What is incentive compensation?

2. Example of accounting for incentive compensation

Letís assume that each year Big Company (a fictitious entity) pays its executive John Smith an annual bonus of 4% of net income (before income taxes). At the year-end, the company determines its net income to be $1,000,000. Therefore, the company has to pay its executive $40,000 (i.e., $1,000,000 x 4%). The company would make the following journal entry to accrue the bonus liability:

Account Titles

Debit

Credit

Bonus Expense

40,000

 

      Bonus Liability

 

40,000

When the company pays the bonus the following year, it would make the following journal entry:

Account Titles

Debit

Credit

Bonus Liability

40,000

 

      Cash

 

40,000

Letís assume that John Smith postpones the recognition of R&D expense of $100,000. In such a case, the net income before taxes would be $100,000 more (i.e., $1,100,000). As the result, John Smith would receive a larger bonus (i.e., $44,000 = $1,100,000 x 4%). As we can see from this example, incentive compensation plans might create an incentive to manipulate accounting information. As the result, itís important to design appropriate compensation plans and establish strong internal controls.

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