How to Account for Deferred Compensation

Deferred compensation is a term used in the United States to refer to a portion of an employee's pay that is disbursed well after it is earned. Stock options and pensions are the two most common forms of deferred compensation. This type of pay arrangement is generally reserved for top executives and employees in managerial positions, and can have advantageous tax implications. Learning how to account for deferred compensation requires an understanding of the Generally Accepted Accounting Principles (GAAP) underlying the treatment, as well as the portion of the Internal Revenue Code (IRC) that applies. Record the journal entry upon disbursement of cash to the employee. In 2020, the deferred compensation plan matures and the employee is paid. The journal entry is simple. Debit Deferred Compensation Liability for $100,000 (this will zero out the account balance), and credit Cash for $100,000. Taxes on the payment will be paid at this point (by both the corporation and the employee). When the plan is established (in 2015), it represents a liability; that is, an obligation to pay the employee. An entry must be recorded in the general journal to reflect the establishment of the pay plan. Because the amount will be paid out in the future, you'll need to calculate the present value of the compensation that will eventually be paid. The present value takes into account the difference between receiving money now and receiving the same amount at some point in the future. Get the interest rate used for the present value calculation. To calculate the present value, you'll need an interest rate that represents a low-risk investment. The current interest rate on treasury bonds is typically an excellent choice for a present value interest rate. For our purposes, we'll keep things simple and use an interest rate of 1 percent. Determine the terms of the deferred compensation package. Understanding the structure of the pay package is essential to executing the proper accounting treatment. For example, consider a compensation plan issued in 2015 that will pay out a lump sum of $100,000 to an employee in 2020. Every day at wikiHow, we work hard to give you access to instructions and information that will help you live a better life, whether it's keeping you safer, healthier, or improving your well-being. Amid the current public health and economic crises, when the world is shifting dramatically and we are all learning and adapting to changes in daily life, people need wikiHow more than ever. Your support helps wikiHow to create more in-depth illustrated articles and videos and to share our trusted brand of instructional content with millions of people all over the world. Please consider making a contribution to wikiHow today.