1.28 Query: Accounting of encashment of earned leave salary.
1. A leading engineering industrial unit is engaged in the manufacture of earthmoving equipment for supply to various core sectors of the economy. The manufacturing operations are carried at various factory units located in Karnataka State at Kolar Gold Fields, Mysore and Bangalore. Each factory unit is independent for its manufacturing activity and has its own functional departments like factory management and administration including factory personnel, administration and accounts. The overall policy making, superintendence and control is provided by Corporate Office situated at Bangalore where the top management team comprising the chairman, functional directors and the central marketing set-up, corporate personnel and administration, accounts department etc., are located.
2. The querist has stated that Accounting Standard (AS) 15 on ‘Accounting for Retirement Benefits in the Financial Statements of Employers’, issued by the Institute of Chartered Accountants of India, has become mandatory w.e.f. 1.4.1995. According to this standard, ‘leave encashment benefit on retirement’ is considered as one of the retirement benefits. It is a ‘Defined Benefit Scheme’ under which amounts to be paid as retirement benefits are determinable usually by reference to employee’s earnings and/or years of service. Such a liability to be charged to profit and loss account should be actuarially valued or should be estimated by the company.
3. The querist has stated that while auditing the accounts for the financial year ended 31.3.1996, the government auditors were of the view that the company should provide for leave encashment liability after getting it actuarially valued. The company stated that the mandatory accounting standard is not applicable and therefore the question of provision for the same does not arise. In this background, the querist has stated herebelow the facts and procedure followed regarding the leave liability.
4. The employees of the company are classified into 2 categories – one covered by the ESI Scheme, generally known as ‘Staff’ and the other not covered by ESI Scheme, known as ‘Officers’. One of the different kinds of leave provided by the company is earned leave or vacation leave, depending upon the entitlement of the employees. Earned leave is availed off by the officers and vacation leave by the staff. Entitlement of earned/vacation leave is at the rate of 2½ days per month in the case of officers and 1½ days per month in the case of staff. Therefore, the entitlement for officers would be 30 days per year while it is 18 days for staff. Earned leave can be accumulated upto 240 days for officers and 126 days for staff. Encashment is permissible not only during service every year but also at the time of cessation of employment, subject to the ceilings referred to above. According to the querist, in view of such encashment facility no employee would allow any portion of his leave to lapse and the tendency is more for encashment during the service period than for availment of leave and encashment at the time of retirement. Generally, it is found that higher pay segment tends to encash at the time of retirement as the same is exempt from Income-tax.
5. Upto and including the financial year 1993-94, the company debited its profit and loss account with the equivalent amount of earned leave/vacation leave lying at the credit of each of the employee’s account on 31st March. The said sum is arrived at based on the pay comprising basic pay and D. A., drawn by each employee, divided by 26 days.
6. The querist has stated that the Karnataka High Court in the company’s own case (reported in 211 ITR), held that expenditure in respect of earned leave/vacation leave encashment is nothing but a contingent liability arising out of the events, i.e., the employee is choosing the mode of utilisation of leave by way of actual going on leave or preferring the claim for encashment.
7. For and from financial year 1994-95, the company changed its accounting policy of providing accrued leave liability in the accounts as below:
‘Leave salary claimed/encashed in the year is treated as part of employees’ remuneration and benefits’.
However, the company chose to retain the liability in this regard upto 31.3.1994, in the accounts under the head ‘current liability’ and also disclosed this position in the accounts.
8. During financial year 1995-96, as already stated above, the government auditors insisted upon the actuarial valuation and providing the liability. The company pleaded that the Accounting Standard (AS) 15 on ‘Accounting for Retirement Benefits in the Financial Statements of Employers’, issued by the Institute of Chartered Accountants of India, is not applicable as the leave encashment benefits at the time of retirement cannot be reasonably estimated and such liability does not bear the predominant characteristics of provident fund, superannuation and gratuity benefits. As stated by the querist, it is also submitted to the C&AG that the spirit behind AS 15 insisting for an actuarial valuation was basically to fund separately for meeting the liability. Perhaps this principle is hidden in AS 15. Without observing this principle by merely providing liability for the sake of books, no useful purpose would be achieved other than ad hoc in nature.
9. Finally the Government Auditors agreed for a ‘note’ to the accounts as indicated below.
“1. Contingent Liability
(Rs. in lakhs)
1995-96 1994-95
The company is contingently liable for Accrued Leave 500.81 235.10
Explanatory note:
Adhoc provision for accrued leave to employees provided upto 31.3.94 is retained. The requirement of AS-15 “Accounting for Retirement Benefits in the Financial Statements of Employers” with regard to leave encashment benefits at the time of retirement is not applicable as the obligation cannot be reasonably estimated and not bearing predominant characteristics of provident fund, superannuation or gratuity benefits besides being contingent in nature. The liability accounted on claim basis is considered adequate.”
10. The opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India is sought on the following issues:
(i) Whether the leave encashment on retirement is a retirement benefit at all, when all the essential characteristics of provident fund, gratuity and superannuation fund are non-existent and particularly when the benefit of encashment is available while in service also.
(ii) Whether Accounting Standard (AS) 15, on ‘Retirement Benefits in the Financial Statements of Employers’ needs modification in the context of Karnataka High Court’s finding that it is a contingent liability.
(iii) Whether the present accounting policy and disclosure made by the company is adequate to comply with the accounting standard.
Opinion January 15, 1997
1.The Committee notes sub-section (3) of section 209 of the Companies Act, 1956, which is reproduced below.
“(3) For the purposes of sub-section (1) and (2) proper books of account shall not be deemed to be kept with respect to the matters specified therein
(a) ………
(b) If such books are not kept on accrual basis and according to the double entry system of accounting.”
2. The Committee also notes paragraph 1.09 of the ‘Guidance Note on Terms Used in Financial Statements’, issued by the Institute of Chartered Accountants of India, which is reproduced below.
“1.09 Accrued liability
A developing but not yet enforceable claim by another person which accumulates with the passage of time or the receipt of service or otherwise. It may arise from the purchase of services (including the use of money) which at the date of accounting have been only partly performed and are not yet billable.”
3. Based on the above, the Committee is of the view that since the employer’s obligation relating to employees’ right to receive compensation for earned leave is attributable to employees’ services already rendered, the employer should accrue the liability in respect thereof in the period in which the services are rendered. As no contingency is involved, it is an actual liability. The Committee is, therefore, of the view that the liability for leave encashment should be accrued whether it is encashable during the tenure of the service or at the time of retirement or death.
4. The Committee notes that although the querist has stated that the leave encashment in the particular case of the company does not fall in the categories specified in the definition of the ‘Defined Benefit Scheme’ as per para 3 or Accounting Standard (AS) 15 on ‘Accounting for Retirement Benefits in the Financial Statements of Employers’, he has not provided complete details of the scheme. However, the querist has mentioned, as per para 5 of the query, that up to the year 1993-94, the profit and loss account was being debited with the amount of accrued leave encashment benefit arrived at on the basis of the earnings of the employees. Thus, it is obvious that the leave is encashed on the basis of the earnings of the employees at the time of retirement/death of the employee. Accordingly, despite the fact that the leave can also be encashed during service apart from it being encashed at the time of retirement, it can be considered to be predominantly of the nature of a retirement benefit scheme stipulated in the definition of ‘Defined Benefit Schemes’ as par para 3 of AS 15, reproduced below:
“Defined benefit schemesare retirement benefit schemes under which the amounts to be paid as retirement benefits are determined usually by reference to employee’s earnings and/or years of service.”
5.The Committee also notes that AS 15 has discussed the objectives of funding for the retirement benefits cost and accounting thereof. Para 15 of AS 15 states that “….the objective of accounting for the cost of a retirement benefit scheme is to ensure that the cost of benefits is allocated to accounting periods on a systematic basis related to the receipt of the employees’ services.” Thus, the methods of accounting prescribed in the standard based on the accrual basis of accounting do not imply that funding is their inherent objective.
6. The amount of liability to be accrued in respect of leave encashment should be estimated on rational basis keeping in view factors like past experience about the benefit actually availed of, possibility of availing the past leave in future etc.
7. Based on the above, the following is the opinion of the Committee on the issues raised by the querist in para 10 of the query:
(i) Leave encashment liability, whether to be discharged during the course of employment or on retirement or death, should be accrued in the period in which the relevant service is rendered by the employees as per the accrual basis of accounting prescribed in section 209(3) of the Companies Act, 1956, and AS 15.
(ii) AS 15 on ‘Accounting for Retirement Benefits in the Financial Statements of Employers’, is basically for the purposes of accounting for the costs of a retirement benefits to ensure that the accounts give a true and fair view as per the provisions of the Companies Act, 1956. The Committee is, therefore, of the view that the decision given by the court for taxation purposes does not necessitate a modification in the accounting standard.
(iii) The accounting policy and disclosures made by the company do not meet the requirements stated in (i) and (ii) above. ________________________________ |