Many severance plans provide benefits that vest (i.e., they are payable regardless of who initiates the action that leads to termination of employment) or accumulate (i.e., the benefits increase in amount based on length of employment) and are, thus, attributable to past services. An employer should accrue a liability when all four of the ASC 710-10-25-1
conditions are met. A benefit that an employee is entitled to upon any termination of service (including voluntary termination), sometimes referred to as a termination indemnity, should generally be accrued over the vesting period. The liability at each reporting date should at least reflect the amount currently vested. Although the timing of the payment may not be known, it would generally be considered probable that the company will pay the benefits at some point in the future. This type of arrangement may be more common in certain foreign countries.
Some companies may have a history of paying severance benefits for involuntary terminations absent a written severance plan. In that case, the history of the severance payments should be analyzed to determine whether a substantive plan exists. A benefit arrangement that is mutually understood by an employer and its employees would constitute a substantive plan even if that arrangement is unwritten. A history of paying special termination benefits, as defined in ASC 712
(see PEB 8.2
), would not constitute such a plan, however, because employers have no obligation to pay benefits until employees accept an offer to voluntarily terminate their employment.
For severance benefits that vest or accumulate, companies should accrue a liability when payment of the benefits is probable and reasonably estimable. Generally, three different situations may occur for companies with written or substantive severance plans:
- Severance occurs from time to time, but is not probable and estimable. Companies should record a liability when payment of benefits becomes probable and estimable.
- Some minimum level of probable severance benefits can be predicted and estimated with reasonable accuracy covering normal recurring involuntary terminations. If the severance benefits vest or accumulate, they should be accrued over the related service period under the ASC 710-10-25-2 approach. Unusual levels of severance (e.g., resulting from a restructuring or plant shutdown) would be accrued when probable and reasonably estimable, generally when management has made the decision to initiate the terminations.
- Some very large companies may have so many work locations that the natural evolution of their businesses results in a reasonably predictable pattern of workforce reductions (e.g., through small reorganizations, plant shutdowns, and other actions). In those situations, overall severance costs, including those related to various termination “events,” could be considered probable of payment and reasonably estimable even though a decision has not been made to close any specific plant. As such, the value of severance benefits that vest or accumulate should be accrued over the relevant employee service periods.
If the termination benefits represent contractual termination benefits (see PEB 8.3
), a liability for such benefits would be recognized when it is probable that the specified event that would trigger a requirement to pay benefits (e.g., plant closing) will occur.
One-time termination benefits provided to involuntarily terminated employees under the terms of a one-time benefit arrangement (an arrangement established by a plan of termination that applies for a specified termination event or for a specified future period) should be accounted for under ASC 420
if the benefits are not provided in the form of an enhancement to an ongoing benefit plan. See PEB 8.5
for additional discussion of one-time termination benefits.
Question PEB 8-9
On December 15, 20X1, a company makes a general announcement that cost-cutting measures are underway and an involuntary workforce reduction will occur soon. As of December 15, 20X1, the company has identified affected employees, but has not notified them and does not plan to do so until January 20X2. The company does not have a written pre-existing severance plan; however, it has a history of compensating severed employees four weeks of base salary for every year of continuous employment, and plans to do so in this case. Employees understand how their benefits would be calculated if they were to be involuntarily terminated.
What model for termination benefits should be used? When should the liability and related expense be recorded?
The company would likely conclude that it has a substantive involuntary termination benefits plan because it has a consistent past practice of providing termination benefits that employees understand. The liability and related expense for the termination benefits would be accrued on December 15, 20X1 for the identified employees, as there is a mutual understanding of benefits that employees will be entitled to receive at that time and the amount is both probable and estimable. Note that the assessment of what constitutes a “consistent past practice” involves considerable judgment, as further described in PEB 8.5
Question PEB 8-10
To record a liability for one-time termination benefits, ASC 420
requires an employer to, among other things, communicate to its employees the benefits they will be entitled to receive if they are terminated. Must this communication be made for a liability to be recorded for severance benefits pursuant to an ongoing benefit plan?
No. ASC 712
addresses the accounting for benefits that are provided under the terms of an ongoing postemployment benefit plan. A plan represents the benefit arrangement that is mutually understood by an employer and its employees. Thus, if an employer has an ongoing benefit plan that provides involuntary termination benefits, employees are already aware of the benefits they will receive if they are terminated involuntarily so the communication of the benefit is not necessary for an obligating event to occur.
Example PEB 8-1 discusses the timing of recognition of a liability related to a reduction in force.
EXAMPLE PEB 8-1
Timing of recognition of liability for severance benefits for a reduction in force
An employer has a written involuntary termination benefit plan that is distributed to all of its employees at their date of hire. The plan provides that, upon an involuntary termination of employment for other than cause, each terminated employee will receive one week of severance pay for every year of service. If an employee voluntarily terminates employment, the employee will receive no termination benefit under this arrangement.
The employer has previously concluded that involuntary terminations were not probable and/or reasonably estimable.
During its fiscal fourth quarter, the company determines that it will initiate a reduction in force (RIF). Management can reliably estimate the expected number of involuntary terminations that will occur. The RIF is expected to occur approximately six months after the fiscal year end and specific affected employees will be notified at that time and terminated immediately.
What accounting would be required under these circumstances?
Because the benefits accumulate—i.e., the amount of severance increases based on years of service—the plan is subject to the guidance in ASC 712
. Although no benefits were previously accrued because management concluded payment was not probable or reasonably estimable, the decision to initiate a RIF in the fourth quarter and establish the number of terminations expected to occur makes payment probable and reasonably estimable under the plan. Because payment of the benefit is probable and the amount can be reasonably estimated, the company would recognize a liability during the fourth quarter for the cost of benefits earned by employees’ services rendered through the end of the fiscal fourth quarter. The amount should be based on expected future payments of benefits earned for service to date, taking into account the possibility that some individuals may voluntarily terminate their employment before being notified of the RIF and will not be entitled to the benefits. The liability would be increased in the first and second quarters of the next fiscal year as employees who will be terminated as part of the RIF render additional service that earns them a larger benefit (i.e., they reach another anniversary date to be eligible for another week of pay).
If the company did not have a written plan or a substantive plan based on a history of paying benefits for past terminations, but rather announced what the severance benefits for this RIF will be in the fourth quarter when it reached the decision to perform a RIF, the benefit arrangement would be accounted for as a one-time termination benefit. In that case, because individuals must be employed on the termination date in order to receive the benefit and the minimum retention period to receive the benefits is greater than 60 days, the cost of the benefits and corresponding liability would be accrued from the date that all of the conditions in ASC 420-10-25-4
are met (management commitment, employee groups identified, terms established in enough detail that employees can determine benefits if they are terminated, unlikely significant changes to plan will be made and communication to affected employees) through the termination date.
Question PEB 8-11
Company A terminated a key employee. The employee has historically been instrumental in Company A's revenue growth, developing and maintaining a significant number of the company's customer relationships. At the time of termination, Company A and the employee negotiated a $2 million severance payment, as well as a three-year non-compete agreement.
Should Company A expense the $2 million upon termination or capitalize some or all of the $2 million and attribute the amount over the three-year term of the non-compete?
It depends. The determination of whether some or all of the $2 million should be expensed or attributed over a future period is dependent on whether the non-compete agreement is considered an asset (i.e., whether there is a probable future economic benefit that is controlled by the company) consistent with the guidance in ASC 350-30-25
regarding the recognition of an intangible asset. This evaluation would consider whether the non-compete agreement is substantive, and whether Company A has the intent and legal ability to enforce the non-compete agreement.
If the non-compete is determined to be substantive and Company A has the intent and ability to enforce it, the fair value of the non-compete, not to exceed the total payment, would be capitalized and amortized over the three-year term of the non-compete. The fair value of the non-compete may be an amount less than the $2 million total payment. Any amount paid in excess of the fair value of the non-compete would be expensed as a severance payment.