Pension Funds and Accounting Entries

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Reference: https://corporatefinanceinstitute.com/resources/knowledge/accounting/pension-accounting/

In addition to salaries, many companies offer other benefits to their employees such as pension’s plans, health insurance, stock option benefits, fitness memberships, or life insurance plans.  There are very specific requirements around pension accounting, which will be outlined in this article.

For regular benefits, the accounting is relatively simple – the employer records an expense for the amount of the benefits employees earn in a year.

However, the accounting treatment becomes more complicated when employees earn the rights to the benefits NOW but receive those benefits later in the FUTURE. A clear example of such a benefit is the pension.

How a pension works:

A pension trust is a legal entity that holds the pension investments and disburses the funds later, when necessary.

Trusts are managed by trustees, who are independent of the company.

Relationship 1: Employees provide services to the employer and in return, they receive wages.

Relationship 2: Employers make contributions to the pension trust.

Relationship 3: Funds are used from the pension trust to pay the employee in the future and sometimes, employees can also make contributions to the trust.

Two types of pensions:

There are two kinds of pensions available today. One is the defined contribution plan and the other is the defined benefits plan. Below is a tabular comparison between the two:

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 Pension Liability Funds Transfer: DR Pension Bank CR Operational bank When gratuity is paid to an employee: DR Pension Liability CR Employee Liability Account	Journal Entry: More complicated. Explained below.

  

Defined benefits plan

Under the defined benefits plan, the employee is guaranteed a certain amount of benefits/payments in the future. Because pension payments are usually made much later in the future, there is a clear time difference between when employees receive the future payments and when employees actually earn those benefits. Because of this difference, companies must use the accrual basis of accounting instead of when cash changes hand.

The pensions accounting treatment for defined benefit plans require:

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

Pension expense is an expected value and when the actual value of the pension differs, those deviations are recorded through other comprehensive income (OCI) under IFRS. For Canadian private companies that adhere to ASPE, there is no such OCI account.

Pension accounting example:

XYZ Company has a defined benefit pension plan. At the end of 2015, the fair value of the assets and liabilities in the pension amounted to $6 million. In 2016, the pension expense was $10 million and the company contributed $5 million to the pension plan. At the end of 2016, the fair value of the pension assets and liabilities was at $10 million.  Let’s see how the pension accounting works.

To record company contribution to pension

DR Defined Benefit Pension Liability             5,000,000

CR Cash                                                          5,000,000

To record pension expense

DR pension expense                                       10,000,000

CR Defined Benefit Pension Liability              10,000,000

To adjust pension liability to fair value

DR Other comprehensive income (OCI)         1,000,000

CR Net defined benefit liability                       1,000,000

            

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