Accounting: The Language of Business (Part 71)

The liabilities are always 100 percent good. It's the assets you have to worry about.

Charlie Munger

 Current Liabilities (Part F)

by

Charles Lamson

Employees' Fringe Benefits

Many companies provide their employees a variety of benefits in addition to salary and wages earned. Such fringe benefits may take many forms, including vacations, medical, and post retirement benefits, such as pension plans.

When the employer pays part or all of the cost of the fringe benefits, these costs must be recognized as expenses. To properly match revenues and expenses, the estimated cost of these benefits should be recorded as an expense during the period in which the employee earns the benefit, as will be illustrated in the next section for vacation pay.

Vacation Pay

Most employers grant vacation rights, sometimes called compensated absences, to their employees. Such rights give rise to a recordable contingent liability (A contingent liability is recorded if the contingency is likely and the amount of the liability can be reasonably estimated.) The liability for employee's vacation pay should be accrued as a liability as the vacation rights are earned. The entry to accrue vacation pay may be recorded in total at the end of each fiscal year, or it may be recorded at the end of each pay period. To illustrate this latter case, assume that employees earn one day of vacation for each month worked during the year. Assume also that the estimated vacation pay for the payroll period ending May 5 is $2,000. The entry to record the accrued vacation pay for this pay period is shown as follows.

If employees are required to take all their vacation time within one year, the vacation pay payable is reported on the balance sheet as a current liability. If employees are allowed to accumulate their vacation time, the estimated vacation pay liability that is applicable to time that will not be taken within one year is a long-term liability.

When payroll is prepared for the period in which employees have taken vacations, the vacation pay payable is reduced. The entry debits Vacation Pay Payable and credits Salaries Payable and the other related accounts for taxes and withholdings.

Pensions

A pension represents a cash payment to retired employees. Rights to pension payments are earned by employees during their working years, based on the pension plan established by the employer. One of the fundamental characteristics of such a plan is whether it is a defined contribution plan or a defined benefit plan.

Defined Contribution Plan

In a defined contribution plan, a fixed amount of money is invested on the employee's behalf during the employee's working years. It is common for the employee and employer to make contributions. There is no promise of future pension benefits payments. The amount of the final pension depends on the total contributions and investment returns earned on those contributions over the employee's working years. The employee bears the investment risk under defined contribution plans.

One of the more popular defined-contribution plans is the 401K plan. Under that plan, employees may contribute a limited part of their income to investments, such as mutual funds. A 401K plan offers employees two advantages: (1) the contribution is deducted, before taxes, from current period income, and (2) the contributions and future investment earnings are tax deferred until withdrawn at retirement.

The employer's cost of a defined contribution plan is debited to Pension Expense. To illustrate, assume that the pension plan of Heaven Scent Perfumes, Inc., requires an employer contribution of 10% of employee monthly salaries, paid at the end of the month to the employee's plan administrators. The journal entry to record the transaction, assuming $500,000 of monthly salaries, is as follows:

Defined Benefit Plan

Employers may choose to promise employees a fixed annual pension benefit at retirement, based on years of service and compensation levels. An example would be a promise to pay an annual pension based on a formula, such as the following:

1.5% X years of service X average salary for most recent 3 years prior to retirement

Pension benefits based on a formula are termed a defined benefit plan. Unlike a defined contribution plan, the employer bears the investment risk in funding a future retirement income benefit. As a result, many companies are replacing their defined benefit plans with defined-contribution plans.

The accounting for defined benefit plans is usually very complex due to the uncertainties of projecting future pension obligations. These obligations depend upon such factors as employee life expectancies, employee turnover, expected employee compensation levels, and investment income on pension contributions.

The pension cost of a defined benefit plan is debited to Pension Expense. The amount funded is credited to Cash. Any unfunded amount is credited to Unfunded Pension Liability. For example, assume that the pension plan of Hinkle Co. requires an annual pension cost of $80,000, based on an estimate of the future benefit obligation. Further assume that Hinkel Co. Pays $60,000 to the pension fund. The entry to record this transaction is as follows:

If the unfunded pension liability is to be paid within one year, it will be classified as a current liability. That portion of the liability to be paid beyond one year is a long-term liability.

Postretirement Benefits Other Than Pensions

In addition to the pension benefits described above, employees may earn rights to other postretirement benefits from their employer. Such benefits may include dental care, eye care, medical care, life insurance, tuition assistance, tax services, and legal services for employees or their dependents. The amount of the annual benefits expense is based upon health statistics of the workforce. This amount is recorded by debiting Post Retirement Benefits Expense. Cash is credited for the same amount if the benefits are fully funded. If the benefits are not fully funded, a postretirement benefits plan liability account is credited. Thus, the accounting for postretirement health benefits is very similar to that of defined benefit pension plans.

A business's financial statements should fully disclose the nature of its post retirement benefit obligations. These disclosures are usually included as notes to the financial statements.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 453-455*

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