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Financial Institution Letters Office of the Comptroller of the Currency Board of Governors of the Federal Reserve System Federal Deposit Insurance Corporation Office of Thrift Supervision
Interagency Advisory on Accounting for Deferred Compensation Agreements and Bank-owned Life Insurance Purpose
Institutions often purchase life insurance in conjunction with establishing deferred compensation programs. Therefore, this advisory also addresses the appropriate accounting treatment for bank-owned life insurance (BOLI). The agencies believe the guidance in this issuance is consistent with generally accepted accounting principles (GAAP) as specified in Accounting Principles Board Opinion No. 12, Omnibus Opinion1967, as amended by Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (SFAS 106) [hereafter referred to as APB 12], and FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance (FTB 85-4). Institutions are expected to apply the guidance in this issuance when preparing Reports of Condition and Income (Call Reports) and Thrift Financial Reports (TFRs). Background
IRPs are one type of deferred compensation agreement that institutions enter into with selected employees. IRPs are typically designed so that the spread each year, if any, between the tax-equivalent earnings on the BOLI covering an individual employee and a hypothetical earnings calculation is deferred and paid to the employee as a postretirement benefit. This spread is commonly referred to as "excess earnings." The hypothetical earnings are computed based on a pre-defined variable index rate (e.g., cost of funds or federal funds rate) times a notional amount. The notional amount is typically the amount the institution initially invested to purchase the BOLI plus subsequent after-tax benefit payments actually made to the employee. By including the after-tax benefit payments and the amount initially invested to purchase the BOLI in the notional amount, the hypothetical earnings reflect an estimate of what the institution could have earned if it had not invested in the BOLI or entered into the IRP with the employee. Each employee's IRP may have a different notional amount upon which the index is based. The individual IRP agreements also specify the retirement age and vesting provisions, which can vary from employee to employee. An IRP agreement typically requires the excess earnings that accrue before an employee's retirement to be recorded in a separate liability account. Once the employee retires, the balance in the liability account is generally paid to the employee in equal, annual installments over a set number of years (e.g., 10 or 15 years). These payments are commonly referred to as the "primary benefit" or "preretirement benefit." The employee may also receive the excess earnings that are earned after retirement. This benefit may continue until his or her death and is commonly referred to as the "secondary benefit" or "postretirement benefit." The secondary benefit is paid annually, once the employee has retired, in addition to the primary benefit. Accounting for Deferred Compensation Agreements Including IRPs APB 12 requires that an employer's obligation under a deferred compensation agreement be accrued according to the terms of the individual contract over the required service period to the date the employee is fully eligible to receive the benefits, i.e., the "full eligibility date." Depending on the individual contract, the full eligibility date may be the employee's expected retirement date, the date the employee entered into the contract, or a date between these two dates. APB 12 does not prescribe a specific accrual method for the benefits under deferred compensation contracts, stating only that the "cost of those benefits shall be accrued over that period of the employee's service in a systematic and rational manner." The amounts to be accrued each period should result in a deferred compensation liability at the full eligibility date that equals the then present value of the estimated benefit payments to be made under the individual contract. APB 12 does not specify how to select the discount rate to measure the present value of the estimated benefit payments. Therefore, other relevant accounting literature must be considered in determining an appropriate discount rate. The agencies view an institution's incremental borrowing rate1 and the current rate of return on high-quality fixed-income debt securities2 to be acceptable discount rates to measure deferred compensation agreement obligations. An institution must select and consistently apply a discount rate policy that conforms with GAAP. For each IRP, an institution should calculate the present value of the expected future benefit payments under the IRP at the employee's full eligibility date. The expected future benefit payments can be reasonably estimated, should be based on reasonable and supportable assumptions, and should include both the primary benefit and, if the employee is entitled to excess earnings that are earned after retirement, the secondary benefit. The estimated amount of these benefit payments should be discounted because the benefits will be paid in periodic installments after the employee retires. The number of periods the primary and any secondary benefit payments should be discounted may differ because the discount period for each type of benefit payment should be based upon the length of time during which each type of benefit will be paid as specified in the IRP. After the present value of the expected future benefit payments has been determined, the institution should accrue an amount of compensation expense and a liability each year from the date the employee enters into the IRP until the full eligibility date. The amount of these annual accruals should be sufficient to ensure that a deferred compensation liability equal to the present value of the expected benefit payments is recorded by the full eligibility date. Any method of deferred compensation accounting that does not recognize some expense for the primary benefit and any secondary benefit in each year from the date the employee enters into the IRP until the full eligibility date is not systematic and rational. Vesting provisions should be reviewed to ensure that the full eligibility date is properly determined because this date is critical to the measurement of the liability estimate. Because APB 12 requires that the present value of the expected benefit payments be recorded by the full eligibility date, institutions also need to consider changes in market interest rates to appropriately measure deferred compensation liabilities. Therefore, to comply with APB 12, the agencies believe institutions should periodically review their estimates of the expected future benefits under IRPs and the discount rates used to compute the present value of the expected benefit payments and revise the estimates and rates, when appropriate. Deferred compensation agreements, including IRPs, may include noncompete provisions or provisions requiring employees to perform consulting services during postretirement years. If the value of the noncompete provisions cannot be reasonably and reliably estimated, no value should be assigned to the noncompete provisions in recognizing the deferred compensation liability. Institutions should allocate a portion of the future benefit payments to consulting services to be performed in postretirement years only if the consulting services are determined to be substantive. Factors the agencies would consider in determining whether postretirement consulting services are substantive include, but are not limited to, whether the services are required to be performed, whether there is an economic benefit to the institution, and whether the employee forfeits the benefits under the agreement for failure to perform such services. Refer to the appendix for examples of the full eligibility date accounting requirements for a basic deferred compensation agreement. Accounting for Bank-Owned Life Insurance
Changes in Accounting for Deferred Compensation Agreements
The agencies have observed that accounting errors under APB 20 that relate to IRPs often result from one or a combination of the following items:
For Call Report and TFR purposes, an institution must determine whether the reason for a change in its accounting for deferred compensation agreements meets the APB 20 definition of an accounting error. If the reason for the change meets this definition, the error should be reported as a prior period adjustment in the Call Report or TFR if the amount is material. Otherwise, the effect of the correction of the error should be reported in current earnings. If the effect of the correction of the error is material, the institution should also consult with its primary federal regulatory agency to determine whether any of its prior Call Reports or TFRs should be amended. If amended Call Reports or TFRs are not required, the institution should report the effect of the correction of the error on prior years' earnings, net of applicable taxes, as an adjustment to the previously reported beginning balance of equity capital. For the Call Report, the institution should report the amount of the adjustment in Schedule RI-A, Item 2, "Restatements due to corrections of material accounting errors and changes in accounting principles," with an explanation in Schedule RI-E, Item 4. For the TFR, the institution should report the amount in Schedule SI, Line SI668, "Prior period adjustments." The effect of the correction of the error on income and expenses since the beginning of the year in which the error is corrected should be reflected in each affected income and expense account on a year-to-date basis in the next quarterly Report of Income or Consolidated Statement of Operations to be filed and not as a direct adjustment to retained earnings. Reporting of BOLI and Deferred Compensation Agreements in Call Reports and TFRs The table below sets forth the appropriate reporting of BOLI in Call Reports and TFRs.
The following table sets forth the appropriate reporting of deferred compensation agreements in Call Reports and TFRs.
Additional Information Appendix Examples of Accounting for Deferred Compensation Agreements
Institutions that enter into deferred compensation agreements with employees, particularly more complex agreements, such as IRPs, should consult with their external auditors and their primary federal regulatory agency concerning the appropriate accounting for their specific agreements. Example 1: Fully Eligible at Agreement Inception Other key facts and assumptions used in determining the benefits payable under the agreement and the liability and expense to be recorded by the company in each period are summarized in the following table:
At the employee's expected retirement date, the present value of a lifetime annuity of $20,000 that begins on that date is $142,109 (computed as $20,000 times 7.10545, the factor for the present value of 10 annual payments at 6.75 percent). At the inception date of the agreement, the present value of that annuity of $102,514 (computed as $142,109 times 0.721375, the factor for the present value of a single payment in five years at 6.75 percent) is recognized as compensation expense, because the employee is fully eligible for the deferred compensation benefit at that date. The following table summarizes one systematic and rational method of recognizing the expense and liability under the deferred compensation agreement:
The following entry would be made at the inception date of the agreement (the final day of "Year 0") to record the service component of the compensation expense and related deferred compensation agreement liability:
[To record the column "B" service component]
In each period after the inception date of the agreement, the company would adjust the deferred compensation liability for the interest component and any benefit payment. In addition, the company would reassess the assumptions used in determining the expected future benefits under the agreement and the discount rate used to compute the present value of the expected benefits in each period after the inception of the agreement and revise the assumptions and rate, as appropriate. Assuming no changes were necessary to the assumptions used to determine the expected future benefits under the agreement or the discount rate used to compute the present value of the expected benefits, the following entry would be made in "Year 1" to record the interest component of the compensation expense:
[To record the column "C" interest component (computed by multiplying the prior year column "F" balance by the discount rate)] Similar entries (but for different amounts) would be made in "Year 2" through "Year 15" to record the interest component of the compensation expense. The following entry would be made in "Year 6" to record the payment of the annual benefit:
[To record the column "A" benefit payment]
Similar entries would be made in "Year 7" through "Year 15" to record the payment of the annual benefit. Example 2: Fully Eligible at Retirement Date Other key facts and assumptions used in determining the benefits payable under the agreement and the liability and expense to be recorded each period by the company are summarized in the following table:
The following table summarizes one systematic and rational method of recognizing the expense and liability under the deferred compensation agreement:
No entry would be made at the inception date of the agreement. The following entry would be made in "Year 1" to record the service component of the compensation expense and related deferred compensation agreement liability:
[To record the column "B" service component]
Similar entries would be made in "Year 2" through "Year 5" to record the service component of the compensation expense. In each subsequent period, until the date the employee is fully eligible for the deferred compensation benefit, the company would adjust the deferred compensation liability for the total expense (i.e., service and interest components). In each period after the full eligibility date, the company would adjust the deferred compensation liability for the interest component and any benefit payment. In addition, the company would reassess the assumptions used in determining the expected future benefits under the agreement and the discount rate used to compute the present value of the expected benefits in each period after the inception of the agreement and revise the assumptions and rate, as appropriate. Assuming no changes were necessary to the assumptions used to determine the expected future benefits under the agreement or the discount rate used to compute the present value of the expected benefits, the following entry would be made in "Year 2" to record the interest component of the compensation expense:
[To record the column "C" interest component
(computed by multiplying the prior year column "F" balance by the discount rate)] Similar entries (but for different amounts) would be made in "Year 3" through "Year 15" to record the interest component of the compensation expense. The following entry would be made in "Year 6" to record the payment of the annual benefit:
[To record the column "A" benefit payment]
Similar entries would be made in "Year 7" through "Year 15" to record the payment of the annual benefit. Footnotes 1Accounting Principles Board Opinion No. 21, Interest on Receivables and Payables , paragraph 13, states in part that "the rate used for valuation purposes will normally be at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction." 2SFAS 106, paragraph 186, states that "[t]he objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the accumulated benefits when due." The TFR lines reflect changes to the 3TFR form for 2004. For reporting periods prior to March 2004, consult the TFR instructions for the applicable period. 4The net change in the cash surrender value (i.e., gross earnings (losses) on or increases (decreases) in value less BOLI policy expenses) is reported for TFR purposes. For Call Reports, the net earnings (losses) on or the net increases (decreases) in the cash surrender value may be reported. Alternatively, the gross earnings (losses) on or increases (decreases) in value may be reported in Schedule RI, Item 5.l, and the BOLI policy expenses may be reported in Schedule RI, Item 7.d. 5Applicable for Call Reports only if institutions report the gross earnings (losses) on or increases (decreases) in the cash surrender value in Call Report Schedule RI, Item 5.l.
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Last Updated 10/28/2011 | communications@fdic.gov |