Why you may need an actuarial valuation?
In the context of employee benefits, there are various reasons why you may need an actuarial valuation. The most common reason is to prepare year-end financial statements:
- Indian GAAP mandates that a liability is recorded in the financial statements in respect of employee benefit schemes in accordance with AS 15 or Ind AS 19, as applicable. These accounting standards require that you perform an actuarial valuation to estimate the liability and make other disclosures as required by the accounting standard.
- If your company is an India based subsidiary of an international parent, then you may be required to report under the GAAP applicable to the parent company. Depending on where the parent company is located, you may need to report under US GAAP (ASC 715), IAS 19 or FRS 17.
You may also need to carry out an actuarial valuation for reasons other than accounting. For example:
- You want to assess whether the level of assets you need to hold to back your employee benefits liability
- You want to assess how much contribution you need to make to your gratuity fund or trust
- What should be the cost to be paid to take on the benefits liability in a merger or acquisition
- You want to settle the liability as part of discontinuance of operations or winding up your company
Not all types of benefits require an actuarial valuation ….
Gratuity, leave and pension plans most commonly come within the purview of actuarial valuation. If you are familiar with the actuarial valuation process, you would realise that the leave plans are also called ‘compensated absences’, or ‘leave encashment’ plans.
However, many types of employee benefit plans do not require any actuarial valuation. For example, many leave schemes that cannot be encashed do not require an actuarial valuation. This is explained in here.
You can save significant resources by understanding exactly which plans will require an actuarial valuation.
Is actuarial valuation applicable on your organisation?
If your organisation has more than 10 employees, there is a good chance that you will require an actuarial valuation of gratuity scheme for creating a provision in your year-end financial statements. This post explains more about the applicability of actuarial valuation on gratuity plans. Even if the plan is funded or managed by an insurance company like LIC, you will still need to get a separate actuarial valuation done.
For leave plans, the situation is a bit more complex. This is partly explained in the previous paragraph – not all types of benefit plans require an actuarial valuation. Read this post to understand if you require actuarial valuation of leave plans.
How is an actuarial valuation done?
The purpose of an actuarial valuation is to calculate the ‘present value’ of payments that would be made to employees in future as part of an employee benefit plan.
Actuaries start by making assumptions about future salary increment rates, attrition and mortality rates. The assumptions are then used to project the benefit payments that will be made form the employer to its employees, as per the rules of the plan.
Actuaries choose another assumption called the discount rate, to convert the future payments into a present value. This is the liability that you will need to disclose in your financial statements.
Actuarial valuation is generally meant to include not just an estimate of liability, but extended disclosures in the form of an actuarial report. The disclosures are different for different accounting standards. In the context of Indian GAAP, there are differences between AS 15 and Ind AS 19 as far as the disclosures are concerned. This post explains the key differences.
The approach described above is generally applicable for all types of actuarial valuations. However, there are issues to consider for different types of schemes. For example:
- Accounting of pension schemes is generally quite complex and some of the issues are described here.
- Issues related to accounting of leave schemes are described in this publication.
Gratuity scheme is relatively easy to deal with since the rules are prescribed the regulations in most cases.
How to set actuarial assumptions?
Wrong actuarial assumptions lead to wrong liability estimates. Therefore, you need to have a thorough understanding of the accounting standards applicable on your company.
Most accounting standards, including AS 15, Ind AS 19, IAS 19, ASC 715 and FRS 17, place the responsibility for all actuarial assumptions on the Board of Directors of the reporting enterprise. Read this to understand the regulatory context and governance around actuarial assumptions.
Actuarial valuation process requires the following assumptions:
- Discount rate – arguably the most important assumption, this is set based on yields on the central government bonds. This post explains how you should set the discount rate assumption. Numerica publishes the current discount rates here. These rates are compiled from the data from CCIL. We also publish the discount rate reports regularly and you can access an example (as at 30 June 2017) here.
- Salary escalation and attrition rates – these are the reporting enterprise’s best estimates of future salary increments and attrition. This post explains the method for setting the salary escalation assumption and this post explains the considerations for attrition assumption.
- Other assumptions, include mortality, leave availment, disability etc. are relevant and important for specific schemes.
Interpreting the results in an actuarial report
The process of actuarial valuation does not end with getting an actuarial report from an actuary. You need to understand the results, validate and challenge them. The auditors must carry out their own assessment of the actuarial report.
By far the most important part of an actuarial report is the exhibit related to ‘reconciliation of Defined Benefit Obligation’. This disclosure presents an analysis of movement of the DBO and is required under most accounting standards. This post explains how to interpret this disclosure in the context of an AS 15 report.
Frequently asked questions
We have compiled a series of posts summarising commonly asked questions on individual topics around actuarial valuation, based on our own experience with our clients. They can be found here:
FAQ: Setting the discount rate for actuarial valuation
About Numerica
Numerica is a leading provider of actuarial and valuation services to clients in India. We provide full range of actuarial services including actuarial valuation of gratuity, leave and pension plans. We have also introduced a range of other non-traditional actuarial services to Indian companies.