Accrued liabilities expenses already incurred but not yet paid (accrued expenses). represent expenses already incurred but not yet paid (accrued expenses). These liabilities are recorded by adjusting entries at the end of the reporting period, prior to preparing financial statements. You learned how to record accrued liabilities in your study of introductory accounting and you reinforced your understanding in Chapter 2. Common examples are salaries and wages payable, income taxes payable, and interest payable. Although recorded in separate liability accounts, accrued liabilities usually are combined and reported under a single caption or perhaps two accrued liability captions in the balance sheet. General Mills includes accrued liabilities in other liabilities (totaling $1,482 as of May 31, 2009).
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Accrued Interest Payable
Accrued interest payable arises in connection with notes like those discussed earlier in this chapter (as well as other forms of debt). For example, to continue Illustration 13-1, let's assume the fiscal period for Affiliated Technologies ends on June 30, two months after the six-month note is issued. The issuance of the note, intervening adjusting entry, and note payment would be recorded as shown in Illustration 13-1A.
Liabilities accrue for expenses that are incurred but not yet paid.
Note with Accrued Interest
At June 30, two months’ interest has accrued and is recorded to avoid misstating expenses and liabilities on the June 30 financial statements.
Salaries, Commissions, and Bonuses
Compensation for employee services can be in the form of hourly wages, salary, commissions, bonuses, stock compensation plans, or pensions.11 Accrued liabilities arise in connection with compensation expense when employee services have been performed as of a financial statement date, but employees have yet to be paid. These accrued expenses/accrued liabilities are recorded by adjusting entries at the end of the reporting period, prior to preparing financial statements.
VACATIONS, SICK DAYS, AND OTHER PAID FUTURE ABSENCES. Suppose a firm grants two weeks of paid vacation each year to nonsalaried employees. Some take their vacations during the year earned and are compensated then. Some wait. Is the compensation an expense during the year for only those who actually are paid that year for their absence? When you recall what you've learned about accrual accounting, you probably conclude otherwise.
An employer should accrue an expense and the related liability for employees' compensation for future absences (such as vacation pay) if the obligation meets all of the four conditions listed in Graphic 13-5.
Conditions for Accrual of Paid Future Absences
The obligation is attributable to employees' services already performed.
The paid absence can be taken in a later year—the benefit vests (will be compensated even if employment is terminated) or the benefit can be accumulated over time.
Payment is probable.
The amount can be reasonably estimated.
If these conditions look familiar, it's because they are simply the characteristics of a liability we discussed earlier, adapted to relate to a potential obligation for future absences of employees. Also, these conditions are consistent with the requirement that we accrue loss contingencies only when the obligation is both (a) probable and (b) can be reasonably estimated, as discussed in Part B of this chapter.
The liability for paid absences usually is accrued at the existing wage rate rather than at a rate estimated to be in effect when absences occur.12 So, if wage rates have risen, the difference between the accrual and the amount paid increases compensation expense that year. This situation is demonstrated in Illustration 13-2, in which vacation time carried over from 2011 is taken in 2012 and the actual amount paid to employees is $5,700,000:
Paid Future Absences
When the necessary conditions are met, compensated future absences are accrued in the year the compensation is earned.
| ||Davidson-Getty Chemicals has 8,000 employees. Each employee earns two weeks of paid vacation per year. Vacation time not taken in the year earned can be carried over to subsequent years. During 2011, 2,500 employees took both weeks' vacation, but at the end of the year, 5,500 employees had vacation time carryovers as follows:
During 2011, compensation averaged $600 a week per employee.
|When Vacations Were Taken in 2011|
|When Year 2011 Vacations Are Taken in 2012|
|Liability—compensated future absences (account balance) .........|
|Salaries and wages expense (difference) .....................................|
| Cash (or salaries and wages payable) (given) ............................|
Company policy and actual practice should be considered when deciding whether the rights to payment for absences have been earned by services already rendered. Consider an illustrative situation. Suppose scientists in a private laboratory are eligible for paid sabbaticals every seven years. Should a liability be accrued at the end of a scientist's sixth year? No—if sabbatical leave is granted only to perform research beneficial to the employer. Yes—if past practice indicates that sabbatical leave is intended to provide unrestricted compensated absence for past service and other conditions are met.
Customary practice should be considered when deciding whether an obligation exists.
Custom and practice also influence whether unused rights to paid absences expire or can be carried forward. Obviously, if rights vest (payable even if employment is terminated) they haven't expired. But holiday time, military leave, maternity leave, and jury time typically do not accumulate if unused, so a liability for those benefits usually is not accrued. On the other hand, if it's customary that a particular paid absence, say holiday time, can be carried forward—if employees work on holidays, in this case—a liability is accrued if it's probable that employees will be compensated in a future year.
Interestingly, sick pay quite often meets the conditions for accrual, but accrual is not mandatory because future absence depends on future illness, which usually is not a certainty. Similar to other forms of paid absences, the decision of whether to accrue nonvesting sick pay should be based on actual policy and practice. If company policy or custom is that employees are paid sick pay even when their absences are not due to illness, it's appropriate to record a liability for unused sick pay. For example, some companies routinely allow unused sick pay benefits to be accumulated and paid at retirement (or to beneficiaries if death comes before retirement). If each condition is met except that the company finds it impractical to reasonably estimate the amount of compensation for future absences, a disclosure note should describe the situation.
Accrual of sick pay is not required, but may be appropriate in some circumstances.
ANNUAL BONUSES. Sometimes compensation packages include annual bonuses tied to performance objectives designed to provide incentive to executives. The most common performance measures are earnings per share, net income, and operating income, each being used by about a quarter of firms having bonus plans. Nonfinancial performance measures, such as customer satisfaction and product or service quality, also are used.13 In recent years, annual bonuses have been gaining in popularity, not just for executives, but for nonmanagerial personnel as well. Unfortunately for employees, bonuses often take the place of annual raises. This allows a company to increase employee pay without permanently locking in the increases in salaries. Bonuses are compensation expense of the period in which they are earned.
A wide variety of bonus plans provide compensation tied to performance other than stock prices.
Bonuses sometimes take the place of permanent annual raises.
11We discuss pensions in and share-based compensation plans in .
12Actually, FASB ASC 710–10–25: Compensation–General–Overall–Recognition (previously SFAS 43, “Accounting for Compensated Absences”) is silent on how the liability should be measured. In practice, most companies accrue at the current rate because it avoids estimates and usually produces a lower expense and liability. Then, later, they remeasure periodically at updated rates.
13C. D. Ittner, D. F. Larker, and M. V. Rajan, “The Choice of Performance Measures in Annual Bonus Contracts,” Working Paper, The Wharton School, University of Pennsylvania (August 1995).