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  1. 1
    Understand which types of pay can be legally treated as deferred compensation. The term "deferred compensation" in general use refers to "unqualified" deferred compensation - pay packages that do not qualify to be covered under the Employee Retirement Income Security Act (ERISA), passed in 1974.
    • ERISA stipulates that qualified deferred pay must be placed in a fund for the sole benefit of the employee in question. 401(k) plans are the most common type of ERISA-qualified plan. If the firm declares bankruptcy, creditors do not have the legal right to seize funds covered under ERISA.
    • Deferred compensation that does not qualify under ERISA is treated as a general asset of the company. It is held on the balance sheet as an asset, and is at risk of being seized by creditors in the event of a bankruptcy. Unlike ERISA plans, this income is not taxed until is becomes available to the employee.
    • Because of the benefit of tax deferral, deferred compensation plans are closely watched by the Internal Revenue Service (IRS). They must only be granted to high-profile employees who represent a substantial risk of leaving the company for another attractive position.
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    Determine the terms of the deferred compensation package. Understanding the structure of the pay package is essential to executing the proper accounting treatment. For example, consider a compensation plan issued in 2010 that will pay out a lump sum of $100,000 to an employee in 2015.
  3. 3
    Record the journal entries for the establishment of the deferred compensation plan. When the plan is established (in 2010), it represents a liability; that is, an obligation to pay the employee. An entry must be recorded in the general journal to reflect the establishment of the pay plan.
    • First, the present value of the pay package must be determined. The lump sum should be discounted to its present value at the current market rate for comparable fixed-income investments.
    • If the example above is discounted at 10%, the resulting present value is (100,000 / 1.10 ^ 5) or $62,092.
    • To record the journal entry, debit Deferred Compensation Expense for $62,092 and credit Deferred Compensation Liability (a long-term liability account) for $62,092.
  4. 4
    • For example, after the first year, the new total value of the compensation plan is (100,000 / 1.10 ^ 4) or $68,301. The difference between this value and the initial value is (68,301 - 62,092) or $6209.
    • To record the adjusting entry, debit Deferred Compensation Expense for $6209 and credit Deferred Compensation Liability for $6209.
  5. 5
    Record the journal entry upon disbursement of cash to the employee. In 2015, the deferred compensation plan matures and the employee is paid. The journal entry is simple. Debit Deferred Compensation Liability for $100,000 (this will zero out the account balance), and credit Cash for $100,000. Taxes on the payment will be paid at this point (by both the corporation and the employee).
  6. 6
    Record the journal entries to account for the deferred taxes. Because deferred compensation allows the corporation to defer paying taxes until the employee is paid, an entry must be recorded to account for the difference between GAAP income and taxable income.
    • For example, if there is a $30,000 difference between accounting income and taxable income, record the journal entry as follows. Debit Deferred Tax Asset for $30,000 and credit Income Tax Expense for $30,000.

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