Hi. Was hoping someone could help understand the following …
Interest cost - "Increase in PBO associated with the passage of time during the year. This is generally the discount rate multiplied by the beginning of year PBO adjusted for current year expected benefit payments. "
I thought the future benefit is calculated via formula, and then the passage of time was simply captured through PV’ing this (aka current service cost). Would anyone mind explaining in dumb terms what does Interest Cost represents?
Thanks
Employees earn benefits today, but those benefits aren’t paid to them for 10, 20, 30 years. Each year that goes by that they don’t get paid their money, they earn interest on their account. If you owe me money today, but you don’t pay me that money for 30 years, you can bet that I’m going to expect you to pay me interest on it.
The interest expense undoes the discounting.
The alternative, I suppose, would be to record the undiscounted liability, which would not make any sense, and would make pensions look even more underfunded than they already do.