by Damien Strohmier, CPA, CCIFP
Considering an ESOP (Employee Stock Ownership Plan) or have you just implemented an ESOP for owner succession? The technical application of accounting for this transaction generally results in the company presenting a significant deficit where the company previously had equity. But does that have to be the case?
How Equity Deficits Arise
Take a moment to understand how the deficit arises. Transaction price is agreed upon between the owner, or group of owners, and a fiduciary acting on behalf of the ESOP to make sure the transaction price is fair. Funding for the transaction is generally split between outside financing and a seller note, but for simplicity, we will assume the lender funded the entire purchase.
- The lender provides cash to the company. The company records an increase to cash and a liability for the outside loan.
- The company provides this cash to the ESOP trust in return for an inside loan that is booked as contra equity on the company’s financials.
- For the sake of finishing the transaction, the next step is for the ESOP trust to provide the cash to the seller in exchange for stock.
The creation of the contra equity account is where a company accepts the creation of the stockholders’ deficit. Typically, the company may need to operate profitably for years to come, to rebuild the company back to a positive equity position.
There is another option that can be extremely valuable when there are related assets that have a fair value greater than the recorded book value (think of heavy equipment that has been depreciated or land or buildings that have appreciated). This value was inherent in the transaction price. Whatever portion of the transaction price that wasn’t due to value of the assets over book value is due to goodwill or the value that the operation can generate at the company.
In order to reflect the write-ups of equipment, land, or buildings, a company could utilize pushdown accounting. First, the acquiree must determine they qualify for pushdown accounting. While it is recommended anyone considering this option work closely with their accounting firm, the general requirements to apply pushdown are not that restrictive with the primary consideration being that a change in control actually occurred and that the transaction was not scoped out of the guidance (info below in FAQs).
If you make the election, the next step is determining fair values or estimated fair values of the assets and liabilities of the company. Many assets and liabilities would continue with their stated values (i.e. your operating assets and liabilities). Certain assets, such as equipment, land, and buildings, may have fair values that exceed the carrying value on the company’s financial statements and would be written up with a corresponding credit to additional paid-in capital (APIC). Any value of the transaction that could not be allocated to existing assets and liabilities or be absorbed through the write-up of assets would be debited to goodwill with a corresponding credit to APIC.
The credit to APIC will offset the Contra Equity account recognized for the internal loan between the company and ESOP.
It can take years for companies to work their way out of the deficit created by an ESOP transaction, and a company may be able to take advantage of the pushdown election and avoid the deficit altogether. You should be aware that the write up of depreciable or amortizable assets on the front end will increase depreciation and amortization expense in future years, and therefore will suppress future financial statement earnings (but will not impact future EBITDA).
Contact your Blue & Co. advisor regarding any questions related to the technical accounting for ESOPs and making a pushdown accounting election. We’re happy to help!
Frequently Asked Questions about ESOPs and Pushdown Accounting
What types of transactions does pushdown not apply to?
Formation of a joint venture, acquisition of an asset or group of assets that does not constitute a business, combination between entities under common control, certain acquisitions or transactions of not-for-profit entities, and transactions with collateralized financing entities.
What is control and how do I determine whether a change in control event occurred?
Control follows the definition for controlling financial interest under the Accounting Standards Codification (can be as simple as obtaining a majority voting interest). Control can be obtained by transferring cash or other assets, incurring liabilities, issuing equity interests, providing more than one type of consideration, or without consideration, including by contract alone. There are some very technical requirements that must be met here to ensure that the prior owners do not have a continuing equity interest or in effect are the primary beneficiaries of the company if it is determined to be a variable interest entity. This is a crucial determination that must be made before considering the use of pushdown accounting.
When does a company have to make the election to apply pushdown accounting?
Election should be prior to the issuance of financial statements, however, pushdown may be applied to the most recent change in control event as a change in accounting principle. Note that pushdown shall be applied as of the acquisition date of the change in control event.
Can you apply pushdown to subsidiaries of the company that was acquired?
Any subsidiary is also eligible to make the election to its separate financial statements.
My financials are not comparative if this election is made, what do I do?
Financial statements for prior years should be retrospectively adjusted to provide comparative information OR simply present a single year financial statement with adjustments to beginning of year balances to eliminate some of this accounting burden.
Can I change back after applying pushdown guidance?
No, the election to apply pushdown accounting is irrevocable.
Contact your Blue & Co. advisor regarding any questions related to the technical accounting for ESOPs and making a pushdown accounting election.