What is Prior Service Cost?

Prior service cost refers to the expenses incurred when an employer amends a pension plan to grant additional benefits to employees for services they provided in previous periods. These amendments may include improvements in pension formulas, retroactive benefit increases, or adjustments to vesting schedules, often as part of labor negotiations or workforce retention strategies.

Accounting for Prior Service Costs

Since prior service costs relate to past employee service, the cost is not recognized immediately but instead is amortized over future periods, typically following the plan’s vesting or service period guidelines. This accounting treatment ensures that financial statements reflect the cost impact gradually, aligning with the long-term nature of pension obligations. Prior service costs are recorded as a component of other comprehensive income (OCI) and systematically allocated to pension expense over time, helping organizations manage their financial obligations while maintaining fair and competitive retirement benefits for employees.

Example of Prior Service Cost

Owl Corporation has a defined benefit pension plan. In the current year, it increases the benefit that the plan participants will receive, which also expands the benefits associated with prior service years. This represents a $100,000 prior service cost, which the company initially recognizes in other comprehensive income, and gradually shifts into its net periodic pension cost over the remaining service period of the affected employees.