Inside the ESOP Audit: What Plan Sponsors Should Know

Employee stock ownership plans (ESOPs) offer employees a stake in the business, but with that ownership comes fiduciary responsibility. Annual ESOP financial statement audits aren’t just a regulatory requirement. They are essential to protecting participants, ensuring accurate benefit allocations, proper investment valuation and maintaining compliance with Department of Labor (DOL) and the Employee Retirement Income Security Act (ERISA) standards.

An ESOP audit provides assurance that the right employees are receiving the right benefits at the right time. It also verifies that plan activity aligns with the governing plan document and accounting rules.

Whether an ESOP needs an audit depends on the number of participants. Generally, plans with fewer than 100 eligible participants at the start of the plan year are exempt. Once participation exceeds 120, an audit is required. Plans in the 100-120 range fall into a gray area where prior-year counts determine whether an audit applies.

Auditor Guidance and Standards

ESOP audits are governed by specific authoritative frameworks:

• DOL and ERISA requirements: Set compliance and reporting expectations for benefit plans
• The American Institute of Certified Public Accountants’ (AICPA’s) employee benefit plan audit and accounting guide: Assists practitioners in performing and reporting on their audit engagements and to assist management of employee benefit plans in the preparation of their financial statements in conformity with U.S. generally accepted accounting principles (GAAP)
• ASC 820 fair value measurements: Provides a framework for measuring fair value, which is critical for valuing employee stock option plans (ESOPs)

Together, these frameworks guide plan sponsors and auditors in assessing whether the plan’s financial statements fairly represent its condition and whether the valuation of ESOP assets are reasonable.

Phases of an ESOP Audit

A successful ESOP audit follows four key phases:

1. Planning and kickoff: The auditor meets with management and trustees to confirm scope, timelines and milestones, and to discuss any new regulatory changes.
2. Internal controls testing: Auditors evaluate systems and processes related to participant data, share allocations and contribution calculations.
3. Fieldwork: Documentation and valuations are reviewed in detail, and auditors test compliance with ERISA and plan provisions.
4. Wrap-up and reporting: Findings are summarized, and recommendations are discussed to ensure the plan remains in good standing.

Tips for a Smoother Audit

The most effective audits start well before year-end. Taking these steps proactively can clear the way for a smoother audit path:

• Communicate early and often: Reach out to your auditor throughout the year on questions or issues, not just at audit time.
• Hold an audit kickoff meeting: Review information requests, timelines and expectations.
• Stay organized: Keep valuation reports, trustee communications and supporting schedules readily available.
• Engage experienced partners: Choose providers who understand ESOP requirements. Record keepers and third-party administrators (TPAs) play an important role.

Common Pitfalls

Avoiding certain pitfalls comes down to preparation, communication and collaboration with professionals who understand ESOP dynamics. Some of the more common barriers to success include:

• Allocation errors in stock distributions are the most frequent and often the costliest.
• Missing or incomplete documentation can delay filings or trigger compliance questions.
• Late valuation reports can create a domino effect that postpones audit completion.
• Inexperienced administrators may misinterpret plan requirements or overlook updates in audit or DOL guidance.

Valuation Reviews: More Than a Compliance Step

Valuation is at the heart of an ESOP audit. The valuation report represents an independent opinion of the fair market value of the company’s shares and is typically reviewed by the trustee and auditors and relied upon by the administrators. Auditors evaluate whether the valuation firm’s approach, assumptions and conclusions are reasonable. Most valuations incorporate the three approaches:

• Asset approach: Based on the value of net tangible assets, often used for asset-heavy companies
• Income approach: Relies on projected cash flows and risk adjusted discount rates applicable to the circumstances of the company
• Market approach: Compares the company to publicly traded peers or recent private or internal company transactions

A sound valuation should clearly document key assumptions, methods and supporting evidence.

Red flags in Valuation Reviews

Even when an ESOP valuation is performed by experienced professionals, certain issues can undermine its reliability and delay the audit process. Auditors often encounter:

Unsupported assumptions: Every valuation depends on its underlying assumptions, such as discount rates, selection of market data and marketability adjustments, to name only a few. If those inputs lack supporting evidence or documentation, auditors may challenge their reasonableness. Each factor must be tied back to objective data and/or a clear rationale.

Overly optimistic projections: Future cash flows and performance expectations drive the valuation. When projections appear inconsistent with past results or too aggressive compared to market trends, auditors and trustees will ask how they were developed, who prepared them and whether assumptions were stress-tested for realism.

Inappropriate comparable companies: Under the market approach, valuation professionals often benchmark against publicly traded companies. Problems arise when those “comparables” differ significantly in size, service mix or business model. Guideline companies should closely mirror the ESOP company’s risk profile and operations to ensure meaningful comparisons.

Misapplied methodologies: The best valuations consider multiple approaches such as asset, income and market and reconcile them appropriately. Overreliance on a single method or inconsistent use of methods year over year may distort the result.

Documentation and timing issues: Missing transaction reports, late valuation deliverables or incomplete trustee correspondence can delay the audit and create compliance risk. Timely, complete documentation ensures auditors can verify the valuation’s basis and issue the report on schedule.

A careful valuation review should test each of these areas for reasonableness, consistency and adequate support. The goal is not just compliance but confidence that plan participants are receiving fair value for their ownership interests.

The Bottom Line

An ESOP audit is more than a box-checking exercise. It’s an opportunity to strengthen governance, improve documentation and validate the share values. Weaver can help organizations take a proactive approach, building confidence among plan participants and demonstrating a commitment to transparency. Contact us to learn more about Weaver’s ESOP audit and valuation services.

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