Pension Accounting Overview for the CPA FAR Exam
Understand defined benefit pension accounting for the CPA FAR exam, including PBO, plan assets, pension expense components, and funded status reporting.
Introduction to Pension Accounting
Pension accounting under ASC 715 (Compensation - Retirement Benefits) is one of the most complex and frequently tested topics on the CPA FAR exam. The standard requires employers to recognize the funded status of their defined benefit pension plans on the balance sheet and to report various components of pension cost in the income statement and other comprehensive income.
Types of Pension Plans
There are two main types of pension plans. Defined contribution plans, such as 401(k) plans, involve the employer making contributions to employee accounts. The employer's obligation is limited to those contributions, and the accounting is straightforward: expense equals the contribution. Defined benefit plans promise employees a specified benefit at retirement, usually based on years of service and compensation levels. The employer bears the investment risk and the actuarial risk, making the accounting significantly more complex.
Key Pension Measures
Projected Benefit Obligation (PBO)
The PBO represents the actuarial present value of all benefits attributed to employee service rendered to date, using assumptions about future salary levels. The PBO increases with service cost, interest cost, plan amendments (prior service cost), and actuarial losses, and it decreases with benefits paid to retirees and actuarial gains.
Plan Assets at Fair Value
Plan assets are the investments held in the pension trust to pay benefits. They increase with employer contributions and actual returns on plan assets, and they decrease with benefits paid to retirees and administrative expenses.
Funded Status
The funded status equals plan assets at fair value minus the PBO. If plan assets exceed the PBO, the plan is overfunded and the employer reports a noncurrent asset. If the PBO exceeds plan assets, the plan is underfunded and the employer reports a liability (allocated between current and noncurrent based on expected benefit payments in the next 12 months).
Components of Net Periodic Pension Cost
Net periodic pension cost (pension expense) has several components. Only the service cost component is reported in operating income; the remaining components are reported below the line or in other comprehensive income.
Service Cost
The actuarial present value of benefits attributed to employee service during the current period. This is the only component classified as an operating expense in the income statement.
Interest Cost
Interest cost equals the PBO at the beginning of the period multiplied by the discount rate. It represents the growth of the pension obligation due to the passage of time.
Expected Return on Plan Assets
This is calculated as the fair value of plan assets at the beginning of the period multiplied by the expected long-term rate of return on plan assets. It reduces pension expense. Note that the expected return, not the actual return, is used in the calculation of pension expense.
Amortization of Prior Service Cost
When a plan is amended (retroactively granting increased benefits), the resulting prior service cost is initially recorded in other comprehensive income (OCI) and then amortized into pension expense over the remaining service period of the employees expected to receive benefits under the plan.
Amortization of Net Gain or Loss
Gains and losses arise from changes in actuarial assumptions and from differences between the expected and actual return on plan assets. These are initially recorded in OCI and amortized into pension expense using the corridor approach: amortization is required only when the cumulative unrecognized net gain or loss exceeds 10% of the greater of the PBO or the fair value of plan assets at the beginning of the year. The excess is amortized over the average remaining service period of active employees.
Balance Sheet Reporting
The employer reports the funded status of the plan (plan assets minus PBO) as a single net asset or net liability on the balance sheet. Items not yet recognized as components of pension expense (prior service cost and net actuarial gains and losses) are reported in accumulated other comprehensive income (AOCI) on the balance sheet.
Worksheet Approach for Exam Simulations
Many CPA candidates find it helpful to use a pension worksheet with columns for journal entries, the PBO, plan assets, and OCI items. The worksheet tracks all activity during the period and ensures the balance sheet reflects the correct funded status. On the exam, simulation questions often require candidates to prepare partial worksheets or calculate individual components.
Exam Preparation Tips
- Memorize the five components of net periodic pension cost and which items increase or decrease each one.
- Know that only service cost is an operating expense; the rest are non-operating.
- Understand the corridor approach for amortizing gains and losses from OCI into pension expense.
- Practice reconciling the beginning and ending PBO, plan assets, and funded status.
- Remember: expected return on plan assets is used for pension expense, not actual return. The difference goes to OCI.
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