When a company hires employees, they provide it with services. In turn, the company, as their employer, reimburses their time spent with a remuneration package.
This usually consists mostly of a salary but can include various other benefits, some of which may be mandated by law or local legislation. One of those benefits is the annual paid vacation.
IAS 19 Employee Benefits
IAS 19 provides guidance on the matter of accounting treatment for such benefits. It requires that we match the expense for employee benefits to the period where they earned the entitlements.
The standard stipulates the entity has to recognize an expense whenever the employee provides services in exchange for employee compensation. Companies also have to record a liability if they pay the benefits in the future. Keep in mind that, for this article, I will use liability, obligation, and provision interchangeably.
IAS 19 provides much information on the matter of recognizing a vacation accrual. However, it does not state whether we should use the personnel’s current salaries or adjust the calculation for expected future salary increases. When working on our model, it’s a great idea to discuss such specifics with our external auditors.
Booking the obligation in our accounting records is straight-forward:
Presentation and Disclosures
Some professionals believe the unused paid leave liability should be treated as accrual and presented as part of Trade and other payables in the company’s balance sheet. Others follow the definition for a provision and believe we should show the UPL as such since it’s of uncertain timing and amount.
Then we will follow the disclosure and presentation requirements of IAS 37 Provisions, Contingent Liabilities, and Contingent Assets. To remain consistent with other provisions, we will include the following two items in our financial statements:
- A reconciliation between the opening and closing balance of the vacation obligation;
- Description of its nature and expected time of settlement.
If a company offers paid leave to its employees, it must have a policy about what happens with unused days at the end of the year. Commonly, employers will roll these forward for one more year. However, some legislations allow businesses to adopt a policy that employees forfeit unused days.
For unused days rolled forward to the next period, the company must recognize an expense in the current period against liability for unused paid leave.
Keep in mind, the policies of companies are usually subject to local labor legislation.
We need to consider some exceptional circumstances that may arise. One such typical case is when employees work on a project that meets a qualifying asset’s requirements. The company has to recognize compensation for their services as an asset following IAS 23 Borrowing Costs.
Unused Paid Leave Accrual
Companies that provide a paid vacation benefit to their employees might have to recognize a vacation accrual (unused paid leave accrual).
The Unused Paid Leave Accrual represents the days the employee has already worked for but not taken yet. It’s a liability for the business.
To do so, the entitlement has to meet specific requirements.
- Employees didn’t use their compensated absence time during the period when they earned it;
- Vacation time is rolled forward to the next period and not forfeit at year-end
- If employees leave the company, they receive compensation for their unused paid leave
- We can reasonably estimate the vacation obligation
We can record the liability on every new pay period or some other basis. Most companies elect to calculate and recognize the unused paid leave liability once per annum as part of their year-end close process. This choice has to do with the calculation being time-consuming, and often the result is immaterial.
Some legislations allow employees to roll forward only a limited number of vacation days. If you end up with fifteen days of unused paid leave at year-end, and the company only allows you to roll forward ten days, then you will have to forfeit the other five. This effectively results in a smaller UPL liability as of year-end.
Each company has its vacation accrual policy. These depend highly on the applicable accounting standards and the local labor laws and legislation.
It is crucial to remember that the vacation liability should only include compensated absences that employees can carry forward into the next period.
When we estimate the accrual for unused paid leave, we have also to consider whether it is a vesting or non-vesting obligation.
The paid leave liability will be vesting if employees are entitled to a payout should they leave the company. On the other hand, a non-vesting vacation obligation is when the entity doesn’t have to compensate the employee when they leave. If this is the case, we have to adjust our calculation with our personnel’s expected future turnover rate.
The formula we can use to calculate the Unused Paid Leave provision is quite simple:
If we have an employee with monthly compensation of €4,200 and 5 days of unused vacation left at year-end, then his UPL will be:
We base the calculation on the assumption that the average working days per month are 21.
And if someone gets an increase in their compensation, we have to recalculate their vacation provision. If they were to leave, the company must pay them the unused paid leave at their latest salary level.
Unused Paid Leave Analysis
On an annual basis, the entity’s accounting department reviews the vacation accrual by benchmarking it to prior periods. They would also check the liability for accuracy and completeness and perform reasonability tests.
It is critical to follow-up on leaves review and ensures no employees are piling up a significant number of unused paid leave days. If they leave the company and we have to pay their unused vacation, this can turn into a cash outflow the business can’t handle.
Accumulating vacation days also means the employee is not resting enough, which can have a highly adverse effect on their performance.
Most payroll modules in ERP’s offer the functionality to track unused paid leaves. This allows us to look into potential future payouts and improves our cash flow management.
Unused Paid Leave Calculation Example
In practice, a paid leave accrual calculation would start with obtaining a list of all employees, their gross salaries, and their balance of vacation days.
Keep in mind that in a setting where employees often get bonuses or their compensation is performance-based, we might need to adjust the gross salary to reflect the average premium we expect them to receive per month in the next period.
We also have planned salary growth percentages per department.
We will also incorporate some assumptions in our model. To calculate the UPL accrual, we need the average workdays per month and the social security percentage. Also, in some countries, there can be a lower or upper bracket for taxable income. In the current legislation, we have an upper limit of €4,000.
We can start by applying the salary growth percentages to the data we have, as we expect to settle the unused paid leave in the future at the increased compensation level.
To calculate the salary provision, we would apply a simple proration formula. The gross salary, divided by the average workdays and multiplied by the unused vacation days, will give us the vacation accrual for each employee.
The other thing we need to consider is the social securities on behalf of the employer. In the current legislation, these amount to about 25% of the gross salary. However, we need to consider that once an employee starts receiving above the upper limit for taxable income, securities are only due up to this limit. We can use the IF formula first to determine whether we should use the gross salary or the upper limit, and then we apply the social security percentage and prorate.
Once we calculate the total, we can summarize the provision changes, which we need for the annual financial statements. We start with the vacation accrual’s opening balance, deduct the amount we realized over the year, and add the newly recognized provision. This way, we arrive at the closing balance to be presented in the balance sheet.
Employees are entitled to various benefits as part of their compensation package, depending on what company they work in and the legal environment this company operates in. When a company provides compensated leave to its workers, it has to match the corresponding expenses to the same period when employees earned their vacation.
At least once a year, the entity’s accounting department should review the accumulated unused vacation and prepare the unused paid leave calculation.
It is essential to keep track of the vacation days of employees and perform the analysis regularly. If our workers start piling up too many vacation days, this may turn into a severe cash flow issue for the company.
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FCCA, FMVA, Co-founder of Magnimetrics
Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.
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The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics accepts no responsibility for any damages or losses sustained in the result of using the information presented in the publication.