Your Guide to ESOP Accounting: Leveraged and Non-Leveraged Plans

Employee stock ownership plans (ESOPs) are an excellent benefit to employees and a smart financial tool for many businesses, yet they certainly impact company financial statements. ESOP accounting affects your company’s balance sheet and income statement in ways that differ from traditional accounting.

From leveraged ESOPs to non-leveraged plans, proper accounting ensures compliance and transparency. Let’s go over the key components of ESOP accounting as your company prepares to transition into an ESOP model.

ESOP Accounting Authority and Background

Both leveraged and non-leveraged ESOPs must follow ESOP accounting rules under GAAP principles as governed by the Financial Accounting Standards Board (FASB). Accounting for ESOP plans specifically fall under Accounting Standards Codification (ASC) Subtopic 718-40. This subtopic relates to stock compensation and equity awards. 

ASC 718-40 ensures that companies properly record and report ESOP activities at fair value, helping maintain transparency and consistency in financial reporting while protecting the interests of both the company and ESOP participants. The most important point to understand about ASC 718-40 is that it requires that all equity awards granted to employees and nonemployees be accounted for at “fair value.” 

For example, let’s say your company establishes an ESOP and contributes shares worth $1 million based on an independent appraisal. This full fair market value of $1 million must be recorded in your financial statements – not the historical cost of acquiring those shares or an estimated future value. This ensures transparency and accuracy in reporting the true economic benefit provided to ESOP participants.

ESOP Accounting Basics

Now that we have an understanding of the importance of ASC 718-40, let’s cover some common questions regarding ESOP accounting. 

How do I record ESOP expenses?

ESOP expenses are accounted for as a liability on the balance sheet. ESOP compensation expenses should be reported based on the fair market value of the shares that were released during the reporting period.

How does an ESOP affect the balance sheet?

Of the three parts to a balance sheet, ESOPs only affect liabilities and equity. ESOPs do not affect the assets section since plan assets are not reported as sponsor assets.

ESOPs can create the appearance of excessive liability on a company’s balance sheet because accounting rules do not allow companies to record ESOP inside loan receivables as an asset. As a result, the balance sheet reflects not only an increased liability, but also reduced company equity.

Is ESOP an expense?

ESOP contributions do appear as an expense on the balance sheet, specifically, as compensation expenses.

What type of account is an ESOP?

The IRS classifies ESOPs as IRC section 401(a) qualified defined contribution retirement plans that are stock bonus plans.

Considering Accounting in ESOP Transactions

Businesses that are considering forming an ESOP should discuss the plan with a CPA who is familiar with ESOPs to understand exactly how an ESOP will affect their financial statements. Consulting a CPA experienced in ESOP accounting ensures compliance with ESOP accounting rules and accurate reporting of leveraged ESOP accounting.

This is particularly important for companies that will create leveraged ESOPs because lenders will be examining these financial statements closely. This is one reason why it is helpful to work with lenders who are familiar with the ins and outs of ESOPs, and how these plans can affect financial documents and the amount of debt liability a business appears to have. 

Working with an experienced ESOP trustee is vital throughout this process, as they can provide oversight and make trusted referrals. 

Accounting for Leveraged ESOPs

Most ESOPs begin as leveraged ESOPs. Leveraged ESOPs borrow funds to purchase shares from the company owner (who is selling to the ESOP) and subsequently to the selling shareholders in later stages as an ESOP matures. These shareholders are typically plan participants who are retiring and seeking their distributions.

Record Debt as a Liability. According to ASC 718-40, leveraged ESOPs must record the debt of the ESOP as a liability. Any shares that are purchased should be recorded as a contra equity account on the balance sheet. The contra-equity accounting remains in place until the shares are no longer used as collateral against the borrowing. As debt is repaid, the liability is reduced and shareholder equity increases. 

For example, if ESOP borrows $10 million to purchase company shares, the transaction would affect the balance sheet in two ways. 

1. The $10 million would be recorded as a liability under "ESOP Debt." 
2. The purchased shares would be recorded as a $10 million reduction in the stockholders' equity section as "Unearned ESOP Shares" (the contra-equity account). 

As the ESOP debt is paid down - let's say by $2 million - the liability would decrease to $8 million, and the contra-equity account would also decrease by $2 million, effectively increasing stockholders' equity.

Contributions Classified as Compensation Expenses: Amounts contributed to the ESOP each year are recognized as compensation expense. The dollar amount value of these expenses is based on the fair market value of the shares the year they are released from the suspense account. Any dividends paid also qualify as compensation expenses.

Accounting for Interest: Any interest on contributions must be separately identified and charged as interest expense. 

Using the Footnotes: Plan sponsors should use the footnotes section of the financial statements to disclose the terms of the debt, the interest rate, and other significant information regarding the guarantee.

Accounting for Non-Leveraged ESOPs

Since non-leveraged ESOPs do not borrow funds to acquire company stock, the accounting for ESOP plans is simplified. Non-leveraged ESOPS are funded directly by the employer via cash contributions or stock contributions.

• Cash Contributions: When a company contributes cash to the ESOP, the company records compensation expense equal to the amount of cash contributed. The ESOP then uses this cash to purchase company stock, either from existing shareholders or newly issued shares.
• Stock Contributions: When a company contributes its own stock directly to the ESOP, the company records compensation expense equal to the fair market value of the shares contributed. The fair value must be determined by an independent appraiser as of the date of contribution.

Shares and Cash Contributions are Compensation Expenses: Newly issued shares, cash contributions to the plan, or dividends are classified as compensation expenses on the balance sheet. The reported amount equals the cash contribution or, if shares, the fair market value of the shares on the date they were contributed to the plan. In non-leveraged ESOPS, all contributions will qualify as tax deductions for the plan sponsor.

Using the Footnotes: Use footnotes to provide relevant information about ESOP funding. This may include the company’s ESOP funding policy, who the ESOP covers, and the amounts contributed and charged as expenses during the reporting period.

Contact Aegis For ESOP Guidance  

Aegis Trust Company is not a CPA, and nothing in this post should be taken as financial advice. We recommend consulting with a CPA who is familiar with ESOPs for financial advice related to ESOP accounting. 

As experienced ESOP trustees, we understand the complexities of ESOP structures and can provide valuable guidance throughout the process. Whether you're considering a leveraged or non-leveraged ESOP, our team can help ensure proper oversight and compliance with ESOP requirements. Contact Aegis for help in navigating the complexities of employee ownership.