Key Jargon: “Interest Cost” in Actuarial valuations

Content

• Background
• Technical Definition as per IND AS 19 or AS 15 Revised
• Measurement of Interest Cost (How to measure)
• Validation of Interest Cost by Auditors
• Recognition of Interest Cost in Books of Accounts

Background

Interest Cost is defined as the increase in the present value of liability during the valuation period which arises because the benefits are one period closer to settlement.

In another word, it is the annual interest accrued on the defined benefit obligation (DBO) at the start of the year.

Another way of looking at the interest cost is that it is an “unwinding” of the discount rate for one year compared to the valuation one year before. The discount rate is applied to liability at the start of the year adjusted for expected benefit payments for the year to get the interest cost.

As each year passes, employees participating in the pension or gratuity plan are one year closer to receiving their retirement benefit. Therefore, the company incurs a cost that is equal to the discount rate multiplied by the opening balance of the Defined Benefit Obligation (adjusted for expected benefit payments during the period).

Technical Definition as per IND AS 19 or AS 15 (Revised 2005)

As per Para 82 of AS 15 (Revised 2005);

Interest cost is computed by multiplying the discount rate as determined at the start of the period by the present value of the defined benefit obligation throughout that period, taking account of any material changes in the obligation. The present value of the obligation will differ from the liability recognized in the balance sheet because the liability is recognized after deducting the fair value of any plan assets and because some past service cost is not recognized immediately. [Appendix A illustrates the computation of interest cost, among other things]

Measurement of Interest Cost (How to measure)

Example:

Consider the gratuity benefit of XYZ Limited. Suppose the DBO as of 1 Apr 2018 was Rs. 18,05,000 and the discount rate used to determine the DBO was 7% p.a. The company expects to pay Rs. 2,01,700 during FY 2018-19 then Interest cost for FY 2018-19 will be calculated as follows:

Interest cost = (DBO – 0.5 X Expected benefit payments) X Discount Rate
= (18,05,000 – 0.5 X 2,01,700) X 0.07
= 119,291

Validation of Interest Cost by Auditors

The Auditors can validate Interest Cost for the current year approximately by using the formula,

Opening DBO * Discount Rate

If we take the above mentioned example,
Interest Cost = 18,05,000 * 0.07
= 1,26,350

This is approximately the same as actual Interest Cost.

Recognition of Interest Cost in Books of Accounts

Interest cost is typically one of the largest components of a company’s pension expense each year. Interest Cost is recognized as an expense in Profit and Loss Account of the year.