EP24 - Accounting for Leveraged ESOP Transactions

In this episode, Makenzie breaks down a leveraged ESOP transaction and the resulting impacts to a company's financial statements. This episode highlights the journal entries required for a simplified, leveraged ESOP transaction in accordance with generally accepted accounting principles including common mistakes to avoid. 

Transcript

[0:11] Welcome back to another episode of Journey to an ESOP and Beyond where we discuss all things related to Employee Stock ownership plans, I'm your host for today Mackenzie worth um you may or may not know me from our last episode if you gave it a listen thanks for listening if you have not be sure to go check it out. If you have listened um you may, no we are discussing today which is a very exciting topic or at least something that I'm going to try to make somewhat engaging is accounting for esops.

[0:49] And before I scare maybe half of you away or before you hit next or move on to the next episodelet me preface that I'm gonna not only just speak on yes some debits and credits here and there but I'm also just going to break down an ESOP transaction piece by piece um I'm going to attempt to explain an inside note what that means how an inside note, comes aboutall aspects of an ESOP transaction specifically a leveraged ESOP transaction. So again speaking on accounting for esops I'm not going to get into the tax implications of things or tax accounting this is specifically Accounting in accordance with us gaap um generally accepted accounting principlesthis is a cruel based um, and this will be from the perspective of the the company the um plan sponsor the employer.

[1:50] Um and as a reference just for anyone that's in the accounting field and wants to kind of do your own research or digging into the authoritative literature this all falls under um FaZe ASC 718.

[2:05] So if you want to go nerd out on accounting guidancego for it um but hopefully I can get you a high-level summary here today that can kind of put things into perspective, um you're probably wondering how is she going to pull this off, I'm not sure either so we're gonna we're gonna do this together and see how this goes um if there's anything that I.

[2:28] Say that results in further questions or clarifications feel free to reach out to us use um journey to aesop.com um use our chat box there to ask us questions clarifying questions and we'll we'll get those addressed and uh subsequent episodes, um So first let's let's talk about why this is even important why dedicate an entire episode to accounting for esopsum well first. Before undergoing an ESOP transactions it's very important to understand the financial impacts this transaction will have on your financial statementsum. This is important for if well 1 just to make sure you're maintaining accurate, financial reporting um 2 if you're getting a review or an audit done you want to ensure that you're recording the proper entries and um disclosing the proper information on your financial statements and also if you're maybe subject to bonding requirements um you you you may just need you need to understand the implications of any soft transactionum and how that's going to impact the company's financials.

[3:37] So as I mentioned we are going to first kind of break down an ESOP Transaction what is even what are all the different pieces that are going on and, again we're going to be speaking specifically to a leveraged ESOP transaction which is, the most common type of ESOP transaction which essentially just means that ESOP is leveraged the ESOP purchases shares of a company with debt, um So the first piece here you have a company with an owner for purposes of Simplicity we're just going to assume there's 1 owner and we're going to refer to them as the selling shareholder. So this 1 selling shareholder sells their shares to a trust otherwise known as the ESOP Trustand the ESOP trust is set up solely for the purpose of this transaction and to serve as the trust holding the sharesfor the benefit of the employees. So specifically in a leveraged ESOP Trustwhen the trust acquires those shares they are held in suspense. This means they are not yet allocated to participating employees accounts because they serve as collateral for the debt that the ESOP took on to purchase these shares.

[4:55] So selling shareholder sells their share to an ESOP Trust, in return the ESOP trust issues a seller notea seller note is a form of debt which is a promise to pay the seller back over time under terms negotiated in the transaction. For the purchase price that was negotiated to as well in the transaction which is. In an ESOP transaction the fair market value at the timeso. Again this trust is set up solely for the purpose of this transaction and and to for the employees to essentially own the shares so at the time the trust has nothing it has no cash nothing to pay, pay their pay this debt off, so the trust goes to the company the company agrees to pay the selling shareholder back on behalf of the trust, so nowthe trust has no debtThe company took it on insteadthe company says I will pay back the selling shareholder for you.

[5:58] Now the ESOP Trustissues a note to the company because the ESOP trust is not owe money to the selling shareholder now it owes money to the company because the company is paying the selling shareholders for them, so the issue a note to the company where the ESOP trust says hey I promised to pay you back, thank you for paying the selling shareholder for me I will pay you back over timeand again this. This note can have completely different terms it has the same amount so if I'm if, the selling shareholder sells their shares to the trust for 5 million the selling shareholder receives 5 million over time. Well now the company and the ESOP trust have a note between each other for that same amount we'll call it 5 million however, the term of the note May differ. The company may be paying back the sellers over 5 years however the trust could be paying the company back over30 yearsum they're a completely separate notes. And sothis note between the company and the trust is what's referred to as an inside note um.

[7:12] And again this is a promise for the trust to pay back the company, well you might be thinking McKenzie you just said that the ESOP trust could not pay the seller back so how are they going to pay the company back. Great question so as part of the, ESOP plan the actual employee benefit plan that is designed through the formation of the ESOPthe company commits to make annual cash contributions to the trust, in an amount that is sufficient for the trust to pay the company back for the inside note. So againas part of the employee Benefit Planthe company makes annual contributions to the trust. The trust takes that cash and pays it right back to the companyto pay down the inside noteso.

[8:13] As the inside note gets paid down remember when the when the trust required these shares they're held in suspenseas this inside note gets paid down Shares are released from suspense, and proportionto the pay down of the inside note. So if 5% of that inside note balance gets paid down in a given year 5% of total shares in suspense are released to employees accounts.

[8:45] So what does this look like from an accounting perspective.

[8:49] So again kind of high level rewindselling shareholder sells to the trusttrust owes the selling shareholders money. The company agrees to pay the selling shareholders back on of the trustand now the trust owes the company money.

[9:10] The companysince they assumed that the seller notethey're going to credit a seller note payable. And again back to the the number I used earlier we're going to call it 5 millionthe company now owes the selling shareholder 5 million because they agreed to pay the selling shareholder back for or on behalf of the trust. So your debit in this scenario under ASC 718 is what's called unearned ESOP shareswhich is a contra Equity account so it has a normal debit position. So your debit is on an ESOP shares for 5 million credit seller note payable for 5 millionthis on an ESOP shares balance, essentially reflects the amount of shares that are held in suspense by the trust.

[10:05] You may be thinking okay well there's a note between the company and the ESOP shouldn't there shouldn't the company have some sort of note receivable, nospecifically under ASC 718 it explicitly States neither the company nor the ESOP should record the inside note, so the company will never record a note receivable it will never record interesting come the ESOP never records um a note payable or interest expense related to thisguidance specifically says do not record that, what is only recorded relative to the inside note is this Contra Equity account called unearned ESOP shares.

[10:43] So again debit on an ESOP shares for 5 million credit seller note payable for 5 million at the time of the transaction.

[10:53] Now as I mentioned each year as the company makes annual contributions to the trustShares are released. What does this look like from an accounting perspective remember these top shares account isessentially what it it reflects these shares that are in suspenseso as Shares are released, your credit the honor and ESOP shares account.

[11:17] We'll go back to my example if 5% of the inside note gets paid down in a given year5% of total shares and suspense are releasedwe'll assume that this, 5 million transaction was for a million shares being sold to the trustso 5% $50,000 or 50,000 shares get released. The amount that you credit to the underneath of shares account under under gaap. Is going to be equal to the number of shares times the price that the trust paid for the shares. So at the trust paid 5 million for the shares there's a million shares that's 5 dollars a share, 5 dollars a share of times the 50,000 shares that got released this yearmeans I'm crediting on an ESOP shares for 250,000.

[12:12] My debitis a non-cash ESOP compensation expense. However this is not going to have the same amount that we're recordingas the creditthe compensation expense amount is based onthe fair value at the time the shares are released.

[12:34] So if you're if you're already an ESOP you you'll be familiar with this you may already know um each year as an ESOP you are required to have an independent valuation done this will tell you at the end of each yearwhat your what the share price is so. Wellso that in a given year. In the current year in the beginning it's usually it's lower than what the trust paid for it because of all the debt that kind of that decreases the value but essentially it, that uh grows but in the beginning it's lower so we'll say assume it's 3 dollars um 3 dollars a share50,000 shares of released. That results in 150,000 as your compensation expense. So you have a debit to compensation expense your non-cash ESOP compensation expense equal to 150,000 and your credit is equal to 250,000. If you know accounting you know your debits need to be equal your credits their difference is going to fall out to retained earningsso in this scenario your debit you're going to have another debit to retain earnings for $100,000.

[13:43] Sothat is the entry from the company's perspectivethere's 1 more piece here.

[13:54] As I mentioned the contribution that the company is makingto the trustis in an amount that is sufficient for the trust to pay down the inside note.

[14:06] We're going to assume a given inside note for 5 million whatever if it's over 30 years, um applicable federal rate we're just going to make up numbers here we're going to assume that this results in a total annual payment of $100,000 a year. This is a commonuh mistake I guess made relative to ESOP accounting that even though, the company is remember in this scenario they're going to pay the trust and dollars that trust is going to send the $100,000 right back to the company.

[14:44] And soyour cash is going out but it's coming right back inIt ultimately nuts out. And so the op the offsetting side of your entrytypically can just be a suspense account since this is going to net out. Immediatelyum this happens all around the same day so you're going to debit a suspense account credit cash. As soon as that money comes back in you're going to debit cash credit the suspense accountso really there is truly no accountingimpact from the payment that goes in and out, or I should say relative to the amount that is going in and out um. The entries that are madeand that actually have a financial statement impact is the credit to the honor and ease out shares account and the debit to the non-cash ESOP compensation expense.

[15:45] So again as a summary um we havekind of. 3 separate or 4 Separate entries going on first when the ESOP is set upyou have a debit to honor an ESOP shares which is a contra Equity accountyou have a credit to seller note payable. Going forward the seller note payable that entry gets recorded like any other debt as as you paid off um in accordance with the the terms of the the note and the resulting amortization table you willum. He'll debit yourseller note payable you'll have interest expense credit cash just like any other noteum.

[16:29] Then at the end of each year as the company makes contributions to the trustignore the payment amount that actually goes through which is based on the inside note. You will credit your honor and ESOP shares account. Based on the number of shares that were released that year times the price that the ESOP trust paid for the shares to begin with. Your debit to the ESOPnon-cash ESOP compensation expense is going to equal to the number of shares times the share price at that time. And your difference will fall out to retain earningsso it's a cash physically has to transfer back and forth between the company and the trust. You can record the actual payment that gets paid from in accordance with the inside note example earlier was around $400,000, we'll say that that debit is a suspense account the credit is cash but remember the cash comes right back to the companyand is a debit to cash credit to suspense account shows so it should offset, common mistake is. Companies will record uman ESOP compensation expense for the amount of that contribution as opposed to. Based on the number of shares released times the share price at the end of that year.

[17:53] Umso that is a summary of the accounting for esops again, not the easiest to explain probably not the easiest to digest um if you're just listening to this or even watching it's it's just meum but if there are any clarifying questions or anything I can explain better or um, any any, clarifications just please don't hesitate to reach out so we can clear that up for you but hopefully this um gives you an idea of the accounting for esops andum what that looks like remember the biggest things are. Your cash payment that goes in and out that amount is not equal to your compensation expense2 there's no note receivable or interest income recorded by the company. And3 don't forget the Contra Equity account on our ESOP shares. So yeah thank you for listening thanks for hanging with me I know this was a weird 1 um but hopefully it provides some color on accounting for esops thank you for listening.