Employee Ownership
Simplifying Employee Share Plan (ESP) Accounting: Key Variables that Impact The Accounting Treatment for ESP
What are the financial and tax implications of implementing an Employee Share Plan? We’ve prepared this comprehensive information for owners, accountants and CFOs to better understand the accounting treatment for ESOPs.
However, the following information is general and not to be taken as financial advice. When you decide to progress with your ESOP, your engagement with Succession Plus will include critical elements of tax planning, which can be laid out in partnership with your preferred accounting partner.
How do ESOP shares impact business financial statements?
The accounting treatment for an Employee Share Plan (ESP) and an Employee Share Ownership Plan (ESOP) in Australia — which are types of share-based payment arrangements — is governed by the Australian Accounting Standards, particularly AASB 2 Share-based Payment.
The standard requires companies to recognise share-based payments, including ESOPs, in their financial statements. This includes recognising expenses and equity in financial reporting for each share-based payment transaction.
Share-based payment transactions involve different types, such as cash-settled and equity-settled payments, and it is crucial to recognise these transactions accurately in financial statements.
The accounting impact and the way the transactions are recorded in the financial statements are also partly determined by the type of plan and the taxation rules that apply.
The treatment varies depending on the specifics of the plan but generally involves the following key aspects:
Recognising the Employer contribution
The accounting treatment for Employee Stock Ownership Plans (ESOPs) begins with recognising the employer’s contribution to the ESOP as a compensation expense, as these are equity instruments granted to employees.
Leveraged ESOPs involve borrowing money to purchase company stock, which has specific implications for accounting practices, including how shares are allocated to employees over time. This reflects the company’s commitment to sharing its success with its employees.
For instance, when a company contributes $50,000 to the Peak Performance Trust (PPT) as part of its profit share plan, it is recorded as an ESOP contribution expense.
The ESOP expense is tax-deductible for the company and represents a subscription of capital in the PPT (i.e. no taxation in the plan itself, as it is capital). For employees, it is tax-deferred.
Issue of Units in the Employee Stock Ownership Plan to Employees
Usually, the trust acquires shares in the company on behalf of the employees, and then issues units in the trust granted in the PPT to employees. The units are considered equity instruments.
For example, when employees buy units in the PPT using their own funds, such as a $10,000 investment, it is treated as a subscription of capital in the PPT, and the PPT then uses those funds to acquire shares in the employer.
The shares and units are “matched” and must be separately identifiable. The PPT trust will produce its own financial statements and record the number of units each employee holds and the corresponding shares in the employer company.
Payment of Dividends in Employee Stock Ownership Plans
When a company pays dividends, it’s a sign of financial health and profitability. In the context of an ESOP, dividends can be paid to the trust (PPT), which then distributes them to the employees based on the number of units they hold.
Let’s use the example of a company paying a dividend of $25,000. The company would record it as dividends paid, impacting the retained earnings. The PPT would record it as dividends received.
The PPT would then make payments to employees to distribute the dividend. Importantly, the PPT cannot “hold” dividends; it is a pass-through vehicle. These dividends then become additional income in the hands of employees.
Employee Redemptions
Employee redemptions are a part of the ESOP lifecycle where employees may exit, resign or retire. While the ESOP itself reduces the likelihood of this occurring earlier than planned, it does still happen for various reasons.
If an ESOP loan is utilised to fund the purchase of company shares, that may impact financial statements and transition from leveraged to non-leveraged ESOPs during the repayment process. Leveraged ESOPs, where ESOP trusts borrow money to buy stock from selling shareholders, can be crucial in managing these redemptions.
The redemption process needs to be managed carefully to ensure that it aligns with the company’s financial strategy and the ESOP’s rules. In most cases, units held by the exiting employee are either purchased (by another plan participant) or redeemed.
Accounting for Discounted Units and Disqualifying Discounts in Share-Based Payment Arrangements
What are Disqualifying Discounts in an ESOP
In the context of Employee Share Ownership Plans (ESOPs), and especially employee ownership trusts like the PPT, a disqualifying discount is applied when an employee leaves the company before a certain period, which is stipulated by the ESOP’s terms. This discount reduces the value of the shares or options that the employee is entitled to based on the duration of their employment.
Impact of ESOP Disqualifying Discounts
The disqualifying discount table is based on time. When exiting with a disqualifying discount, the amount the employee receives is reduced accordingly. For instance, an employee may only be entitled to 40% of the value of the shares they hold if they leave the company in less than four years. If they remain employed with the company beyond the four-year mark, the disqualifying discount is irrelevant. Your particular disqualifying discount table can be amended and percentages adjusted — they need not be equal every year.
Tax Considerations for ESOP shares
The redemption amount (whether discounted or not) is paid out to the employee and is nearly always a taxation trigger. However, when an employee exits, the underlying shares are retained by the trust and held as unallocated, which may have different tax implications.
Accounting for Bad Leavers
A “Bad Leaver” is typically an employee who leaves the company under circumstances that are not favourable, such as dismissal for cause or violation of non-compete clauses. The accounting treatment for Bad Leavers can vary, but generally, any unredeemed units held by a Bad Leaver may be forfeited. The accounting entries would reverse any previously recognised expenses related to these units, and the forfeited units would be available for reissue to other employees or cancellation.
Conclusion
The accounting treatment for ESOPs is a systematic process that ensures transparency and fairness in distributing company profits to employees.
It involves recognising the expense contribution, issuing units to employees, managing redemptions, and paying dividends. Each step is crucial in maintaining the integrity of the ESOP and ensuring that it continues to serve as a tool for employee engagement and retention.
Before embarking on the ESOP journey, company leadership and ownership must thoroughly understand these accounting requirements and seek professional advice. The accounting treatment of ESOPs can be complex, especially in determining the fair value and dealing with changes in vesting conditions or modifications to the plan.
Fair value measurement is particularly important in ESOP accounting as it ensures that the valuation of employee share options is consistent with the fair value objective stated in accounting standards.
One final note: It’s imperative to update the fair value measurements of share-based payments at each reporting date to ensure accurate financial reporting. Additionally, companies must stay updated with any changes or interpretations in the accounting standards that could affect the treatment of ESPs.
Are you curious to learn more about how ESOPs can benefit your business? Explore the best practices without any commitment! Book a no-obligation consultation to discuss your next steps and gain clarity on implementing an ESOP tailored to your needs. Let’s navigate this journey together!
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