38 ASC 710 Compensation—General
Deferred Compensation Contracts
Example of Deferred Compensation Contract
PERSPECTIVE AND ISSUES
Subtopics
ASC 710, Compensation-General, contains one subtopic:
ASC 710-10, Overall, which is divided into two subsections:
- General, which provides guidance on compensated absences, deferred compensation, and lump-sum payments under union contract
- Deferred Compensation—Rabbi Trusts.
Scope and Scope Exceptions
ASC 710 applies to all entities, but as listed in 710-10-15-5, it does not apply to the following transactions:
- Benefits paid to active employees other than compensated absences
- Benefits paid at retirement or provided through a pension or postretirement benefit plan including special or contractual termination benefits payable upon termination from a pension or other postretirement plan are covered by Subtopics 715-30 and 715-60.
- Individual deferred compensation contracts that are addressed by Subtopics 715-30 and 715-60, if those contracts, taken together, are equivalent to a defined benefit pension plan or a defined benefit other postretirement benefit plan, respectively.
- Special or contractual termination benefits that are not payable from a pension or other postretirement plan are covered by Topic 712
- Stock compensation plans that are addressed by Topic 718
- Other postemployment benefits (see Topic 712) that do not meet the conditions in paragraph 710-10-25-1 and are accounted for in accordance with Topic 450.
In addition, the Deferred Compensation—Rabbi Trusts Subsections does not address the accounting for stock appreciation rights even if they are funded through a rabbi trust (ASC 710-10-15-8).
DEFINITIONS OF TERMS
Compensated Absences. Employee absences, such as vacation, illness, and holidays, for which it is expected that employees will be paid.
Full Eligibility Date. The date at which an employee has rendered all of the service necessary to have earned the right to receive all of the benefits expected to be received by that employee (including any beneficiaries and dependents expected to receive benefits). Determination of the full eligibility date is affected by plan terms that provide incremental benefits expected to be received by or on behalf of an employee for additional years of service, unless those incremental benefits are trivial. Determination of the full eligibility date is not affected by plan terms that define when benefit payments commence or by an employee's current marital or dependency status.
Rabbi Trusts. Rabbi trusts are grantor trusts generally set up to fund compensation for a select group of management or highly paid executives. To qualify as a rabbi trust for income tax purposes, the terms of the trust agreement must explicitly state that the assets of the trust are available to satisfy the claims of general creditors in the event of bankruptcy of the employer.
Sabbatical Leave. A benefit in the form of a compensated absence whereby the employee is entitled to paid time off after working for an entity for a specified period of time. During the sabbatical, the individual continues to be a compensated employee and is not required to perform any duties for the entity.
CONCEPTS, RULES, AND EXAMPLES
Compensated Absences
Compensated absences refer to paid vacation, paid holidays, paid sick leave, and other paid leaves of absence. ASC 710-10-25 requires an employer to accrue a liability for employee's compensation for future absences if all of the following conditions are met:
- The employee's right to receive compensation for future absences is attributable to employee services already rendered.
- The right vests or accumulates.
- Payment of the compensation is probable.
- The amount of the payment can be reasonably estimated.
Vesting. If an employer is required to compensate an employee for unused vacation, holidays, or sick days even if employment is terminated, then the employee's right to this compensation is said to vest. Accrual of a liability for nonvesting rights depends on whether the unused rights either expire at the end of the year in which they are earned (often referred to as a “use it or lose it” policy) or accumulate and are carried forward to succeeding years. If the rights expire, a liability for future absences is not accrued at year-end because the benefits to be paid in subsequent years would not be attributable to employee services rendered in prior years. If all or a portion of the unused rights accumulate and increase the benefits otherwise available in subsequent years, a liability is accrued at year-end to the extent that it is probable that employees will be paid in subsequent years for the increased benefits attributable to the accumulated rights and the amount can be reasonably estimated.
Sick pay. ASC 710-10-25-7 allows an exception for employee paid sick days that accumulate but do not vest. No accrued liability is required for sick days that only accumulate. However, an employer is permitted to accrue these benefits if the four conditions are met. FASB believed that these amounts are rarely material and the low reliability of estimates of future illness coupled with the high cost of developing these estimates indicates that accrual is not necessary. The required accounting is to be determined by the employer's actual administration of sick pay benefits. If the employer routinely lets employees take time off when they are not ill and allows that time to be charged as sick pay, then an accrual is required.
Other types of paid time off. Pay for other employee leaves of absence that represent time off for past services (jury duty, personal days) are considered compensation subject to accrual. Pay for employee leaves of absence that will provide future benefits and that are not attributable to past services rendered are not subject to accrual.
ASC 710-10-25-4 et seq. governs the accounting for sabbatical leaves or other similar benefit arrangements that require the completion of a minimum service period, and for which the benefit does not increase with additional years of service. Under these arrangements, the individual continues to be a compensated employee and is not required to perform duties for the entity during their absence. Assuming the four conditions set forth above are met, the compensation cost associated with a sabbatical or other similar arrangement must be ratably accrued over the presabbatical periods of service.
ASC 712, Nonretirement Postemployment Benefits, specifies the use of the same four conditions to identify the need to accrue an obligation for postemployment benefits other than pensions. Postemployment benefits other than pensions are benefits paid after termination of employment but before retirement to or on behalf of former or inactive employees, their beneficiaries, and covered dependents. Examples of those benefits are salary continuation agreements, supplemental unemployment compensation, severance benefits, workers' compensation and other disability-related payments, job training or job outplacement services, and continuation of health care or life insurance benefits after employment. If the four conditions are met, a liability is accrued. If one or more of the conditions are not met, the employer is to assess whether a liability is required to be accrued under ASC 450, Contingencies. If neither ASC 710-10-25 nor ASC 450 is applicable because the amount cannot be reasonably estimated, this fact must be disclosed.
Bonus Payments
Bonus payments may require estimation since the amount of the bonus may be affected by the entity's net income for the year, by the income taxes currently payable, or by other factors. Additional estimation is necessary if bonus payments are accrued on a monthly basis for purposes of interim financial reporting but are determinable only annually by using a formula whose values are uncertain until shortly before payment.
Deferred Compensation Contracts
If the aggregate deferred compensation contracts with individual employees are equivalent to a pension plan, the contracts are accounted for according to ASC 715-30 and ASC 715-30. All other deferred compensation contracts are accounted for according to ASC 710.
ASC 715-60 states that the terms of the individual contract will govern the accrual of the employee's obligation for deferred compensation and the cost is to be attributed over the employee service period until full eligibility is attained.
Per ASC 710, the amount to be accrued is not to be less than the present value of the estimated payments to be made. This estimated amount is accrued in a systematic and rational manner. When elements of both current and future employment are present, only the portion attributable to the current services is accrued. All requirements of the contract, such as continued employment for a specified period, availability for consulting services, and agreements not to compete after retirement, need to be met in order for the employee to receive future payments. Finally, the total amount is amortized to expense over the period from the date the contract is signed to the point when the employee is fully eligible to receive the deferred payments.
One benefit that may be found in a deferred compensation contract is for periodic payments to employees or their beneficiaries for life, with provisions for a minimum lump-sum settlement in the event of early death of one or all of the beneficiaries. The estimated amount to be accrued is based on the life expectancy of each individual concerned or on the estimated cost of an annuity contract, not on the minimum amount payable in the event of early death.
The Clear Eye Corporation enters into a deferred compensation contract with its president, Dr. Smith. Under the terms of the agreement, Clear Eye will pay Dr. Smith an amount equal to twice his annual salary in a lump sum on the date of his mandatory retirement from Clear Eye, which is four years in the future. His salary is currently $120,000. In addition, Clear Eye will pay Dr. Smith an annual pension of $45,000 beginning on his mandatory retirement date, or a minimum $200,000 lump-sum payment in the event of his early death. However, these payments are contingent upon his working the remaining four years prior to his mandatory retirement. The actuarial present value of a lifetime annuity of $45,000 that begins at Dr. Smith's expected retirement date is $392,000.
Clear Eye makes the following entry each year to record its annual expense under the lump-sum payment agreement, which is based on a lump-sum payment of $240,000:
After two years, Dr. Smith receives a pay raise to $140,000, which increases the amount of his guaranteed lump-sum payment to $280,000. Since Clear Eye has thus far recognized a deferred compensation expense of $120,000, it must now increase its annual expense recognition to $80,000 in order to recognize additional expense totaling $160,000 over the remaining two years prior to the payment date. It makes the following entry to record the actual cash payment to Dr. Smith:
Clear Eye must also record the $392,000 present value of the lifetime annuity over the remaining four years of Dr, Smith's employment rather than the smaller $200,000 early death payment, which it does with the following annual entry:
Note that all of the foregoing entries assume that Clear Eye Corporation chooses to record the full (i.e., nondiscounted) amount of the estimated future liability pro rata each year. It would also have been acceptable under ASC 710 to record the discounted present value amounts. In that case, while the charge for deferred compensation would have been lower in the earlier years, the accrued amounts would have to be further accreted to reflect interest on the obligation, so the overall charge over the four-year accrual for the lump-sum payment would have still equaled $280,000. The charge for the lifetime annuity over the four years until the payments commence would have been less than the estimated $392,000 obligation, since the amount recorded as of the inception of the annuity (i.e., retirement date) would be the present value of the future estimated payments.