Net periodic pension cost has five components: service cost, plus interest cost, minus the expected return on plan assets, plus amortization of prior service cost, plus or minus amortization of net gain or loss. The framework is ASC 715 (formerly SFAS 87, 88, and 106). The current AICPA blueprints don't list pension cost among FAR's representative tasks, so check the current blueprint before you spend long on it. Pension amounts still reach FAR as items of other comprehensive income.
Most candidates miss pension questions for one of two reasons. They mix up the components or get a sign wrong, or they forget the ASU 2017-07 income-statement split, which was a major change in 2018.
The five components
ASC 715 is the FASB codification for employer accounting for defined-benefit pension plans and other post-retirement benefits, with much the same substance as the old standards. The sponsor recognizes NPPC as an expense (with the post-2018 split), puts the funded status (assets minus PBO) on the balance sheet, discloses reconciliations of the PBO, plan assets and funded status in the notes, and runs unrealized gains and losses through other comprehensive income (OCI), amortizing them into NPPC later. A full pension problem has you compute NPPC, classify it on the income statement and report the funded status.
SC is service cost, IC is interest cost, ER is the expected return on plan assets (subtracted, since it reduces cost), APSC is amortization of prior service cost, and AGL is amortization of net gain or loss.
Service cost is the present value of benefits employees earned during the year. The actuary computes it with the projected unit credit method, it's always positive, and it's the only component that goes in operating income under ASU 2017-07.
Interest cost is the growth in the projected benefit obligation from the passage of time, the unwinding of the discount on the existing obligation. It's always positive, and it uses the discount rate set at the beginning of the year:
Expected return on plan assets is a credit to pension cost, because investment returns reduce the net cost of providing benefits. It's computed at the beginning of the year:
NPPC uses the expected return, never the actual return. The difference between the two is a gain or loss in OCI that gets amortized later through the fifth component, and mixing them up is one of the most common errors on exam questions.
Prior service cost comes from a plan amendment that grants extra benefits for past service. The increase in PBO goes to OCI immediately and is then amortized to pension expense, adding to cost, over the average remaining service period of active employees:
Net gains and losses come from actual returns differing from expected returns and from changes in actuarial assumptions (discount rate, mortality, salary growth), and the cumulative total sits in OCI. Under the corridor approach, only the part above 10% of the larger of beginning PBO or beginning fair value of plan assets gets amortized, over the average remaining service period:
A loss above the corridor adds to NPPC and a gain above it subtracts, which is why the master formula has the .
A worked example
An employer's defined-benefit plan has this data for the year:
- Beginning PBO: $1,200,000
- Beginning fair value of plan assets: $1,000,000
- Discount rate: 5%
- Expected long-term rate of return on assets: 7%
- Service cost (per the actuary): $80,000
- Prior service cost amortization: $10,000
- Net loss in OCI: $50,000 (below the corridor, so no amortization)
The corridor is 10% of the larger beginning balance, $120,000, so the $50,000 loss isn't amortized. Step 1 is to work out each component:
- SC = $80,000
- IC = 5% $1,200,000 = $60,000
- ER = 7% $1,000,000 = $70,000
- APSC = $10,000
- AGL = $0 (the loss is below the corridor)
Step 2 is to add them up:
Net periodic pension cost is $80,000.
Step 3 is the income-statement classification. Before ASU 2017-07 all five components sat in operating income. Since 2018, only service cost goes above the operating line, and the other four go to a non-operating or "Other Income/Expense" line, which let sponsors with big interest cost and amortization show higher operating income on the same total NPPC. Here, operating income gets service cost of $80,000, and the non-operating line gets IC ($60,000) + APSC ($10,000) - ER ($70,000) = $0. They net to zero, but you still report them separately by category, because the split matters for ratio analysis.
A classic pension stem asks for "Pension expense in operating income" and lists all five components. The answer is just service cost, and summing all five is the trap.
Step 4 is the funded status, assuming no contributions, no benefits paid and no gains or losses:
Under ASC 715-20 it goes on the balance sheet, as a pension asset when positive (overfunded) and a pension liability when negative (underfunded). The PBO grows by interest cost and service cost, less benefits paid:
Plan assets grow by the expected return, assuming the actual return matches:
Funded status = $1,070,000 - $1,340,000 = -$270,000. The plan is underfunded, and the $270,000 pension liability goes on the balance sheet. In a real year the funded status also moves with contributions and with gains or losses through OCI (benefits paid from the plan cut the PBO and the assets equally, so they leave it unchanged), and that reconciliation is the largest pension-disclosure table in the financials.
What pension questions test
Three liability measures get confused. The projected benefit obligation (PBO) is the present value of benefits earned to date using projected future salaries, and it's what NPPC uses. The accumulated benefit obligation (ABO) uses current (frozen) salaries and is used for minimum-funding tests and certain disclosures. The vested benefit obligation (VBO) is the non-forfeitable part of the ABO. For an active plan with future salary growth, .
ASC 715-20 requires extensive footnote disclosure: PBO and plan-asset reconciliations, funded status and balance sheet amounts, NPPC components for each year, the discount rate, expected return and salary growth assumptions, expected benefit payments for each of the next 5 years and in total for years 6-10, and the asset allocation. Questions rarely test the tables in full. The usual form is "Which of the following must be disclosed?"
A defined-contribution plan like a 401(k) has none of this: the employer's expense is the contribution, with no PBO, no plan-asset return and no actuarial assumptions, and ASC 715 covers DC plans in a few sentences. Other post-retirement benefits (OPEB), like retiree healthcare and life insurance, use the same framework with the accumulated postretirement benefit obligation (APBO) in place of the PBO, and the calculation runs in parallel.
Pension questions come in a handful of forms:
- A direct NPPC calculation, watching the sign on expected return.
- Naming a component from a description ("increase in PBO due to passage of time" is interest cost).
- Operating versus non-operating classification under ASU 2017-07.
- Funded status from PBO and plan assets, and whether it's an asset or a liability.
- A PBO reconciliation: beginning PBO, plus IC, plus SC, less benefits paid, plus or minus actuarial gains and losses, equals ending PBO.
- Corridor amortization.
- A task-based simulation: the journal entry for the year, the disclosure schedule, or the PBO reconciliation.
Most misses come from adding expected return instead of subtracting it, using the actual return, putting all five components in operating income, confusing the PBO with the ABO, or forgetting the corridor. It helps to write the master formula at the top of every pension question:
Computing NPPC, classifying the components and computing the funded status are the core of pension accounting, and you want to get through all three in under 4 minutes. In a task-based simulation the numbers also have to go in the right cells, which is where most candidates lose points. The CPA FAR formula sheet has the components, and the free CPA FAR question bank includes the other comprehensive income questions where pension items turn up.