The Statement of Financial Accounting Standards, SFAS No. 43 entitled “Accounting for Compensated Absences provides guidence on how to record accruals and conditions that must be met.

Compensated absences mean employees’ absences for which they will be paid. Examples are: vacation or Personal Time Off (PTO), holidays and illness.An expense is recognized for such payments in the period when the employee provided services that entitled him or her to be compensated. A liability arises when employee did not use all of such compensated absences. In this case a liability is accrued for the unused portion.

If all the following conditions are met, a liability for compensated absences is accrued:

a. Services already rendered by employees
b. Employees have to have rights that vest or accumulate. Vested rights are no contingent on an employee future service and should be paid when an employee leaves his or her employment. Accumulate refers to earned but unused rights that are carried over to future periods.
c. Payment is probable and the amount can be reasonably estimated.

For example, Meicor, LLC estimates that at the end of the year 2009 its employees have earned vacation pay of $110,000 and its employees will receive their vacation pay in 2010. Meicor, LLC must accrue a liability for employees’ rights to receive vacation pay benefits if the conditions above identified in SFAS 43 are met. According to this example, the conditions are met:

a. The obligation is attributable to employees’ services already rendered.
b. Meicor LLC employees’ are vested and can accumulate their vacation as stipulated in the company’s handbook.
c. Payment of the compensation is probable and the amount is reasonably estimated as employees have earned vacation pay of $110,000 that will be paid during the year 2010.

The substance of the employer’s sick leave policy takes precedence over its form. Note that an employer generally is not require to accrue a liability for no-vesting accumulating rights to receive sick pay benefits. Future compensation for sick leave is accrued if employees customarily are allowed compensated absences for accumulated, non-vesting sick leave days, even though employees are not actually absent as a result of illness.

The entry to record the compensated absence of $110,000 is:

Wages Expense $110,000(dr)
Vacation Payable $110,000(cr)
To record earned vacation at the end of 2009.

If in February 2010 Albert Leroy took vacation for $4,000, out of which $3,500 were accrued as of 12/312009, the entry is:

Wages Expense 500(dr)
Vacation Payable 3,500(dr)
Cash $4,000(cr)
To record payment at current rates of previously earned vacation time.

Forensic accountants look closely to these types of transactions as unscrupulous individuals commit fraud by reducing expenses related to compensated absences to help companies meet earnings targets and fraudulently fail to disclose in their financial statements the changes in accounting for compensated absences.