Working and living under COVID-19 restrictions, many employees have deferred vacation and sick days until restrictions are likely to be lifted, resulting in perhaps the greatest buildup of liabilities for compensated absences that we have ever seen.
Accountants and auditors this year need to take special care in computing, disclosing, and auditing liabilities for compensated absences. Furthermore, managers and the people who advise them must begin to think about the financial and operational costs of redeeming these liabilities.
Defining compensated absences
As they work, most employees earn the right to take days off for a variety of reasons, including vacation, illness, personal care, and family time. Employers’ policies may provide for accumulated rights that carry forward to future periods if they are not used in the current period. They may also provide for vested rights that create an obligation to pay for compensated absences even after terminating employment. Companies should take care that their policies are consistent with state and local regulations. Furthermore, companies with operations outside the United States must be mindful to follow the laws of the countries where their employees work.
FASB has labeled these days off as compensated absences. U.S. GAAP requires accruing a liability for the cost of these future absences when all the following conditions exist:
- The employer’s obligation to pay for future absences arises from employees’ services already rendered;
- The obligation relates to rights that vest or accumulate;
- Payment of compensation is probable; and
- The amount to be paid can be reasonably estimated (FASB ASC Paragraph 710-10-25-1).
This definition makes clear that a company with a “use it or lose it” policy for vacation or sick pay would not need to accrue a liability because their employees’ sick and vacation days do not vest or accumulate.
Entities do not necessarily account for vacation days in the same way as sick days; it is possible for a company to grant vesting rights for vacation days but not even accumulated rights for sick days. Sick days would only be accrued if a company permits employees to bank these days and use them as compensated absences when they are not feeling ill, i.e., they accumulate or vest.
The accrual for compensated absences should take into account the substance of the employer’s vacation and sick policies, rather than their form. When an employer’s past practices indicate that employees receive compensated absences above and beyond their legal rights and posted policies, the liability for compensated absences should encompass all reasonably estimable compensation likely to be paid, and not just those compensated absences that employees are legally entitled to.
Accruing for compensated absences
Accountants would best take a balance sheet approach toward accruing compensated absences, estimating the period-end liability and then adjusting the expense accordingly. To prepare an accrual, the accountant should multiply the current pay for each employee by the number of outstanding accumulated and vested absences at the end of the period. Exhibit 1 shows a practical spreadsheet layout for an entity with four employees, listing each employee in a separate row and populating columns for the number of outstanding sick days, the number of outstanding vacation days, and the current pay per day.
For hourly workers, the current pay per day would be computed as the hourly compensation rate on the date of accrual multiplied by the total number of hours to be compensated for one day. The hourly compensation rate should include the related cost of fringe benefits and employer taxes earned. For salaried workers who are paid by the year, divide the annual salary, including the cost of fringe benefits and employer taxes, by the average number of days worked each year.
FASB standards do not prescribe a rate for accruing compensated absences. Accountants can choose between the current rate or the likely compensation rate when the employee will redeem the vacation days, discounted to present value. For the sake of verifiability, many accountants use the current rate.
To compute the accrual for each employee, multiply the total number of days by the pay per day, as shown in Exhibit 1.