Wednesday, 1 March 2017

How Provisions and Contributions for Employee benefits is recorded.


I am going to explain this in a simple manner. Provisions are required in defined benefits pan. Defined benefits, are estimates of expenses that has to be paid to the employees. Since they are estimates, they are provided for (provisions) in the balance sheet. Provisions for Gratuity, leave encashment are examples. 

There are two kinds of provisions for employee benefits that needs to be recorded by a company.

Short term provisions.

                       Short term provisions are quite simple to record. They are liabilities which are due to employees within a years time. Lets take a look at the entry for a short term provision.

 Employee benefit expense                   XXX
 Provision for Employee benefit                                  XXX

We do not need a separate fund for paying for these provisions, as they come under current liabilities.

Long term provisions.

                       Long term provisions are provisions estimated and recorded every year in anticipation of a lump sum payout to employees, when they retire, or when they complete the tenure required for availing the benefit. There are various methods used for estimating the long term liability to the company for these lump sum payments. Lets look into an example.

Company XYS Ltd  gives salary to an employee of 10000 per year. He is eligible to retire after 5 years with a gratuity of 10% of his last annual salary multiplied by the years of his service to the company. 

The company estimates a salary rise of 10% each year. 

His last year salary can be estimated as 10000 X (1.1)^5 = 16105

So the company will have to pay him 5 X 16105 X 10% = 8052.5 when he retires.

For this the company has to make a provision each year till he retires. 

For that the company divides 8052.5 by 5 and multiplies by the present value factor to obtain the estimate for the provision for each year. 

For year 1, year 2, year 3, year 4 and year 5  the provision estimate is calculated as 1099, 1209, 1330, 1464 and 1610. Along with that, some other costs are added such as interest costs and other costs. Now the provisions are increased to say 1500, 1750, 2000, 2250, and 2500. The entry for provisions for each year will be

Year 1

Employee gratuity expense                   1500
Provision for Employee gratuity                                  1500

Investments                                           1500
Cash                                                                              1500

Year 2

Employee gratuity expense                   1750
Provision for Employee gratuity                                  1750

Investments                                           1750
Cash                                                                              1750

Year 3

Employee gratuity expense                   2000
Provision for Employee gratuity                                  2000

Investments                                           2000
Cash                                                                              2000

Year 4

Employee gratuity expense                   2250
Provision for Employee gratuity                                  2250

Investments                                           2250
Cash                                                                              2250

Year 5

Employee gratuity expense                   2500
Provision for Employee gratuity                                  2500

Investments                                           2500
Cash                                                                              2500

Note that an equivalent amount of investments is done each year. Some companies do not make investments,but rather manage the expenses by insuring for the same.

Along with these expenses, additional expenses such as acturial Gain/loss, Gain/ Loss from Investments, and Actual settlements/ curtailments is charged to income statement each year.


These are contributions done by companies on monthly basis for future payments to the employees. The amount for these contributions are know to the company, so there is no need for any provisions. Which is why they come under defined contributions plan. They are recognized in Profit and loss as expenses.  Contributions to provident fund and superannuation are examples.

The entry for a contribution is

Contribution to PF/ Superannuation               XXX
Payables/cash                                                                                      XXX

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