation (PBO) is the present value of the retirement benefits earned by employees, the company incurs an annual expense equal to the discount rate used to determine the PBO multiplied by the starting balance of the PBO.Moneyzine EditorSeptember 20th, 2023
- The term return on plan assets refers to the dividends, interest, and capital gains generated by assets held in a company's pension fund. Accounting rules require companies to differentiate between the expected and actual return on their plan's assets.Moneyzine EditorSeptember 21st, 2023
