What is involved in accounting for deferred compensation?

Deferred compensation disbursements are generally not requested by the employee until after he or she retires.

Deferred compensation is an agreement between the employer and the employee to pay the employee sometime in the future, rather than when the payment would normally be due. The agreement to defer compensation may be informal or formal. Sometimes compensation is kept in escrow, to ensure that the employee will be paid. In deferred compensation accounting, an employee’s pay is recorded at the end of an accounting period as an adjustment to interim accounts.

Adjustments come in two forms, deferrals and accruals. Deferrals are cash payments made for assets before they are used, or payments for liabilities before income is earned. Provisions are income earned or expenses incurred but not paid or recorded prior to adjustment. Therefore, while accounting for deferred compensation is labeled as deferred, it is actually a provision in accounting terms.

Accountants often use accrued expense techniques when adjusting and accounting for deferred compensation. The accountant cannot record the compensation during daily expense calculations because no money was actually spent. An adjustment for deferred compensation serves two purposes: it records the salary on the company’s balance sheet and it recognizes the expense as a liability pertaining to the current accounting period. Before adjusting, the company’s expenses and liabilities are listed as lower than they actually are.

The deferred compensation accounting process usually begins with the accountant identifying the time period in which the salary expense was incurred. For example, if a company uses one-month accounting time periods, the accountant determines which offsetting expenses occurred in the current month. This identifies the appropriate amount of compensation for the time period. The accountant then records the total amount of the compensation under the heading of salary expenses, labeling it as salaries payable to distinguish the compensation from other types of salary expenses.

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On the company’s balance sheet, the accounting for deferred compensation appears on the left – or asset – as payroll expenses, and on the right – or liability – as salaries payable. The registration process is different if the compensation is deposited in escrow. Instead of using accrued expense techniques, the accountant will likely only use the method the company applies for regular salary payments. The US Internal Revenue Service (IRS) requires companies to apply regular payroll tax codes when accounting for deferred compensation.

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