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.

The Answer is explanatory so it is given as under:

Explanation:

Part 1. At the start of the year:

The part of the salary includes $150,000 per year for the next 10 years and this must be recorded as an deferred compensation liability. All we have to do is to calculate the present value of the annual salary payments.

Present Value = Annual Payment * Annuity factor

And for Annuity factor we will use 5% rate of interest.

So

Annuity Factor = (1 - (1-r) ^n) / r

Here

r = 5%

n = 10 years

Which means

Annuity Factor = (1 - (1 + 5%) ^10) / 5% = 7.722

Hence

Present value = $150,000 * 7.722 = $1,158,260

So the journal entry would be as under:

Dr Deferred Compensation expense $1,158,260

Cr Deferred Compensation Liability $1,158,260

Part 2. At the end of the Year 1:

At the first year end, the annual payment of $1,158,260 will be discounted back by using the following formula:

Discounted Back Amount = Annual Amount * (1 - (1+r) ^n)

Remember for the first year n is 10, for second n is 9 and so on.

Discounted Back Amount = 150,000 x (1 - 0.614) = $57,913

Dr Deferred Compensation Expense $57,913

Cr Deferred Compensation Liability $57,913

Part 3. And when the first payment of the salary is made, the journal entry would be:

Dr Deferred compensation Liability $ 150,000

Cr Cash Account $150,000

Likewise we will till the year 10 and will record the part 2 and part 3 until at the end of the year 10, the whole of the deferred tax liability is reduced to zero.

The life insurance policy payments can not be offset against the deferred compensation liability because it will be accounted for as a different transaction and hence must not be treated as Riley desires.

So the Cash surrender value will be treated as an asset and annual increase in this asset would be treated as an income.