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7.3 Accounting for deferred compensation plans
Publication date: 30 Jun 2022
us Pensions guide
Payments to be made following the period of active employment should be considered additional compensation for services rendered during the period of active employment, unless it is evident that postretirement advisory and consulting services will be substantive.
7.3.1 Substantive postretirement service requirement
An assessment of the substance of postretirement services should consider whether:
- The individual’s compensation is reasonable in comparison to the services to be provided,
- There is a clear understanding of the individual’s role and responsibilities, and
- There is supervision of the individual’s performance and monitoring of hours worked.
If these criteria are met, some or all of the deferred compensation might be attributable to future services and be appropriately charged to income of the future periods. However, assigning a value to postretirement services will usually be very difficult and will often be impracticable. While employment contracts frequently include requirements regarding availability for advisory services and agreement not to compete after retirement, in many cases, those provisions do not impose any substantive obligation on the executive and the reporting entity does not obtain any significant benefits from the requirements. The accounting should reflect the substance of the arrangement.
In some instances, circumstances may indicate that an agreement characterized as a deferred compensation plan may, in substance, be a bonus with deferred settlement. If substantive future service is not required, the cost of such an agreement is generally required to be accrued at the date of grant rather than over the remaining employment or service period. If, however, the future payments require future services by the employee, then the charge to income would be based on the services rendered through the balance sheet date.
7.3.2 Measurement of the deferred compensation liability
ASC 710-10-30 requires the accrual of an employer's obligation under an individual deferred compensation contract in accordance with the terms of the contract, such that the present value of the obligation is fully accrued at the date the employee attains full eligibility for the benefits. The full eligibility date, as defined in ASC 710-10-20, is the date at which an employee has rendered all of the services necessary to have earned the right to receive all of the benefits expected to be received by the employee. This is the earliest date at which the employee has both completed the service required to earn full benefits under the contract and those benefits are 100% vested (nonforfeitable). This accounting is required even if the full eligibility date precedes the expected retirement (payment) date. When full eligibility has been attained, the present value of the benefits expected to be paid should be accrued. If a deferred compensation contract that requires future service is granted shortly before full eligibility, the total amount to be accrued should be recorded over the remaining period to full eligibility or in the year of grant if within the last year of eligibility.
When the amounts to be paid involve more than one individual (for example, employee and spouse) and/or are payable for at least a guaranteed minimum period of time in the event of early death, those features should be included in the actuarial calculations used to determine the present value of the accrued benefit obligation.
Some deferred compensation contracts provide that benefits are payable immediately if an employee dies or becomes disabled during the eligibility period. Unless death or disability during the eligibility period is considered probable, which would be rare, benefits should be accrued over the eligibility period. If death or disability unexpectedly occurs during the eligibility period, the benefit obligation would be remeasured, and any previously unrecognized amount should be immediately recognized at the date of the event.
7.3.2.1 Deferred compensation liability — credit for prior service
An employer may enter into a deferred compensation contract during an employee's period of active employment and grant credit for prior service in determining eligibility for the benefit to be provided. If the benefit is not vested, the employer should accrue the total obligation under the deferred compensation contract in a systematic and rational manner over the employee's future service period to the date full eligibility for the benefits is attained. However, if the credit for prior service results in a vested benefit, the obligation for that vested benefit should be fully accrued at the time the contract is entered into.
Generally, that vested benefit would be determined on the date the contract is entered into, assuming that employment is terminated immediately, with no future service performed and no future salary earned under the contract. The present value of the vested benefit obligation (based on the expected timing of payment) would be recognized at contract inception. Any unvested benefit based on past service and benefits to be earned for future service should be accrued over the period from contract inception to the full eligibility date. If the deferred compensation contract is amended after contract inception, the present value of any change in the vested benefit obligation would be recognized immediately at the amendment date, with any unvested benefit (whether calculated based on past service or for future service) accrued over the future period until full eligibility.
7.3.2.2 Deferred compensation liability — methods of accrual
ASC 710-10-25-9 specifies that the cost of benefits should be accrued over the period of the employee's service in a systematic and rational manner.
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.
If elements of both current and future services are present, only the portion applicable to the current services shall be accrued. Example 1 (see paragraph 710-10-55-4) illustrates this guidance.
Two approaches that are often used are the sinking fund method and the equal annual accrual method.
Sinking fund method
Under the sinking fund method, the periodic accrual is based on a sinking fund calculation to determine fixed "deposits" that, together with interest, will accumulate to the total amount required at the end of the accrual period, the date of full eligibility. The periodic accrual will be the "deposit" plus the theoretical interest cost on the obligation. This method will produce an increasing charge to expense over the accrual period.
In order to develop the sinking fund calculation, management must determine a discount rate. One basis for determining the discount rate is the approach used for purposes of ASC 715, that is, the rates of return on high-quality, fixed-income investments currently available whose cash flows match the timing and amount of expected benefit payments (see ASC 715-60-35-80 through ASC 715-60-35-83). For these purposes, “high quality” is defined as one of the two highest ratings given by a recognized rating agency (e.g., a rating of Aa or higher from Moody's Investors Service, Inc.). This basis generally would be appropriate for long term arrangements that provide benefits similar to those provided by typical defined benefit pension programs.
For other arrangements when the obligation is more akin to a long-term payable, it would also be appropriate to determine the discount rate using an entity-specific credit adjustment to the risk-free rate of return—i.e., an approximate “fair value” measure of the obligation, as described in ASC 420-10-30-2. In more limited circumstances involving longer term arrangements with potentially highly variable cash flows, it may also be appropriate to use a discount rate that reflects not only the entity’s credit risk but the uncertainty in the underlying cash flows, consistent with the fair value measurement guidance in ASC 820.
Equal annual accrual method
Under the equal annual accrual method, discounting is ignored and the total estimated payment amount is divided by the number of periods through the full eligibility date to obtain the periodic accrual.
7.3.3 Remeasurement and changes in estimates
The deferred compensation liability is subject to regular remeasurement at each reporting period. When the deferred compensation is to be paid over a period of years (for example, for life), the obligation would continue to be remeasured after commencement of payments. The remeasurement should reflect current assumptions regarding future compensation levels (if applicable), mortality, discount rate, benefit commencement date, employment termination date, and form of benefit payment, as applicable.
Unlike pension and OPEB arrangements subject to ASC 715, when a deferred compensation obligation subject to ASC 710 is remeasured to reflect emerging experience and updated assumptions, any resulting gains and losses are recognized immediately in income for the portion of the obligation attributable to past service (generally as a component of compensation expense). The impact of the remeasurement of the obligation attributable to future service would be included in compensation expense in future periods using the same accrual convention (sinking fund or equal installment) used prior to the remeasurement.
In certain deferred compensation arrangements, the liability is more akin to a long-term payable. For example, a deferred compensation plan may call for a fixed cash flow stream over a fixed period of time (e.g., 10 years). For such plans, it would also be acceptable to accrete the liability over time at the historical interest rate at which the liability was initially discounted, similar to a note payable carried at amortized cost, rather than remeasuring each period using current interest rates.
Based on the terms of the plans, balances that have been accrued may sometimes be forfeited—for example, due to death, failure of the employee to comply with the contract, or other causes. Forfeited balances should be credited to compensation expense in the same line items as the cost was recognized and in the appropriate period based on the reporting entity’s policy on accounting for forfeitures (see PEB 6.3.3).
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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