Prior Service Cost

Prior Service Cost Employee Benefits Pension Plan Retirement Benefits Defined-Benefit Plan Accounting Financial Reporting
Prior service cost refers to the obligations a company incurs for employee benefits under a pension plan related to service provided by the employee before a specific date.
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Definition

Prior service cost is the cost attributed to plan amendments, changes, or initiation of benefits in a pension plan that applies to time periods of employee services rendered before a certain date. These benefits arise from changes in pension plans which grant additional benefits to employees based on their earlier services. These prior service costs need to be recognized and amortized over the expected remaining service lives of the affected employees.

Examples

  1. Company A Pension Amendment: Company A decides to improve its pension benefits effective from 1st January 2023. Employees who worked before this date will receive increased pension benefits for their prior years of service. The obligation related to this improvement is the prior service cost.

  2. New Defined Benefit Plan: Company B introduces a new defined benefit pension plan in 2022, which grants benefits to employees for their past 10 years of service. The cost associated with this retroactive benefit is recognized as the prior service cost.

Frequently Asked Questions (FAQs)

What is the impact of prior service cost on financial statements?

The prior service cost increases the pension liability on the balance sheet and is amortized over the expected remaining service period of the employees. The amortized expense is recognized in the profit and loss statement.

How is prior service cost amortized?

Prior service cost is usually amortized using the straight-line method or based on the years of remaining service of the currently active employees participating in the plan.

Can prior service cost occur in both defined benefit and defined contribution plans?

Prior service cost is typically associated with defined benefit plans, as these plans calculate benefits based on a formula considering years of service and salary history. Defined contribution plans do not usually generate prior service costs.

Yes, contributions to fund the prior service cost are generally tax-deductible for the employer. However, the IRS regulatory requirements and deductible limits must be adhered to.

Does prior service cost affect the pension expense in the income statement?

Yes, the amortized portion of the prior service cost is included in the pension expense in the income statement, increasing the total pension expense recognized.

  • Pension Obligation: The total value of benefits promised to employees under the retirement plan.
  • Amortization: The process of gradually writing off the initial cost of an asset over a period.
  • Defined Benefit Plan: A retirement plan where employee benefits are calculated based on a formula including salary history and duration of employment.
  • Net Periodic Pension Cost (NPPC): The total cost recognized related to the pension for a period, including service cost, interest cost, return on plan assets, and amortization components.

Online References

Suggested Books for Further Studies

  1. Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
  2. Accounting for Pensions: A Century of Success? by Aubrey A.G. Manning
  3. Pension Fund Risk Management by Nicholas Greifer

Fundamentals of Prior Service Cost: Accounting Basics Quiz

### What is prior service cost? - [x] The cost of benefits attributed to employee services prior to the amendment of the pension plan. - [ ] The annual cost of employee salaries. - [ ] The administrative cost of managing the pension plan. - [ ] Extra deductions from employees’ current salaries. > **Explanation:** Prior service cost is the cost incurred for benefits granted to employees for their past services before a certain upgrade or initiation date of the pension plan. ### How is prior service cost reflected in financial statements? - [ ] As a cash expense in the income statement. - [x] As an amortized cost spread over the remaining service period of the employees. - [ ] As a direct deduction from equity. - [ ] As a revenue item. > **Explanation:** Prior service cost is amortized and recognized gradually over the service period of the employees still active under the pension plan. ### Can prior service cost occur in defined contribution plans? - [ ] Yes - [x] No - [ ] Sometimes - [ ] Only if explicitly stated by the employer > **Explanation:** Prior service cost is typically associated with defined benefit plans where benefits calculations consider years of service. ### What happens when a company amends its pension plan to provide additional benefits? - [x] The company generates prior service cost. - [ ] The company reduces its pension obligation. - [ ] Employees have to contribute more. - [ ] The employer can discontinue contributions. > **Explanation:** Any improvement or amendment to provide additional benefits based on the past service generates prior service costs for the company. ### Which financial standard covers accounting for pensions and related retirement benefits? - [ ] GAAP Section 706 - [x] FASB ASC Topic 715 - [ ] IFRS 15 - [ ] SOX Section 404 > **Explanation:** FASB ASC Topic 715 pertains to Compensation—Retirement Benefits and covers accounting for pensions. ### During which period is the prior service cost recognized in the financial statements? - [x] Over the remaining service period of the employees - [ ] Immediately at the time of plan amendment - [ ] Once the employee retires - [ ] Only upon the settlement of all plan benefits > **Explanation:** Prior service cost is recognized gradually (amortized) over the remaining service period of the affected employees. ### Who is impacted by prior service cost? - [x] Employees - [ ] Only the shareholders - [ ] Only the executives - [ ] All stakeholders equally > **Explanation:** Employees who benefit from retroactive improvements in pension plans are directly impacted by prior service costs. ### What is the usual method for amortizing prior service costs? - [ ] Double-declining balance method - [x] Straight-line method - [ ] Sum-of-the-years'-digits method - [ ] Units-of-production method > **Explanation:** The straight-line method is commonly used to amortize prior service costs, though others may be applied depending on circumstances. ### Is there a tax deduction for the contributions to fund prior service costs? - [x] Yes, subject to IRS rules - [ ] No - [ ] Only in certain circumstances - [ ] Reserved for non-profit organizations > **Explanation:** Contributions to fund prior service costs are generally tax-deductible, conforming to IRS guidelines and deductible limits. ### Which term is directly related to prior service cost in pension accounting? - [ ] Current Period Cost - [ ] Pension Asset - [x] Pension Obligation - [ ] Contribution Margin > **Explanation:** Pension obligation, which represents the total benefits promised by the employer, is directly related to prior service costs.

Thank you for engaging in our deep dive into prior service cost and participating in the quiz. Your understanding of pension-related financial nuances just got stronger!

Wednesday, August 7, 2024
Prior-Period Adjustments
Prior Period Adjustment
Noncontributory Qualified Pension or Profit-Sharing Plan January 1, 1
Past Service Credit January 1, 1
Accounting Cycle January 1, 1
Accounting Principles January 1, 1
Accounting Standards Committee (ASC) January 1, 1
Accrued Benefits January 1, 1
Accrued Taxes January 1, 1
Accumulated Postretirement Benefit Obligation (APBO) January 1, 1
Allocated Benefits January 1, 1
Amortization January 1, 1

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