For companies that sponsor a leveraged ESOP, the accounting rules can be unique, and even counterintuitive at times. It’s important for companies to understand these rules not just for compliance with U.S. GAAP, but to have financial statements presented properly so that lenders, valuators, and the trustee can properly understand them.
Avoid these common accounting mistakes when it comes to ESOP accounting:
- Recording of 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 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 as “unearned ESOP shares”) representing the shares acquired by the ESOP.
- Interest income on the inside loan. The inside loan often has an interest component. Similar to the note itself, 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 or unearned ESOP shares).
- 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 company shares that get released to participants when the repayment of the inside loan occurs. To value these shares, the company uses 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 to additional paid-in capital.
- Recording 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. Leveraged ESOPs will have both allocated and unallocated shares, so it’s important to correctly allocate any dividends between the two.
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 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.
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