Accounting for Voluntary Deferred Compensation and Informal Funding

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1 Accounting for Voluntary Deferred Compensation and Informal Funding Executive Summary Nonqualified executive benefit programs are critical components in attracting and retaining key talent, although their accounting can involve unfamiliar concepts to the Companies sponsoring these plans. And while accounting industry practice is generally well-defined, the rules for accounting for deferred compensation plans and specific informal funding approaches are not always clear cut. To provide clarification, this report outlines the journal entries for the accounting associated with nonqualified deferred compensation arrangements, as well as for the most common types of informal funding vehicles used to finance these plans benefit liabilities. Proper recognition of NQDCP accounting entries is an important component of plan recordkeeping, and requires specific knowledge of and compliance with various rules. Our Specialty Your Success SM

2 Accounting for Deferral Plan Liability Initial Deferral Deferred compensation is booked as a deferred compensation expense instead of a compensation expense. The deferral creates a deferred tax asset, representing the tax deduction that may be taken in the future when the benefit is distributed. As a result, there is no incremental impact to the Income Statement from the deferral aside from any interest credited as a result of earnings. Example: Journal entries made for the deferral of $1,000,000 of compensation. Deferred Comp Expense Income Statement $1,000,000 Deferred Comp Liability Balance Sheet $1,000,000 Deferred Tax Asset Balance Sheet $400,000 Income Tax Expense Income Statement $400,000 Earnings Credited to Deferred Compensation Account When earnings are credited to the deferred compensation account, they result in a charge to earnings on a book basis. In the previous $1 million deferral example, we assume a 40% income tax rate, and 10% return on the tax-adjusted deferral balance. The credited interest earnings result in a $60,000 charge. Similarly, a company matching contribution would create the same expense booked as credited positive earnings. Deferred Comp Expense Income Statement $100,000 Deferred Comp Liability Deferred Tax Asset Balance Sheet $40,000 Income Tax Expense Income Statement $40,000 Benefits Paid When a benefit is paid out, the tax deduction is taken. This example shows journal entries at the time of distribution of a $3,000,000 deferred compensation benefit payment. Deferred Comp Liability Balance Sheet $3,000,000 Balance Sheet $3,000,000 Balance Sheet $1,200,000 Deferred Tax Asset Balance Sheet $1,200,000

3 Accounting for Informal Funding Using Life Insurance If your company elects to use life insurance as a funding vehicle for your deferred compensation plan, accounting is governed by FTB Initial Purchase For the initial purchase of $1,000,000, journal entries would be as follows: Premium Expense Income Statement $1,000,000 Balance Sheet $1,000,000 Insurance Surrender Value Balance Sheet $1,000,000 Gain from Insurance Income Statement $1,000,000 Value Growth As the cash value of the life insurance grows, journal entries would be accounted as a debit to the balance sheet and a credit on the income statement. The following journal entries assume a $100,000 growth in cash value. Insurance Surrender Value Gain from Insurance Income Statement $100,000 Policy Loan If you were to take a loan from the life insurance policy, cash would be debited on the balance sheet and a loan credit would appear. This example of a $100,000 loan presumes 8% policy loan interest. Life Insurance Policy Loan At Death When the insured dies, the company receives the death benefit on a tax-free basis. The difference between the death proceeds received and the cash value already booked as an asset is recognized as a gain from insurance on the Income Statement. In this example we see a $3.5 million death benefit. Balance Sheet $3,500,000 Insurance Value Balance Sheet $1,500,000 Gain from Insurance Income Statement $2,000,000

4 ACCOUNTING FOR INFORMAL FUNDING USING TAXABLE SECURITIES Securities Classified as Trading An investment carries a Trading classification if it is held principally for trading in the near term. Accounting for these investments is governed by FAS115. Initial Purchase Using these accounting rules and assuming all realized gains will be reinvested, an initial purchase has no impact on the Income Statement. Investment A Balance Sheet Assets $1,000,000 (Investment Purchase) Balance Sheet $1,000,000 Gain in Asset Value (Investment A ) A $100,000 growth in the asset would result in a $100,000 debit on the Balance Sheet and a combined unrealized and realized credit gain on the Income Statement. Realized and unrealized temporary losses in asset value would be booked as opposite entries from that shown below. Taxable Asset Balance Sheet Assets $100,000 Unrealized Gain Income Statement $40,000 Realized Gain Income Statement $60,000 In addition to accounting for the asset, FAS 109 requires accounting for deferral taxes. Because Trading classification accounting treats all gains as realized, there is only one set of journal entries to account for taxes, unlike the Available for Sale method of accounting, which requires booking two sets of journal entries. The following assumes the same $100,000 asset growth taxed at 40%. Income Tax Expense Income Statement $100,000 Deferred Tax Liability Balance Sheet Liability $20,000 (Income Tax Payment) Balance Sheet $80,000

5 Asset Reallocation In instances where your company elects to sell a portion of one investment to purchase another, the accounting for the reallocation is governed by FAS 115. A reallocation triggers the realization of gains, losses and appropriate taxes which impact your Income and Flow Statements. In the following example, a$100,000 reallocation results in a $12,000 net gain on the Income Statement (Realized Gain Income Tax Expense) and an $8,000 decrease in cash flow. This assumes a 40% tax rate. (Sale of Investment A ) Realized Gain Income Statement $20,000 Investment A Balance Sheet Assets $80,000 Income Tax Expense Income Statement $8,000 (Income Tax Payment) Balance Sheet $8,000 Investment B Balance Sheet Assets $100,000 (Investment Purchase) Income Statement $100,000 Conclusion There is no single source for nonqualified deferred compensation plan accounting rules, with various opinions, pronouncements and statements issued by the Financial Accounting Standards Board (FASB), its Emerging Issues Task Force (EITF), and the Accounting Principles Board (APB) all coming into play. MullinTBG continues to monitor accounting changes and updates as they occur, and publishes Special Reports for our clients that provide overviews of key announcements and guidance. In addition, MullinTBG can prepare customized accounting letters for nonqualified deferred compensation plan financial reporting needs. Prepared by our staff of financial professionals, these reports provide a summary of the plan s effect on the balance sheet and income statement, including detailed accounting entries that can be used to record activity directly into the general ledger. Our experienced finance team members are deeply knowledgeable of nonqualified plan accounting specifics, and are available for consulting services and to answer questions about the plan s impact on corporate financials. Please feel free to contact MullinTBG with any additional inquiries, and consult your regular advisors for specific legal, tax, accounting and other advice. Investments in securities involve risks including the possible loss of principal. When redeemed, shares may be worth more or less than their original value. Any hypothetical investment performance data contained within this document are included for illustrative and informational purposes only, and not indicative of the performance of any particular investment or as a representation of past or future results. Actual results will vary from those illustrated. 100 North Sepulveda Blvd., Suite 500, El Segundo, CA 90245, Tel: MullinTBG. All Rights Reserved. Insurance products offered through MullinTBG Insurance Agency Services, LLC ( MullinTBG ). Investment Advisory Services provided by MullinTBG Advisory Services, LLC ( MullinTBG Advisors ), a Registered Investment Adviser and a subsidiary of MullinTBG. Securities offered through M Holdings Securities, Inc., a Registered Broker/Dealer, Member FINRA/SIPC. MullinTBG and MullinTBG Advisors are owned and operated independently from M Holdings Securities, Inc.