2. Example of accounting for incentive compensation

Let’s 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:

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

Let’s 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, it’s important to design appropriate compensation plans and establish strong internal controls.

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