A privately held company with an employee stock ownership plan carries a promise that does not show up in the trial balance: when participants leave and take their shares, someone has to buy them back for cash. That repurchase obligation drives liquidity and going concern analysis, and it rests on a share price set by an appraiser.
This guide covers what the auditor needs to understand, test and obtain, for both ERISA ESOPs and the broader case of employee shares with repurchase features.
Two different questions
Separate two frameworks at planning.
Employee shares and options granted as compensation. ASC 718 applies to share-based payment transactions with employees, but it carves out equity instruments held by an employee stock ownership plan. Those fall under ASC 718-40, Employee Stock Ownership Plans.
Repurchase features on employee-held shares outside an ESOP trust. Here the classification question sits in ASC 718-10-25-9. A puttable or callable share awarded to an employee is a liability if the repurchase feature lets the employee avoid bearing the risks and rewards of ownership for a reasonable period, or if it is probable the employer would prevent the employee from bearing them. A period of six months or more is a reasonable period, and an employee begins to bear those risks and rewards once all requisite service has been rendered. A feature exercisable only on a contingent event outside the employee's control, such as an IPO, does not meet the condition until the event becomes probable within that period.
A company can have both.
The repurchase obligation under the plan
For an ERISA plan holding stock that is not readily tradable, the plan document and the Internal Revenue Code define the obligation. The IRS sample plan language for pre-approved ESOPs sets out the mechanics the auditor should read in the client's own document:
- Put option periods. The first period is 60 days beginning the day after the stock is distributed. The second is 60 days in the following plan year.
- Payment timing. For an installment distribution, payment is made within 30 days of the offer to sell. For a total distribution, payment commences within 30 days, and the employer may pay in a single payment or in substantially equal periodic payments, at least annually, over a period not exceeding five years, with adequate security and interest at a reasonable rate.
- Mandatory put variants. Companies that are S corporations, or whose charter restricts ownership as described in Code Section 409(h)(2)(B)(ii)(I), use different language, so identify which version the client adopted.
- Independent appraiser. Valuations of employer stock must be made by an independent appraiser who meets requirements similar to the regulations under Code Section 170(a)(1), in good faith and based on all relevant factors for determining fair market value (Code Section 401(a)(28)(C)).
Read the actual plan and amendments. The put terms, who is obligated (the company or the plan) and the installment option determine the cash profile.
Valuation: the estimate that carries the file
The stock price flows into allocations, contributions, the repurchase obligation estimate and, for the company's own books, compensation expense. Apply the same discipline as any significant estimate under AU-C 540:
- Evaluate the competence, capabilities and objectivity of the appraiser, and the scope of the appraiser's engagement. Learn who engaged the appraiser, the company or the plan trustee, because that bears on objectivity. See management's specialist and auditor's specialist.
- Obtain the full valuation report and test the data that management supplied to the appraiser: financial statements, projections, debt balances, comparable transactions. Compare the projections with budget history.
- Look at the effect of ESOP debt. Where the ESOP's purchase is loan-funded, discount rates, marketability discounts and the treatment of ESOP debt all move the price. Ask why inputs differ from the prior year.
- Reconcile the valuation date to the plan's valuation date and the balance sheet date, and consider subsequent events. Many concepts overlap with a 409A valuation; the standard of value and the purpose differ.
- Where fair value measurement guidance applies to the company's own accounting, tie the inputs to the fair value framework and treat unobservable inputs as Level 3.
Classification and measurement for the company
For employee shares with repurchase features outside the ESOP trust, the following outcomes follow from ASC 718-10-25-9 and the SEC's temporary equity guidance:
- A feature that fails the six-month test makes the shares a liability, remeasured each reporting period through the income statement.
- After the shares have been held for the six-month period, a fair value repurchase is akin to a repurchase from an ordinary shareholder, and the final remeasured amount is reclassified to equity.
- A potential repurchase at less than fair value leads to ongoing liability classification and remeasurement.
- Awards that remain in equity under ASC 718 require presentation outside permanent equity under ASC 480-10-S99-3A when they are redeemable at the option of the holder or on an event not solely within the issuer's control. That includes shares whose repurchase feature the employee exercises only after six months of vesting.
Check for a pattern of cash settlement too. Regular buybacks from employees before they bore the risks and rewards of ownership can drive liability classification regardless of the documents.
Worked example (illustrative numbers)
A closely held manufacturer has an ESOP holding 1,000,000 shares. The year-end independent valuation is $42.00 per share. Participants with a combined 60,000 vested shares are expected to separate in the following plan year and take total distributions. The plan elects the five-year installment payout with adequate security.
- Expected value of shares put back: 60,000 x $42.00 = $2,520,000.
- Under the installment election, the annual principal is $2,520,000 / 5 = $504,000, plus interest at the plan's stated rate.
- If the next valuation moves to $46.00, the same shares represent $2,760,000, an increase of $240,000 in the obligation.
For the audit, the repurchase forecast is a liquidity input. Compare the $504,000 annual principal with operating cash flow and credit facility covenants, and carry the result into the going concern evaluation. A year in which separations double changes the outlook even if the share price is flat.
Typical audit procedures
- Obtain the plan document, adoption agreement, trust agreement and loan documents; map the put option and payment terms.
- Obtain the independent appraisal and evaluate the appraiser and the inputs.
- Recalculate the repurchase obligation estimate using vested balances by participant and the appraised price.
- Reconcile the plan's allocation records and the trustee statement to shares outstanding on the company's stock ledger.
- Test contributions, loan payments, and the release of shares under ASC 718-40 to the loan amortization.
- Review board minutes for repurchases, tender offers and amendments.
- Evaluate classification, presentation, disclosure and subsequent events.
PBC items
- Plan document, adoption agreement and amendments
- Trustee statements and participant-level share ledgers
- Independent appraisal reports for the audit year and the prior year
- Repurchase obligation study or cash forecast
- ESOP loan agreement, amortization schedule and security documents
- Stock ledger and cap table
- Board and trustee minutes
Red flags
- A valuation that rises while projections are cut
- Repurchases at prices other than the appraised price
- Put terms in practice that differ from the plan document
- Cash settlement of employee shares shortly after vesting
- No repurchase forecast, or one that ignores growth in vested balances
- Appraiser fees tied to the outcome, or an appraiser hired by management
Sources
- IRS, Employee Stock Ownership Plan Listing of Required Modifications and Information Package (ESOP LRM), put option, payment terms and independent appraiser language (Code Sections 401(a)(28)(C) and 409(h))
- FASB ASC 718-10-10-2, 718-10-25-9 and 25-10, 718-40, and ASC 480-10-S99-3A, as reproduced and discussed in Grant Thornton, Share-based payments: Navigating the guidance in ASC 718
- KPMG, Hot Topic: Structured equity transactions (temporary equity under ASC 480-10-S99-3A)
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures
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