ESPP Fundamentals: Accounting and Administration for the ESPP Lifecycle

Employee stock purchase plans (ESPPs) are a powerful, cost-effective tool for driving employee engagement throughout an organization by broadening share ownership. As ESPPs increase in popularity, it’s essential to understand the versatility of plan features available, as well as the downstream accounting and compliance implications. We’ve published numerous in-depth pieces on ESPPs, but here we want to zoom out and cover the fundamentals. We’ll walk through the full lifecycle of an ESPP offering, from enrollment to purchase (or rollover), and provide practical solutions to some of the more common accounting and plan administration challenges along the way.

If you are in a financial reporting or technical accounting role, this article will bridge the different ESPP design features available to their accounting consequences. If you are in HR, you’ll walk away with a grasp of how different design features impact the program cost. In our experience helping megacaps all the way to newly public companies with all flavors of ESPPs, there is no single perfect ESPP design. However, where we see companies forming regrets is when they are unaware of a program feature they could have adopted or surprised by the cost implications of a feature they did adopt. Here we hope to demystify these issues.

Enrollments

The first phase of the ESPP lifecycle is enrollment. During this period, eligible employees decide whether to participate in the offering and, if so, authorize payroll deductions for future stock purchases. This means selecting a percentage or fixed dollar amount of each paycheck to contribute, which is automatically withheld throughout the offering period and accumulated until the purchase date.

For accounting purposes, companies must immediately estimate contributions from each employee. This will determine the estimated shares to be purchased and is the basis for expense amortization. Any imprecision in this calculation can lead to expense shocks later.

Here are some common considerations when estimating contributions and shares.

• IRS cap. For plans to be qualified under Section 423(b) and receive preferable tax treatment, subsection 423(b)(8) states that “no employee may be granted an option…to accrue at a rate which exceeds $25,000 of fair market value of such stock (determined at the time such option is granted) for each calendar year in which such option is outstanding at any time.” Therefore, this $25,000 limit should be factored into the estimated contributions since employees wouldn’t be allowed to purchase more. This calculation is nuanced even in stable markets, but can become quite complex when there is turbulence.

• Company-specific cap. Many companies specify either a share or a contribution cap in their governing documents. This is often done to manage the dilutive impact to common shareholders.

• Bonus/commission contributions. Many plans allow employees to contribute from bonuses or commission payments in addition to salary. Given that these aren’t regular payments, special care must be taken to ensure they flow through correctly while estimating contributions.

A common question that arises is what happens when your ESPP grant date or purchase date falls on a non-trading day. More specifically, how do you determine the strike or purchase price? Many plan documents explicitly outline how to handle non-trading days, so that’s always the best place to start. Otherwise, the most common approach is to use the price from the next available trading day for the grant or the previous day for the purchase calculation. If your plan document is silent, we recommend consulting with legal counsel, establishing a consistent precedent, and documenting the approach for future reference.

Once you’ve estimated the total amount of contributions and the price at which participants are expected to purchase, you can use those two components to estimate the total number of shares expected to be purchased. This will be your basis for accruing expense.

If you don’t have a lookback feature, expense accruals simply need to factor in the amount of the discount for the fair value. However, once you have a lookback component, the valuation requires an option pricing model due to the ability to lock in the purchase price on the offering date and inherent downside protection if the stock price decreases (i.e., the ability to buy more shares). Depending on the interest rate environment, you may also want to layer in a discount due to the dollars being locked up during the purchase period and unavailable for investment at the risk-free rate.

On the administrative side, it’s equally important to ensure that payroll systems are properly configured. This includes handling ESPP deductions accurately, tracking IRS or other jurisdictional contribution limits, and managing any related tax withholdings.

Now that we’ve covered the enrollment, let’s look at three types of activity you may encounter before the plan purchases.

Contribution Adjustments

Once enrollment is complete, some ESPP plans allow participants to adjust their contributions mid-offering. This flexibility takes two common forms:

1. A lump-sum contribution outside of regular payroll deductions
2. A change to the contribution percentage/amount for future paychecks

Each scenario carries distinct accounting implications. In the first, allowing employees to contribute ad hoc cash after enrollment can undermine the “mutual understanding” of the award’s terms. According to ASC 718-50-55-2 and 55-32, this effectively nullifies the original grant date. As a result, the award would no longer qualify for fixed accounting treatment and the fair value would immediately be marked to market.

In our experience, cash infusions are rare. However, we’ve seen companies surprised when this happens, so it’s important to ensure all of the ramifications have been considered before allowing this feature.

In the second type of adjustment, if an employee increases their contribution percentage, this is considered a modification. Under ASC 718-50-55-29, standard modification accounting rules would apply, and the incremental fair value must be measured and recognized prospectively. Further, these changes must be tracked appropriately to ensure compliance with IRS limits.

If the employee decreases their election percentage, the reduction is disregarded, per ASC 718-50-35-2. But what if the decrease is due to a salary reduction instead of a contribution election? This is a gray area since it’s not explicitly covered in ASC 718. A commonly accepted argument is that if you have a grant date, you shouldn’t decrease expense below your grant date estimate.

Practically speaking, it can be difficult to differentiate between decreases in contribution elections and decreases in pay. Since decreases in salary and other pay tend to be rare, we typically see companies ignore all decreases, make the grant-date estimate the floor for expense, and consider election increases only for incremental cost.

Terminations and Withdrawals

When an employee terminates, the accounting treatment is generally straightforward. Any expense related to unpurchased shares should be reversed, similar to a forfeiture of traditional equity awards, and any previously withheld contributions must be refunded to the employee.

However, when an employee voluntarily withdraws from the plan, the treatment differs. In this case, no reversal of expense is recorded. The rationale aligns with the accounting treatment for a cancellation without consideration of an equity award. As a result, any remaining unrecognized expense is accelerated and recognized immediately.

It’s possible for an employee to withdraw from an ESPP first and subsequently terminate. In that case, the initial withdrawal triggers an acceleration of expense, but the later termination allows for reversal of any previously recognized expense. This is due to service not ultimately being provided for the duration of the offering period.

Suspensions

Many ESPP plans allow employees to suspend contributions mid-offering and resume them later. Suspensions may be initiated by the employee or triggered administratively (e.g., when an employee reaches their contribution limit or goes on an extended leave of absence).

We’ve seen a variety of approaches for handling suspensions. Most fall into one of three categories:

1. Immediate withdrawal. A withdrawal is processed on the suspension date. This is common when an employee hits the contribution cap and is unlikely to contribute further during the offering period.

2. Deferred withdrawal. Assuming this is an offering with multiple purchase periods, the employee is treated as withdrawn at the start of the next purchase period. This is common when the suspension becomes a formal withdrawal in the administration system if contributions are still suspended at the start of the next offering period.

3. Suspended contributions. Contributions are set to zero during the suspension period and reinstated once the employee resumes participation. This method maintains the employee’s enrollment status without triggering a formal withdrawal.

Recall that a formal withdrawal triggers acceleration of all unamortized expense, whereas a contribution decrease is ignored for accounting purposes. So it’s important to understand whether the employee is truly withdrawn in the system and unable to contribute further, or if they’re temporarily suspended and may reinstate contributions in the future.

Given the nuances involved, it’s essential to establish robust processes for tracking suspensions and applying the necessary treatment consistently.

With that, let’s move on to what happens on the purchase date.

Purchase True-Ups

The purchase date is when estimates meet reality and you know exactly how many shares will be purchased. At this stage, the accounting treatment depends heavily on whether the plan includes a lookback feature.

Without a lookback, the accounting is straightforward (and the complexities regarding contribution modifications and withdrawals don’t apply). Expense must equal the value of shares purchased. This means that no matter which of the events above occurred, expense must be adjusted to equal the purchased shares. For those curious as to why, if there’s no lookback feature, then participants don’t begin to benefit from—or be adversely affected by—subsequent changes in the employer’s stock price until the purchase date. Therefore, there’s not an established accounting grant date until the purchase date.

With a lookback, the treatment is more nuanced. If fewer shares are purchased than originally estimated, there’s no true-down of expense, in line with the grant-date estimate principle. However, if more shares are purchased than estimated, then you need to dig deeper.

1. Was the increase due to higher employee contributions? If yes, then additional expense must be recognized immediately to comply with ASC 718-10-35-3, often referred to as the floor provision.

2. Was the increase due to a drop in the stock price? If so, no additional compensation cost is recognized, since the value delivered to the employee remains consistent with the original estimate. The option valuation performed on the grant date already factored into the ability to purchase more shares if the price drops as part of the “put option” valuation component.

3. What if both occurred—higher contributions and a price drop? In that case, the impact must be bifurcated. Additional expense is recognized only for the portion attributable to increased contributions, with no additional expense for the portion attributable to the price drop.

These calculations quickly become complex, especially in large-scale plans, so it’s important to have reporting systems and controls in place to handle each scenario accurately.

Let’s wrap up with one more type of activity that can occur around the purchase date.

Resets and Rollovers

In the most lucrative ESPPs, reset and rollover mechanisms are popular, especially when there are multiple purchase periods under a longer offering window. These features are triggered when a subsequent offering price is lower than the original (or most recent) offering price.

In a reset, the current purchase is executed, and then the lookback price for future purchases is reset to the new, lower price.

When a reset is combined with a rollover, the current purchase is executed and the lookback price for future purchases is reset to the new, lower price. Then additional purchases are added to the end of the offering as needed to ensure that the participant has a full offering worth of purchases anchored to the new, lower price.

From an administrative perspective, many systems handle a rollover by canceling the current offering and enrolling participants into a new one. Despite this operational treatment, the original enrollment must be maintained for accounting purposes. These are modifications and must be treated accordingly under ASC 718.

Given the complexity of this topic, we’ve dedicated an entire article to effectuating resets and rollovers.

Closing Thoughts

ESPPs continue to proliferate as a means for delivering meaningful value to employees at all levels of the organization. However, as plan designs grow more sophisticated, so do the accounting and operational complexities. Without robust, automated processes in place, even well-intentioned plans can become difficult to manage and report accurately.

That said, lucrative plan features are no longer considered bleeding edge, and in some industries they are becoming tablestakes. We’ve helped countless companies compare and contrast the cost/benefit implications of competing designs to provide data-driven decision analysis.

If you have any questions about ESPP design, accounting, or administration, please don’t hesitate to reach out.