How to correctly interpret the “matching” concept? According to the existing principle of accrual accounting, reporting entities maintain double-entry accounting records about facts subject to accounting in the period to which the facts relate on an accruals basis (hereinafter the “reporting period”). If it is impossible to apply this method, they may also account for them in the reporting period in which they identified the facts. In the reporting period, reporting entities account for the facts in line with accounting policies, recognising all expenses and income regardless of when they were incurred or received.
In determining the type of accruals/deferrals, the following simplified rules are observed:
- Known amount, known period – deferred expenses, deferred income (accrued expenses and accrued income)
- Known period, unknown exact amount – estimated receivables or payables
- Unknown period and/or unknown exact amount, other uncertainty/other risk – reserves
Tour of the past
Many of us still remember the time when the Labour Code made it impossible to carry forward a vacation entitlement to subsequent years. Employees were forced to use up their time off no later than by the end of the subsequent year, otherwise their vacation entitlement expired, and if the operating or other conditions on the part of the employer or employee made it impossible to use up the time off in the subsequent year, the employer refunded the entitlement.
Accounting regulations before the amended Labour Code
In practice, the above-described situation meant that the time off taken by the employee in the current year was ordinarily accounted for through payroll costs and the outstanding entitlement (which had to be used up or refunded no later than in the subsequent year) was accounted for as an estimated payable. Therefore, the entitlement to the outstanding vacation days refund was recognised in the reporting period in which the entitlement actually originated, whereby the method of matching expenses and income was observed: ie, expenses and income were reported in the period in which they originated rather than in the period in which they were paid. The vacation entitlement is related to the calendar-year period and is stipulated by law – ie, it is entitlement-based.
This accounting treatment complied with the definition of the substance of estimated payables stipulated by the Regulation, according to which these estimated balances contain payables arising, for example, from contracts that are not substantiated by all necessary documents and, as a result, their exact amount is unknown. Accounting for estimated payables is also expressly governed by Section 3.11.7. of Czech Accounting Standard No. 017 “Accounting Relations”: If the employee becomes entitled to the refund of the wage or salary for outstanding vacation days under a different legal regulation and if it is paid in the subsequent reporting period, it will also be accounted for through the relevant “Estimated Payables” accounts. In the period until the Labour Code was amended, this applied to all entitlements to outstanding vacation days of both “continuing” employees and those in respect of whom it was known as of the balance sheet date that their employment would terminate either based on a notice, agreement or retirement, or that it would be refunded owing to their taking maternity leave etc. Both categories of employees were entitled, as of the balance sheet date, to a “compensation” for outstanding vacation days, whether in the form of taking time off in the subsequent reporting period or through a payment.
Accounting regulations between the Labour Code amendment and 31 December 2015
The Labour Code amendment introduced a fundamental change in the issue of the employee’s right to time off. As has been described in the introduction, the Labour Code has stipulated since 1 January 2016 that the employee’s right to time off does not expire.
Accounting regulations did not immediately respond to this change or, to be precise, they started to be interpreted so as to be applicable to the new situation.
The General Financial Directorate has issued a statement, according to which the Labour Code amendment did not have an impact on accounting or the Income Taxes Act.
According to the GFD’s opinion, the compensation of the salary for time off is supposed to be accounted for in the employer’s costs as late as in the year in which the time off (for the current or prior period) is taken – ie, when the employee becomes entitled to a refund of the salary for the time off taken.
In the GFD’s view, the entitlement to the compensation of the salary for time off that originated in the given year yet was untaken in that same year cannot be charged to expenses through a tax-deductible estimated payable. Instead, it is appropriate to recognise a reserve, which is excluded from the tax base.
The only exception when the compensation of the salary for outstanding vacation days is accounted for through an estimated payable is the situation when the employee becomes entitled to a compensation of the salary for outstanding vacation days that will be paid in the subsequent reporting period. According to the applicable wording of the Labour Code, this entitlement originates in respect of the employee only if his or her employment terminates, provided the employee did not take the time off to which he or she was entitled: ie, in terminating employment based on an agreement, notice, retirement, maternity leave etc.
However, at the time of issuing the statement, reserves were defined and their substance determined in an enumerative manner in Section 26 of the Accounting Act: “Under this act, reserves include a reserve for risks and losses, income tax reserve, reserve for pensions and similar liabilities, reserve for restructuring. Furthermore, reserves include technical reserves or other reserves under special legal regulations.” The enumerative list of reserves in which a reserve for outstanding vacation days was absent resulted in a portion of experts from among the public incorrectly believing that the recognition of such a reserve was in violation of this provision of the Accounting Act.
Given the non-deductibility of the reserve, many reporting entities (tax payers) hesitated in accounting for the payable on this basis.
Let us add that the GFD’s statement was supported by the wording of Section 3.11.7. of Czech Accounting Standard No. 017 “Accounting Relations”: If the employee becomes entitled to a refund of the wage or salary for outstanding vacation days under a different legal regulation and if it is paid in the subsequent reporting period, it will also be accounted for through relevant “Estimated Payables” accounts, although it had originally been designed for a different legal situation (the expiry of the employee’s right to time off).
At this point, please note the accounting fundamentals applicable to Czech financial statements as well as reporting under foreign accounting standards, eg IFRS or US GAAP: the entitlement to time off is stipulated by law and is related to the reporting period: ie, no doubts exist as to the recognition of outstanding vacation days as a payable relating to the reporting period, whether in the form of an estimated payable or reserve – in other words, if the employee did not use up his or her time off in the current period and the entitlement does not expire, it constitutes a payable that is used or refunded in the subsequent period.
Amendment to the Accounting Act as of 1 January 2016
The central problem of using the reserves account for recognising the entitlement to outstanding vacation days – an enumerative definition of reserves – was eliminated by the amendment to the Accounting Act effective as of 1 January 2016, revising the wording of Section 26. Instead of the previous enumerative list, Section 26 of the Accounting Act newly stipulated that reserves are intended to cover the payables or costs the nature of which is clearly defined and that are likely or certain to be incurred as of the balance sheet date but are uncertain as to their amount or the date on which they will arise. As of the balance sheet date, a reserve must represent the best estimate of costs that are likely to be incurred or, in respect of liabilities, an amount needed for their settlement.
The definition of estimated payables according to the Regulation as well as the wording of Section 3.11.7 of Czech Accounting Standard 017 remained unchanged.
The answer to the question as to how the compensation of outstanding vacation days should be accounted for has been, according to a vast majority of experts from among the public, found following the amendment to Section 26 of the Accounting Act.
Reporting entities should, always no later than as of the balance sheet date, identify the existence of employees’ entitlements to time off and measure their value. If the resulting value is immaterial (eg, start-ups with a small number of employees, small reporting entities, traditional enterprises with compulsory company vacation, businesses affected by the seasonal taking of time-off prior to the year-end etc), the option of not reporting the payable may be considered. In other situations, the payable arising from the entitlement to outstanding vacation days must be undoubtedly accounted for.
How? Take inspiration from this reasoning:
Employee entitlements to outstanding vacation days which are certain to be refunded as of the balance sheet date, ie entitlements of employees whose employment will terminate, who are about to take maternity leave or retire, will be accounted for through estimated payables. The exact amounts of these entitlements are not yet known and neither are all necessary supporting documents ready in respect of them; nevertheless, the employer’s payable exists and the requirements imposed on this category by both the Accounting Act (Section 26) and the Regulation (Sections 17 or 18) as well as Standard No. 017 have been met.
The amendment to Section 26 of the Accounting Act helped resolve the issue of accounting for the remaining portion of entitlements of “continuing” employees to outstanding vacation days. The employee’s entitlement to outstanding vacation days representing an existing payable of the employer that originates in the current period and will be settled at some point in the future has the attributes necessary for accounting for reserves. The nature of the payable is clearly defined and the costs of outstanding vacation days are likely or almost certain to be incurred as of the balance sheet date but uncertain as to their amount. In our view, it is correct to account for the payable as a reserve, regardless of whether the employees will have a future possibility of taking the time off and having their salary compensated or the entitlement will be refunded if their employment terminates or they take maternity leave etc.
The article is part of dReport – March 2019, Accounting news.