A proper assessment of Risk lies in the proper assessment of Stability of "Value" (Howard Marks). Stability of Value depends on "stability of future cash flows" (Mike Mauboussin). Stability of future cash flows in turn, depends on Industry Stability and Competitive Strategy/Position of the business in the Industry (Howard Marks)
Wednesday, 1 March 2017
How Provisions and Contributions for Employee benefits is recorded.
PROVISIONS FOR EMPLOYEE BENEFITS
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
Employee gratuity expense 1500
Provision for Employee gratuity 1500
Employee gratuity expense 1750
Provision for Employee gratuity 1750
Employee gratuity expense 2000
Provision for Employee gratuity 2000
Employee gratuity expense 2250
Provision for Employee gratuity 2250
Employee gratuity expense 2500
Provision for Employee gratuity 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.
CONTRIBUTIONS TO EMPLOYEE BENIFITS
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