A pension is a contractual benefit promised by an employer to provide an employee with a source of income during his or her retirement years. In the corporate world, there are two primary retirement schemes: defined benefit plans and defined contribution plans. In this chapter, we focus mainly on the accounting challenges posed by the former.
Under IFRS and US GAAP, the primary principle underlying all of the detailed requirements in pension accounting is that the cost of providing retirement benefits should be recognized in the period in which the benefit is earned by the employee, not when it is paid or payable.
In a defined contribution plan, the employer promises to contribute a certain amount to a pension plan each period for each employee. The amount of the contribution is usually a specified percentage of the employee’s salary. The term “defined contribution” implies that while the amount contributed by the employer is specified, the retirement benefits received by the employee are not. The amounts eventually received by the employee depend on the investment performance of the pension plan. In short, the risk of ensuring adequate pension fund returns to fund the employee’s retirement needs is borne entirely by the employee.
The account for defined contribution plans is straightforward. As pension benefits are earned in a given period, the employer makes the following entry: