Accounting Considerations

Accounting for Deferred Compensation

While the tax treatment of a non-qualified deferred compensation(NQDC) is governed by the Internal Revenue Code, the financial accounting is determined by generally accepted accounting principles (GAAP). For fiscal years beginning after Dec.15, 1992, the accounting for NQDC is restricted to a single method under GAAP. The statement of financial accounting standards (SFAS) 106 defines this method.

Most accountants consider the NQDC benefits to be material and therefore includable in the calculation of the company's net income under GAAP. If for some reason the accountant deems the costs immaterial, then no liability needs to be accounted for until an event occurs that creates a liability under the plan, such as retirement, death or disability. It should be cautioned however, that after years of accumulation, what once appeared immaterial on a yearly basis may become material in the aggregate.

If the employer agrees to pay NQDC benefits, both GAAP and FASB state that the liability should be recorded on the company's financial statements.

EXAMPLE: Company decides to establish a NQDC plan for employee in 1999 that will pay him $50,000 each year for 5 years. Company will record a liability and an expense in 1999 equal to the present value of the future payments to be made to Employee. Assuming a 10% discount rate, the journal entry would be:

Deferred compensation expense: $189,535

Deferred compensation liability: $189,535

This entry will impact both the balance sheet and the income statement. The deferred compensation liability amount will reduce the company's net worth on the balance sheet. The deferred compensation expense amount will reduce the company's net income on the income statement. Absent guidance, many accountants base the discount rate on current rates of return on high quality fixed-income investments.

Accounting for contingent unfunded NQDC obligations must accrue the estimated amounts, equal to the present value of all future benefits expected to be paid on a systematic and rational basis (i.e. may adjust amount for employment contingencies). The yearly accrual amount should depend on the particular facts and circumstances involved.

EXAMPLE: A NQDC plan for a 55-year-old officer states that the Officer will forfeit the benefits if he/she resigns prior to attaining age 65. In this case, the likelihood that the benefits will be forfeited should be considered in the accrual amount. In most cases, the company may accrue the liability without adjustments for contingencies. Most companies accrue the cost on a straight-line basis from the effective date of the contract to the end of the active service period. If the Officer is still employed with the Company upon attaining age 65, the accrued amount should be equal to the then present value of all the future benefits expected to be paid.

If the benefit is based on the performance of future services, the liability should be accrued over the employees years of service up to the full eligibility date. Therefore, an expense and liability would be recorded each year even though the company may never be required to pay the benefits. When accruing the liability and expense, the risk of forfeiture may be considered until the benefits fully

Accounting for Tax Deferral Impact

Since the accounting rules require that an expense be recorded for the accrual of the NQDC benefits, net income is reduced each year on the financial statements. For income tax purposes, the NQDC deduction is deferred until the amounts are paid. Therefore, each year that the NQDC benefit accrues the employers financial accounting net income will be lower than their taxable income. This temporary timing difference, the book-to-tax difference, must be reflected on the employers financial statements.

EXAMPLE: Assuming the company has a 40% income tax rate, the entry to record the income tax liability is:

Income tax expense: $40,000

Income tax liability: $40,000

Assume that there is a $50,000 difference in financial accounting income and taxable income caused by a $50,000 NQDC accrued liability. Another entry is needed to reflect the temporary timing difference on the financial statements:

Deferred tax asset: $20,000

Income tax expense: $20,000

For financial accounting purposes, the net income tax expense is reduced by $20,000 ($50,000 x 40%) and the deferred tax asset is reported on the financial statements in order to reflect the future NQDC deduction amount when the benefit is paid.

Accounting Impact of a Death Benefit

In the event the NQDC provides a death benefit, the estimated liability and expense for the NQDC obligation should be based on the life expectancy of each individual concerned, based on the most recent mortality tables, or on the estimated cost of an annuity contract.

Accounting for Payment of Benefits

The payment of the retirement benefit results in a reduction of the accrued liability and a payment of interest on the deferred amounts.

EXAMPLE: A company contracts to pay an employee $20,000 each year for 10 years beginning at retirement. Based on a 10% discount rate, the prevent value of the stream of payments is $122,891. After all ten payments have been made, the Deferred Compensation Liability account will be reduced to zero. The first $20,000 annual payment would be reflected as follows:

Deferred compensation liability: $20,000

Cash: $20,000

Interest expense: $12,290

Deferred compensation liability: $12,290

Accounting for Informal Funding

If life insurance is chosen to informally fund NQDC plans, the life insurance is accounted for separately from the NQDC obligation and therefore does not impact the accounting for the life insurance.

The establishment of a rabbi trust will not change the accounting treatment. Since the assets in a deferred compensation trust are accessible by the company's general creditors, they are treated as corporate assets for accounting purposes (i.e., shown as assets on the balance sheet).

Return to Understanding Non-qualifed Deferred Compensation

Neither AUL nor its agents/representative give legal or tax advice. Please consult your attorney or tax advisor for answers to specific tax questions.