Finding the Right Audit Firm for your ESOP

There are over 70,000 retirement plans audited in the US by CPA firms every year. The vast majority of these take the form of the traditional 401(k) plan, and over 3,500 audit firms in the US perform these audits. A much less common, and more complex, type of qualified retirement plan is the ESOP (Employee Stock Ownership Plan). There are fewer than 1,000 of these in the US requiring audits and a much smaller number of CPA firms that are qualified to serve as the IQPA (Independent Qualified Public Accountant) and perform the required audit for these plans, and there’s a reason: the complexities are much more substantial and any ESOP audit firm needs unique expertise and experience to do this work. Here are some of the main areas where an ESOP significantly differs from a 401k plan:
- Contribution calculation —Contributions in an ESOP are not determined by participant deferral elections or employer match calculations – instead the contribution is generally a fixed amount based on the debt service for the ESOP loan, and is allocated based on ESOP-eligible wages (which may be different than eligible wages for the company’s 401(k) plan).
- Leveraged ESOP allocation — Each year in a leveraged ESOP, a calculation is necessary to determine the number of shares that are allocated to participant accounts. This can be based on the principal only method, the principal & interest method, or another method. The unallocated portion of the plan has its own separately presented net assets calculation in the plan financial statements.
- Distributions — ESOPs have a unique type of distribution known as a diversification, where participants can take a certain portion of their ESOP account and roll it to investments outside of the company stock — but only at certain times and in certain amounts. Vesting is another crucial concept for ESOP participants, which almost always have a six-year graded vesting schedule. A common finding for ESOP distributions is failure to properly calculate the vesting, which can lead to participants having too much, or too little, in forfeitures from their gross distribution. This is key to the plan and other active employees, as forfeitures are usually allocated to other participants each year.
- Stock valuation — Although auditors are not expected to be stock valuation experts, their responsibility extends farther than simply taking a stock price number and dropping it into the report. An auditor is responsible for having a basic understanding of private company ESOP stock valuation methodology, reading the appraisal report in full, determining that the report is prepared by an appropriately qualified expert, and performing additional procedures related to some of the key financial assumptions in the report. This differs from most 401(k) plan audits, which generally require no specific expertise or substantial procedures related to investments, which are almost always priced based on an active market.
- Loan testing and verification — A 401(k) plan will never have leverage, but an ESOP almost always has at least one loan associated with the acquisition of the stock. That loan will need to be tested and the amortization schedule re-audited each year. Generally, the auditor will confirm the debt directly with the holder, which can be a financial institution or the original stockholder of the company.
- Financial statement presentation & disclosure — A leveraged ESOP financial statement may look similar in some ways to a traditional 401(k), but there are a number of additional complexities. As previously noted, the net assets and changes in net assets must be presented separately for the allocated and unallocated portions of the plan, and there are significant additional disclosures related to the allocation, ESOP loan(s), put option, and stock valuation.
- Compliance considerations — ESOPs are subject to their own set of compliance tests that the auditor must be experienced enough to understand. Most prominent among these is the required 409(p) anti-abuse testing, but there are also tests related to annual additions limits, employee coverage, and plenty more.
- Unique ESOP transactions — As an ESOP ages past its initial years, there will be advanced transactions such as re-leveraging, recycling vs. redeeming shares, additional share issuance, dividends used to pay debt service, and others. An ESOP auditor must understand these transactions and their unique effects on the plan.
Unsure when your ESOP will need to be audited for the first time? Remember that the participant count is determined by the number of participants who have balances as of the first day of the plan year — this includes not only all current employees who have received an allocation of contributions, but also all former employees who still have balances in the plan. For ESOPs where most employees receive an allocation and employees often do not take their balances out quickly, participant count can add up quickly!
With all the complexity present in any leveraged ESOP, the plan trustee and administrator will want to ensure you’re hiring an auditor with the necessary experience, not just in auditing retirement plans, but the unusual complexities of ESOPs. If you have questions about whether your ESOP will need an audit soon, or you’re unsure whether your ESOP’s current auditor has the necessary experience, please reach out to our ESOP audit team!