Understanding the Accrual Basis of Accounting for Revenue Recognition
Unlike the cash basis of accounting, which recognizes revenue and expenses only when money changes hands, the accrual basis accounts for transactions when they are earned or incurred, regardless of the actual cash flow. The Revenue Recognition Principle dictates that revenue should be recognized in the accounting records when it is earned, not when it is received. While recognizing employee and employer contributions on the accrual basis seems logical, knowing when the commitment to contribute arises can be challenging.
What is Accrual Basis Plan Compensation?
Accrual basis plan compensation does not have to be the same amount as the accrual basis compensation for the employer.
For example, when plan contributions are based on paycheck dates, plan sponsors can link accrual basis compensation for the plan to the paychecks issued to participants during the plan year, disregarding any workdays for which the participant has not been compensated. This approach treats the paycheck as the trigger for the contribution obligation. Additional compensation for unpaid days would be accrued as wages payable on the company financial statements, but the related plan contribution for would not be accrued as a contribution receivable on the plan books until the paychecks are issued.
The reasoning behind using wages includable in the W-2 as the accrual basis plan compensation is that most plan documents permit deferral election changes at any time, or at least once a month. As such, the deferral elections in place for the first paycheck of each plan year may not be the same as the ones in effect for the last paycheck of the previous year. For that reason, most plans treat the paychecks included in W-2 wages as the basis for contribution accruals.
Revenue Recognition Should Reflect the Plan Operations
In our experience as auditors, plan administrators define eligible plan compensation as any paycheck the participants receive after their entry date, regardless of when that pay was earned.
For example, if a participant’s entry date is Thursday, January 1, and the participant receives a paycheck on Friday, January 2nd, the deferral withholding election is observed for that paycheck, even though the work was done before the participant’s entry date to the plan. The same compensation would count as eligible compensation for employer-match contributions attributable to deferrals withheld from that paycheck.
If paychecks received after the participant’s entry date are included as plan compensation, regardless of when the work was performed, then the cash basis wages reportable on Form W-2 constitute accrual basis wages for plan purposes: a paradox.
Using W-2 compensation, which represents wages received, as the accrual basis eligible compensation for plan purposes, even when the employer accrues compensation for wages earned but not yet paid, is a seemingly self-contradictory statement or proposition that when investigated or explained may prove to be well founded and true.
We had never seen a deviation from the use of paid eligible compensation to determine an employer contribution until last year, when a plan sponsor used accrual basis compensation on the corporate books to compute the discretionary profit-sharing contribution. In this case, accruing a contribution receivable on the plan books based on accrual basis compensation would be accurate. We thought our client’s profit- sharing computation using accrual basis wages was an exception to the norm, but FinREC recently stated that it is a common practice. Taking it one step further, FINREC accepts the consistent practice of accruing a contribution receivable even when paycheck dates are used to compute the contributions, disregarding the fact that the deferral elections could change to zero, or to some other deferral percentage before the next paycheck is issued:
“FinREC understands that there is diversity in practice with respect to whether a contribution receivable as described in FASB ASC 962-310-25-1 should be accrued for the employee and the employer’s related matching contribution, if any, in pay periods in which amounts have been earned by the employee but have not yet been withheld from employee compensation. For example, for a calendar year-end DC plan, the final pay period begins on December 26, 20X1 and ends on January 8, 20X2; the employee contributions attributable to the last week of December are not withheld and the related employer matching contributions are not remitted to the plan until January 8 of the following year (20X2). Some plans use the ERISA definition 3 of plan assets to determine whether an accrual should be made based on when amounts have been withheld from employee compensation while others consider whether a formal commitment exists in determining whether an accrual is appropriate based on compensation earned. FinREC believes that a DC plan can elect to recognize the employee and the related employer matching contribution either (1) in the period related to the participant’s service or compensation (even if not yet withheld), or (2) in the period the employee contribution is withheld. Regardless of which accounting policy is established, FinREC believes that the DC plan’s accounting policy with respect to recognizing employee contributions receivable and the related employer matching contributions should be applied on a consistent basis and the DC plan should consider whether it is a significant accounting policy that should be disclosed in the notes to the financial statements.”
Although FINRec’s guidance provides welcome flexibility, the more common practice is to use ERISA’s definition of when participant contributions are considered plan assets to establish whether a receivable should be accrued on the plan’s books:
329 CFR 2510.3-102 defines when participant contributions are considered plan assets for ERISA purposes. Section 2510.3-102(a)(1) states that for purposes of subtitle A and parts 1 and 4 of subtitle B of title I of ERISA and section 4975 of the Internal Revenue Code, the assets of the plan include amounts (other than union dues) that a participant or beneficiary pays to an employer, or amounts that a participant has withheld from his wages by an employer, for contribution or repayment of a participant loan to the plan, as of the earliest date on which such contributions or repayments can reasonably be segregated from the employer’s general assets.
Under the ERISA method, the plan sponsor’s actual withholding of a deferral contribution from a paycheck triggers the commitment to contribute to the plan. The corresponding employer match would be accrued consistently. Discretionary profit-sharing contributions can be accrued based on the actual compensation used to compute the amount owed to the plan.
As auditors, we would accept both methods as approved by FINRec, but our preference and recommendation would be for plan sponsors to use the paychecks includible in the W-2 as the triggers of a contribution commitment.
In our previous blog, Form 5500 Participant Count: Cash or Accrual Basis? To Audit or Not to Audit?, we discussed the challenges of accrual basis accounting with respect to plan assets and counting participant balances for the audit determination. To round out our accrual basis trilogy, stay tuned for a discussion of accrual basis challenges for plan distributions.
