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Because it’s a qualified benefit plan, an employee stock ownership plan’s accounting must comply with the Employee Retirement Income Security Act of 1974 (ERISA), a federal law that sets minimum standards of fiduciary duties, among other requirements, for all ESOPs.

It’s important to understand that, in addition to specific ESOP accounting requirements outlined in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 718-40, there are important financial accounting and tax accounting best practices that can help ESOPs ensure full ERISA compliance and audit-ready status.

Your trusted third-party administrator (TPA) serves as your go-to expert for ESOP accounting services related to FASB ASC 718-40 and ERISA compliance. But what about making sure your company’s financial statements are optimally prepared to meet other ESOP-related needs?

Should you follow principles for accrual-, cash-, or tax-based accounting standards? What are the implications of submitting internally prepared financials, versus CPA-reviewed or audited statements? And how do you know that your CPA understands the special needs of an ESOP company, and hasn’t missed important details in your reporting?

In this article, we’ll cover the basics of ESOP accounting for leveraged and non-leveraged plans, as well as some fundamental best practices in financial accounting of ESOPs.

How Accounting Practices Can Impact ESOP Companies

Following best practices enables ESOP-sponsoring companies to achieve several goals, including:

  • Arriving at an accurate and optimal business valuation, both at the time of initial ESOP transaction and annually thereafter
  • Minimizing tax liabilities at the time of sale and annually thereafter
  • Optimizing ESOP cash flow advantages
  • Ensuring the ongoing ability to meet repurchase obligations
  • Developing accurate business projections 
  • Securing lender financing when needed

In short, accounting practices can have implications for ERISA compliance, transaction price, tax planning, and much more. Banks and other lenders can require specific types of financial documents as a condition for loans. 

Plus, in the context of an employee-ownership culture, accounting and financial reporting best practices deliver higher quality information to company leadership, empowering them to make decisions, and helping them deliver accurate updates to employee-owners.

RELATED: Does an ESOP Need Specialized Accounting, Legal & Tax Services?

ESOP Accounting Nuances as Covered Under FASB ASC 718-40

Previously outlined in Statement of Position 93-6, Employers’ Accounting for Employee Stock Ownership Plans, guidance on generally accepted accounting principles (GAAP) for leveraged and non-leveraged ESOPs is now covered under FASB Accounting Standards Codification (ASC) 718-40.

These ESOP accounting standards specifically apply to the qualified retirement plan — the ESOP balance sheet — and address the sponsoring company’s periodic contributions of stock or cash to the plan. 

Non-leveraged ESOPs — ESOPs that are created without borrowing funds — have much simpler requirements than leveraged ESOP accounting demands. When a company makes a contribution of stock or cash to the plan, it receives a tax deduction equal to the value of the stock and/or cash contributed.

Since most ESOPs are leveraged at one point or another in their existence, it’s important to understand how to record the liability for the loan. In short, the company lends cash to the ESOP for use in purchasing shares, and the ESOP pays back cash to the company to service the debt. While the leveraged ESOP’s internal loan is cash neutral, cash does change hands and must be recorded as such in journal entries. Other considerations, such as dividends, distributions, compensation expense, and synthetic equity can require the expertise of an experienced TPA to correctly execute, record, and report.

It’s important to understand that the assets held by the ESOP are not part of the company’s balance sheet. ESOP assets are owned by the ESOP trust and administered by the ESOP trustee, with consultative help from the TPA.

ALSO READ: What is Balance Forward Accounting? How Can it Impact ESOP Participants?

Financial Accounting Best Practices for ESOP Companies

One significant question ESOP company leaders need to answer is whether to use a cash basis, tax basis, or accrual basis for financial statements. In short, accrual practices lead to more accurate reporting of revenues and expenses, and more accurately depict future cash flows. So, accrual accounting delivers a clearer picture of the company’s overall financial strength.

Because forecasts are an important aspect of valuation, it makes sense to use the accrual basis for accounting, even if your ESOP never needs an outside loan.

What about the choice of who prepares your financial statements? Many companies prepare their financials internally, or they rely on an outside accountant for compilation services only. While reviewed or audited financials are not technically required for ERISA compliance, they are certainly a best practice among ESOP companies, to help document the performance of fiduciary duties. 

In fact, many independent ESOP trustees require, at minimum, reviewed (if not audited) financials to be the regular accounting procedure for companies they are willing to serve.

So if you’re investigating an ESOP among potential exit strategies but you’ve always used a cash basis for financial statements, or you’ve prepared your financials internally, then now is an ideal time to reach out to an ESOP expert. An experienced TPA can help get your company on solid footing in preparation for the transition to employee ownership.

That means consulting as a resource for both you and your CPA, clarifying the details down to the journal entries and footnote disclosures in your financial reports. Your TPA can help you understand the nuances of ESOP accounting, and help both you and your CPA ensure that your reporting, forecasting, and all other required documents are valuation-ready, lender-ready, and audit-ready.

Learn more about what’s needed to properly forecast, report, and support your company’s repurchase obligation for an ESOP that’s sustainable over the long term. Just download our free tip sheet, ESOP Repurchase Obligation Forecasting, Reporting & Funding.

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