Compensated absence accounting
/What is a Compensated Absence?
A compensated absence is employee time off with pay, which can arise in such situations as sick leave, holidays, vacations, and jury duty. These absences routinely arise for employees, but not for contract workers - who are only paid for the hours they work. During these absences, employees receive their regular salary or wages despite not performing work. Businesses must account for the cost of these absences as liabilities on their financial statements when the entitlement is earned but not yet used.
How to Account for a Compensated Absence
To account for a compensated absence, it is not necessary to separately recognize the expense when it is earned and used within the same period, since it is typically rolled into the general compensation expense. However, it must be charged to expense and recorded as a liability when it is earned and its use is deferred to a later period.
An employer should accrue a liability for compensated absences payable to employees for their future absences, but only if all of the following conditions are met:
The payment obligation for future absences is based on employee services already rendered
The amount of the obligation can be reasonably estimated
Payment is probable
The obligation is for employee rights that vest or accumulate
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The Impact of Forfeitures on a Compensated Absence Liability
When calculating the amount of the accrual, you can factor in the amount of anticipated forfeitures. Also, you should record the accrual in the year in which employees earn the compensation. If the cost associated with an expected compensated absence is immaterial, as is typically the case with jury duty compensation, it is not necessary to accrue the expense in advance; instead, these costs are charged to expense as incurred, and should have no notable effect on the income statement.
When Not to Accrue for a Compensated Absence Liability
If a compensated absence has non-vesting rights and the rights expire at the end of the year in which they are earned, then you do not have to accrue a liability for future absences, since there may never be a related payout to an employee.
Examples of the Accounting for a Compensated Absence
Here are several examples of the accounting for compensated absences:
Vacation pay accrual. An employee earns two weeks of paid vacation annually, which can be carried over if unused. At the end of the year, the employee has one week of unused vacation. The company must recognize a liability for the unused vacation time. If the employee’s salary is $1,000 per week, the journal entry would be a debit to salaries expense for $1,000 and a credit to the vacation pay liability account for $1,000. This entry ensures that the cost of vacation time is recognized in the period when the employee earned it.
Sick leave without carryover. Employees receive 10 days of sick leave annually, but unused days cannot be carried over or paid out. An employee uses five days of sick leave during the year. No liability is recorded for unused sick days since they are not carried over. Sick leave taken is expensed as it occurs. Thus, the accounting treatment in this situation is to debit the salaries expense account for five days’ pay, and credit the cash or wages payable account for the same amount. This reflects the immediate cost of sick leave used without creating a liability for unused days.
Holiday pay accrual. A company pays employees for six public holidays each year. As of the balance sheet date, one holiday is approaching but has not yet occurred. A liability for holiday pay is accrued if employees have worked enough to qualify for the holiday benefit. For an employee earning $200 per day, the proper accounting treatment is to debit the salaries expense account for $200 and credit the holiday pay liability account for $200. This anticipates the cost of the upcoming paid holiday based on work already performed.
Military duty pay. A business pays its employees 50 percent of their normal compensation if they are called for active military duty, and for the entire period of their military service. However, if they are not called for duty, then the benefit expires. Since the right expires, the company should not accrue for this type of compensated absence.
Paid time off (PTO) bank with carryover. An employee accrues 15 days of PTO annually, which can be used for vacation, sick leave, or personal time and can be carried over. By year-end, the employee has five unused PTO days. The company records a liability for the unused PTO based on the employee's daily wage. If the daily wage is $150, the entry would be a debit to salaries expense for $750 (5 days x $150/day) and a credit to the PTO liability account for $750. This reflects the obligation to pay for the unused PTO in future periods.