Out of the four CPA exam sections, the Financial Accounting and Reporting (FAR) test usually requires the most study time.
Consequently, many CPA candidates struggle with pension-related questions that are covered on the FAR exam. Furthermore, these concepts are often poorly explained which only adds to the confusion.
Use these study tips to learn about pension plan accounting to ensure you pass the FAR CPA exam.
Pensions – Defined Benefit & Contribution Plans
A pension provides a flow of payments to a retired worker; pensions are offered through employers. Pensions are a valuable benefit because they provide an income to retirees. If a worker is not able to generate sufficient income from retirement assets, a pension may be the primary source of income.
To study pension accounting, you need to understand the two types of pensions and look for these terms in test questions. A company’s liability to pay a pension amount to a worker may be a defined benefit or a defined contribution plan.
Defined Benefit Plan
In a defined benefit plan, the company is obligated to pay a series of pension payments to retired worker that are based on a formula. Defined benefit plans take into account the worker’s last salary before retirement, their number of years of company service, and other factors to determine the pension payments.
Assume, for example, that Acme Manufacturing offers a defined benefit pension plan and Sally has just retired from the company. Based on her years of service and her salary when she retired, Acme must pay Sally a pension of $2,000 per month for the rest of her life.
Here’s a key point: the company is obligated to pay the monthly pension expense amount, regardless of the dollars invested in the pension plan, or the earnings (or lack of earnings) on the pension plan assets.
Because of this requirement, businesses offering pension plans must post a pension liability in their financial statements for the entire dollar amount of pensions due in all future years. The liability is based on the current number of retirees, the monthly pension amounts, and the estimated life expectancy of each retired worker.
Defined benefit plans require a specific dollar amount of pension payments for each worker. Consequently, many companies are moving away from this type of plan.
Defined Contribution Plan
A growing number of companies are using defined contribution plans, which require firms to contribution a specific dollar amount into the pension plan for each worker. The ultimate pension payments depend on the investment performance of the dollars in the pension plan.
The company’s pension liability is an investment amount per worker, not a specific income payment.
To change the example, assume that Acme Manufacturing offers a defined contribution plan. Acme must contribute 2% of Sally’s gross wages into a pension plan each year. Sally’s monthly pension payment is not fixed; the income she receives depends on the investment performance of the dollars contributed into the plan.
Cash Inflows And Outflows
Once you understand the types of pensions, you should also consider the cash inflows and outflows that impact a pension plan:
A defined contribution plan requires a specific dollar amount per worker based on the employee’s gross wages and the percentage contribution required. If, for example, Sally’s salary is $50,000, Acme must contribute 2% of her salary into the plan, or $1,000 annually. If Acme contributes these amounts, the company is meeting its pension obligation requirement.
On the other hand, assume that Acme’s defined benefit plan must pay Sally a pension of $2,000 per month for the rest of her life. Acme must invest enough to make the pension payments, and the annual contribution amount depends on the company’s assumptions about investment returns and other factors.
Expected Rate Of Return (ERR)
Pension accounting also assumes some rate of return on the dollars invested in the plan, and the earnings increase the total assets in the plan. Companies rely on investment professionals to calculate an expected return on assets.
Service costs refer to the company’s liability for a pension payment. If Sally, for example, must receive $2,000 a month, that dollar amount is a service cost.
It’s also common to require a pension plan to pay the worker a specific rate of interest on the plan assets, and the interest expense is a cost to the pension plan.
To understand the cash inflows and outflows, think of the pension plan as a “bucket:” employer contributions and investment earnings going into the bucket, and service costs coming out of the bucket.
Assets And Liabilities
If a company operates a pension plan, the firm’s balance sheet must report on the assets in the plan and the liabilities associated with the plan.
The projected benefit obligation (PBO) is the term used for the liability; you’ll note that the word “projected” is used. Remember that companies must forecast the pension liability for years into the future, based on pensions that they expect to pay to retirees.
If the plan assets are more than enough to cover the PBO, the firm has a net pension asset, meaning that the company has “extra money” in the bucket. Many firms, however, have a PBO that far exceeds plan assets, which is a net pension liability.
US auto manufacturers, for example, typically have very large pension liabilities because they’ve required large numbers of workers to produce cars for decades. In some cases, large companies have not funded their pension plans sufficiently to cover the PBO; the media refers to this situation as “underfunded pensions”.
Understand The Components
Pension test questions typically provide information on several components of the pension calculation, and the candidate is asked to calculate total plan assets, PBO, or both totals.
Use these tips to successfully answer the pension questions and pass the FAR test; you’ll thank me once you’ve become as a CPA!