actuarial valuation of gratuity, leave and pension schemes

Why you may need an actuarial valuation?

In the context of employee benefits, there are various reasons why an actuarial valuation may be needed. 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 an actuarial valuation is performed to estimate the liability.
  • Indian subsidiaries of international companies also report under the GAAP applicable to their parent companies, such as US GAAP (ASC 715), IAS 19 or FRS 17. These accounting standards also require an actuarial valuation for assessment of liability.

Not all types of benefits require an actuarial valuation ….

While gratuity, leave, pension and many other employee benefits are required to be valued actuarially, some benefit schemes fall outside its scope.

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 or members in future as part of an employee benefit plan. In order to estimate future payments, actuaries make assumptions about future salary increment rates, attrition and mortality rates. Once the future payments have been estimated, actuaries choose another assumption called the discount rate, to convert the future payments into a present value, which is the liability measure that will be recorded in 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. In the context of Indian GAAP, though the principles of estimation of liability remain very similar, there are differences between AS 15 and Ind AS 19 as far as the disclosures are concerned. This post explains the key differences.

Though an actuarial valuation of any employee benefit scheme generally involves estimating the future payments, calculating the present value and preparing the required disclosures, there are scheme specific issues that come into picture. Gratuity scheme is straightforward, but there are issues to be considered for a leave scheme, which are explained here.

How to set actuarial assumptions?

Wrong actuarial assumptions lead to wrong liability estimates, defeating the whole purpose of an actuarial valuation. Therefore, it is important that the assumptions are set with a thorough understanding of the relevant accounting standard.

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. This post explains 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 this assumptions should be chosen. Numerica publishes the current discount rates here. Regular discount rate reports are also published and an example as at 30 June 2017 can be accessed 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. The results need to be interpreted, validated and challenged. The auditors must carry out their own assessment of the actuarial report.

By far the most important part of understanding and validiating an actuarial report is to thoroughly review and understand the exhibit related to ‘reconciliation of Defined Benefit Obligation’. This disclosure is required under both AS 15 and Ind AS 19. This post explains how to interpret this disclosure in the context of an AS 15 report, and a similar post for Ind AS 19 is currently being written.

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

More topics around actuarial valuation of employee benefits can be found in our guide below:

Actuarial valuations for AS 15 and Ind AS 19