April 5, 2013 at 5:45 pm#176981

iampei
Member

On December 31, Company Inc. amended its overfunded pension plan and recorded prior service cost of
$250,000. On that date, Company had an effective tax of 30% and its employees had an average future service
period of 25 years. What effect will the plan amendment have on Spacers December 31 financial statements?
A) Increase net periodic pension cost
B) Decrease AOCI
C) Increase pension benefit asset
D) Decrease retained earnings
The answer is B: Decrease AOCI. The explanation says Changes in the funded status of a pension plan due to
plan amendment must be reported in OCI in the period incurred. Therefore, at December 31, Company will
record prior service cost as a debit to OCI, which will decrease the AOCI balance at December 31:
Dr: OCI $250,000
Dr: Deferred Tax Asset $75,000
Cr: Deferred tax benefit OCI $75,000
Cr: Pension Benefit Asset $250,000

Amortization of Prior Service Cost

Definition
The term amortization of prior service cost refers to the systematic recognition of a pension expense
in future periods resulting from a retroactive change to the plan's benefit formula. When a company

modifies or amends their pension plan, accounting rules require the calculated prior service
obligation to be amortized over the average remaining years of service for the plan's participants
affected by the change.

Explanation
Companies provide employees with a pension plan as part of a larger array of employment benefits.
The FASB Statement of Financial Accounting Standards No. 87 requires firms to measure and
disclose pension obligations as well as the performance and financial condition of their plans at the
end of each accounting period.
When a company makes a change to their pension plan that affects a participant's future retirement
benefit, it must recalculate the obligation earned by plan participants in prior years. This is referred
to as a prior service cost.
Accounting rules require companies to amortize this increase in the pension obligation to pension
expense. The amortization should occur over a future time span that aligns with the average
remaining future service of the plan's participants that benefited from the amendments to the
pension's formula.
In addition to prior service cost, the overall level of pension funding depends on variables such as
the return on plan assets, interest costs, service costs, changes to the plan's formula, and the plan's
gains and losses.

Example
Company A recently amended their pension plan. The change in rule increased Company A's
projected benefit obligation by $300,000. The amendment to the plan affected 100 of Company A's
employees, and the average time until retirement for this group was ten years.
Accounting rules dictate Company A amortize this pension cost of $300,000 over ten years; thereby
increasing its pension expense by $300,000 / 10 years, or $30,000 per year for the next ten years.

Related Terms
pension plan, defined benefits plan, defined contributions plan, pension obligation, accumulated
benefit obligation, vested benefit obligation, projected benefit obligation, service cost, pension
interest cost, return on plan assets