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4 Common Mistakes in ESOP Accounting

September 25, 2023 5 Min Read Article, ESOPs
Steven P. Feimster, CPA
Steven P. Feimster, CPA Director, Audit & Accounting, Manufacturing & Distribution Industry Group Leader, ESOP Specialty Area Leader

An Employee Stock Ownership Plan (ESOP) retirement plan allows an employee to own part or all of the company they work for and is a valuable part of a company’s shareholder transition strategy.

However, some companies that sponsor a leveraged ESOP do not fully understand ESOP accounting rules — for these rules can be unique, even counterintuitive at times — on how unallocated shares are presented, and contributions of shares are recorded. Because of this, it’s pertinent you look out for pitfalls when managing your plan.

Having a clear understanding of ESOP accounting matters not only for the purpose of achieving compliance with U.S. GAAP, but to also have financial statements appropriately presented in a way that lenders, valuators, and the trustee can use the statements to their full potential.

Avoid these four common mistakes regarding ESOP accounting for private companies:  

ESOP Accounting Mistake #1: Not properly recording the inside loan.

ESOP transactions are often structured so that the company borrows funds from a bank, and in turn, lends those funds to the ESOP so that the ESOP can buy company shares from the selling shareholder(s). As a result, the company now has a receivable from the ESOP (often referred to as the “inside loan”) and, intuitively, many think this is recorded as an asset.

However, the receivable is not recorded on the company’s financial statements. Instead, the company records a contra-equity (often referred to as “unearned ESOP shares”) representing the shares acquired by the ESOP.

How to fix mistake #1: When accounting for the inside loan, think of the loan as treasury stock rather than a receivable. The contra-equity balance represents the historical cost of the shares acquired by the ESOP, and the balance is reduced as shares are released to participants (by comparison, moved out of treasury).

ESOP Accounting Mistake #2: Not properly recording interest income on the inside loan.

The inside loan often has an interest component. Similar to the note, the company should not record this interest income within their income statement, since companies cannot earn income on the sale of their own stock.

When cash is returned to the company to repay the inside loan, the company credits equity (either additional paid-in capital (APIC) or unearned ESOP shares).

How to fix mistake #2: This fix goes hand-in-hand with ESOP accounting mistake #1 above. When shares are released, the company will credit the unearned ESOP account based on the number of shares released, at their historical cost. The difference between this amount and the cash received from the ESOP is recorded in APIC.

ESOP Accounting Mistake #3: Not properly recording the correct ESOP compensation.

For leveraged ESOPs, often a large component of ESOP compensation is the contribution the company makes to the ESOP, which is then returned to the company as a repayment of the inside loan. For other employee benefit plans such as a 401k, the contribution would equal the expense.

However, since these funds are being returned to the company, the expense does not equal the dollar amount contributed, but rather the value of the company shares that get released to participants when the repayment of the inside loan occurs.

How to fix mistake #3: To value these shares, the company should use an average share price derived from the beginning and end-of-year valuations. The difference between the dollars contributed and the value of the shares contributed is recorded as additional paid-in capital. Since the year-end valuation is usually not completed until well after the year-end close, this adjustment is typically done in tandem with completing the year-end audit or review. However, if the company wants more accurate internal reporting, management can use an estimated share price to value the shares, based on the prior year share price and current year operating results. This would then get adjusted to actual once the valuation is completed.

ESOP Accounting Mistake #4: Not properly recording your dividends.

Ordinarily, dividends (or distributions) are recorded in equity as a direct reduction to retained earnings. However, with ESOPs, proper recording of dividends depends on the status of the underlying shares on which the dividends are paid.

If dividends are paid on allocated shares (that is, shares that are no longer held in suspense and have been allocated to participants), the dividends are accounted for as they normally would. But if dividends are paid on unallocated shares, they are recorded in the income statement as a component of ESOP compensation.

How to fix mistake #4: Leveraged ESOPs have allocated and unallocated shares, so it’s important to correctly apportion any dividends between the two. The easiest place to verify this is in the prior year Plan Administration Report, completed by the ESOP third-party administrator (TPA). This report will show the number of shares in suspense (unallocated) and number of shares released (allocated) each year. Any dividends declared in the following year should be allocated pro rata based on the prior year’s share classification.

The Value of Working With a CPA That Specializes in ESOP Accounting

These are just a few of the added complexities that come with an ESOP. Due to the very unique characteristics of ESOPs as they relate to not only accounting but also to tax and legal matters as well, it’s important to surround yourself with advisors who specialize in ESOPs from the moment an ESOP transaction begins to take shape.

Not sure if an ESOP is the right move for your business? Let our CPAs help you decide and walk you through the process. Kreischer Miller has deep experience in ESOP accounting as well as with the tax and regulatory complexities of ESOP plans, including leveraged plans, share allocation, and the valuation process.

Steven P. Feimster can be reached at Email or 215.441.4600.

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Steven P. Feimster, CPA

Steven P. Feimster, CPA

Director, Audit & Accounting, Manufacturing & Distribution Industry Group Leader, ESOP Specialty Area Leader

Manufacturing & Distribution Specialist, Owner Operated Private Companies Specialist, Private Equity-Backed Companies Specialist

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