Actuarial basis of accounting definition
/What is the Actuarial Basis of Accounting?
The actuarial basis of accounting is the method used to calculate the amount of ongoing, periodic contributions to be made into a pension fund. This basis of accounting mandates that the amount of contributions plus the assumed investment earnings must at least equal the amount of payments made by the fund to pensioners. This calculation includes a number of factors, including the following:
The discount rate applied to future benefit payments
The estimated number of years that employees will continue to work
The rate at which employee wages will increase in the future
The rate of return on plan assets
When you are reviewing the financial statements of a business that discloses information about its pension plans, be sure to examine whether the entity is using conservative or aggressive estimates in this area. If the estimates are conservative, it is more likely that the business making reasonable amounts of contributions to its pension fund. When this is not the case, the business will probably need to increase its contributions in the future.
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Example of the Actuarial Basis of Accounting
A company sponsors a defined benefit pension plan for its employees. The company needs to recognize pension costs and obligations in its financial statements. Its key assumptions are as follows:
Discount rate: 5%
Salary growth rate: 3% per year
Mortality rates: Based on the most recent actuarial tables
Employee turnover: Varies by age and tenure
The company’s actuary determines that the firm’s projected benefit obligation is $10 million. This is the present value of all future pension benefits earned by employees as of the valuation date. The pension expense for the year is calculated based on a service cost of $500,000, an interest cost of $500,000 and an expected return on plan assets of $300,000, resulting in a total pension expense for the year of $700,000. If the company contributes $600,000 to the pension fund during the year, the unfunded obligation increases by $100,000, which is added to the firm’s balance sheet liability.