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.
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.
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.
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