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What are Compensated Absences?

After a full year of COVID-19 related restrictions, many employees have deferred the usage of their vacation and sick days.  Because companies must account for the possibility of these hours being used in the future, it is likely that the compensated absences liability will be substantially larger for 2020 than in previous years.  Compensated absences is the term that means the accumulated rights that an employee has earned in employment that can be carried forward to a future period for use.  Compensated absences also include the vested rights of a previous employee who has terminated employment but earned the days prior to the end of employment.  Generally Accepted Accounting Principles (GAAP) require employers to accrue a liability for the cost of future absences that employees have earned the right to take prior to year-end.

Generally Accepted Accounting Principles (GAAP) requires an accrual for compensated absences liability if the following conditions are all met:

• The employer’s obligation to pay for future absences arises from previously-rendered employee services.
• The employer’s obligation related to rights that accumulate or vest.
• The payment of the compensation is probable.
• The amount of the compensation to be paid can be reasonably estimated.

Company policy determines how employees earn and vest their vacation and sick days.  However, the policies must be consistent with state and federal regulations.  Additionally, employers do not have to apply the same accumulation policy to both vacation and sick leave.  Many employers allow for the accumulation and vesting of vacation days but do not offer the same policy for sick days.  Some companies may allow employees to accumulate sick days and use them as vacation days which would require them to be included in the accrual.  Also, employers could follow a ‘use it or lose it’ policy which means that an employee could not vest or accumulate any time off and there would be no need for a liability to be accrued.  

The basic accrual calculation is to multiply an employee’s current pay per day by the number of unused accumulated and vested absences at the end of the period.  For hourly employee calculations, the hourly rate on the date of the accrual calculation should be used.  For salaried employees, the annual salary should be divided by the average number of days worked to get a daily pay rate.  For both hourly and salary calculations, the cost of fringe benefits and employer taxes should be included in the accrual.  The liability to be recorded can be discounted based on an estimate of the likelihood of rights being forfeited.  This estimate can be based on historical data or another type of projection.  

The journal entry to record the compensated absence liability would first adjust the payable account depending on the balance from the previous period.  The other side of the entry would be recorded to the salaries or wages expense account.

On the financial statements, the compensated absences liability must be recorded on its own line under current liabilities if it is material.  If the amount cannot be reasonably estimated then this fact must be disclosed in the notes to the financial statements.