Employers provide pension and health care benefits to their employees. In many cases, the obligations created by these benefits are extensive and a failure by the firm to adequately fund these obligations needs to be revealed in financial statements.
a. Pension Plans
In a pension plan, the firm agree to provide certain benefits to their employees, either by specifying a 'defined contribution" (where a fixed contribution is made to the plan each year by the employer, without any promises on the benefits which will be delivered in the plan) or a 'defined benefit" (where the employer promises to pay a certain benefit to the employee). Under the latter, the employer has to put sufficient money into the plan each period, such that the amounts with reinvestment, are sufficient to meet the defined benefits.
Under a defined contribution plan, the firm meets its obligation once it has made the pre-specified contribution to the plan. Under a defined-benefit plan, the firm's obligations are much more difficult to estimate, since they will be determined by a number of variables including - the benefits that employees are entitled to, which will change as their salaries and employment status changes, the prior contributions made by the employer and the returns they have earned and the rate of return that the employer expects to make on current contributions. As these variables change, the value of the pension fund assets can be greater than, less than or equal to pension fund liabilities (which include the present value of promised benefits). A pension fund whose assets exceed its liabilities is an over-funded plan, whereas one whose assets are less than its liabilities is an under-funded plan, and disclosures to that effect have to be included in financial statements, generally in the footnotes.
When a pension fund is over-funded, the firm has several options - it can withdraw the excess assets from the fund or it can discontinue contributions to the plan or it can continue to make contributions on the assumption that the over-funding is a transitory phenomenon that could well disappear by the next period. When a fund is under-funded, the firm has a liability, though the FASB rule requires that firms reveal only the excess of accumulated pension fund liabilities over pension fund assets on the balance sheet.
b. Health Care Benefits
A firm can provide health care benefits in one of two ways - by making a fixed contribution to a health care plan, without promising specific benefits (analogous to a defined contribution plan), or by promising specific health benefits, and setting aside the funds to provide these benefits (analogous to a defined benefit plan). The accounting for health care benefits is very similar to the accounting for pension obligations. The key difference between the two is that firms do not have to report the excess of their health care obligations over the health care fund assets as a liability on the balance sheet, though a footnote to that effect has to be added to the financial statement.