In 1987, the FASB issued Statement No. 87, “Employers’ Accounting for Pensions.” This statement changed significantly the way in which pension costs are accounted for by the employer. This chapter is based upon that statement.
There are two types of pension plans: defined contribution plans and defined benefit plans. In a defined contribution plan, periodic defined contributions are made by the employer into a trust fund administered by a third-party trustee. When an employee retires, the accumulated value in the fund determines how much is to be paid to the employee. If the fund has been invested wisely, the employee will receive a greater payout than if it was invested poorly. Thus the benefit to the employee is undefined and the employer’s obligation extends only to making the specified defined contribution.
On the other hand, defined benefit plans guarantee the employee a specified retirement income related to the employee’s average salary. The periodic contribution to the fund is based upon the expected future benefits to be paid. Thus the benefit is defined, while the contributions are undefined, and the employer is responsible to make sure the employee receives the defined benefits as specified in the plan.
Because the accounting for defined contribution plans is relatively easy (the periodic contribution is simply debited to Pension Expense), Statement No. 87 focuses on defined benefit plans. We will do the same in this chapter.