Employers' accounting for employee stock ownership plans.
* ESOPs invest primarily in the sponsoring corporation's stock.
* ESOPs are permitted to borrow from or with the assistance of a related party, namely the employer sponsor.
A leveraged ESOP borrows money to acquire employer shares. The debt generally is repaid by the ESOP using employer contributions and dividends. As debt is repaid, shares are released from a suspense account and must be allocated to individual participant accounts by the end of the ESOP's fiscal year. (For a glossary of ESOP terms, see the sidebar on page 55.)
EVOLUTION OF ESOPs
The first leveraged ESOPs were formed in the 1970s. These plans generally were straightforward and had the characteristics of defined contribution retirement plans. The accounting treatment was fairly straightforward as well. At that time, the contentious accounting matter was whether employers should report ESOPs' debt in their balance sheets. In 1976, the American Institute of CPAs accounting standards executive committee (AcSEC) issued Statement of Position no. 76-3, Accounting Practices for Certain Employee Stock Ownership Plans, to provide guidance on accounting for ESOPs.
As financial innovation and additional favorable tax legislation in the 1980s made ESOPs more desirable, additional companies began to recognize their value as
* Corporate financing techniques.
* Effective tools to motivate and compensate employees.
* Ways for closely held business owners to sell their shares to employees.
As a result, ESOPs proliferated in the following years. The number of companies with ESOPs has grown from 2,500 in 1976 to approximately 10,000 today.
During this time, the nature and the terms of ESOPs also became more diverse; for example, ESOPs were developed with
* Unusual debt terms, such as interest-only loans or negative amortizing loans.
* Special classes of stock, some of which paid unusually high dividends.
* The goal of funding employee benefits established independently of the ESOP, such as employers' matches of IRC section 401(k) plans and employers' contributions to profit-sharing plans.
As ESOPs changed, more contentious accounting issues arose and the Financial Accounting Standards Board emerging issues task force (EITF) found itself dealing with a number of ESOP issues. Although the EITF reached consensuses on some issues, it felt constrained by the conclusions in SOP no. 76-3, which many believed were inadequate in the current environment. The consensuses were viewed as short-term solutions. Because AcSEC issued SOP no. 76-3, it was deemed the appropriate body to develop guidance to resolve the issues. Accordingly, late in 1989 AcSEC formed an ESOP task force to reconsider existing ESOP guidance and develop new rules.
There currently are two primary sources of guidance on accounting for ESOPs--SOP no. 76-3 and EITF issue no. 89-8, Expense Recognition for Employee Stock Ownership Plans.
Under SOP no. 76-3
* An ESOFs debt is recorded as a liability in the employer's financial statements, with the offsetting debit as a contra-equity account.
* The debt and contra-equity accounts are reduced simultaneously as the ESOP makes payments on the debt.
* Contributions to the ESOP are charged to interest expense and compensation expense.
* Dividends on ESOP shares are charged to retained earnings.
* All shares held by an ESOP are considered outstanding.
Under issue no. 89-8, which modified SOP no. 76-3 somewhat, the shares-allocated method is used to determine the amount of compensation expense (shares allocated times the cost per share to the ESOP minus dividends). To the extent the shares-allocated method results in compensation expense that is more or less than the amount determined based on the employer contribution, the expense and contra-equity accounts are adjusted.
What's wrong with existing guidance? The most significant defects identified by the task force were
* Measurement of compensation cost. Under the existing accounting guidance, employers essentially fix the cost of providing future employee benefits by investing in their own stock. The shortcomings are most apparent when the ESOP is used to fund a benefit established outside the ESOP. (See exhibit 1, page 56.)
* Treatment of dividends on unallocated shares used for debt service. Under the existing accounting guidance, dividends on unallocated employer shares are used by the employer for purposes of reducing compensation expense. (See exhibit 2, page 56.)
PROPOSED AICPA SOP
The objectives of AcSEC's reconsideration of SOP no. 76-3 were to
* Review accounting for ESOPs on a comprehensive basis.
* Address current ESOP issues not previously addressed.
* Provide guidance that reflects the economic substance of employers' transactions with ESOPs and thereby enhances the understandability and relevance of E SOP accounting.
In December 1992, AcSEC issued an exposure draft of an SOP, Employers' Accountering for Employee Stock Ownership Plans, which it believes accomplishes these objectives. The proposed SOP deals the both leveraged and nonleveraged ESOPs. However, because most of the contentious accounting issues involve leveraged ESOPs and the proposed SOP would not change existing accounting for nonleveraged plans, this article deals only with leveraged ESOPs.
OVERVIEW OF PROPOSED SOP
The primary concept underlying the conclusions in the proposed SOP is that employers' accounting for ESOP debt (the financing element, if an outside loan is involved) should be separate from their accounting for the ESOP shares (the compensation element). Although the financing and compensation elements are related, each should be analyzed and reported separately. The proposed SOP contains a detailed discussion of the basis for the conclusions.
Accounting for the establishment of an ESOP. Employers would report the issuance of new shares, the sale of treasury shares or the ESOP's purchase of shares on the market when the issuance, sale or purchase of the shares occurs and would charge unearned compensation, which is a contra-equity account. Employers would report loans from outside lenders to ESOPs as liabilities on their balance sheets. Employers with leveraged ESOPs financed solely by an employer loan (internally leveraged) would not report the loan receivable from the ESOP as an asset and would not report the ESOP's debt as a liability. (See exhibit 3, page 57.)
Accounting for contributions. Because ESOP contributions are used to repay what is effectively the employer's debt, under the proposed SOP employers would report ESOP contributions as a reduction of debt and of accrued interest payable. (See exhibit 4, page 57.)
Accounting for dividends. Once shares are allocated to participants' accounts, the employer does not control the use of such dividends, except to the extent it chooses to pay them to participants in stock rather than cash. Accordingly, under the proposed SOP employers would charge dividends on allocated ESOP shares to retained earnings and credit dividends payable just as they account for dividends on other outstanding shares. However, employers control the use of dividends on unallocated shares and generally decide to use them for debt service. Under the proposed SOP, employers accordingly would report dividends on unallocated shares either as a reduction of debt and of accrued interest or as compensation cost. The determination is made on the basis of whether the dividends are used for debt service or paid to participants. (See exhibit 4.)
Accounting for employee benefits established independently of the ESOP but funded by the ESOP. Some employers agree to provide a specified or determinable benefit to employees and use the ESOP to partially or fully fund that benefit, such as the employers' contribution to a 401(k) plan or to a formula profit-sharing plan. Under the proposed SOP, the employer should recognize compensation cost and liabilities associated with providing the benefits to employees as it would have had an ESOP not been used to fund the benefit. (See exhibit 5, page 58.)
Accounting for release of shares. The proposed SOP recognizes ESOP shares are released for different purposes: to compensate employees directly, to settle employer liabilities for other employee benefits and to replace dividends on allocated shares used for debt service. Under the proposed SOP, the purpose for which the shares are released determines the accounts to be charged.
* For ESOP shares committed to be released to compensate employees directly, employers would recognize compensation cost equal to the fair value of the shares committed to be released.
* For ESOP shares committed to be released to settle or fund liabilities for other employee benefits, employers would report satisfaction of the liabilities when the shares are committed to be released to settle the liabilities.
* For ESOP shares committed to be released to replace dividends on allocated shares used for debt service, employers would report satisfaction of the liability to pay dividends when the shares are committed to be released for that purpose.
As shares are committed to be released, employers would reduce unearned compensation based on the cost of the shares to the ESOP. The difference between the amount reported based on the fair value of the shares and the amount credited to unearned compensation would be charged or credited, as appropriate, to additional paid-in-capital. (See exhibit 6, page 58.)
Earnings per share (EPS). Under the proposed SOP, ESOP shares would be considered exchanged for employee service or for employer obligations as they are committed to be released. Accordingly, for purposes of computing primary and fully diluted EPS under the proposed SOP, ESOP shares that have been committed to be released should be considered outstanding. Likewise, ESOP shares that have not been committed to be released should not be considered outstanding.
The proposed SOP would be effective for fiscal years ending after December 15, 1993, as of the beginning of the fiscal year in which it is adopted.
ESOP shares to which the SOP must be applied. The proposed SOP would be applied prospectively to shares acquired by ESOPs after September 23, 1992 (new ESOP shares), that have not yet been committed to be released as of the beginning of the year in which the SOP is adopted.
AcSEC concluded that the date for the grandlathering provision should be the date when all approvals for issuing the ED were received. Representatives of AcSEC met with the FASB on September 23, 1992, and received the final clearance necessary to issue the ED.
ESOP shares to which the SOP may be applied. Employers would be allowed to elect to apply the proposed SOP to shares acquired by ESOPs before September 23, 1992 (old ESOP shares). For employers electing to apply the proposed SOP to old ESOP shares, the proposed SOP would be applied prospectively to the shares that have not yet been committed to be released as of the beginning of the year in which the SOP is adopted.
However, this opportunity to apply the proposed SOP to old ESOP shares would be available only for financial statements for years ending on or before December 31, 1994. An exception would permit employers that initially elected not to apply the proposed SOP to old ESOP shares that establish a significant new ESOP or add a significant number of shares to an existing ESOP after December 31, 1994, to apply the proposed SOP to the old ESOP shares that have not been committed to be released as of the beginning of the year in which the new ESOP shares are purchased.
The principal argument in favor of the grandlathering provision is it would be fair to companies that established ESOPs at great cost with a reasonable expectation the accounting in SOP no. 76-3 would remain in place. The argument against the provision is it would have a negative effect on the comparability of financial statements of employers with ESOPs for a long time (many current ESOPs have remaining terms that are longer than 10 years).
Disclosures. All employers with ESOPs would be required to make the disclosures required by the proposed SOP regardless of whether they adopt the accounting provisions. In addition, public companies that retain their current accounting for ESOPs would have to disclose pro forma income before extraordinary items, net income and EPS computed as if the employer had adopted the proposed SOFs provisions. (To determine which companies are public, the proposed SOP uses the definition of nonpublic companies that is found in FASB Statement no. 21, Suspension of the Reporting of Earnings Per Shave and Segment Information by Nonpublic Enterprises.)
Initial reaction to the proposed SOP has been mixed. At one end of the spectrum are those who argue current ESOP accounting is fine; at the other end are those who believe the proposed SOP should be finalized as proposed.
Opponents of the proposed SOP believe ESOPs would be less desirable because the proposed guidance would result in less predictable earnings and EPS, lower earnings in times of rising share prices and less reliable amounts being reported as compensation expense in the financial statements (for companies with nontraded shares). Opponents believe employees will suffer and there will be a negative impact on companies' growth.
Some proponents of the proposed SOP believe the new guidance provides more straightforward and relevant accounting for ESOPs, making ESOP accounting easier to explain to employees, executive officers, analysts, shareholders and potential investors. Some companies favor the proposed SOP because the current value of their shares is below the cost of the shares to the ESOP. If the proposal is adopted, these companies could improve current earnings by applying the guidance, although share values could change in the future.
In other instances companies are willing to accept the proposal as written because the new guidance would have a positive effect on earnings (even when current share values are above the shares' cost to the ESOP) because ESOP shares would not be considered outstanding until committed to be released. Under existing guidance all shares are considered outstanding from the date the ESOP purchases them.
There is, however, a sizable group in between that agrees with some of the proposal's provisions and disagrees with others. For example, a minority of AcSEC believes the provisions related to using fair value of shares to measure compensation cost should be used for some ESOPs and not others. The proposed SOP reflects their belief the provisions should apply only to ESOPs that release shares to settle or fund liabilities for other employee benefits such as the employer's match of a 401(k) plan.
Based on the initial reactions that AcSEC has received thus far, there are many diverse views about accounting for ESOPs. The deadline for commenting on the proposed SOP (product no. 800042JA) is March 19, 1993. Copies can be obtained by calling the AICPA order department at 1-800-TO AICPA. The first copy is free. AcSEC hopes to issue a final SOP in the fourth quarter of 1993.
* SINCE THE INCEPTION of leveraged ESOPs in the 1970s, there has been concern about whether employers should report ESOPs' debt on their balance sheets. SOP no. 76-3, Accounting Practices for Certain Employee Stock Ownership Plans, provided guidance on ESOP accounting.
* AS ESOPs HAVE EVOLVED, more and more contentious accounting issues have arisen; many believe SOP no. 76-3 is inadequate in the current environment. In 1989 AcSEC formed an ESOP task force to develop new guidance.
* IN DECEMBER 1992, AcSEC issued an exposure draft of an SOP, Employers' Accounting for Employee Stock Ownership Plans. Most of the proposed changes involve leveraged ESOPs.
* THE PREMISE UNDERLYING the conclusions in the proposed SOP is that employers' accounting for ESOP debt should be separate from their accounting for the ESOP shares. The most significant changes the proposed SOP would make are that employers would use the fair value of shares released to measure compensation cost and would charge dividends only on allocated ESOP shares to retained earnings.
* THE PROPOSED SOP WOULD be effective for fiscal years ending after December 15, 1993, as of the beginning of the fiscal year in which the SOP is adopted. Transition rules describe ESOP shares to which the proposed SOP must be applied and shares to which it may be applied.
* THE DEADLINE FOR RECEIVING comments on the proposed SOP is March 19, 1993. AcSEC expects to issue a final SOP in the fourth quarter of this year.
GLOSSARY OF ESOP TERMS
Allocated shares. The shares in an ESOP trust that have been assigned to individual participant accounts based on a known formula. IRS rules require allocations to be nondiscriminatory (that is, generally based on compensation, length of service or a combination of both). For any particular participant such shares may be vested, unvested or partially vested.
Dividends on allocated shares used for debt service. The allocation of shares to participant accounts replacing the cash dividends on allocated shares that were or will be used for debt service. Under the IRC, dividends on shares held by an ESOP that have been allocated to participant accounts cannot be used for debt service unless the employers allocate to those participants shares whose dollar value is no less than the dollar value of the dividends that were used for debt service. (The Internal Revenue Service has not issued guidance on what employers would be required to do to make up the difference between the value of any dividends withdrawn and the shares allocated. In practice, plan sponsors apply a wide variety of techniques to satisfy the code requirements.)
Released shares. Shares that have been released from suspense and from serving as collateral for ESOP debt as a result of payment of debt service. These shares are required to be allocated to participant accounts by the end of the ESOP's fiscal year. Formulas used to determine the number of shares released can be based either on (1) the ratio of the current principal amount to the total original principal amount (in which case the unearned compensation and debt balance move in tandem) or (2) the ratio of the current principal plus interest amount to the total original principal plus interest to be paid. Shares are released more rapidly under the second method. The tax law permits the first method only if the ESOP debt meets certain criteria.
Shares committed to be released. Shares not legally released but that will be released by a future scheduled and committed debt service payment and will be allocated to employees for service rendered in the current accounting period. The period of employee service to which shares relate is generally defined in the ESOP documents.
Suspense shares. Shares that have not been released, committed to be released or allocated to participant accounts. Suspense shares generally collateralize ESOP debt.
Top-up shares. The shares or cash an employer contributes to an ESOP because the fair value of the shares released is less than the employees liability for a particular benefit, such as a savings plan match.
D. GERALD SEARFOSS, CPA, is a partner and national director of academic development of Deloitte & Touche in Wilton, Connecticut. He is a former member of the American Institute off CPAs accounting standards executive committee and chair8 its ESOP task force. DIONNE D. McNAMEE, CPA, is a technical manager in the AICPA accounting standards division. She staffs the ESOP task force.
Ms. McNamee is an employee of the American Institute of CPAs and her views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.
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|Title Annotation:||includes glossary|
|Author:||McNamee, Dionne D.|
|Publication:||Journal of Accountancy|
|Date:||Feb 1, 1993|
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