Most companies (and their auditors) getting their employee benefit plans valued actuarially under Accounting Standard 15 (Revised) have several questions in connection with the data requirement and methodology adopted to comply with this regulation. In this article, we have compiled a list of the most frequently asked questions pertaining to employee benefits actuarial valuations.
Do we need to make provision for employees who have not completed 5 years of service?
This is one of the most frequently asked questions. As per the ASB guidance notes on ‘Implementing AS 15(R) Employee Benefits’, a provision needs to be made for each employee as on the balance sheet (closing) date, irrespective of whether the employee has completed 5 years or not.
The major concern the employer has is that the employee has a right to receive the benefit only if he completes 5 years of service; the question that lingers in their minds is “what if he does not complete 5 years then why do we burden ourselves with an unwanted expense”.
Although there is a possibility that the benefit may not vest, there is also a probability that the employee may complete the minimum period of five years and become eligible for gratuity. The obligation arises when the employee renders the service though the benefit is not vested.
While arriving at the actuarial present value of the defined benefit obligation the probability that the benefit may not vest is taken into account by considering the attrition rate assumption.
Do we have to include employees who have resigned before valuation date but their last working day is after the valuation date?
While deciding on whether to include / exclude such employees we need to check whether a liability exists or not as on the valuation date. For example – if the employee is unvested and has already resigned then it might be fair to remove him from valuation but in case of vested employees the liability still exists and hence the employees should either be included in the data or his actual pending settlement should be added. We advise the companies to check the same with their auditors before making such decision.
Should we value expats / directors?
This will depend on their employment terms with the company.
Should we value employees on contract?
If there is a possibility of contract renewal due to which the employee can complete the requisite years of service for the benefit to get vested, then the employees should be valued.
Why do you need CTC for Leave Valuation when our Encashment salary is Basic?
There is always a possibility that an employee may avail leaves from his accumulated balances. When he does so, the employee would be entitled to basic wage, allowances and other benefits as well. As per the guidance note issued by ICAI on implementing AS15 (R), such situations would require estimation of the additional amount the enterprise expects to pay considering the pattern of leave availment. So in effect, the encashed portion of leaves is valued on the encashment salary as per Company leave policy and only the availment portion is getting calculated on CTC.
Why do you need SL details, although accumulation is allowed but it is non vesting in nature?
Accumulating sick leaves increase the employee’s entitlement of sick leaves in future period. As per the ICAI guidance note, a liability should be recorded for the cost created due to this increased entitlement based on the probability of the employees availing these Sick Leaves in future. This is valued on CTC using availment rates.
Why ‘No vesting condition” is mentioned in the actuarial valuation report for Gratuity?
As per para 70 of AS15(R), Gratuity provision is to be made for all employees, irrespective of them being vested or not. Therefore, in the actuarial report the vesting condition is stated as “None” which means that all active employees as on the valuation date have been valued and not just the vested employees.
How is the actuarial liability calculated?
Actuarial calculations involve projecting the future cash flows right to the expected retirement age of each employee taking into consideration probabilities of death and withdrawal each year. Also, the probable salary increases are factored in. These cash flows are then discounted to arrive at a present value of the benefit liability. This method as prescribed by AS 15(R) is called the Projected Unit Credit (PUC) method.
What is future service and how do we arrive at it?
Future service is the average expected remaining working lives of the employees in the organization. It is calculated taking into consideration the probabilities of attrition and mortality of each employee for each year right up to the retirement age.
For attrition (i.e., the probability of leaving the company) we use the assumption provided by the company and for the mortality decrement we use standard LIC mortality table.
This future service in other words is the term to maturity of the employee benefit liabilities and is then matched to the Zero-coupon yield curve to arrive at the discount rate.
Future Service is not arrived at by subtracting the average age from the plan’s retirement age. The probability of the employee leaving the company or his death whilst in service must be taken into consideration.
What do you mean by discount rate and how do you arrive at it?
Since the calculations involve cash-flow projections for each employee right up to retirement age, these cash-flows need to be discounted to get its present value. The discount rate is based on the zero-coupon yield curve, i.e. the Government bond rates with term matching the future service of the company as on the valuation date reflecting the economic conditions as of the measurement date. We take this from the FIMMDA website.
For e.g. Let us assume “Company A”
31st March 2021
Future Service = 7.75 years
Therefore, Discount rate= 6.6%
The Discount rate is inversely proportional to the liability thus an increase in discount rate leads to a reduction in liability and vice versa.
What is Zero coupon yield curve (zcyc)?
The zero coupon rate is the return, or yield, on a bond corresponding to a single cash payment at a particular time in the future. This would represent the return on an investment in a zero coupon bond with a particular time to maturity. The zero coupon yield curve shows in graphical form the rates of return on zero coupon bonds with different periods to maturity. The reason for constructing a zero-coupon yield curve is for use as a basic tool in determining the price of many fixed income securities.
A zero-coupon bond does not pay interest but instead carries a discount to its face value. The investor therefore receives one payment of the face value of the bond on its maturity. This face value is the equivalent of the principal invested plus interest over the life of the bond. The yield on the bond might be calculated based on the amount of discount and the length of time to maturity, and it is equivalent to the internal rate of return on the investment.
Why don’t we use same the discount rate as used in the LIC certificate?
Valuation provided by LIC is purely with a purpose of suggesting funding requirement. We provide liabilities for accounting and hence we follow the method as prescribed by AS 15 (R) for arriving at the discount rate for valuation.
How will a change in assumption impact liability?
It is very important to note that other than discount rate all assumptions like salary increment rate, withdrawal rate etc. are set with a long-term perspective and should not be changed year on year, i.e. it should not be based on that year’s actual increase unless a definite increasing/ decreasing trend is seen to make the revision. These assumptions are used for cash-flow projections right up-to retirement age.
The assumptions in combination work differently for every company and its impact is dependent on the underlying census being valued.
Increase / Decrease in Salary increment rate assumptions
Salary increment rate assumption is directly proportional to the liability. Since salaries of all employees are projected till retirement, when the salary increment assumption is increased, the liability will also increase due to compounding effect of this increase in assumption and vice versa
Increase/ Decrease in Withdrawal rate assumption
Attrition rate or withdrawal rate affects the gratuity liability in combination with the other assumptions like salary scale and retirement age. It also works differently depending on the underlying census.
A high attrition
All other assumptions being same, if most employees in a particular company are vested, a high attrition will mean that their payouts are closer to maturity and hence their actuarially calculated liability would be near to their actual liability and thus on the higher side. On the contrary if they are unvested employees, the probability of reaching the vesting period or increase in the number of years of service reduces and hence will lead to a lower liability. Hence the impact of attrition rate will be determined by the demographic composition as well as other assumptions such as salary increment and discount rate.
Similarly, while calculating the leave liability, the impact the attrition rate on the liability will depend on assumptions like salary rate, attrition and availment rate.
Again, the effect of variations in these assumptions cannot be generalized since they also depend upon the census being valued.
How have you arrived at / checked the appropriateness of salary and withdrawal rate assumption.
As per the various accounting standards, the onus of setting the assumptions lies with the enterprise. We advise the companies to set assumptions looking at past trends and also taking into consideration the future expectations since assumptions are long-term in nature. We check the company’s past data to analyse the appropriateness and in case we find substantial deviations we inform the company about the same. In absence of past trends, we check the reasonableness of the assumptions by comparing it to similar industry trends.
How do we arrive at the Current Liability?
There are various interpretations of the guidance note issued by the ICAI on Schedule III to the Companies Act. 2013 on the calculation of current liability for employee benefit plans.
For Gratuity Plan
For a Funded Plan
The most common and generally accepted method for arriving at the current liability for a funded gratuity plan is to consider the current liability as the expected contribution towards the fund in the next year. If the employer is unable to provide this information on “next year’s contribution”, the entire net liability is disclosed as the current liability. (Net liability =Assets-Liabilities)
For an Unfunded Plan
Gratuity current liability is calculated as the expected payouts during the next year. This is arrived at using the probabilities of attrition, mortality and retiring in the next 12 months. The attrition rate assumption and the retirement age used are as provided by the Company.
For Leave encashment Plan
Most companies do not have a cap on availment / utilization of accumulated leave balances forcing the employer to book the entire leave liability as current liability.
However, most employers and their auditors are of the view that although the employees have earned the right to avail the entire leave balance, it is a rare possibility that all the employees will together consume their entire leave balance during the next year itself. Also the general actuarial opinion was that it is appropriate to classify the liability into current and non-current based on actuarial assumptions of attrition, availment rate, mortality and retirement in the next 12 months (expected payouts during the next year).
How is experience gain/loss different from actuarial assumption gain/loss?
The actuarial gain/loss arises due to the following two reasons:
- change in assumptions used for the valuation
- when the actual experience differs to the assumptions used for the valuation.
For example: –
- Gain/loss due to change in assumptions
- Suppose a company ‘A’ changes their salary increment rate from 20% to 10%, keeping all other assumptions constant.
- There will be an actuarial gain because the liability calculated will be less than what we had assumed last year.
- Gain/loss due to change in experience
- Company ‘B’ may use a Salary increment assumption of 10% but their actual salary increment for the year happened to be 30%. Here we will end up with an actuarial loss.
Why is expense in the statement of Profit and Loss account not equal to contribution made towards the fund for the period under consideration?
Expense is the amount to be recognized in the statement of Profit and Loss account.
The components of Expense include –
Increase in plan benefits due to Current Service Cost, an addition of Interest Cost due to passage of time offset by the Expected Returns on Plan Assets, Curtailment/settlement Costs and Net Actuarial Gain Loss.
Thus, expense amount depends upon the calculated actuarial liability and the expected returns from the plan assets. Due to lack of Minimum Funding Requirements for employee benefit plans in India, there is no obligation on the employer as to the amount to be contributed to the fund. The fund manager may recommend a certain amount to be paid during the year, but the company may or may not make the contribution as per the recommended amount.
Since these are two different components, hence contribution to the fund cannot be the expense for the year.
Why is expense booked under IND AS 19 not the same as expense under AS15?
Under AS 15 (R) all actuarial gains and losses are immediately recognized through profit and loss account. But in Ind AS 19 all actuarial gains and losses, termed as Remeasurements, are recognized immediately in OCI i.e. Other Comprehensive Income in the Balance sheet. This leads to difference in charge to P&L under both standards for Post-Retirement benefit plans like Gratuity, Pension etc.
In IND AS 19 reports, why is expected ROR not same as LIC interest rate?
Under IND AS 19, the interest cost is calculated using the opening discount rate and it is not based on the schemes’ asset mix. Therefore, the expected rate of return on scheme assets assumption is not relevant.
Why is of Past Service Cost not amortized in IND AS 19?
AS 15 (R) gives an option of amortizing the non-vested portion of the past service cost till the benefits become vested. But as per IND AS 19, the vested as well as the non-vested past service cost needs to be recognized immediately through profit and loss account in the year of plan amendment.
Why isn’t there an OCI component in leave?
The recognition of gains and losses for other long-term benefits such as Leave encashment plans, Long service awards, Loyalty bonus, retention bonus and long-term disability benefit are same under IND AS 19 and AS15. For these plans, under both the standards, the gains and losses are to be taken through the profit and loss account.
What will be the definition of wages as per new wage code bill?
The Wage Code seeks to provide a single uniform definition of ‘wages’ as applicable to minimum wages, payment of wages and payment of bonus. As per the Wage Code – (i) basic pay, (ii) dearness allowance and (iii) retaining allowance have been included as components of ‘wages’. All other components have been excluded from the definition of ‘wages’.
Whether the Basic salary will have to be revised?
Currently, the basic salary ranges from 25% to 40% of the CTC of the employee which forms the basis for both provident fund and gratuity contributions. The wages under the new wage code should be at least 50% of the CTC, hence the employer will have to adjust the Basic salary accordingly when the wage code becomes applicable.
When will the code become applicable?
The Code on Social Security, 2020 is not expected to be implemented in financial year 21-22 due to the delay in the drafting of rules by the states and for political reasons.