Query No. 7

Subject:

Provision for provident fund liability on accrued encashable earned leave liability.¹

A. Facts of the Case

1. A wholly owned Government of India undertaking under the Department of Defence Production, Ministry of Defence, registered under the Companies Act, 1956, manufactures a wide range of products, like super alloys, titanium alloys, maraging steel, molybdenum, etc., for strategic sectors, like space, aeronautical, nuclear power, and for commercial sectors, like furnace, instrumentation, electronics, communications, petroleum, petrochemicals, fertilisers, etc. The company’s turnover (including excise duty, less returns) in the financial year 2005-06 was Rs.15,297 lakh.

2. As per the provisions of the company’s leave rules, all permanent employees are eligible for 2½ days of earned leave for every 30 days of service. The leaves thus earned by the employee can either be utilised or encashed, subject to the terms of the leave encashment rules. An employee is entitled to encash 50% of the leaves standing to his credit, subject to a minimum of 10 days, calculated on the basis of the last pay drawn as on the date of encashment. The leave encashment can be availed by an employee once in a financial year. (Copy of the company’s leave rules has been furnished by the querist for the perusal of the Committee.) With effect from 1-1-2005, the earned leave encashment was also reckoned as wages/salary for the purpose of provident fund contributions. (Copy of circular dated 9-5-2005 issued by the personnel department of the company has been furnished by the querist for the perusal of the Committee.)

3. The querist has stated that he has been informed by the company that the company was accounting for leave encashment, on cash basis up to the year 1994-95. From the year 1995-96, with a view to conform to the mandatory requirements of accounting for transactions on accrual basis, the company adopted accrual basis of accounting for leave encashment liability. The accounting policy which is now being followed for leave encashment is as under:

“Provision for leave encashment liability to employees is made on the basis of actuarial valuation as at the year end.”

Consequently, the provision for leave encashment liability as on the date of balance sheet is being provided on the basis of actuarial valuation, which, according to the querist, is in consonance with Accounting Standard (AS) 15.

4. As informed by the querist, the actual expenditure incurred on leave encashment/utilisation is debited to the profit and loss account during the year. The actual liability as at the end of the year is provided for/withdrawn based on the opening balance standing to the credit of leave encashment provision account.

5. A decision has been taken by the company with effect from 1-1-2005 that a matching contribution of 12% towards provident fund will be made on the leave encashed by the employee. This decision was taken based on the communication dated 29-4-2003 from Employees’ Provident fund Organisation that the leave encashment constitutes pay. Accordingly, the company has been making the matching contribution of 12% towards provident fund as and when leave is encashed by the employee. The querist has been informed that this is being followed in other defence public sector undertakings also.

6. At the end of every year, the company provides information to the actuary giving details of name of the employee, employee’s staff number, date of birth, date of joining, salary particulars (basic plus dearness allowance), and earned leave to the credit of employee as on 31st March, to enable calculation of actuarial value of the accrued encashable leave salary liability. As on 31-03-06, an amount of Rs. 510.76 lakh was provided towards accrued liability on leave encashment. This represents the provision made for leave encashment liability to the employees on the basis of actuarial valuation as at the year-end and does not include the provident fund contribution of the employer.

7. The querist has informed that the government auditors, while auditing the accounts for the year 2005-06, have commented that there is an understatement of liabilities to the extent of Rs. 61 lakh as on 31-3-2006, due to non-provision of employer’s liability at 12% towards contribution to provident fund on the accrued leave liability of Rs. 510.76 lakh as on 31-3-2006, keeping in view the fundamental principle of accrual basis of accounting.

8. According to the querist, the liability on account of employer’s provident fund contribution on the accrued leave encashment liability does not arise on account of the following:

(a) In terms of accounting policy of the company, liability towards leave encashment to the employees is made on the basis of actuarial valuation, which is in consonance with AS 15.

 

(b) The company’s contribution towards provident fund on leave encashment is in the nature of ‘matching contribution’.

 

(c) The definition of ‘matching contribution’ as extracted by the querist from a website is “the amount, if any, a company contributes on an employee’s behalf to the employee’s retirement account usually tied to the employee’s own contribution”. This establishes the fact that the liability of the company would devolve only at the time of encashment of leave by the employee and is tied to his contribution to provident fund on such leave encashment. (Emphasis supplied by the querist.)

 

(d) The amount on account of provident fund, if brought into books, cannot be retained and the individual provident fund accounts of the employees cannot be credited with the employer’s share only as there is no matching employee contribution.

B. Query

9. Keeping in view the above, the querist has sought the opinion of the Expert Advisory Committee as to whether provision is required to be made towards employer’s provident fund liability on the accrued leave liability as at the year-end.

C. Points considered by the Committee

10. The Committee, while expressing its opinion, has considered only the issue raised in paragraph 9 above and has not touched upon any other issue arising from the Facts of the Case. The Committee has also not examined as to whether the provident fund benefit is a defined benefit plan or a defined contribution plan as the required information is not available in the Facts of the Case. Further, the Committee notes that the querist has not stated as to whether AS 15 mentioned in the Facts of the Case refers to AS 15 (1995), ‘Accounting for Retirement Benefits in the Financial Statements of Employers’ or AS 15 (revised 2005), ‘Employee Benefits’. However, these matters do not affect the determination of issue as to whether provision is to be created towards provident fund contribution on the accrued leave liability.

11. The Committee notes that with effect from 1-1-2005, the company has decided that earned leave encashment is also to be reckoned as wages/salary for the purpose of provident fund contributions of both, employees and employer. This is as per the circular dated 9-5-2005 issued by the personnel department of the company.

12. The Committee is of the view that accrual being one of the fundamental accounting assumptions, the cost of providing benefits to employees in return for the services rendered by them in an accounting period should be accounted for in that period. The underlying principles of AS 15 (1995) as well as AS 15 (revised 2005) are based on the aforesaid principle. AS 15 recognises that a liability towards employee benefits should be provided as and when the services are rendered.

13. The Committee is of the view that though the ‘matching contribution’ of 12% towards employer’s contribution to provident fund on leave encashment is paid to the relevant trust or a similar entity only on actual leave encashment, it accrues as and when the underlying liability towards leave encashment accrues. Accordingly, the provision for provident fund contribution should include provident fund contribution in respect of accrued leave liability.

14. The Committee is of the view that mere creation of a provision on accounting considerations does not necessarily mean that the individual provident fund account of the employees should be credited. Credit to individual provident fund account of the employees is based on the terms and conditions of the Provident Fund Scheme.

15. The Committee notes that as regards quantum of provident fund contribution to be provided on accrued leave liability, depending upon whether the provident fund benefit is a defined benefit plan or a defined contribution plan, the relevant measurement rules of AS 15 will apply.

D. Opinion

16. On the basis of the above, the Committee is of the opinion that provision is required to be made towards estimated employer’s contribution to provident fund on the accrued leave liability as at the year-end.


1 Opinion finalised by the Committee on 14.5.2007.