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
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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.
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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.
Are there any tax implications related to prior service cost?
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.
Related Terms
- 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
- Financial Accounting Standards Board (FASB): FASB ASC Topic 715: Compensation—Retirement Benefits
- IRS Guidelines: Retirement Plans Frequently Asked Questions
Suggested Books for Further Studies
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- Accounting for Pensions: A Century of Success? by Aubrey A.G. Manning
- Pension Fund Risk Management by Nicholas Greifer
Fundamentals of Prior Service Cost: Accounting Basics Quiz
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