Leveraged employee stock ownership plans (ESOPs) can be a viable ownership transition strategy for privately held businesses. However, accounting for leveraged ESOPs under U.S. GAAP can add complexity to the financial reporting process. Accounting Standards Codification (ASC) Subtopic 718-40 governs accounting for leveraged ESOPs. This article will explore the five most common mistakes encountered when accounting for leveraged ESOPs.
- Mistake 1 – Receivable for the Internal Loan – Typically, in a leveraged ESOP, the ESOP borrows funds from the company to purchase shares from the selling shareholders, therefore creating an internal loan between the ESOP and the company. A common mistake is for the company to record a receivable for this loan. Instead, ASC 718-40 states the internal loan shall be recorded as Unearned ESOP Shares on the company’s balance sheet as a contra-equity account. A contra-equity account is recorded because the ESOP has no financial resources to satisfy the loan, except through contributions from the company.
- Mistake 2 – Annual ESOP Expense Equals Cash Contributed – Each year, the company contributes cash to the ESOP in an amount sufficient to enable the ESOP to make the annual payment required on the internal loan. Based on a formula defined in the ESOP loan agreement, each payment on the internal loan releases shares from the suspense account to be allocated to eligible participants. A common misconception is that the expense recorded by the company is equal to the amount of cash contributed by the company for the ESOP loan payment. However, ASC 718-40 states the company records an expense equal to the average fair market value of shares released as a result of the company contribution used by the ESOP to make its loan payment.
- Mistake 3 – Unearned ESOP Shares Should Equal the Principal Balance of the Internal Loan – Another common assumption is the Unearned ESOP Shares account is reduced annually based on the amount of principal paid by the ESOP on the internal loan. Instead, when the ESOP makes the loan payment on the internal note, ASC 718-40 states the company will record a credit to Unearned ESOP Shares in an amount equal to the original cost basis of the shares released in that year. Effectively, the company will amortize the balance in the Unearned ESOP Shares account over the life of the internal loan, based on the original cost of the shares released annually. To calculate the cost basis, the company would take the amount the ESOP paid for the shares, divided by the number of shares the ESOP purchased. For example, if the ESOP paid $700,000 for 1 million shares, then the cost basis per share equals $0.70 ($700,000 / 1,000,000 shares). If the loan payment on the internal loan released 20,000 shares in a given year, then the credit to Unearned ESOP Shares would be $14,000.
- Mistake 4 – Cash Does Not Have to Transfer Hands – As previously described, the company will make annual contributions to the ESOP, and the ESOP will immediately use the contributions to make a payment on the internal loan. One may believe the cash does not have to be physically transferred between the parties, and that recording the entry, without transferring cash, is satisfactory. However, the IRS views these as two separate transactions, and best practice is for the cash to be physically transferred. First, there is a contribution from the company to a qualified retirement plan. Second, there is a loan payment made by the ESOP to the company, which is the mechanism that releases shares to eligible participants. As such, the company needs to physically send the funds to the ESOP for the retirement plan contribution, and the ESOP needs to physically send those funds back for the loan payment.
- Mistake 5 – The Company Records a Liability for ESOP Repurchase Obligation – When a vested participant terminates, the company is ultimately required to purchase the shares held by the terminated participant at the fair value of the shares at the time the distribution is made, based on the distribution provisions of the ESOP plan document. This is referred to as the company’s repurchase obligation (RO). A common misconception is that the company should record a liability for the future RO. Instead, ASC 718-40 states that private companies are not required to record a liability for the RO. The company, however, must disclose in its financial statement footnotes the existence and nature of any RO, including the fair value of shares allocated to participant accounts as of the balance sheet date.
Learn more about ESOP transactions in our webinar, “Plan Sponsor ESOP Accounting – Advanced Sponsor Topics.” For additional details on plan sponsor accounting for leveraged and non-leveraged ESOPs or to have questions answered, please reach out to a professional at Forvis Mazars.