What is Deferred Compensation?

Deferred compensation is earned in one period but paid out in a later period. Because the compensation is delayed, the associated income taxes are also deferred until the eventual payout date. If the deferred payment occurs after the recipient has retired, then the individual will likely be in a lower tax bracket at that time, resulting in a lower tax payment.

Accounting for Deferred Compensation

If a deferred compensation arrangement is based on employee performance during a specific time period, accrue the cost of the deferred compensation in that performance period. If the deferred compensation is based on both current and future service, only accrue an expense for that portion of the compensation attributable to current service. As of the full eligibility date for the deferred compensation, the employer should have accrued the present value of those benefits expected to be paid in the future. Depending on the terms of the arrangement, it may be necessary to record an accrual based on the life expectancy of the employee, as supported by mortality tables, or on the estimated cost of an annuity contract.

Example of Deferred Compensation Accounting

As an example of deferred compensation accounting, Armadillo Industries creates a deferred compensation agreement for its CEO, under which he will become eligible for the benefits stated in the contract after five years have passed. The terms of the agreement indicate that the CEO will render services for five years in order to earn the deferred compensation, so Armadillo accrues the cost of the contract over the intervening five years.