Whether a company is considering an employee stock ownership plan (ESOP) or has already worked through the complexities of an ESOP transaction, it’s important to understand the ESOP’s effect on the company’s financial statements.
Generally Accepted Accounting Principles (GAAP)
The company’s accounting for both leveraged and nonleveraged ESOPs falls under Accounting Standards Codification (ASC) Subtopic 718-40.
A nonleveraged ESOP doesn’t borrow funds to buy company stock. Instead, the company will periodically contribute newly issued stock, stock from treasury or cash to the ESOP. If cash is contributed, the ESOP may use the funds to purchase stock. Accounting for a nonleveraged ESOP is fairly simple:
- When the company contributes cash or stock to the ESOP, the company will record compensation expense in the year in which employees render services, even if the contribution isn’t made until the following year.
- Compensation expense will be equal to the amount of cash contributed or the fair market value (FMV) of the shares as of the commitment date. At this point, shares are then allocated to employee accounts within the ESOP based on a formula described in the plan document.
- Allocated shares within the ESOP create a future repurchase obligation to the company. The company is required to buy back shares from ESOP participants when the participant is entitled to receive a distribution from the plan as defined in the plan agreement, but generally at death or retirement or other separation of service event. The future repurchase obligation isn’t recorded within the company’s balance sheet. Instead, the repurchase obligation is disclosed in the footnotes to the financial statements. This repurchase obligation is similar to many private companies in that upon a shareholder’s separation of service, it provides an avenue of liquidity for the shareholder.
A leveraged ESOP borrows funds to purchase stock from either the company or existing shareholder(s). There are three types of ESOP loans:
- Indirect loan – a lender makes a loan to the company, the company then loans the proceeds to the ESOP
- Direct loan – a lender makes a loan directly to the ESOP
- Internal loan – the company directly makes a loan to the ESOP without any outside lenders
For both indirect and direct loans, lenders typically require the purchased stock to serve as collateral and for the company or selling shareholder(s) to guarantee the debt.
Accounting for leveraged ESOPs is more complex and can significantly affect the company’s financial statements. Here are some other key considerations:
- It’s important to note the assets held by the ESOP—leveraged or nonleveraged—aren’t included on the company’s balance sheet. Instead, ESOP assets are required to be held separately in a trust that’s administered by a trustee with fiduciary responsibilities under the Employee Retirement Income Security Act of 1974 (ERISA).
- The company doesn’t record a note receivable from the ESOP as an asset on the balance sheet for the loan between the company and the ESOP.
- Accounting for outside debt, whether indirect or direct, is the same:
- Both types of loans must be recorded as a liability on the company’s balance sheet (debit cash and credit notes payable).
- At the same time, a loan is established between the company and the ESOP. The company records the loan using a contra-equity account called “unearned ESOP shares” (debit unearned ESOP shares and credit cash). This is similar to how any other unfunded purchase of company stock would be recorded.
- The unearned ESOP shares account represents the shares—at historical cost—that are held as collateral for the internal loan (a loan between the company and the ESOP). Within the ESOP, these shares are held in a suspense account, which means the shares are not yet allocated to employee accounts.
- The unearned ESOP shares account is presented separately in the equity section of the balance sheet and on the statement of changes in equity. The unearned ESOP shares account reduces over time as the internal loan between the company and the ESOP is repaid.
- This contra-equity is a reduction to equity, and in some instances may cause a company to have negative equity. The reduction to equity combined with new additional debt may be concerning to companies and their lenders if they’re not familiar with accounting for leveraged ESOPs. Financial ratios could all be affected, influencing debt covenants and borrowing capacity.
- Principal and interest related to the outside debt, i.e., debt between the company and a bank or the company and the selling stockholder, are accounted for similar to any other non-ESOP debt.
- The company will make annual cash contributions to the ESOP, and the ESOP will use those funds to make debt payments back to the company. Repayment of the internal loan releases shares held in suspense based on the percentage of the annual debt repayment to the total expected principal and interest to be repaid over the term of the internal loan. The company will record contribution expense (debit expense) equal to the FMV of the shares being released. The company will credit the unearned ESOP shares account for the historical cost of the shares released. The difference between the FMV of the stock and this historical cost is charged against additional paid-in capital and, in some instances, retained earnings.
- As the internal loan is repaid, the shares will be released and allocated to employee accounts within the ESOP. Similar to nonleveraged ESOPs, allocated shares create a future repurchase obligation for the company. Again, the repurchase obligation isn’t recorded within the company’s balance sheet but must be disclosed in the company’s footnotes. As cash contributions are made to the plan to fund the repurchase obligation, the company recognizes an expense equal to the amount of the cash contribution.
These are just a few of the nuances of ESOP accounting. In addition to the repurchase obligation noted above, ASC 718-40 requires certain additional disclosures within the company’s footnotes for both leveraged and nonleveraged ESOPs. To learn more about these required footnote disclosures under ASC 718-40 or ESOP-specific accounting, contact Kristine or your trusted BKD advisor.