Preparers of financial statements – and practitioners who perform attest engagements on those statements – often ask questions about how deferred compensation arrangements should be properly reflected in reporting entities’ financial statements.
In most practice situations, the Financial Accounting Standards Board’s Accounting Standards Codification (FASB ASC) Topic 710, Compensation – General, provides the relevant guidance for accounting for these types of arrangements.
The exception would be deferred compensation arrangements that are in substance pension or other postretirement benefit plans. Then the applicable guidance is in FASB ASC 715, Compensation – Retirement Benefits, which will not be covered in this article.
Under the guidance in FASB ASC 710, to the extent the terms of deferred compensation contracts attribute all or a portion of the expected future benefits to:
- An individual year of employee service – The cost of those benefits is required to be recognized in that particular year.
- A period of service greater than one year – The cost of those benefits is required to be accrued over that period of employee service in a systematic and rational manner.
In circumstances in which arrangements include elements of both current and future services, only the portion applicable to the current services should be accrued.
Some deferred compensation contracts provide for periodic payments to employees or their surviving spouses for life, with provisions for a minimum lump-sum settlement in the event of the early death of one or all of the beneficiaries. The estimated amount of future payments to be made under these types of contracts needs to be accrued over the period of active employment from the time the contract is agreed upon or entered into.
Using the provisions of FASB ASC 710, amounts to be accrued periodically are required to result in an accrued amount at the full-eligibility date equal to the then-present value of all future benefits expected to be paid.
These estimates are required to be based on the life expectancy of each individual concerned (based on the most recent mortality tables available) or on the estimated cost of an annuity contract, rather than on the minimum payable in the event of early death.
At the end of the accrual period, the aggregate amount accrued needs to equal the then-present value of the benefits expected to be provided to the employee, any beneficiaries and covered dependents in exchange for the employee service to that date.
In an effort to put some debits and credits around a hypothetical example often noticed in practice, assume that Richards Corporation, the reporting entity, enters into a deferred compensation contract with its president, Susanne Richards. The terms of the arrangement clearly stipulate that the reporting entity will pay the president a lump sum equal to twice her annual salary on the date of her mandatory retirement, which is five years in the future.
Her current salary is $150,000. Twice that salary would result in a deferred compensation expense of $300,000 that should be attributed to the five remaining service years.
The reporting entity would make the following entry each year under the lump-sum payment agreement, which is based on a lump-sum payment in the amount of $300,000:
|Deferred Compensation Expense|
|Deferred Compensation Liability|
Now suppose that, during the attribution period, the president receives a pay raise that increases the amount of the lump-sum payment she is entitled to receive. The amount expensed in each reporting period would need to increase prospectively to take into account the catch-up adjustment necessary to reflect the actual lump-sum payment that the president would receive at retirement.
Assuming that there was no increase in pay for the president during the five years of remaining service, the entry to record the lump-sum payment would be as follows:
|Deferred Compensation Liability|
The two entries illustrated above are based on a choice by the reporting entity not to discount the estimated amount of the future liability.
The reporting entity made this choice to comply with the FASB ASC 710 requirement that amounts accrued not be less than the present value of the estimated payments that will be made. Essentially, while it would have been acceptable to record amounts using present value calculations, the election was made not to use that option.