Accounting for ESOPs

There are many reasons why company owners may consider selling their ownership stake to an employee stock ownership plan (ESOP). But doing so may also create some challenges. This column looks at the accounting for ESOPs and some possibly unexpected quirks.

In recent years, there has been an uptick in the number of companies that are wholly or partially owned by an employee stock ownership plan (ESOP). There are many reasons why company owners may consider selling their ownership stake to an ESOP, including as an exit strategy, as an advantageous tax planning tool, or to boost employee morale and engagement. But doing so may also create some challenges. This column will look at the accounting for ESOPs and some possibly unexpected quirks.

First, let’s learn a bit more about leveraged ESOPs for context. A leveraged ESOP is a structure where the ESOP trust (ESOPT) has acquired some or all of a company’s stock from a selling shareholder in exchange for a note payable to the company that is referred to as the internal loan. The acquired stock serves as loan collateral. The company itself likely incurred debt to finance the buyback of the stock from the former shareholder. The lender in this case can be a bank, the seller of the stock (seller notes), or a combination of both. This loan is referred to as the external loan. The internal loan structure allows for the acquired stock to be released to participant accounts over many years and provides a meaningful employee benefit now and into the future. Company stock also can be transitioned to the ESOPT by other means: the ESOPT can purchase stock with liquidity from previous retirement plan contributions or shares can be contributed as a noncash retirement plan contribution.

The accounting for the external loan is relatively straightforward. The loan is reflected as a liability on the company’s books following FASB ASC 470, Debt. It is not uncommon for seller notes to have subordination features to bank debt and may be issued with warrants to compensate the seller for potentially below-market interest rates. Loan documents should be carefully reviewed for such.

Accounting for the internal loan may be less intuitive. For clarity, the internal loan represents the cost of the shares on the ESOP transaction date that were purchased by the ESOPT in exchange for a promissory note to the company. For our example, I’ll use $1 million.

Muscle memory might have you crediting cash (or bank/seller note payable) and debit a note-receivable asset account. FASB ASC 505, Equity, and FASB ASC 718, Compensation – Stock Compensation, however, instruct us to debit a contra-equity account, often referred to as Unearned ESOP Shares, because the ESOPT has no financial means of repaying the loan and is entirely reliant on the company to create the liquidity to service this debt. As such, asset recognition is not appropriate. The entry in our example is as follows:

The internal loan will have an amortization table that stipulates annual principal and interest payments due from the ESOPT to the company: $25,000 + $75,000 = $100,000 for our example. However, the ESOPT has no ability to generate cash to meet this obligation.

The solution to this conundrum would be that the company makes an annual cash contribution to the ESOPT, usually right before the loan payment is due. On the next day, the ESOPT will make the principal and interest payment back to the company using those funds. It is necessary for this circular cash flow to actually occur instead of just posting an accounting entry.

So, how should the company record these two cash events? Again, muscle memory may lead you down the wrong path to record entries similar to the following:

(Do not record it this way!)

ESOP-owned companies need to refer to FASB ASC 718-40 for guidance on these transactions, which is quite different from what is suggested above. Before we explore the correct entry, we need to learn about another concept.

Recall that the acquired shares collateralize the internal loan. When the annual loan payment is made by the ESOPT, a portion of these shares is released from collateral and transferred within the ESOPT to participant accounts. In other words, the employees are compensated in the form of company stock for their efforts. U.S. GAAP, in principle, seeks to record equity-based compensation at fair value, which will help you understand the following accounting entry. The company will recognize compensation expense equal to the average fair value of the shares released to participants. Assuming this is a privately held company, the average fair value is calculated by using the annual stock appraisals required by ERISA. The Unearned ESOP Shares contra-equity account is credited by the original cost of the shares multiplied by the number of shares released. The entry is balanced by a debit or credit to additional paid-in-capital (APiC). Remember that APiC cannot have a debit balance. So, if necessary, the balancing portion of the entry can be posted directly to retained earnings. As an example, let’s assume the beginning fair value of the stock is $50 per share and the ending fair value is $60 per share. Seventy shares were released from loan collateral, with an original cost per share of $100. The following entry would be needed:

The transaction documents will include a formula that stipulates the number of shares released from loan collateral for each debt service payment. There are different methods available. Due to the accounting treatment noted above, the Unearned ESOP Share account balance may not reconcile back to the promissory note amortization table.

The example above intentionally uses a fair value per share that is lower than the cost of the shares on the transaction date. This is not uncommon in the years after a transaction because the company likely incurred debt (external loan) to facilitate the buyout of the former shareholders. As the external loan is repaid, usually the stock value recovers.

It is important to note that the internal and external loan are two separate instruments. In all likelihood, they will have different interest rates and maturity dates. Prepayment on the external loan does not require prepayment on the internal loan.

When participants are entitled to receive distributions from the ESOP, company cash resources are needed to facilitate those payments. A common method is the recycling of shares. The company will make a cash contribution to the ESOPT, which would follow the accounting of a profit-sharing retirement plan contribution. It is as simple as a credit to cash and debit an expense account. Within the ESOPT, this cash contribution will be used to pay the distributions due to participants, and the shares previously held by those participants are redistributed within the ESOP. Alternatively, shares can be redeemed. In this case, the company buys back the stock into treasury and issues payments to the participants, reducing the number of shares outstanding. The entry in this case is a credit to cash and a debit to the treasury stock equity account.

The company is obligated to facilitate the liquidity for benefit payments due to participants, which can be a significant cash requirement at times. This concept is referred to as the repurchase obligation. The repurchase obligation is not recorded as a liability, but rather requires footnote disclosure and should be carefully monitored by company management to anticipate future cash flow impact.

ESOP transactions can be structured in different ways and vary in complexity. This article attempts to outline the general accounting concepts. The accounting entries for your ESOP transaction will need to be tailored after careful review of the transaction structure.

Nicole K. Cradic, CPA, is a partner with Trout CPA in Mechanicsburg. She can be reached at ncradic@troutcpa.com.