A company that promises an employee a lump sum on retirement has borrowed from that employee. Nobody writes it up as a loan. It pays no coupon, and the lender can't sell it. In every other respect it behaves like a zero-coupon obligation: a known payment, or a distribution of possible payments, at a known future date, whose present value rises as the discount rate falls.
How is the defined benefit obligation calculated?
Nandan Forgings runs a gratuity plan, which every Indian employer of ten or more people runs, because the Payment of Gratuity Act, 1972 makes it compulsory. The formula pays roughly fifteen days of last-drawn salary for each completed year of service, and it vests after five years of continuous service. An actuary takes the current employees, projects their salaries forward at an assumed growth rate, applies a mortality table and an attrition rate, works out what each will be owed on leaving, and discounts the whole stream back.
The output is one number. Under Ind AS 19 that number is discounted at the yield on government bonds of a matching term. Under IAS 19 outside India it's discounted at the yield on high-quality corporate bonds, and government bonds only where no deep market in corporate bonds exists. Under ASC 715 it's the rate at which the obligation could effectively be settled, which in practice means a high-grade corporate bond yield curve. So you get three different rates for one identical promise.
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What does the discount rate do to the obligation?
The gap between a government yield and a high-grade corporate yield is a credit spread, and applying it to a pension obligation says something odd: that a promise to your own employees should be discounted at a rate that reflects the credit risk of somebody else's bonds. The standard setters know this and have argued about it for thirty years. For reading a filing, the point is narrower. An Indian filer's obligation is discounted at a lower rate than an American filer's would be on the same promise, so it looks larger, and none of that difference is economic.
Everything else in the pension section follows from treating the obligation as a bond. The obligation accretes interest because a year has passed and the payment is a year closer. It grows by service cost because employees worked another year and earned another slice of entitlement. It falls when benefits are paid, just as a bond's principal falls on repayment. And it jumps when the assumptions change. That's the pension equivalent of a yield move, except that the change goes to a reserve instead of to profit.
The obligation roll-forward, line by line
Six movements take a defined-benefit obligation from one year-end to the next. A published note discloses all six, usually in a table headed something like "changes in the present value of the defined benefit obligation", and your job is to be able to derive any one of them from the other five.
| Movement | What it is | Where its expense lands |
|---|---|---|
| Opening obligation | Last year's closing figure | Balance sheet only |
| Current service cost | The present value of benefits earned by this year's service | Operating profit, both rulebooks |
| Interest cost | Opening obligation times the discount rate | Finance cost under IFRS as part of net interest; below operating profit under US GAAP |
| Past service cost | The change from a plan amendment or curtailment | Immediately to profit under IFRS; to other comprehensive income then amortised under US GAAP |
| Benefits paid | Cash out to retirees and leavers | Neither statement; it reduces the obligation and the assets together |
| Actuarial remeasurement | Everything else: assumption changes and experience against assumption | Other comprehensive income, both rulebooks |
Worked example: Nandan Forgings
Take Nandan Forgings. It opened the year with ₹42,00,00,000, earned ₹4,35,00,000 of service cost, accreted ₹3,02,40,000 of interest at 7.20%, and paid out ₹2,80,00,000. Those four take it to ₹46,57,40,000. The actuary's closing figure is ₹47,80,00,000, so ₹1,22,60,000 is actuarial loss, and it's a loss because the obligation came out larger than the assumptions predicted.
The plug matters more than the components. Service cost and interest cost are arithmetic once the actuary has given you a rate. Benefits paid is a bank statement. The remeasurement is the residual, and it carries every change in assumption, every death, every resignation and every wage settlement that came out differently from what was assumed a year earlier. When a company's remeasurement line is large and in the same direction three years running, its assumptions are wrong in a consistent way, and that's a finding.
Common mistakes in the interest calculation
There are two common traps in the interest calculation. The first is applying the discount rate to the closing obligation instead of the opening one. Interest accrues on what was owed at the start of the year. The second is forgetting that benefits paid and contributions received during the year earn or accrue partial-period interest, which a careful actuary handles and a hand rebuild usually approximates. Assuming both fall at the year end, as the worked examples do, keeps the arithmetic clean and understates interest slightly. Say which convention you used.