Deferred compensation is an agreement between an employer and employee to pay at a later date. It is recorded as an adjustment to temporary accounts using accrued expense techniques, recognizing the expense as a liability for the current accounting period. The US IRS requires regular payroll tax codes when accounting for deferred compensation.
Deferred compensation is an agreement between an employer and an employee to pay the employee at some point in the future, rather than when payment is normally due. The agreement to defer compensation may be informal or formal. Sometimes the compensation is held in an escrow, to ensure that the employee will eventually be paid. When accounting for deferred compensation, employee pay is recorded at the end of an accounting period as an adjustment to temporary accounts.
Adjustments come in two forms, deferrals and accruals. Deferrals are cash payments for assets before the asset is used, or payments for liabilities before income is earned. Accruals are income earned or expenses incurred, but not paid or recorded before the adjustment. So even though deferred compensation accounting is labeled deferred, it’s actually accrual in accounting terms.
Accountants generally use accrued expense techniques when adjusting and accounting for deferred compensation. The accountant may not record the compensation during daily expense calculations because no money has actually been spent. A deferred compensation adjustment serves two purposes: it records the salary on the company’s balance sheet and it recognizes the expense as a liability that pertains to the current accounting period. Before adjusting, the company’s expenses and liabilities are listed as lower than they actually are.
The accounting process for deferred compensation typically 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 compensation 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 compensation under a heading of salary expenses, labeling it as wages payable to distinguish the compensation from other types of salary expenses.
On the company’s balance sheet, deferred compensation accounting appears on the left side – or under assets – as salary expenses, and on the right side – or under liabilities – as wages payable. The recording process is different if the compensation is put into escrow. Instead of using accrued expense techniques, the accountant will likely use whatever method the company applies to normal 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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