ALTECH'S VACATION DILEMMA

The headline proclaimed, "Why we're letting Virgin staff take as much holiday as they want" (Branson, 2014). Almagoogledthe headlines and found the announcement was getting a lot of press?both CNN and the BBC covered the story.Some, like the British paperThe Guardian,thought the decision to change wasjust an attention-getting move;others?includingUSA Today--felt that Branson was adopting an altruistic andprogressiveapproach to employee relations.Asearch of corporate websitesdisclosedother sizeable firms with an unlimited vacation policy for non-hourly workers (andadoptionyear) includingNetflix (2004), Best Buy (2004), Morningstar (2010), Adobe (2012), Lexmark (2013) and MGM Resorts (2013). Alma thought the stories interesting, but she also thought that they missed the point.

As a senior director of human resources for a mid-size technology firm,Altech, Alma had been involved in her firm's switch to an unlimited PTO policy several years earlier. She knew that the decision to change the vacation policy had not been driven by concerns about employee morale. The decision to switch had largely been the result of straightforward business analysis based on dollars and cents, especially management's concerns with the size of the accrued PTO liability.

Firm Background

Altech, a software solutions firm,was established in the1980's in California's Silicon Valley, hometomany computer and technology startups.Altechprospered by combininginvestment in research and development, product engineering andworld-classmanufacturingwithcustomer service.Altech'ssuccess has led to not only increasedassetsandearnings, but an increase in its employee headcount (see Appendices A, B and C).

Accounting for Vacation Pay

Increasingheadcount naturally resulted in increased employee compensation expenses,includingsalaries, health and other insurance costs, and retirement benefits. Vacation pay, or paid time off (PTO), was another component of employee compensation,butitsimpact on compensation expense was neither consistent nor predictable.

BecauseAltechis headquartered in California, it is subject to that state's strict laws concerning vacation policy.In California, a "use it or lose it" policyfor vacation is illegal. Firms mustcompensate employees for up to two weeks of earned but untaken vacation time annually, either by giving time-off or its equivalent in pay (Suastezv. Plastic Dress Up(1982) 31 C3d 774). Since California is home to approximately 20% of U.S. firms, this one state's PTO laws affect many businesses.

Firms spend considerable time and resources trackingvacation days earned, taken, and paid for.Altech'svacation policy provided employees from 14 to 28vacationdays annually, withanaverageof16 days. PTO was earned proportionally throughout the year?each month 1/12 of the current year's PTO was earned.PTO could be taken as earned,orup to 20 days could berolledforward, or banked, for one year.

Untaken vacation days at the end of the yearbecamea liability on the next year's balance sheetwhoseultimate dispositionwasunknown.If employees usedtheirbankedPTO as days off in the subsequent year, thebankingaccrual was unnecessary--no additionalexpense was incurred by the firm. Whenemployeesdidn't take use their bankeddaysas time off, they were paid for them. Theyreceivedcompensationbeyond their base salaryforforextra time worked,increasingAltech'sexpenses.Depending on employees' behavior,compensation expense (base salary plus paid PTO) could swing widely between years.

Altechactively encouraged employees to take time off,but manyemployeespreferred toreceive cashfor bankedPTO. Departmental managers received memos about the PTO status of their staff throughout the year, reminding them that the behavior of employees regarding PTO would affect both their departments'expensesand cash flow in the current year, and would make budgeting for the next year difficult.Calculating whetherbanked PTO wouldbe used astime off or would require a cash payment was always a guessing game.Alma wasn't sure she understood the problem, but the controller's office said there was adifficulty becausethe contingent liability associated with PTO was created in one year while itselimination?through payment or time off--occurredthe next year.

Some had suggested not booking the vacation expense until it was taken as either time off or in pay, but the controller's department said this wasn't possible, saying that the banked PTO met the definitions of both a liability and contingent liability, terms that just left Alma confused. They also said that both the size of the accrued PTO balance and its volatility impacted the firm's financial statements.

Unlimited Vacation

During the time that top management atAltechwas mulling over this issue, a new concept, called "unlimited vacation," or "unlimitedPTO" was catching on in Silicon Valley.Netflix, Zynga, andXobnidangled the policy as they competed for top engineers, hoping toappeal to top talent. Though not appropriate for hourly workers, unlimited vacation time had many benefits for firms whose employees were salaried professionals.Firms involved in newer technologies and the "new economy" typically had a large, unquantifiable asset in employee knowledge.These firms neededto ensure that their most important asset?their employees?remained. Both thecontroller'sdepartment and the human resources department atAltechbelieved that this new policy could be the ideal solution for them.

A popular version of a work environment being cultivated to complement the unlimited vacation policy was calledROWE?(Ressler& Thompson, 2008)-- Results Only Work Environment--whereemployeeswere expectedto work as needed in order to achieve a specified goal.Altechmanagement realized that, as a relatively young company with a casual workday approach, it was a prime candidate.Acompany with a more traditional approach to work might find it difficult to measure performance any other way thanbytime spent in the office,butAltechalreadyofferedflex-time, and employees expected to occasionallywork from locationsoutside the office.Much of what was done atAltechwas research and service related,soit was not necessary to have all employees on-site at any particular time.Most projects had beginning and end points and were completed in teams,makingthe company a perfect candidate for the implementation ofROWE?. Theswitchwould eliminate costs associated with the tracking ofvacationdays. Management alsoloved that the change would greatly diminish variability in compensation expense and eliminate the contingent liability arising from rolled over PTO.

In an effort to find out how employees felt about the change, and how the companies making the change had been impacted, management scoured many articles on unlimited vacation policies andROWE?; they found thatsomeemployeesloved itfeelingthat they had finally achieved a wonderful work-life balance, while others disliked the change,complainingthey could never really take a vacation.Some felt cheated out of the "compensation bonus" for unused vacationdaysthey'd been counting on.What management found regarding company efficacy after the change, however, convinced them to embrace this new policy.Companies, such asTheGap, Evernote, ASC,Chegg,Dynaronixand tens more, had found that once they converted from a traditional work environment toROWE, there was expanded individual and team capacity,increased productivity, higher levels of customer satisfaction, a better ability to attract top talent and a lowered turnover rate!Altech concluded that the change would be a good one for them.

Making the Change

The last year that vacation pay could be "earned andbanked" was 2009; final payments forrolledvacation days were made in 2010.The transformation took time,butoverall, the change proved to be a positive one.After the initial hit to the income statementcaused by recognizing allbanked PTOas an expense,the PTOliabilitydisappearedandcompensationexpense decreased;the bottom line, even without considering the touted addedproductivity, increased.The"triple bottom line" wasup, andthe financial statements and related ratios lookedbetter than ever.Alma, and management, was pleased.

Student Instructions:Answer the following questions. Your responses should be written in essay form;include all appropriate calculations.

1.Explain why the balance for accrued PTO liability is difficult to calculate.You may use an example.

2.A) Explain how this liability and the associated compensation expense impacts the balance sheet and income statement.

B) Which financial ratios may be affected by these balances (list 3)?

C) Why is volatility in these numbers concerning? To whom are they concerning?You may use an example.

3. To Altech's Board of Trustees explaining how the capital markets could react tothe volatility in the financial statements from theunused vacationcontingent liabiliityon its balance sheet.

4.Based on the information in the case provided above, how important is a company's environment in the decision to implement change?

5.What journal entries are needed to reflect the following? Assume the salary is $1,000 per week, s/he earnsfourweeks PTO annually, accruing it at a rate of 1/12 per month, and the employee can take PTO as earned.

a.Each month, record salary and PTO expense.

b.In year 1, employee rolls over two weeks PTO.

c.In year 2, employee elects to take accrued PTO as days off while rolling over two weeks of current PTO to next year.

d.In year 2, employee receives a check for the prior year's unused PTO while rolling over two weeks of current PTO to next year.

e.In year 2, employee takes prior year accrued PTO as time off and uses all of current year's PTO.

6.PTO must be accrued for as earned, creating a liability. How can the characterization of accrued PTO as a contingent liability be correct?

\f12:06 PM Fri Mar 5 ?100%@jl allyproduction.53.amazonaws.com Appendix -B2 Balance Sheet, 20092012 (in thousands) Assets 2009 2010 2011 2012 Cash and equivalents $67,490 $89,055 $128,255 Investment Securities 154,650 172,997 190,197 Accounts Receivable 49,891 57,094 55,521 Prepaid Expenses 14,239 17,428 15,829 Current Assets 222,527 289,459 389,832 Property, plant & equipment (net) 35,193 40,399 59,785 Patents and intangibles 362,305 395,519 Other 35,580 26,750 Long-term Assets 433 078 469,773 Total Assets 655,605 732,462 809,203 Liabilities & Equity Accounts Payable 5,302 4,719 7,803 Accrued Expenses 37,786 51,039 49,943 Capital Lease Obligations 387 831 Taxes Payable 7,213 5,220 11,120 Deferred Revenue 25,580 34,150 42,867 Current Liabilities 76,268 112,564 Capital Lease Obligations 90,001 m 135,459 Long-term subscriptions 3,838 5,666 Taxes payable 20,109 14,129 Deferred taxes 22,418 9,189 16,348 Other 2m 1m 4_.5_08 Long-term Liabilities 169,251 176,176 182,578 Total Liabilities 265,128 288,741 297,022 Common Stock at $1 par 5,490 5,490 5,490 5,490 Additional Paid in Capital 223,965 224,064 277,965 286,950 Retained Earnings 464,116 526,270 551,993 603,322 Less: Treasury Stock (252,811! {288,490} [314,985I (295,091! Total Equity 440,760 467 333 520 462 600,671 Liabilities and Equity 655,605 732,462 809,203 897,693 12:06 PM Fri Mar 5 100%Z ally-production.s3.amazonaws.com 4 of 4 Appendix C Income Statement, 2005-2008 (in thousands 2004 2005 2006 2007 2008 Net Revenues $151,88 $178,957 $229,977 $284,250 $322,259 COGS 9,754 10,921 24,511 31,481 33,114 Gross Margin 142,128 168,036 205,466 252,769 289,145 Research & Development 28,073 28,017 48,572 55,193 59,583 Sales & Marketing 47,803 53,400 78,043 88,595 98,401 General & Administrative 14,577 18,050 29,249 31,317 39,383 Operating Expenses 90,453 99.467 155,864 175,105 197,367 Operating Income 51,675 68,569 49,603 77,664 91,778 Net Interest Income (Expense) 1,299 1,783 6,057 7,237 3,107 Investment Income (Loss) 226 (117) 5,512 642 1,315 Other Income (Loss) 1,525 1,666 11,569 7,879 4,422 Income Before Tax 53,199 70,235 61,172 85,542 96,200 Taxes 14,155 15,479 16,522 21,431 19,653 Net Income 39,044 $54,757 $44,649 $64,112 $76,547 Income Statement, 2009 - 2012 (in thousands) 009 2010 2011 2012 Net Revenues $265, 186 $342,000 $379,461 $396,331 COGS 26,769 36,340 39,410 43,540 Gross Margin 238,417 305,660 340,05 352,791 Research & Development 49,319 61,230 66,425 68,854 Sales & Marketing 88,833 111,978 124,724 134,454 General & Administrative 38,143 43,050 49,952 43,341 Operating Expenses 176,295 216,258 241,100 246,650 Operating Income 62,122 89,402 98,951 106,141 Net Interest Income (Expense) 2,294 (3,930) 6,200) (6,169) Investment Income (Loss) (1,282) (550) 401 712 Other Income (Loss) 1,012 (4,480) (5,799) (5,457) Income Before Tax 63,134 84,922 93,152 100,684 Taxes 29,933 16,055 19,226 27,179 Net Income $33,201 $68,867 $73,926 $73,50512:06 PM Fri Mar 5 100% Z ally-production.s3.amazonaws.com 2 of 4 Appendix B-1 Balance Sheet, 2005-2008 (in thousands) Assets 2004 2005 200 2007 2008 Cash and equivalents $23,364 $37,874 $69,521 $85,160 $79,781 Investment Securities 94,862 115,211 135,754 94,269 101,948 Accounts Receivable 12,800 18,221 36,613 32,858 42,051 Prepaid Expenses 5,333 ,275 17,543 19,468 22,371 Current Assets 137,359 180,581 259,431 231,755 246,150 Property, plant & equipment 8,946 9,319 20,448 26,078 28,173 (net) Patents and intangibles 11,322 12,191 239,008 229,565 211,449 Other 16,392 17,391 17,548 27,020 38,139 Long-term Assets 36,660 38,901 277,004 282,663 277,761 Total Asset 174,019 219,482 536,435 514,418 523,911 Liabilities & Equity Accounts Payable 3,887 3,694 4,953 6,018 5,026 Accrued Expenses 18,251 2c0,429 27,315 34,509 36,000 Capital Lease Obligations 100 110 119 129 221 Taxes Payable 13,134 13,914 16,961 19,782 5,679 Deferred Revenue 4,682 5,205 11,728 16,595 21,767 Current Liabilities 40,054 43,352 61,075 77,033 68,692 Capital Lease Obligations 9,000 9,900 10,800 11,700 31,500 Long-term subscriptions 577 876 4,917 3,594 3,435 Taxes payable 0 6,300 9,000 11,143 Deferred taxes 7,102 7,090 8,686 13,405 10,560 Other 435 636 718 2,017 1,851 Long-term Liabilities 17,214 18,501 31,421 39,716 58,488 Total Liabilities 57,268 61,853 92,497 116,749 127,180 Common Stock at $1 par 2,700 2,745 5,490 5,490 5,490 Additional Paid in Capital 104,818 118,903 184,843 180,071 198,089 Retained Earnings 201,493 237,471 291,561 331,175 387,081 Less: Treasury Stock (192,260) (201,490) (37,955) (119,066) (193,929) Total Equity 116,751 157,629 443,938 397,669 396,731 Liabilities and Equity 174,019 219,482 536,435 514,418 523,911