With the holidays and flu season just around the corner, many employees will be taking time off from their jobs for both vacations and illnesses. Business owners will need to be aware of the rules surrounding accrual, recognition, and measurement of these absences.
Generally Accepted Accounting Principles (GAAP) refers to payments for employee absences, such as vacation, illness, and holidays, for which it is expected that employees will be paid, as Compensated Balances.
This article will help address how an employer should account for its obligation to compensate employees for future absences, such as vacation, sick days, holidays, sabbatical leave, and similar paid time off.
When to Accrue?
Employer must accrue a liability/compensation expense for these absences if certain conditions are satisfied:
- Employer’s obligation to provide compensation for future absences results from the employees’ past services
- Employees’ rights to paid absences either vest or accumulate
- Employer’s payment of the compensation is probable
- Employer can reasonably estimate the amount of its obligation
Absences vest when the employer has an obligation to make payment to the employee even if employment is terminated, an example is PTO being paid out when an employee leaves. Separately, absences are said to accumulate when used rights can carry forward to another period. An example would be if PTO is not paid out upon termination, but at year-end unused PTO can carry forward to be used in the following year.
It may be that conditions 1-3 above are met, but the employer cannot estimate the obligation as required by step 4. If that is the case, a disclosure is required.
Recognition and Measurement:
Some items to consider when it comes to recognition and measurement of the accrual:
- The expense and related liability for compensated absences should be recognized in the period in which it is earned by the employees.
- Forfeitures should be considered when determining the accrual amount.
- The liability for compensated absences generally is accrued using current salary rates, and the accrual is adjusted when the rates change.
- If an employee is allowed to carry compensated absences forward for multiple years, the employer should consider discounting the liability to present value.
Sabbatical Leave:
GAAP defines Sabbatical Leave as a benefit in the form of a compensated absence whereby the employee is entitled to paid time off after working for an entity for a specified period of time. During the sabbatical, the individual continues to be a compensated employee and isn’t required to perform any duties for the entity.
The employer must accrue a liability for sabbatical leave if:
- Employee’s leave is unrestricted in nature and represents compensation for prior services.
- Other conditions for the accrual of a liability are satisfied.
For example, if the purpose of the sabbatical is to perform research or conduct other work for the employer, and is not based on the employee’s past service, an accrual would not be made. Additionally, no accrual is necessary if the leave or sabbatical is unpaid.
The employer must accrue compensation costs related to the sabbatical leave or over the required service period. If an employee’s right to a sabbatical or similar benefit arrangement is earned after a minimum service period (and the benefit remains the same and does not increase with additional years of service), the compensation cost should be accrued over the entire required service period.
Sick Pay:
GAAP makes an exception from the general rules of compensated absences above for sick pay.
- If sick pay benefits vest (are paid out after termination), accrual is required.
- If sick pay benefits accumulate (can be carried forward) but do not vest, accrual is permitted (if all other conditions of an accrual are met) but not mandatory.
The reason GAAP has this distinction and allows for accumulated sick pay amounts to be excluded from the accrual requirement is due to the fact that the payment of accumulated sick pay benefits is contingent upon future employees’ illnesses.
Tax Effect to Consider
It may be the case that an employer has to recognize compensated absences through an accrual as an expense for financial reporting purposes, but is not able to recognize the expense on their tax return for the same time period, which can result in a deferred tax asset.
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If you are looking for further GAAP guidance on Compensated Absences, FASB ASC provides guidance regarding employee compensation in the following 4 topics:
- FASB ASC 710, Compensation – General
- FASB ASC 712, Compensation – Nonretirement Postemployment Benefits
- FASB ASC 715, Compensation – Retirement Benefits
- FASB ASC 718, Compensation – Stock Compensation
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Please contact us with any questions you may have regarding compensated absences. We are available to discuss and help you determine how to properly account for these situations.