Deferred compensation is an arrangement between an employer and employee to pay the employee sometime in the future, instead of when the pay would normally become 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. In accounting for deferred compensation, the employee pay is recorded at the end of an accounting time period as an adjustment to temporary accounts.
Adjustments come in two forms, deferrals and accruals. Deferrals are cash payments made for assets before the asset is used, or payments for liabilities before the revenue is earned. Accruals are revenues earned, or expenses incurred, but not paid for or recorded before the adjustment. So, even though accounting for deferred compensation is labeled as deferred, it is actually an accrual in accounting terms.
Accountants typically use accrued expenses techniques when adjusting and accounting for deferred compensation. The accountant may not record compensation during daily expense calculations because no money has actually been spent. An adjustment for deferred compensation serves two purposes, it records the salary on the company balance sheet, and it recognizes the expense as a liability belonging to the current accounting time period. Before adjusting, both company 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 proper amount of compensation for the time period. Next, the accountant records the total compensation amount under a salaries expense heading, labeling it salaries payable to distinguish the compensation from other types of salary expenses.
On the company balance sheet, the accounting for deferred compensation appears on the left — or assets — side as salaries expense, and on the right — or liabilities — side as salaries payable. The recording process is different if the compensation is put into escrow. Instead of using accrued expenses techniques, the accountant will probably just use whatever method the company applies to normal wage payments. The U.S. Internal Revenue Service (IRS) requires that businesses apply regular salary tax codes when accounting for deferred compensation.