What is the difference between pension service cost and interest cost, and where do they appear on the income statement?
I'm working through defined benefit pension accounting for CFA Level II and the cost components are confusing. The curriculum breaks pension expense into service cost, interest cost, expected return on plan assets, and actuarial gains/losses. I need clarity on where each goes under IFRS vs GAAP, especially the P&L vs OCI split.
Defined benefit pension accounting has multiple cost components, and IFRS and US GAAP classify them differently on the income statement. Here is the full breakdown:
Component Definitions:
Service Cost is the present value of benefits earned by employees during the current period. Think of it as the 'price' of one more year of employee service. It goes to operating income under both frameworks.
Interest Cost represents the increase in the projected benefit obligation (PBO) due to the passage of time. PBO is a present value — as you get one year closer, the discounted liability grows.
Interest cost = Beginning PBO x Discount rate
Expected Return on Plan Assets (US GAAP) offsets pension expense. Under IFRS, this concept is embedded in the net interest calculation.
Example: Ridgemont Corporation has a defined benefit plan.
| Item | Amount |
|---|---|
| Beginning PBO | $50,000,000 |
| Beginning plan assets (fair value) | $42,000,000 |
| Discount rate | 5% |
| Service cost | $3,200,000 |
| Actual return on plan assets | $2,800,000 |
| Expected return (GAAP) | $2,520,000 |
| Actuarial loss on PBO | $1,100,000 |
Under IFRS (IAS 19R):
- Net interest = (PBO - Plan Assets) x Discount Rate = ($50M - $42M) x 5% = $400,000
- P&L pension expense = Service cost + Net interest = $3,200,000 + $400,000 = $3,600,000
- OCI remeasurement = Actuarial loss - (Actual return - Expected return on assets at discount rate) = $1,100,000 - ($2,800,000 - $42,000,000 x 5%) = $1,100,000 - $700,000 = $400,000 loss
- OCI amount is never recycled to P&L under IFRS
Under US GAAP (ASC 715):
- Pension expense = Service cost + Interest cost - Expected return + Amortization of prior items
- = $3,200,000 + ($50M x 5%) - $2,520,000 = $3,200,000 + $2,500,000 - $2,520,000 = $3,180,000
- Actuarial losses go to OCI, then amortize to P&L using the corridor method (excess over 10% of greater of PBO or plan assets)
Key IFRS vs GAAP differences:
- IFRS uses a single net interest rate; GAAP uses separate discount rate and expected return
- IFRS remeasurements stay in OCI permanently; GAAP amortizes them to P&L
- Past service cost: IFRS recognizes immediately in P&L; GAAP amortizes over remaining service period
For more pension accounting practice, see our CFA Level II FRA course.
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