How to Account for Compensated Absences

Compensated absences are employee benefits for time not worked, such as vacation, sick leave, and holidays. From an accounting perspective, these benefits represent a form of compensation that is earned by employees through their service. Therefore, businesses must follow specific accounting principles to report these obligations accurately in their financial statements.

In the United States, the Financial Accounting Standards Board (FASB) provides these principles through its Accounting Standards Codification (ASC) 710, Compensation-General. This standard governs how companies should account for liabilities from employee services. It ensures that the cost of compensated absences is recognized in the period the benefit is earned by the employee, not when it is paid.

Conditions for Accruing a Liability

For a company to record a liability for compensated absences, it must meet four specific criteria.

• The employer’s obligation must be attributable to services already rendered by the employee. The benefit is not for future work but is a direct result of past performance, establishing a clear obligation for the company.
• The obligation relates to rights that vest or accumulate. Vested rights are those the employer must pay out even if an employee leaves the company, while accumulating rights can be carried forward into future years.
• Payment of the compensation is probable. For benefits like vacation pay that are part of a standard policy, payment is almost always considered probable.
• The amount of the obligation can be reasonably estimated. This is usually straightforward for vacation and holiday pay, which are based on known pay rates and accumulated hours.

If a company has a “use-it-or-lose-it” policy where time off expires at year-end, those benefits do not accumulate, and a liability is generally not recorded for them. If the first three conditions are met but the amount cannot be reasonably estimated, the company must disclose this fact in the notes to its financial statements.

Measuring the Compensated Absences Liability

The calculation should be based on the employees’ current rates of pay, not the rates that were in effect when the time was earned. This ensures the liability on the balance sheet reflects the actual cash outflow that will be required to settle the obligation. If an employee’s salary changes, the accrued liability must be adjusted accordingly.

The measurement should also include additional costs that are directly associated with the compensation. These can include the employer’s share of payroll taxes, such as Social Security and Medicare taxes, as well as contributions to other benefit plans that are based on the employee’s salary. Including these related costs provides a more complete and accurate picture of the total obligation the company has incurred.

Consider a small business with two employees. Employee A earns $30 per hour and has 40 hours of accrued vacation time. Employee B earns $25 per hour and has 20 hours of accrued vacation. The initial liability calculation would be (40 hours $30/hour) for Employee A, which equals $1,200, and (20 hours $25/hour) for Employee B, which equals $500. The total base liability is $1,700.

To complete the calculation, the company must factor in payroll-related costs. For 2025, this includes the 6.2% Social Security tax on wages up to $176,100 and the 1.45% Medicare tax, which applies to all wages. Since the employees’ earnings in this example are below the Social Security threshold, the combined rate of 7.65% applies. The additional liability would be $1,700 multiplied by 7.65%, which equals $130.05. Therefore, the total accrued liability for compensated absences that the company would record is $1,830.05 ($1,700 + $130.05).

Recording and Reporting Requirements

After calculating the total liability, the company must formally record it in its accounting records. This is done through a journal entry that increases both an expense and a liability account. The entry involves a debit to Compensation Expense and a credit to Accrued Compensated Absences Liability.

These accounts appear in different sections of the financial statements. The Compensation Expense is reported on the income statement, reducing the company’s net income for the period. The Accrued Compensated Absences Liability is reported on the balance sheet. The portion of the liability expected to be paid within the next year is classified as a current liability, while any amount to be paid beyond that timeframe is classified as a long-term liability.

Companies are also required to provide disclosures in the footnotes to their financial statements. These notes offer more detail about the company’s policies. The disclosure should describe the company’s policy for paid time off, including how benefits are earned and when they are paid out. This helps users of the financial statements understand the nature and extent of the company’s obligations.