What Are the Actual Deferral Percentage (ADP) & Actual Contribution Percentage (ACP) Tests?

The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are two tests that companies must conduct to ensure that their 401(k) plans don’t unfairly benefit highly-paid employees at the expense of others.

Companies that offer 401(k) plans must conduct the tests in order to retain the qualified status of their plans under IRS rules and the Employee Retirement Income Security Act (ERISA).

If the plan fails either test, the employer must take corrective action in the 12-month period following the close of the plan year in which the oversight occurred. Failure to do so can result in the IRS imposing pecuniary penalty fees, plan disqualification, and fiduciary liability on the part of the employer. 

How ADP and ACP Tests Work

The ADP test compares the average salary deferral percentages of highly compensated employees (HCE) to that of non-highly compensated employees (NHCE). An HCE is any employee who owns more than 5% interest in the company at any time during the current or previous plan year or earned more than $130,000 during the 2020 tax year. 

The ADP test takes into account both pre-tax deferrals and after-tax Roth deferrals, but no catch-up contributions, which may be made only by employees age 50 and over. To pass the test, the ADP of the HCE may not exceed the ADP of the NHCE by more than two percentage points. In addition, the combined contributions of all HCEs may not be more than two times the percentage of NHCE contributions.

The ACP test uses a similar method as the ADP test except that it uses matching contributions or employee after-tax contributions.

Correcting an ADP/ACP Test Failure

When employers fail the ADP/ACP tests, they can remedy the failure by refunding excess contributions back to HCEs in the amount necessary to pass the test. However, these refunds will be liable for income tax for the HCE individuals. 

Some companies set buffer zones within their plan documents to steer plans away from potentially failing the ADP/ACP test in the first place. One option is setting a cap on contributions by HCEs. Another option is to place a contribution limit on HCEs at the point where the plan would fail an ADP/ACP test. Setting plan buffer zones may require employers to conduct ADP/ACP test projections, typically in the middle of the plan year, to determine if any restrictions need to be applied. 

Still, some companies use a Safe Harbor 401(k) plan to avoid the ADP/ACP test entirely.

What Is a Safe Harbor Plan? 

Safe Harbor 401(k) plans allow sponsors to bypass ADP/ACP and other non-discrimination testing in exchange for providing eligible matching or nonelective contributions on behalf of their employees.

To qualify for Safe Harbor, a company must provide a basic match, such as a 100% match on the first 3% of deferred compensation and a 50% match on deferrals of 3% to 5%. They may also provide each employee with a nonelective contribution of at least 3% of compensation, regardless of how much the employee contributes or if they contribute at all.

What Is an Activity Cost Driver?

An activity cost driver is an action that triggers higher or lower variable costs for a business. Sometimes referred to as a causal factor, it is associated with the managerial accounting concept of activity-based costing (ABC). Keeping tabs on activity cost drivers is important as it can help boost efficiency and company profits.

How Activity Cost Drivers Work

A cost driver affects the cost of specific business activities. In ABC, an activity cost driver influences the costs of labor, maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity.

There may be multiple cost drivers associated with an activity. For example, direct labor hours are a driver of most activities in product manufacturing. If the expenditure for labor is high, this will increase the cost of producing all company products or services. If the cost of warehousing is high, this will also increase the expenses incurred for product manufacturing or providing services.

More technical cost drivers are machine hours, the number of engineering change orders, the number of customer contacts, the number of product returns, the machine setups required for production, or the number of inspections. If a business owner can identify the cost drivers, the business owner can more accurately estimate the true cost of production for the business.

Cost Allocation

When a factory machine requires periodic maintenance, the cost of the maintenance is allocated to the products produced by the machine. For example, the cost driver selected is machinery hours. After every 1,000 machine hours, there is a maintenance expense of $500. Therefore, every machine hour results in a 50-cent (500 / 1,000) maintenance cost allocated to the product being manufactured based on the cost driver of machine hours.

Distribution of Overhead Costs

Using cost drivers simplifies the allocation of manufacturing overhead. The correct allocation of manufacturing overhead is important to determine the true cost of a product. Internal management uses the cost of a product to determine the prices of the products they produce. For this reason, the selection of accurate cost drivers has a direct impact on the profitability and operations of an entity.

Special Considerations: The Subjectivity of Cost Drivers

Management selects cost drivers as the basis for manufacturing overhead allocation. There are no industry standards stipulating or mandating cost driver selection. Company management selects cost drivers based on the variables of the expenses incurred during production.

The Bottom Line

Examining activity cost drivers helps companies to reduce unnecessary expenses and get to grips with how much an order really costs. The importance of accessing this knowledge shouldn’t be understated. The ultimate goal is to maximize profits; a key way to accomplish this is by being aware of all expenses and keeping them in check.

What Is Accrued Revenue?

Accrued revenue is revenue that has been earned by providing a good or service, but for which no cash has been received. Accrued revenues are recorded as receivables on the balance sheet to reflect the amount of money that customers owe the business for the goods or services they purchased.

Accrued revenue may be contrasted with realized or recognized revenue, and compared with accrued expenses.

Understanding Accrued Revenue

Accrued revenue is the product of accrual accounting and the revenue recognition and matching principles. The revenue recognition principle requires that revenue transactions be recorded in the same accounting period in which they are earned, rather than when the cash payment for the product or service is received. The matching principle is an accounting concept that seeks to tie revenue generated in an accounting period to the expenses incurred to generate that revenue. Under generally accepted accounting principles (GAAP), accrued revenue is recognized when the performing party satisfies a performance obligation. For example, revenue is recognized when a sales transaction is made and the customer takes possession of a good, regardless of whether the customer paid cash or credit at that time.

Accrued revenue often appears in the financial statements of businesses in the service industry, because revenue recognition would otherwise be delayed until the work or service was finished, which might last several months—in contrast to manufacturing, where invoices are issued as soon as products are shipped. Without using accrued revenue, revenues and profit would be reported in a lumpy fashion, giving a murky and not useful impression of the business’s true value.

For example, a construction company will work on one project for many months. It needs to recognize a portion of the revenue for the contract in each month as services are rendered, rather than waiting until the end of the contract to recognize the full revenue.

Recording Accrued Revenue

Accrued revenue is recorded in the financial statements by way of an adjusting journal entry. The accountant debits an asset account for accrued revenue which is reversed with the amount of revenue collected, crediting accrued revenue.

Accrued revenue covers items that would not otherwise appear in the general ledger at the end of the period. When one company records accrued revenues, the other company will record the transaction as an accrued expense, which is a liability on the balance sheet.

When accrued revenue is first recorded, the amount is recognized on the income statement through a credit to revenue. An associated accrued revenue account on the company’s balance sheet is debited by the same amount in the form of accounts receivable.

When a customer makes a payment for the goods or services received, the accountant makes a journal entry for the amount of cash received by debiting the cash account on the balance sheet, and then crediting the same amount to the accrued revenue account or accounts receivable account.

Examples of Accrued Revenue

Accrued revenue is often recorded by companies engaged in long-term projects like construction or large engineering projects. Similar to the example of the construction company above, companies in the aerospace and defense sectors might accrue revenue as each piece of military hardware is delivered, even if they only bill the U.S. government once a year.

Landlords may book accrued revenue if they record a tenant’s rent payment at the first of the month but receive the rent at the end of the month.

What Is an Accounting Standard?

An accounting standard is a common set of principles, standards, and procedures that define the basis of financial accounting policies and practices.

Understanding Accounting Standards

Accounting standards improve the transparency of financial reporting in all countries. In the United States, the generally accepted accounting principles (GAAP) form the set of accounting standards widely accepted for preparing financial statements. International companies follow the International Financial Reporting Standards (IFRS), which are set by the International Accounting Standards Board and serve as the guideline for non-U.S. GAAP companies reporting financial statements.

The generally accepted accounting principles are heavily used among public and private entities in the United States. The rest of the world primarily uses IFRS. Multinational entities are required to use these standards. The International Accounting Standards Board (IASB) establishes and interprets the international communities’ accounting standards when preparing financial statements.

Accounting standards relate to all aspects of an entity’s finances, including assets, liabilities, revenue, expenses, and shareholders’ equity. Specific examples of accounting standards include revenue recognition, asset classification, allowable methods for depreciation, what is considered depreciable, lease classifications, and outstanding share measurement.

The American Institute of Accountants, which is now known as the American Institute of Certified Public Accountants, and the New York Stock Exchange attempted to launch the first accounting standards in the 1930s. Following this attempt came the Securities Act of 1933 and the Securities Exchange Act of 1934, which created the Securities and Exchange Commission. Accounting standards have also been established by the Governmental Accounting Standards Board for accounting principles for all state and local governments.

Accounting standards specify when and how economic events are to be recognized, measured, and displayed. External entities, such as banks, investors, and regulatory agencies, rely on accounting standards to ensure relevant and accurate information is provided about the entity. These technical pronouncements have ensured transparency in reporting and set the boundaries for financial reporting measures.

U.S. GAAP Accounting Standards

The American Institute of Certified Public Accountants developed, managed, and enacted the first set of accounting standards. In 1973, these responsibilities were given to the newly created Financial Accounting Standards Board. The Securities and Exchange Commission requires all listed companies to adhere to U.S. GAAP accounting standards in the preparation of their financial statements to be listed on a U.S. securities exchange.

Accounting standards ensure the financial statements from multiple companies are comparable. Because all entities follow the same rules, accounting standards make the financial statements credible and allow for more economic decisions based on accurate and consistent information.

Financial Accounting Standards Board (FASB)

An independent nonprofit organization, the Financial Accounting Standards Board (FASB) has the authority to establish and interpret generally accepted accounting principles (GAAP) in the United States for public and private companies and nonprofit organizations. GAAP refers to a set of standards for how companies, nonprofits, and governments should prepare and present their financial statements.