An ESOP is an Employee Stock Ownership Plan, a common type of incentive and retirement fund that businesses offer their employees. ESOPs can take many different forms, but essentially they are funds in which the business manages a collection of stock on behalf of the employees, either shares from the company itself, other organizations or a combination of both. The company then pays dividends out of the fund to employees when employees qualify. Many ESOPs are leveraged, or funded through company debt, and companies often make guarantees of payment on the accounts.
ESOP External Debt
External debt can be associated with ESOPs when a business borrowers money from an outside party to invest in the stock (buying other stocks) or potentially for fund management. This external debt tends to come either from banks or from shareholders willing to loan money to the business, and is one of the easiest types of debt to account for. It is simply included on the balance sheet as a liability like any other debt, and usually has its own account for retirement fund management.
ESOP Internal Debt
An ESOP internal debt or internal loan occurs when a company uses cash already within the company to buy fund shares for the ESOP account, which can be common when the company uses its own shares. In this case, the company accounts for both the liability of ESOP internally, but includes a contra equity account that shows the business is essentially borrowing money from itself by leveraging its own equity. When this is "repaid" company value and interest income are not increased.
When a company actually creates ESOP rules and an employee earns ESOP shares according to those rules, then the shares are seen as committed to release, and require additional accounting. The employer must record a compensation expense for that period in which the shares were earned. According to Internal Revenue Service regulation, this expense must be based on the fair market value of the shares (in the past, it was based on a fixed cash amount).
Finally, when the dividends from the fund are actually paid, the company must account for them as well. Allocated shares must be charged to retained earnings just like conventional dividends that the business pays out. Unallocated shares, such as those used for debt service, should instead be accounted as a reduction in debt, lowering the business' overall liability.