Our vendor has prepared a draft of the 2001 Form 5500 and has recommended that distributed loan balances be reported under Schedule H Part II, 5(B) - Unrealized appreciation. Is this an acceptable treatment?

I don't think so.

On separation from service, you are paying out the former employee's account balance (or part of it). The assets paid include a loan that is receivable by the plan. I can not see any other way to characterize this, other than as a payment of a benefit to a participant.

I agree with John. It makes no sense to put it in that section of the schedule H. I believe it should be reported either in e or g of the Expense section depending on the circumstances of the loan.

Check instructions for line 2(g) of Sch. H.

Line 2(g) is for "deemed distributions", which are loans that go into default or are otherwise no longer eligible under Section 72(p). Although a "deemed distributed" loan is reportable on Form 1099-R, and can be removed from the balance sheet as if it was no longer an asset of the plan, it is still an asset for some purposes, and the loan still exists.

What was described above sounds like a real distribution.