Expert Advisory Committee
ICAI-Expert Advisory Committee
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1.16 Query:

Accounting for leave encashment benefits.

 

1. A company is engaged in textile business. During the audit, a question has been raised whether 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 applicable to the leave encashment scheme of the company. The company maintains that in view of the discussion and analysis of concept of leave encashment as a retirement benefit in AS 15, the scheme of leave encashment of the company is not a retirement benefit. The same has been explained hereunder by the querist:

           

(i)         An employee is entitled to privilege leave for thirty days every year.

 

(ii)        The employee is entitled to either enjoy the leave or encash maximum upto thirty days in a year. Unutilised leaves can be accumulated maximum up to 240 days.

 

(iii)       Upon termination/retirement the unutilised leaves will be paid as leave encashment in full.

 

2. The querist has informed that the company is of the view that leave encashment in this case is not a retirement benefit and as such AS 15 is not applicable to the company’s scheme. It is argued that primarily the scheme provides for availment of leave/encashment of leave every year while the employee is in service, subject to certain restrictions. It is only upon retirement/resignation that the employee is compensated for the accumulated leaves. As such, it is not a benefit to be given only upon retirement. In support of this argument, the company maintains that para 2 of AS 15 provides that the standard applies to retirement benefits in the form of leave encashment benefits, health and welfare schemes and other retirement benefits, if the predominant characteristics of these benefits are the same as those of provident fund, superannuation, pension or gratuity benefits that is if such retirement benefits are in the nature of either a defined contribution scheme or a defined benefit scheme as described in the statement (emphasis supplied by the querist). As the intention of the scheme is to provide the benefit of leave encashment any time during the service rather than as retirement benefit as defined in AS 15, the company is of the view that AS15 is not applicable for leave encashment scheme as it operates.

 

3. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

 

(i)         Whether the leave encashment benefit provided by the company is essentially in nature of a recurring annual benefit or it is a retirement benefit covered by AS 15.

 

(ii)        If it is not a retirement benefit then whether the liability should be treated as accruing every year for the leave entitlement of each employee for that year under accrual system of accounting. Hitherto, the company has been accounting leave encashment on payment basis only.

 

(iii)       Whether this liability should be treated as a contingent liability only as it cannot be said with certainty that the entitlement of leaves every year will be encashed in the subsequent years in view of (a) option of the employee to enjoy the leave rather than encash the same, and (b) a ceiling on the encashment and accumulation of leaves.

 

                                                                        Opinion                                         May 19, 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 further notes that ‘accrual’ is one of the fundamental accounting assumptions underlying the preparation and presentation of financial statements as per Accounting Standard (AS) 1 on ‘Disclosure of Accounting Policies’, issued by the Institute of Chartered Accountants of India. The term ‘accrual’ has been defined in the Standard as below:

 

“Revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate. (The considerations affecting the process of matching costs with revenues under the accrual assumption are not dealt with in this statement).”

 

3.  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 services 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.”

 

4. The Committee further notes that the Guidance Note on Accrual Basis of Accounting, issued by the Institute of Chartered Accountants of India, deals with ‘Authoritative pronouncement of the Institute vis-a-vis accrual accounting’. Para8.1 in this regard, inter alia, states as below:

 

“The Council of the ICAI and its various committees have issued various Guidance Notes, Statements and Accounting Standards. The accounting treatments contained in these documents are primarily based on accrual accounting. Thus, adoption of accounting treatments recommended in these documents would ensure that a company has followed accrual basis of accounting.”

 

5. In view of the above, the Committee notes that the principles of accounting for costs of Retirement Benefits laid down in Accounting Standard (AS) 15 on ‘Accounting for Retirement Benefits in the Financial Statements of Employers’, issued by the Institute of Chartered Accountants of India, are in consonance with the accrual basis of accounting, which is the requirement under the Companies Act, 1956. Accordingly, even though the benefits such as leave encashment benefits which are not exclusively payable at the time of retirement or superannuation but are also available during the tenure of employment of the concerned employee, the principles laid down in AS 15 would still be relevant in view of the accrual basis of accounting, in case the predominant features of the benefits are similar to those dealt with in AS 15.

 

6. On the basis of the facts of the query, the Committee notes that the right to avail/encash leave accrues on the basis of the time for which the services are rendered by the employees and that, normally, the amount of leave encashment is worked out on the basis of the salary (earnings) of the employee concerned. Accordingly, the Committee is of the view that the leave encashment benefit available to the employees of the company in question is of the nature of a Defined Benefits Scheme as defined in AS 15 as below since the benefit is determinable by reference to employee’s earnings and years of service:

 

“Defined benefit schemes are retirement benefits schemes under which amount to be paid as retirement benefits are determinable usually by reference to employee’s earnings and/or years of service.”

 

7. The Committee also notes para 12 of AS 15 as below:

 

“The cost of retirement benefits to an employer results from receiving services from the employees who are entitled to receive such benefits. Consequently, the cost of retirement benefits is accounted for in the period during which these services are rendered. Accounting for retirement benefits cost only when employees retire or receive benefit payments (i.e., as per pay-as-you-go method) does not achieve the objective of allocation of those costs to the periods in which the services were rendered.”

 

8. On the basis of the above, the Committee is of the view that even though the leave encashment benefit is not exclusively available on retirement of the concerned employee, but is available during the course of service, the provision in this regard should be made in the period in which the services are rendered by the employee keeping in view the accrual basis of accounting.

 

9. The Committee is further of the view that since as per the accrual basis of accounting leave encashment benefit is a real liability, it cannot be considered as a contingent liability.

 

10. On the basis of the above, the Committee is of the following opinion in respect of issues raised in para 3 of the query:

 

(i) and (ii) As per the accrual basis of accounting the leave encashment liability should be provided for in the year in which the services are rendered by the employees even though some leaves may be encashed during the tenure of employment and AS 15 may not be strictly applicable in respect thereof.

 

           (iii)            No.

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