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Top Five Misconceptions Related to Leveraged ESOP GAAP Accounting

Read on for a look at the top five misconceptions regarding the proper GAAP treatment related to leveraged ESOP accounting.
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For leveraged employee stock ownership plans (ESOP), the initial and ongoing annual accounting for ESOP-related items is not intuitive, meaning assumptions about how these entries should be recorded are often incorrect. As a result, there are many common misconceptions regarding the proper GAAP treatment related to leveraged ESOP accounting. Accounting Standards Codification (ASC) Subtopic 718-40 governs accounting for leveraged ESOPs. In this article, we will identify the top five misconceptions of accounting for leveraged ESOPs.

  • Misconception 1 – Receivable for the Internal Loan – In a leveraged ESOP, most commonly, the ESOP borrows funds from the company (indirect loan or internal loan) to purchase shares from the selling shareholders, therefore creating an internal loan between the ESOP and the company. A common misconception is that the company will record a receivable for the amount of this loan. Instead, ASC 718-40 states that the internal loan shall be recorded as Unearned ESOP Shares on the company’s balance sheet. This account is recorded in the equity section of the balance sheet as a contra-equity account. A contra-equity account is recorded because the ESOP has no real means of satisfying the receivable, except through contributions from the company.
  • Misconception 2 – Annual ESOP Expense Equals Cash Contributed – Each year, the company contributes at least enough cash to the ESOP for the ESOP to make the regularly scheduled payment on the internal loan. Based on a defined formula, each payment on the internal loan releases shares—previously held in suspense—to eligible participants’ accounts. A misconception is that the expense recorded by the company is equal to the amount of cash contributed by the company for the ESOP to make its loan payment. Instead, ASC 718-40 states the company records an expense equal to the average fair market value of shares released as a result of the company contribution used by the ESOP to make its loan payment. 
  • Misconception 3 – Unearned ESOP Shares Should Equal the Principal Balance of the Internal Loan – Another common misconception is that the Unearned ESOP Shares account is reduced annually based on the amount of principal paid by the ESOP on the internal loan. Instead, and to build upon 1 and 2 above, when the ESOP makes the loan payment on the internal loan, ASC 718-40 states the company will record a credit to Unearned ESOP Shares in an amount equal to the original cost basis of the shares released in that year. Effectively the company will amortize Unearned ESOP Shares over the life of the internal loan, based on the original cost of the shares released annually. To calculate the cost basis, the company would take the amount the ESOP paid for the shares, divided by the number of shares the ESOP purchased. For example, if the ESOP paid $700,000 for 1 million shares, then the cost basis per share equals $0.70 ($700,000 / 1,000,000 shares). If the loan payment on the internal loan released 20,000 shares in a given year, then the credit to Unearned ESOP Shares would be $14,000.
  • Misconception 4 – Cash Does Not Have to Exchange Hands – As stated before, the company will make annual contributions to the ESOP, and the ESOP will immediately use the contributions to make a payment on the internal loan. A misconception is that cash does not have to be physically transferred between the parties, and that recording the entry, without exchanging cash, is satisfactory. However, the IRS views these as two separate transactions and generally requires that cash be physically transferred. First, there is a contribution from a company to a qualified retirement plan. Second, there is a loan payment made by the ESOP to the company; that is the mechanism that releases shares to eligible participant accounts. As such, the company needs to physically send the funds to the ESOP for the retirement plan contribution, and the ESOP needs to physically send those funds back for the loan payment.
  • Misconception 5 – The Company Records a Liability for Its ESOP Repurchase Obligation – When a vested participant terminates, the company is ultimately required to purchase the shares held by the terminated participant based on the fair value of the shares at the time the distribution is made, based on the distribution provisions of the ESOP plan document. This is referred to as the company’s repurchase obligation (RO). A common misconception is that the company should record a liability for the future RO. Instead, ASC 718-40 states that private companies are not required to record a liability for the RO. The company, however, is required to disclose in its financial statement footnotes the existence and nature of any RO, including the fair value of shares allocated to participant accounts as of the balance sheet date.

To learn more about plan sponsor accounting for leveraged and non-leveraged ESOPs, check out the archived version of our webinar Plan Sponsor ESOP Accounting – An Overview. If you have questions or need assistance in the meantime, reach out to a professional with FORVIS or submit the Contact Us form below.

 

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