Question

Riley Company promises to pay Janet Anderson or her estate $150,000 per year for the next 10 years, even if she leaves the company or passes away to try to induce her to stay with the company. Riley Company wants to properly record this transaction as deferred compensation but is unsure how to record the cost. In addition, Riley Company purchased a whole life insurance policy for Janet, naming the company as the beneficiary. Riley Company wants to determine if it can offset the cash surrender value of the life insurance policy against the deferred compensation liability.

Answer 1

The $ 150,000 per year to be paid each year for the next 10 years by Riley Company to Janet Anderson should be recorded as a deferred compensation liability. The present value of the annual payments should be calculated. For calculating the present value generally the risk free interest rate is considered as the discount rate. If the discount rate is 5% then the PV of the cash payments for the next 10 years will be 150,000 x PV factor which is 150,000 x 7.721735 = $ 1,158,260.24. (Please refer excel tables below)

Hence the following entry should me made to record the expense and liability

Debit Deferred Compensation expense $ 1,158,260.24

Credit    Deferred Compensation liability $ 1,158,260.24

At the end of first year before making the payment of 150,000 the Deferred compensation liability amount has to be adjusted to reflect the new present value which will be 150,000 x 8.107822 = $ 1,216,173.25.

The increase of ($1,216,173.25.- $ 1,158,260.24) = $ 57913.01 should be recorded

Debit Deferred Compensation expense   $ 57913.01

Credit    Deferred Compensation liability $ 57913.01

When the first year payment is made, the following entry should be recorded

Debit Deferred compensation Liability $ 150,000

Credit Cash    $ 150,000

Like this we have to do for the 10 years till the deferred tax liability becomes zero at end of year 10.

As regards the cash surrender value in respect of the whole life insurance policy wherein the company is named as beneficiary, the same cannot be offset against the Deferred Compensation liability. The Cash surrender value has to be recorded as an Asset and the increase in the surrender value after each year has to recorded by increasing the asset value and recognizing the increase in the profit loss a/c..

The relevant entries in company's books will be

Debit Insurance Expense ( the premium paid)

Credit Cash ( the premium paid)

Debit Cash Surrender value ( Asset) - with the surrender value at end of year 1

Credit Insurance expense