The accounting of employee benefits is one of the most critical areas in financial reporting as it directly impacts both the liabilities of an enterprise and the rights of employees. In India, the framework for recognising and measuring employee benefits is provided under Ind AS 19, Employee Benefits. This standard prescribes the principles for accounting and disclosure of obligations relating to various forms of employee benefits, including post-employment benefits like gratuity, pensions, and provident funds. Gratuity, in particular, has always been a matter of discussion given its statutory mandate under the Payment of Gratuity Act and the complexities involved in its classification under accounting standards.
This series sets the stage by exploring the fundamental concepts of Ind AS 19, classification of employee benefits, and a detailed analysis of post-employment benefit obligations. By the end of this section, the conceptual distinction between defined contribution plans and defined benefit plans will be clear, along with an understanding of the implications of actuarial and investment risks borne by employers.
Background of Employee Benefit Accounting in India
Employee benefits are the rewards and facilities provided by employers to employees in exchange for their services. These include not only wages and salaries but also a variety of post-employment and other benefits. In India, accounting for such benefits historically followed the guidance of Accounting Standard (AS) 15, Employee Benefits, which was issued by the Institute of Chartered Accountants of India. With the adoption of Ind AS, aligned broadly with International Accounting Standards, companies now follow Ind AS 19 for the recognition, measurement, and disclosure of employee benefits.
The shift from AS 15 to Ind AS 19 was not merely a change in nomenclature but a significant step towards aligning Indian financial reporting practices with global standards. Ind AS 19 requires companies to measure and disclose liabilities arising from employee benefits in a more transparent manner, especially in the case of defined benefit obligations such as gratuity.
Classification of Employee Benefits under Ind AS 19
Ind AS 19 classifies employee benefits into four categories, each requiring different accounting treatments.
Short-term Employee Benefits
These include wages, salaries, paid annual leave, profit-sharing, and other benefits expected to be settled wholly within twelve months of the end of the reporting period. The accounting is straightforward, as the obligation is measured on an undiscounted basis and recognised when the employee has rendered service.
Post-employment Benefits
These are benefits payable after the completion of employment. The most common examples are gratuity, pensions, and provident funds. The accounting for post-employment benefits is complex, as the employer’s obligation often extends into the future and involves actuarial assumptions.
Other Long-term Employee Benefits
Benefits such as long-service leave, jubilee benefits, and long-term disability payments fall into this category. These require actuarial valuation but usually involve less complexity than post-employment benefits.
Termination Benefits
These are benefits provided when employment is terminated before the normal retirement date or when an employee accepts voluntary redundancy.
Among all these categories, post-employment benefits create the most significant accounting and financial reporting implications, and gratuity is at the centre of this discussion in India.
Understanding Post-Employment Benefits in the Indian Context
In India, gratuity is governed by the Payment of Gratuity Act, 1972. This law mandates that employers provide gratuity to employees who have completed a minimum of five years of continuous service, subject to certain exceptions. The gratuity entitlement is based on the last drawn salary and years of service, with a statutory cap of 20 lakh rupees per employee.
This statutory obligation makes gratuity a central element of employee benefits accounting. Even though employers may set up separate gratuity funds or insurance schemes, the ultimate responsibility to ensure payment of gratuity lies with the employer. The employer’s obligation is thus not restricted to mere contributions but extends to guaranteeing the employee’s entitlement as per the law.
Defined Contribution Plans under Ind AS 19
A defined contribution plan is a post-employment benefit plan under which the employer pays fixed contributions into a separate fund, such as a provident fund or superannuation scheme. Once the contributions are made, the employer has no further obligation to pay additional benefits, regardless of whether the fund has sufficient assets to meet employee entitlements.
In this scenario, the actuarial and investment risks lie with the employees, since the ultimate benefit depends on the performance of the fund. The accounting for such plans is relatively simple, as the expense recognised in the financial statements equals the contribution due for the period. Examples of defined contribution plans in India include the employer’s contribution to provident funds and certain superannuation funds where the obligation ends with the contribution.
Defined Benefit Plans under Ind AS 19
A defined benefit plan is any post-employment benefit plan that does not qualify as a defined contribution plan. In such plans, the employer guarantees a specific benefit to the employees, which may be based on years of service and final salary. Gratuity is the most common defined benefit plan in India.
Under defined benefit plans, the employer bears both actuarial risk and investment risk. Actuarial risk arises from the possibility that benefits will cost more than expected, while investment risk arises when assets set aside to meet benefits generate lower returns than anticipated. As a result, the employer must cover any shortfall between the assets and the promised benefits.
Accounting for defined benefit plans requires actuarial valuation using the projected unit credit method. This involves estimating the present value of the obligation based on assumptions about salary growth, employee turnover, mortality, and discount rates. Actuarial gains and losses arising from changes in assumptions or experience are recognised in other comprehensive income.
Distinguishing Between Defined Contribution and Defined Benefit Plans
The fundamental distinction between these two categories lies in the nature of the employer’s obligation. In a defined contribution plan, the employer’s obligation ends with the contribution, whereas in a defined benefit plan, the employer undertakes to provide the promised benefits, irrespective of fund performance or contribution caps.
This distinction is crucial in the context of gratuity accounting. Even if the employer makes contributions towards a gratuity fund, the legal obligation to ensure payment of gratuity as per the Payment of Gratuity Act remains. Hence, the employer cannot treat gratuity as a defined contribution plan merely on the basis of contributions made.
The Role of Actuarial and Investment Risks
Actuarial and investment risks are central to understanding defined benefit obligations. Actuarial risk arises when employees live longer than expected, salaries increase more than forecasted, or employee turnover is lower than projected. Investment risk arises when the assets of the gratuity fund underperform relative to expectations.
In both cases, the employer is ultimately responsible for covering the shortfall. This contrasts sharply with defined contribution plans, where such risks are borne by employees. Ind AS 19 requires companies to explicitly account for these risks when measuring obligations under defined benefit plans.
Global and Indian Practices around Gratuity Benefits
Globally, many countries provide post-employment benefits in the form of pensions or retirement savings schemes. The classification between defined contribution and defined benefit plans under International Accounting Standard (IAS) 19 is similar to Ind AS 19. However, the prevalence of gratuity as a statutory obligation is unique to India and a few other jurisdictions.
In India, most companies account for gratuity as a defined benefit plan. Even if a company has established a trust or taken insurance cover through the Life Insurance Corporation of India, the ultimate responsibility remains with the employer to ensure payment of gratuity to eligible employees.
Introduction to Contribution Caps and Government Guidelines
In certain sectors, government regulations restrict the amount that employers can contribute towards employee benefits. For instance, under some Department of Public Enterprises guidelines, employers cannot contribute more than 30 percent of base pay, which includes basic salary and dearness allowance, towards employee benefit schemes.
This cap on contributions raises questions about whether gratuity obligations should still be classified as defined benefit plans under Ind AS 19. The reasoning is that if the employer’s contribution is capped, then perhaps the obligation should also be considered capped, similar to defined contribution plans.
However, as explained by the Expert Advisory Committee of ICAI, the cap applies only to the contribution and not to the statutory entitlement of employees under the Payment of Gratuity Act. Therefore, employees continue to be entitled to gratuity up to the statutory limit, and the employer remains responsible for paying the difference if the fund falls short.
Importance of Ind AS 19 in Providing Transparency
The significance of Ind AS 19 lies in its requirement for companies to measure and disclose obligations accurately. By mandating actuarial valuation for defined benefit plans, the standard ensures that companies recognise the full extent of their liability. This prevents under-reporting of obligations and provides transparency to stakeholders regarding the company’s financial commitments.
For gratuity, the application of Ind AS 19 means that even if contributions are capped, the company must still account for the entire obligation through actuarial valuation. This ensures that employees’ rights are protected and that companies reflect the true cost of employee benefits in their financial statements.
The Practical Scenario of Capped Contributions
Certain companies, particularly those under the control of the government, are required to follow guidelines that restrict their contribution towards employee benefit funds. For instance, a rule may state that the employer cannot contribute more than 30 percent of base pay, which consists of basic salary and dearness allowance, towards employee benefits. On the surface, this creates a ceiling on what the company can put aside annually to meet its future obligations.
The confusion arises when employers attempt to align these capped contributions with the definitions of benefit plans under Ind AS 19. Since defined contribution plans involve fixed contributions with no further obligation, companies may argue that a cap makes their obligation similar to a defined contribution scheme. However, such reasoning does not hold when examined against the statutory framework of gratuity and the requirements of the accounting standard.
Understanding the Employer’s Obligation under Gratuity
The Payment of Gratuity Act creates a statutory right for employees to receive gratuity once they complete the prescribed years of service. The amount payable depends on the last drawn salary and years of service, subject to a statutory maximum. This obligation cannot be reduced or extinguished by limiting contributions. Even if the contributions are capped, the employee’s entitlement remains the same.
This creates a clear distinction between contributions made and obligations owed. While contributions may be limited under certain regulations, the obligation remains governed by law. Employers are therefore required to ensure that employees receive gratuity as per statutory requirements, regardless of the contribution cap. This characteristic is what keeps gratuity within the definition of a defined benefit plan under Ind AS 19.
The Confusion Regarding Classification under Ind AS 19
At first glance, capped contributions appear to mimic the structure of a defined contribution plan. In such a plan, the employer’s obligation is restricted to a specific contribution, and once paid, the employer bears no further risk. However, in the case of gratuity, the statutory entitlement is not reduced by the contribution cap. Employees continue to have the right to receive their gratuity, and employers must meet this obligation even if it requires additional funding.
This subtle but critical distinction is at the heart of classification. If the employer must bear the risk of shortfall between contributions and obligations, then the plan is a defined benefit plan. The presence of a contribution cap does not alter the employer’s underlying responsibility, as the Payment of Gratuity Act overrides contribution limits when it comes to employee entitlements.
Role of Actuarial Valuation in Measuring Liabilities
Ind AS 19 requires companies to measure defined benefit obligations using actuarial valuation techniques, specifically the projected unit credit method. This approach considers future salary increases, employee turnover, mortality, and other assumptions to estimate the present value of obligations. The method ensures that the liability recognised reflects not only current contributions but also the future cost of benefits that employees are expected to earn.
In the case of capped contributions, actuarial valuation becomes even more important. Since contributions are limited, there is a higher likelihood that assets set aside may fall short of meeting the obligation. Actuarial valuation helps quantify the gap between the obligation and the assets, ensuring that the company recognises this shortfall in its financial statements. This prevents a misleading picture where contributions alone are treated as expenses, while the true liability remains unrecognised.
Expert Advisory Committee Clarification
The Expert Advisory Committee of the Institute of Chartered Accountants of India has addressed this issue in its opinions. The committee observed that under defined benefit plans, the employer’s obligation is not limited to contributions but extends to the benefits promised to employees. If actuarial or investment experience turns out to be less favourable than expected, the employer is required to cover the difference. Therefore, the expense recognised in the financial statements is not simply the contribution made but the cost of providing the promised benefits.
The committee further clarified that the cap relates only to the contribution, not to the benefit entitlement of employees. Employees remain entitled to gratuity as per the Payment of Gratuity Act, and the employer remains responsible for ensuring payment. Consequently, gratuity must continue to be classified and accounted for as a defined benefit plan under Ind AS 19.
Why Contribution Caps Do Not Change the Nature of Obligations
It is important to distinguish between a contribution restriction and a benefit entitlement. Contribution restrictions limit how much the employer can set aside in advance, while benefit entitlements define what employees are entitled to receive upon retirement or termination. A contribution cap does not modify the statutory benefit entitlement. Therefore, employers remain exposed to actuarial and investment risks, since they must meet any shortfall between contributions and obligations.
This distinction is vital in preventing the misclassification of gratuity schemes. Treating capped contribution gratuity as a defined contribution plan would understate the employer’s liability and mislead stakeholders. Ind AS 19 ensures that the economic substance of the transaction prevails over form, meaning that the employer’s actual responsibility must be recognised rather than only the contribution made.
Illustrations of Accounting Differences
To understand the implications more clearly, consider two scenarios.
In the first scenario, an employer contributes ten percent of an employee’s salary to a provident fund. The employer has no further obligation once the contribution is made, and the benefit the employee receives depends on the fund’s performance. This is a defined contribution plan, and the expense recognised equals the contribution.
In the second scenario, an employer provides gratuity benefits as per the Payment of Gratuity Act. Contributions to a fund may be capped at thirty percent of base pay, but the employee remains entitled to gratuity benefits based on years of service and last drawn salary. If the fund falls short, the employer must cover the deficit. This is a defined benefit plan, and accounting requires actuarial valuation of the obligation, not just recognition of contributions. These examples highlight why capped contributions do not change the fundamental nature of gratuity obligations.
Compliance with Ind AS 19 Paragraphs 57 and 64
Paragraph 57 of Ind AS 19 requires entities to use the projected unit credit method to determine the present value of defined benefit obligations. Paragraph 64 further states that the rate used to discount post-employment benefit obligations should be determined by reference to market yields on government bonds at the end of the reporting period. These requirements ensure that liabilities are measured accurately and consistently across entities.
For gratuity schemes with contribution caps, these paragraphs are particularly significant. They mandate that companies must continue to perform actuarial valuations and recognise the entire obligation in their financial statements. This prevents companies from limiting their recognition to the capped contributions and ensures that employees’ entitlements are fully reflected as liabilities.
Practical Challenges Faced by Companies
While the accounting requirements are clear, companies often face practical challenges in implementing them. One of the biggest difficulties lies in explaining to management and stakeholders why expenses recognised in financial statements may be higher than the contributions actually made. For example, even if a company contributes only a limited amount due to regulatory caps, actuarial valuation may reveal a much larger liability, leading to additional expense recognition.
Another challenge arises from volatility in actuarial assumptions, such as discount rates, salary escalation, and employee turnover. These assumptions can cause significant fluctuations in liabilities from year to year, affecting the company’s reported financial position and performance. Companies must therefore develop robust processes to manage and communicate these variations to stakeholders.
Importance of Transparent Disclosures
Ind AS 19 requires extensive disclosures about defined benefit obligations, including the actuarial assumptions used, the sensitivity of obligations to changes in assumptions, and a reconciliation of opening and closing balances of the obligation and plan assets. For companies with capped contributions, these disclosures become critical in explaining the gap between contributions and obligations.
Transparent disclosures not only ensure compliance but also help build trust with investors, regulators, and employees. By presenting a clear picture of liabilities and risks, companies can demonstrate their commitment to meeting employee entitlements and managing long-term financial stability.
Broader Implications for Stakeholders
The classification of gratuity as a defined benefit plan despite contribution caps has implications for multiple stakeholders. For employees, it provides reassurance that their statutory entitlements are secure and will not be compromised by contribution restrictions.
For investors, it highlights the potential long-term liabilities that companies must manage, allowing them to assess financial stability more accurately. For regulators, it reinforces the principle that statutory obligations take precedence over contribution limits. By ensuring that the economic substance of obligations is recognised, Ind AS 19 protects the interests of all parties and promotes transparency in financial reporting.
Importance of Accurate Measurement
Measurement of post-employment benefit obligations under Ind AS 19 is critical for presenting a true and fair view of an entity’s financial position. Gratuity obligations, being long-term in nature, are subject to uncertainties regarding future salaries, mortality rates, employee turnover, and discount rates. Since these factors cannot be predicted with certainty, actuarial valuation is used to estimate the present value of defined benefit obligations.
The Payment of Gratuity Act provides the formula for determining gratuity, but accounting under Ind AS 19 requires companies to go further and measure obligations on a projected basis, not just at current levels. This ensures that liabilities recorded reflect the cost of benefits earned by employees up to the reporting date, taking into account expected future salary increases and service periods.
The Projected Unit Credit Method
Ind AS 19 requires the use of the projected unit credit method for measuring defined benefit obligations. This method treats each year of service as giving rise to an additional unit of benefit entitlement and measures each unit separately to build up the total obligation.
The method involves the following steps:
- Estimating the benefit that employees have earned in return for their service in the current and prior periods.
- Projecting these benefits to reflect expected future salary increases.
- Discounting the projected benefits to their present value using an appropriate discount rate.
- Allocating the cost of benefits to the periods of service using the benefit formula specified in the Payment of Gratuity Act.
The projected unit credit method ensures that the obligation recognised is consistent with the accrual principle, recognising benefits as they are earned by employees rather than when they become payable.
Actuarial Assumptions and Their Impact
The accuracy of actuarial valuation depends heavily on the assumptions used. The key actuarial assumptions include:
- Discount rate: Determined with reference to market yields on government bonds at the reporting date. A lower discount rate increases the present value of obligations, while a higher rate reduces it.
- Salary escalation rate: Assumptions regarding future salary increases have a direct effect on projected gratuity payments. Higher salary growth increases the obligation.
- Employee turnover rate: Assumptions about attrition affect the number of employees expected to qualify for gratuity. Lower attrition results in higher obligations.
- Mortality rate: Life expectancy assumptions influence the timing and probability of benefit payments.
- Retirement age: Assumptions regarding the age at which employees retire also impact the valuation.
Even small changes in these assumptions can significantly alter the present value of obligations. Ind AS 19 therefore requires disclosure of the sensitivity of obligations to changes in key assumptions, which helps stakeholders understand the degree of estimation uncertainty involved.
Recognition of Defined Benefit Costs
Once the present value of obligations and the fair value of plan assets are determined, the defined benefit cost for the period is recognised in the financial statements. Ind AS 19 classifies defined benefit cost into three components:
- Service cost: Includes current service cost, past service cost, and gains or losses on settlements.
- Net interest on the net defined benefit liability or asset: Calculated by applying the discount rate to the net obligation at the beginning of the reporting period, adjusted for contributions and benefit payments during the year.
- Remeasurements: Comprise actuarial gains and losses arising from changes in assumptions or experience adjustments, as well as the return on plan assets excluding amounts included in net interest.
Service cost and net interest are recognised in profit or loss, while remeasurements are recognised in other comprehensive income. This split presentation ensures that short-term fluctuations in actuarial assumptions do not distort reported earnings, while still being transparently disclosed in the financial statements.
The Net Defined Benefit Liability or Asset
The amount recognised in the balance sheet is the net defined benefit liability or asset, which represents the difference between the present value of the defined benefit obligation and the fair value of plan assets.
- If the obligation exceeds plan assets, a net liability is recognised.
- If plan assets exceed the obligation, a net asset is recognised, subject to a limit known as the asset ceiling, which restricts the amount of surplus that can be recognised.
This net presentation reflects the employer’s ultimate responsibility to settle the obligation, taking into account the resources already set aside.
Presentation in the Financial Statements
Ind AS 19 prescribes specific requirements for presenting defined benefit plans in financial statements.
- In the balance sheet, the net defined benefit liability or asset is presented separately from other liabilities or assets.
- In the statement of profit and loss, service cost and net interest are presented as part of employee benefits expense and finance costs respectively.
- Remeasurements are presented in other comprehensive income and are not reclassified to profit or loss in subsequent periods.
This clear presentation helps users of financial statements distinguish between the recurring cost of providing employee benefits and the non-recurring effects of changes in actuarial assumptions.
Disclosure Requirements
Ind AS 19 requires extensive disclosures to provide a comprehensive understanding of defined benefit plans. The key disclosures include:
- Description of the plan: Nature of the benefits provided and the regulatory framework, such as the Payment of Gratuity Act.
- Reconciliation of obligations and assets: Movement in the present value of obligations and plan assets from the beginning to the end of the reporting period.
- Actuarial assumptions: Key financial and demographic assumptions used in the valuation, along with sensitivity analysis showing the impact of changes in these assumptions.
- Plan assets: Breakdown of the fair value of plan assets by asset class, distinguishing those with quoted market prices from those without.
- Funding arrangements: Information about the funding policy and expected contributions in the next reporting period.
- Remeasurements: Amounts recognised in other comprehensive income during the period.
These disclosures enable stakeholders to evaluate the financial impact of defined benefit plans, the risks associated with them, and the entity’s strategy for managing these obligations.
Challenges in Disclosure of Gratuity Obligations
While the standard requires detailed disclosures, companies often face challenges in providing them. Gathering reliable actuarial data can be resource-intensive, particularly for large organisations with thousands of employees. Moreover, translating actuarial reports into disclosures that are understandable to non-specialist users of financial statements requires careful communication.
Another challenge is balancing the need for transparency with concerns about confidentiality, especially regarding salary escalation and turnover assumptions. Companies must work with actuaries and auditors to ensure that disclosures meet the requirements of Ind AS 19 without compromising sensitive information.
Impact of Contribution Caps on Measurement and Disclosure
As discussed earlier, contribution caps imposed by government regulations do not alter the nature of gratuity as a defined benefit plan. However, they do affect how companies manage funding and disclose information.
Since contributions are limited, there is often a gap between the statutory obligation and the resources set aside. This gap is highlighted through actuarial valuation and must be disclosed transparently in the financial statements. Users of financial statements can then assess the extent to which the company is underfunded and the potential risks associated with meeting future obligations.
The disclosure of expected contributions in the next reporting period is particularly important for capped contribution schemes, as it shows how much funding will be available relative to the obligations.
Case Illustration: Capped Contribution Gratuity Plan
Consider a company that contributes up to 30 percent of base pay towards employee benefits as per government guidelines. At the end of the reporting period, the actuarial valuation shows a present value of gratuity obligations of 500 crore and plan assets of 350 crore.
The net defined benefit liability of 150 crore must be recognised in the balance sheet. In the profit and loss account, the company recognises service cost and net interest expense, while actuarial gains or losses are taken to other comprehensive income. Disclosures include the assumptions used in valuation, a reconciliation of obligations and assets, and information about the funding policy.
This example demonstrates how contribution caps do not restrict the liability recognised. The company remains responsible for the full obligation, and financial statements must reflect this reality.
Importance of Sensitivity Analysis
Ind AS 19 requires disclosure of sensitivity analysis for key actuarial assumptions. This is especially important for gratuity obligations, which are highly sensitive to discount rates and salary escalation rates.
For instance, a one percent decrease in the discount rate could increase the obligation by a significant amount, while a one percent increase in salary escalation could also lead to higher liabilities. By presenting these sensitivities, companies provide stakeholders with insights into the risks associated with estimation uncertainty.
Remeasurements and Their Volatility
Remeasurements of defined benefit obligations, comprising actuarial gains and losses, can introduce significant volatility into other comprehensive income. These arise due to changes in actuarial assumptions or differences between expected and actual experience, such as higher-than-expected salary increases or lower attrition rates.
Although remeasurements do not affect profit or loss, they directly impact equity. Companies must therefore monitor these movements closely and explain them in the notes to accounts. Over time, large remeasurements can have a material effect on the financial position of the company, even if they do not affect earnings directly.
Role of Governance in Managing Gratuity Obligations
Given the complexities involved in measuring and disclosing gratuity obligations, strong governance practices are essential. Companies should establish clear policies for working with actuaries, reviewing assumptions, and communicating results to stakeholders. Regular monitoring of funding levels and proactive management of plan assets can help mitigate risks associated with underfunding.
Governance also extends to disclosure practices, ensuring that financial statements provide clear, accurate, and transparent information about gratuity obligations. This enhances the credibility of financial reporting and builds trust with stakeholders.
Conclusion
The accounting for gratuity benefits under Ind AS 19 requires a clear understanding of the distinction between defined contribution and defined benefit plans. While contribution caps may initially create confusion, the core principle remains that an employer’s obligation is determined by the nature of the benefit promised to employees rather than the funding mechanism alone. Since gratuity entitlements under the Payment of Gratuity Act remain unaffected by caps on contributions, companies continue to carry the ultimate responsibility to settle the benefit in full, making such schemes defined benefit plans.
The measurement of gratuity obligations through actuarial valuation ensures that liabilities reflect future expectations rather than only present conditions. The projected unit credit method, reliance on critical actuarial assumptions, and recognition of remeasurements in other comprehensive income together provide a robust framework that aligns the financial statements with the economic reality of employee benefit obligations. By recognising service cost and net interest in profit or loss while isolating actuarial gains and losses in equity, Ind AS 19 strikes a balance between faithful representation and reduced earnings volatility.
Disclosures form an equally important part of compliance. By presenting detailed reconciliations, assumptions, sensitivity analyses, and funding arrangements, companies provide stakeholders with transparency into both the risks and the strategies adopted to manage gratuity obligations. This level of detail not only fulfils regulatory requirements but also enhances confidence among investors, employees, and regulators.
Ultimately, accounting for gratuity under Ind AS 19 goes beyond technical compliance. It reflects an organisation’s commitment to recognising the long-term value of its workforce, managing financial risk responsibly, and ensuring clarity in communication with stakeholders. When companies approach defined benefit obligations with discipline, strong governance, and transparent disclosure, they not only safeguard their financial position but also reinforce the trust that underpins sustainable business growth.