A pension plan provides benefits to retirees for services provided during employment. A pension fund is often used as an intermediary to satisfy the employer's pension obligations. Pension fund assets need to be invested to meet the needs of the retirees.

There are two types of pension plans.

Defined Contribution Plans

In a defined contribution plan, the employer agrees to contribute a certain sum each period based on a formula. This formula may consider such factors as age, length of employee service, employer's profits, and compensation level. Only the employer's contribution is defined; no promise is made regarding the ultimate benefits paid out to the employees.

The accounting for a defined contribution plan is straightforward. The employer's responsibility is simply to make a contribution each year based on the formula established in the plan. If the contribution is less than the pension expense, the employer accrues a liability. If the contribution is more than then pension expense, the employer accrues an asset.

Defined Benefit Plans

A defined benefit plan defines the benefits that employees will receive at the time of retirement.

• The employer is committed to specified retirement benefits.
• The trust accumulates assets, and the employer is the trust-beneficiary. That is, the employer assumes the risk of the investment. As long as the plan continues, the employer is responsible for the payment of the defined benefits, regardless of what happens in the trust.
• Retiree benefits are a fixed amount. Any shortfall in the accumulated assets held in the trust must be made up by the employer, and any excess accumulated in the trust can be recaptured by the employer.

The employer needs to determine what the contribution should be today to meet the pension benefit commitments that will arise at retirement. It is at risk because it must be sure to make enough contributions. The liability is often controversial because its measurement and recognition relate to unknown future variables.

The plan's return objective is to meet the actuarial rate of return, which is the discount rate used to find the present value of the plan's future obligations and therefore determines the size of the firm's annual contribution to the pension plan.

The principal elements of a defined benefit plan are (1) the obligation for benefits to be paid to retirees and (2) the plan assets that will be used to meet that obligation.

Accounting for Defined-Benefit Plan under US GAAP

The determination of pension cost is a function of the following components:

• Service cost
  Service cost is the actuarial present value of pension benefits attributed to employee service in a period, based on the pension benefit formula.
  Example
  Assume that the annual retirement benefit earned by one employee in the current period is $5,000. Determine the service cost for the current year assuming an 8% discount rate, 15 years until retirement, and 10 years of retirement payments.
  Annual retirement benefit: $5,000
  Present value of an annuity factor (PVA, 8%, 10 periods of payments): 6.71008
  Present value of $1 factor (PV1, 8%, 15 periods until retirement): 0.31524
  Service cost = $5,000 x 6.71008 x 0.31524 = $10,576

• Interest cost
  Interest cost is the growth in Projected Benefit Obligation (PBO) during a reporting period. It is calculated as PBO_Beginning x discount rate of the previous period.
  Example
  Assume that 20x5 is the first year of a retirement plan. PBO is $650,000 on 12/31/20x5 and $740,000 on 12/31/20x6. If the discount rate is 8%, what is the interest cost for 20x5 and 20x6, respectively?
  Interest cost is calculated by multiplying the PBO at the beginning of the year by the discount rate.
  PBO 1/1/20x5 = $0 x 8% = $0
  PBO 1/1/20x6 = $650,000 x 8% = $52,000

• Expected return on plan assets

• Actuarial gains and losses
  These occur when changes in assumptions about future events, such as quit rates, retirement dates, mortality, and the discount and compensation increase rates, decrease or increase PBO.

• Prior service costs
  Prior service costs (PSC) result from the granting of pension benefits for service rendered before the pension plan began or from plan amendments granting increased pension benefits for service rendered before the amendment. It is the present value of the retroactive benefits.

Accounting for Defined-Benefit Plan under IFRS

The change in the net pension asset or liability each period has three components. 1. employees' service costs. 2. the net interest expense or income. 3. re-measurements, which include actuarial gains and losses, and actual returns. The first 2 are recognized as pension expense in the income statement, and the 3rd is recognized in other comprehensive income.

Share-Based Compensation

Options grant the holder the right to purchase stock at a set price (exercise price) over some fixed time period, usually the closing price at the issue date. They are a one-directional participation in the success of the company - the employee benefits (will exercise the options) only if the stock price goes up. If the price goes down, there is no loss to the employee. Presumably, options therefore give employees the incentives to behave as owners of the company.

The principal debate on accounting for stock options is whether compensation expense should be recognized for stock options and, if so, the periods over which it should be allocated, and the value of options granted.

The key accounting requirements:

• Recognize compensation expense based on the fair value of the award. Since no cash is exchanged upon the grant, the offsetting account for the compensation expense is additional paid in capital.

• The grant date fair value is recognized as compensation expense over the vesting period.

• Upon exercise, the company increases equity by the fair value of the options on the grant date plus the cash provided by the employee upon exercise.

The valuation technique, or option pricing model, that a company uses is an important choice in determining fair value of options used in a compensation agreement and is disclosed in the notes to financial statements. Key inputs into option pricing models include such items as exercise price, stock price volatility, estimated life of each award, estimated number of options that will be forfeited, dividend yield, and the risk-free rate of interest.