Question

CP 11-6

Recognizing pension expense

The annual examination of Felton Company's financial statements by its external public accounting firm (auditors) is nearing completion. The following conversation took place between the controller of Felton Company (Francie) and the audit manager from the public accounting firm (Sumana):

Sumana:

You know, Francie, we are about to wrap up our audit for this fiscal year. Yet, there is one item still to be resolved.

Francie:

What's that?

Sumana:

Well, as you know, at the beginning of the year, Felton began a defined benefit pension plan. This plan promises your employees an annual payment when they retire, using a formula based on their salaries at retirement and their years of service. I believe that a pension expense should be recognized this year, equal to the amount of pension earned by your employees.

Francie:

Wait a minute. I think you have it all wrong. The company doesn't have a pension expense until it actually pays the pension in cash when the employee retires. After all, some of these employees may not reach retirement, and if they don't, the company doesn't owe them anything.

Sumana:

You're not really seeing this the right way. The pension is earned by your employees during their working years. You actually make the payment much later—when they retire. It's like one long accrual—much like incurring wages in one period and paying them in the next. Thus, I think you should recognize the expense in the period the pension is earned by the employees.

Francie:

Let me see if I've got this straight. I should recognize an expense this period for something that may or may not be paid to the employees in 20 or 30 years, when they finally retire. How am I supposed to determine what the expense is for the current year? The amount of the final retirement depends on many uncertainties: salary levels, employee longevity, mortality rates, and interest earned on investments to fund the pension. I don't think an amount can be determined even if I accepted your arguments.

1. Evaluate Sumana's position. Is she right, or is Francie correct? Explain yourself, show your work.

Answer 1

Sumana's advice is correct.

The pension is earned by your employees during their working years. You make the payment much later—when they retire.

Pension expense is accrual expense that is earned by employees during the current period and payment made by the company in the future.

As per the accrual concept, the expense is recorded when they incurred rather than the payment made.

I agree that "The amount of the final retirement depends on many uncertainties: salary levels, employee longevity, mortality rates, and interest earned on investments to fund the pension." But the company can use the expected rate to determine the pension expense.

Thus, the company needs to record the pension expense entry for the current period.