Accounting for pensions primarily deals with two issues: how to report an employer’s pension obligation over time and how to recognize the funding of its pension obligation through pension expense each year in the financial statements. An employer’s pension plan often involves a third-party administered pension fund to which the employer contributes money over time. The pension fund holds the pension plan assets and pays out benefits to retirees. An employer that underfunds its pension obligation must record any shortage as a liability on the balance sheet. However, accounting for pensions allows total pension obligation and pension plan assets to be recorded off the balance sheet.
Pension Benefit Obligation
Pension benefit obligation is an employer’s promise to pay retirement benefit to employees for the services they performed. As employees work during each year, the employer incurs additional pension benefit obligations. Once recorded, funding of the obligation through contributions to the pension fund does not change the amount of the obligation. The obligation is reduced only when the pension fund pays out benefits to retired employees. Thus any underfunding of the accumulated pension obligation cannot be found in the recorded total pension obligation. Accounting for pensions does not record pension obligation as a balance sheet liability account. It is recorded off the balance sheet in the so-called memo record.
Pension Plan Assets
Pension plan assets are the total pension contributions that an employer has made to its pension fund, plus any investment returns that the pension fund has earned. Pension plan assets are decreased when the pension fund makes benefit payments to retired employees. Ideally, the amount of total pension plan assets should equal the amount of the total pension benefit obligation, a condition referred to as fully funded. Any shortage in the amount of pension plan assets compared to the amount of the pension benefit obligation indicates the underfunding of a pension. But like the pension benefit obligation, pension plan assets are recorded in the memo record off the balance sheet rather than on the balance sheet.
Annual Pension Expense
Accounting for pensions allows annual pension expense to be reported in the financial statements as a regular expense account. Annual pension expense mainly consists of the pension obligation accumulated during the year. But the net amount of the annual pension expense as reported can be lower or higher because any investment gains or losses that the pension fund has incurred during the year reduce or increase the pension expense based on pension obligation. Once the pension obligation is expensed for the year, benefit payments made to retired employees later by the pension fund off the balance sheet would not result in any more expense transactions in the financial statements.
Pension Underfunding Liability
The use of annual pension expense is a key to reporting any pension underfunding on a balance sheet. As an employer accumulates pension obligation and incurs pension expense, it becomes liable to fund the amount by making cash payments. The underfunding of a pension occurs when the cash payments are short of the pension expense as reported. To record pension expense and cash payments, a debit is entered for pension expense and a credit for cash payments, which leaves a difference on the credit side. The difference, or the underfunding of a pension, is then credited into an account called accrued pension cost and reported as a liability on the balance sheet, which should conform to the amount by which off-balance-sheet pension obligation exceeds total pension assets.