What Is the Corridor Rule?
In pension accounting, the corridor rule requires the disclosure of any actuarial gain or loss that exceeds 10% of the greater of the pension benefit obligation or the market value of the plan's assets and allows this actuarial gain or loss to be amortized over time into the income statement.
The effect of the corridor rule is a smoothing out of the plan sponsor's income statement. The gradual amortization keeps shocks from being introduced into the company's income statement as a result of the added pension expense, which may impact the company's stock price. If the actuarial gain or loss is less than 10% and therefore inside the corridor, it is not reported.
The actuarial gain or loss is a reference to the rise or fall in the projections that are used to determine a company's defined benefit pension plan obligations.
- The corridor rule sets out rules for reporting actuarial gains or losses in a pension plan.
- Actuarial gains or losses are the projections used when assessing the obligations of a defined benefit plan.
- Under the corridor rule, losses or gains that exceed 10% of the greater of the pension benefit obligation or plan assets must be disclosed.
- These losses or gains can also be amortized gradually to smoothen their impact on a company's income statement.
- Actuarial gains or losses that are less than 10% fall inside the "corridor" and are not reported.
How the Corridor Rule Works
The corridor rule can be seen as having a smoothening effect with respect to reporting pension gains and losses. The Financial Accounting Standards Board established the corridor rule in December 1985 when it issued Statement No. 87.
According to this statement, the prior accounting standards for pension reporting were too weak, and resulted in inconsistent reporting methods between companies, and sometimes even different methods from one period to the next. Establishing the corridor rule ensured that all companies were now subject to the same reporting requirements, and pensions would be held to the same accounting standards.
The year that the corridor rule was established by the Financial Accounting Standards Board.
Example of the Corridor Rule
XYZ Company offers its workers a pension that will pay workers 80% of their final salary each year after they retire. As employees enter the pension program, money is put away into the pension fund each year the employee works for the company. These pension dollars are invested in different types of securities and fluctuate with changes in market prices. If the market has a bad year, XYZ Company might have to report the loss.
If it's a large loss, it might hurt the company's financials and, therefore, its stock price. However, since the corridor rule allows these losses to be reported over a period of time, the impact of the loss is "smoothed," as XYZ Company can report the loss in pieces over a long period of time.