Accounting for Deferred Compensation Contracts

Deferred compensation contracts are arranged for paying employees at a later date. Employers set aside a proportion of deferred liability to compensate employees at retirement.

An employer can use different methods to fund deferred compensation contracts. The employees can also participate in a volunteer contribution plan such as an insurance plan to fund their compensation.

The accounting for deferred compensation contracts is accounted for according to ASC 710.

What is a Deferred Compensation Contract?

Deferred compensations are the payments received by employees at deferred intervals. Employees can opt for deferred compensation due to tax benefits.

Deferred compensation contracts arranged by an employer with its employees to defer their compensations. The contract includes the payment terms, service requirements, retirement date, and other relevant information.

The employer accounts for the compensation of an employee’s current service contract. By the retirement date, the employer must accrue the full compensation amount.

Accounting for Deferred Compensation Contracts

ASC 710 and ASC 715 offer insights into the accounting treatment of the deferred compensation plans.

If the aggregate compensation amount of an employee is equal to the pension plan, it should be treated under ASC 715-30. Otherwise, all deferred contracts are accounted for according to ASC 710 guidelines.

ASC 710-30 states that a deferred compensation plan should be arranged such that the obligation is fully accrued by the date an employee attains full eligibility.

ASC 710-10-20 defines the eligibility date as the date of completion of the service for the employee. This is the date at which the employee has rendered all services and earns the benefits as agreed with the employer.

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In some cases, there will be an extension of service such that the employee will render future services as well. In that case, the arrangement should reflect the adjusted amount for an additional period as well.

The employee must fulfill all requirements of the employment contract such as continued employment until a specific date, post-retirement services, and so on. The amortization of the amount starts at the contract signing date until the employee becomes eligible on the service contract completion date.

Accounting for Deferred Compensation Liability

ASC 710-10-25-9 states that the liability amount of deferred compensation should be amortized in a rational and reasonable manner.

ASC 710-10-25-9 states:

“To the extent the terms of a contract attribute all or a portion of the expected future benefits to an individual year of the employee’s service, the cost of those benefits shall be recognized in that year. To the extent the terms of the contract attribute all or a portion of the expected future benefits to a period of service greater than one year, the cost of those benefits shall be accrued over that period of the employee’s service in a systematic and rational manner”.

ASC 710-1025-10 states if both the current and future service options are present, only the portion applicable to the current service should be amortized.

Employers can take two approaches to accrue the deferred compensation liability.

The sinking fund method uses the periodic accrual basis where the deposit amount is amortized using an appropriate discount rate. The arrangement is made in a way that the liability is fully amortized by the date of service completion of the employee.

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If the company does not discount the liability, it can use the equal accrual amount method. In this method, the employer will contribute an equal amount each year without discounting it for the present value.

Funding of Deferred Compensation Contracts

Often employers use life insurance plans to fund deferred compensation contracts. However, both the deferred compensation and life insurance accounts should be recorded separately by the company.

The ASC 715 guidance requires that netting of plan assets and liabilities is only for the pension plans. Thus, assets set aside for deferred compensation liability should not be netted on the balance sheet.

Voluntary Deferred Compensation Arrangements

An employer may allow its employees to participate in a voluntary deferred compensation plan as well. Usually, the employee contributes a fixed amount to the employer-funded insurance plan.

The employee can receive fixed payments at specified future dates as well under the employer-sponsored insurance plan.

Rabbi Trust Arrangements

Some employers may use irrevocable trusts to fund the deferred employee contracts. These trusts are known as Rabbi trusts.

The Rabbi Trust option is used to ensure the compensation of executives is paid by the employer. The employer segregates assets for the Rabbi Trust that legally remain under the ownership of the employer. However, the employer does not have direct control over the assets.

Since the employer does not have legal rights to transfer the contractual rights of the trust, the tax obligation does not incur for the employees with an asset transfer.

Working Example

Suppose Pisey Pvt. Limited enters into a deferred compensation contract with its CEO. The CEO is five years from retirement as per the employment contract terms. Pisey Pvt. agrees to pay the CEO for three times the current salary as a deferred compensation plan.

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Following data related to the CEO employee compensation is available.

Current salary = $ 100,000              Present Value of Annual Pension Plan = $ 500,000.

Lump-sum amount in case of early death = $ 200,000.

The accounting entries by Pisey Pvt. will be recorded as follows.

The annual expense for a lump sum payment at retirement will be:

AccountDebitCredit
Deferred Compensation Expense$ 60,000 
Deferred Compensation Liability $ 60,000

Total Compensation = 3 times $ 100,000 = $ 300,000

Annual compensation expense = $ 300,000 ÷ 5 = $ 60,000.

Suppose the CEO receives a pay rise after 3 years to $ 120,000. The new accounting entry must reflect the increment. The deferred compensation amount will be $ 360,000 now. The company has recorded $ 180,000 for three years.

It must increase the deferred compensation expense to $ 90,000 to accrue the liability in the remaining two years.

AccountDebitCredit
Deferred Compensation Expense$ 90,000 
Deferred Compensation Liability $ 90,000

Accounting entry to record the annual pension expense for lifetime will be:

AccountDebitCredit
Deferred Compensation Expense$ 100,000 
Deferred Compensation Liability $ 100,000
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