What is the Corridor Rule
In financial accounting, the corridor rule is a materiality rule that requires disclosure of a pension actuarial gain or loss, if the gain or loss exceeds 10% of the greater of the Pension Benefit Obligation (PBO) or the fair value of plan assets. If this is the case, then the corridor rule allows this actuarial gain or loss to be amortized gradually over time into the income statement. The effect of this rule is a smoothing of the plan sponsor's income statement. The gradual amortization keeps shocks from being introduced into the company's income statement as the result of added pension expense which may affect the company stock price. If the actuarial gain or loss is less than 10% and therefore inside of the corridor, it is not reported.
BREAKING DOWN Corridor Rule
Overall, the corridor rule can be seen as having a smoothing effect with respect to reporting pension gains and losses. The corridor rule was established under FASB Statement 87 in December 1985. 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. Establishment of the corridor rule ensured that all companies were now subject to the same reporting requirements and pensions would be held the same accounting standards.
Example of the Corridor Rule
For example, XYZ Company offers its workers a pension which will pay out 80% of the final salary each year the employee lives after retiring. 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 for all of the employees are invested in different types of securities and fluctuate with the 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 have a negative effect on the company's financials and therefore stock price. However, since the corridor rule allows these losses to be reported over a period of time, the effect of the loss is "smoothed," as XYZ Company can report the loss in pieces over a long period of time.