Assets of rabbi trusts that are included in the employer’s financial statements should not be offset against the deferred compensation liability, given the fact that the trust assets are explicitly available to general creditors in the event of bankruptcy and remain assets of the reporting entity. While some reporting entities may invest the trust assets to serve as an economic hedge against changes in the deferred compensation liability, earnings on the trust assets should be reported in the employer's income statement in the same manner as returns on other investments and should not be offset against the deferred compensation expense.

Employer shares held by the rabbi trust should be treated as treasury stock for earnings per share purposes—i.e., not considered outstanding and, therefore, not included in the denominator in the basic and diluted EPS calculations. However, if the obligation under the deferred compensation arrangement may be settled in employer shares, it should be reflected in the denominator of the EPS computation in accordance with the provisions of ASC 260, Earnings per Share. ASC 260-10-45-13 provides that, if an obligation is required to be settled by delivery of shares of employer stock, those shares should be included in the calculation of basic and diluted EPS. If the obligation may be settled by delivery of cash, shares of employer stock, or diversified assets, those shares would not be reflected in basic EPS but would be included in the calculation of diluted EPS in accordance with ASC 260-10-45-30 and ASC 260-10-45-45 through ASC 260-10-45-46. If the shares issuable in settlement of the liability are included in the denominator of the diluted EPS calculation, the numerator is not adjusted (as described in ASC 260-10-55-33). See FSP 7 for further discussion of EPS calculations.

For US Federal income tax purposes, companies may receive a tax deduction for dividends paid on shares held in a rabbi trust that does not permit diversification (i.e., it only holds employer stock). The accounting for the tax benefit in those circumstances is similar to the accounting for tax benefits related to share-based payments under ASC 718. That is, when the tax benefit is recognized, either as a reduction to taxes payable or an increase in deferred tax assets, the tax benefit should be reflected in income tax expense. See TX 17.7 for a further discussion of tax benefits associated with these dividends.

It is important to consider the unit of account when analyzing deferred compensation arrangements that utilize a rabbi trust. We believe it may be appropriate to view the unit of account to be at the individual instrument level, at the plan level, or at the trust level.

Example PEB 7-1 highlights the differences in accounting based on different units of account.

EXAMPLE PEB 7-1
Unit of account for a rabbi trust used for deferred compensation

PEB Corporation has one rabbi trust that is used to fund two deferred compensation plans. One plan is a cash bonus arrangement, the other a stock bonus arrangement. The cash bonus arrangement permits diversification within the rabbi trust, while the stock bonus arrangement does not (i.e., it must be settled by the delivery of a fixed number of shares of employer stock). Additionally, dividends on the employer stock are also deferred in the rabbi trust, and will be settled in cash.

What is the appropriate accounting for the rabbi trust? Does the accounting differ depending on the assessed unit of account?

If the unit of account is viewed to be at the trust level, the entire amount in the rabbi trust would need to follow the Plan B through Plan D accounting described in PEB 7.5.1.3 and in ASC 710-10-25-15 through ASC 710-10-25-18. That is, a deferred compensation liability would be recognized at fair value each reporting period (with a corresponding charge to compensation cost) for all amounts (both the cash and employer stock) in the trust.

If the unit of account is viewed to be at the individual deferred compensation plan level, each plan would be analyzed separately to determine the applicable plan type and accounting. The cash bonus arrangement would be considered Plan D because it permits diversification and the liability associated with it would be measured at fair value at each reporting period. The stock bonus arrangement would likely qualify for Plan A accounting, because it requires settlement by delivery of a fixed number of employer shares. However, because the dividends will be settled in cash, the entire stock bonus plan would be subject to Plan B accounting and the obligation would also be marked to fair value each reporting period.

If the unit of account is viewed to be at the individual instrument level, the three components of this arrangement (cash bonus, stock bonus, dividends) would be analyzed separately. The cash bonus component would follow Plan C/D accounting because it can be diversified. The stock bonus component would follow Plan A accounting, because it is settled in a fixed number of shares. The initial payment of the dividend would not require additional compensation expense as it would be viewed as a dividend on an existing equity instrument. Subsequent to the initial payment, the dividends would require Plan B accounting, because they are cash settled. Any change in the value going forward would require additional compensation cost to reflect changes in the fair value; for example, if interest is paid on the cash balance.