I’m forcing myself to remember this part in all of the calculations, but the logic behind interest expense still isn’t making sense.
Is the rationale behind this that the employee is earning interest (equal to the discount rate) on contributions that the employer is making? So I guess the employer is trying to offset these interest expenses with investment returns of their own (which are hopefully greater than the discount rate)?
Can someone tell me if I’m on track here?
Thanks!
The interest expense is calculated using the discount rate multiplied by the Present Value of Liabilities.
I think the idea is that the PVDO is a discounted figure for a payment that will eventually be made at some point in the future.
For example, if you were to make 100 dollars payment next month, but lets assume the present value of this at 2% discount rate is 10 dollars.
10 dollars is what you record on your balance sheet as liability today, but this is not the ACTUAL cashflow to be made, your actual cashflow to be made is 100 dollars. the 10dollars is only a discount of your actual liability. Now this 10 dollars must grow by 2% in each period into the future till we eventually get to the future value of 100 dollars.
This amount of expense is recorded in each period to match the expense with the time in which the benefit is earned.
The term ‘interest’ expense is actually a bit misleading, because when you think interest you usually think fixed income.
All interest expense is, is the guaranteed rate of return you’re supposed to stand behind as the one offering the defined benefit to the employee. It basically means ‘You have to earn this rate of return on plan assets to meet your future promise. If you fall short you (the company) have to make good on that, and if you do better you can pocket the excess’.