New math for ESOPs.
Sharpen your pencils and fire up your calculators, because new ESOP accounting rules have arrived. The Accounting Standards Executive Committee, the rule-making body of the American Institute of Certified Public Accountants, has issued Statement of Position 93-6, effective for fiscal years beginning after December 15, 1993 (the first quarter of 1994 for companies with calendar-year ends). This set of complex new accounting rules puts a whole new spin on ESOP accounting procedures, and the ramifications reach far beyond financial reporting. That's why it's important for financial executives to understand the requirements of SOP 93-6 and its implications.
SOP 93-6 requires you to measure compensation based on the fair value of the ESOP shares committed to be released rather than the cost of the shares to the ESOP. This accounting also applies in situations where companies use ESOPs to settle or fund other employee benefits, such as a 401(k) match (a KSOP) or contributions to a profit-sharing plan.
The SOP also changes accounting procedures for dividends and earnings per share. Before, all ESOP shares were considered to be outstanding. Therefore, dividends on shares the ESOP held were charged to retained earnings, and the shares were outstanding for EPS purposes. By contrast, the SOP requires that only dividends on allocated ESOP shares be charged to retained earnings. Dividends on unallocated shares are now charged to compensation if you pay them to participants or account for them as debt reduction or accrued interest, if you use them for debt service (effectively charging compensation expense for all dividends on unallocated shares). Likewise, only shares committed to be released are considered outstanding for EPS purposes. Earnings per share are also affected by the increased compensation expense.
As shown in the illustration on page 47, which is based on one of the Statement of Position illustrations, the new rules will increase compensation expense in two important ways. First, dividends on unallocated shares used for debt service no longer reduce compensation expense, and the compensation expense is based on the fair value of shares, increasing the expense if that value is turns out to be greater than the cost of the shares.
However, the illustration doesn't show the effect of the increased compensation expense on earnings per share (EPS). Since fewer shares are considered outstanding under SOP 93-6 than under the old accounting, earnings per share may increase or decrease under the new rules, even after accounting for the reduction in net income that stems from adopting the SOP. Another note: Under certain "grandfathering" provisions in the SOP, employers may elect to not apply the new accounting rules to shares acquired by ESOPs before December 31, 1992. These provisions apply not only to measuring compensation cost, but also to the new rules for dividends and EPS.
The illustration on page 47 shows that in certain situations with high dividends but small differences between the fair value of released shares and their cost, the impact of the change in accounting for dividends will be greater than the more publicized change in accounting for the ESOP share value. For example, the illustration shows that the impact of the SOP in year one is an increased expense of $650,000 ($500,000 due to changes in accounting for dividends plus $150,000 from using the fair value of shares released rather than cost). In situations in which the fair value differs significantly from the cost, the relative impact of the change in accounting for dividends may be less than the impact of the change to fair value.
In addition, the impact of the new rules would be the same if you use the leveraged ESOP to fund your 401(k) match in a KSOP arrangement. For example, if a KSOP had features identical to those illustrated, the impact of SOP 93-6 would be the same -- an expense increase of $650,000 in year one. The impact of the new accounting in year two is an increased expense of $450,000 ($400,000 from the change in accounting for dividends plus $50,000 from using fair value).
SOP 93-6 will put leveraged ESOPs or KSOPs on the same footing as non-leveraged plans. Therefore, companies may decide to opt for the simpler, less-regulated approach of contributing stock to the plan annually. At least one company has concluded that contributing more shares to its existing KSOP doesn't give it any kind of advantage.
For established ESOPs or KSOPs, the new accounting rules may influence plans to refinance loans or acquire new shares of stock to allocate. Leveraged ESOPs among public companies may still be attractive if the company thinks it's a takeover candidate and wants to concentrate ownership in employees' hands. Also, the accounting change should have little impact on private companies that want to use an ESOP to acquire shares from a principal owner.
As you can see, the change doesn't mean all companies will decide against establishing new ESOPs. They'll still be attractive vehicles with which to raise new capital; create a marketplace for existing stock; participate in leveraged buy-out financing packages and give owners a tax-advantaged method of ending their ownership. They also can be part of a long-term program to restructure the equity section of a plan sponsor's balance sheet, and companies can use them to defend themselves against hostile takeovers.
However, ESOPs may no longer be appropriate for funding a matching program for a sponsor's 401(k) savings plan, formula-based profit-sharing plan and other employee benefits. Nor are they useful in replacing lost benefits from terminated or curtailed retirement (pension) plans or other postretirement benefit plans, particularly retiree medical benefits.
Clearly, if your company is considering an ESOP or KSOP, or if it plans to refinance loans or acquire new shares of stock to allocate to an existing ESOP, it needs to move quickly. The best way to address these issues is to understand the new accounting rules; determine whether existing ESOP shares fall under the grandfathering provisions; model the potential impact of SOP 93-6 on compensation expense, net income and EPS; and consider alternative plan designs, if necessary.
ESOPS: WHAT STAYS, WHAT GOES
To illustrate how the new ESOP rules work, assume that on the first day of the employer's fiscal year, the ESOP borrows $10 million at 10 percent for five years. It uses the proceeds to buy 1 million shares of newly issued common stock for $10 per share. In year one, the year-end value is $11.50, with an average value of $10.75. The year-end value for year two is $9, with an average value of $10.25.
Each year, the ESOP releases 200,000 shares and allocates them to participants in the following year. Shares are considered to be committed for release over the service period before the release date. The ESOP uses dividends of 50 cents per share on the unallocated shares it holds to pay debt service, which occurs at the end of the year. Therefore, in year one, the principal is $2 million, with $1 million interest. In year two, the same $2 million principal bears $800,000 in interest.
Here's the scoop on what the new accounting looks like for this situation, compared with the old accounting procedures.
TABULAR DATA OMITTED
USING SOP 93-6: A TWO-MINUTE TUTORIAL
* Accounting considers the employer to have consolidated the ESOP.
* Employer reports issuance of shares and a corresponding charge to a contra-equity account.
* Employer reports loan from outside lenders to ESOP as liability on balance sheet.
* For internally leveraged ESOPs, the loan receivable is not an asset and the ESOP's debt is not a liability.
* Dividends on allocated shares charged to retained earnings.
* For ESOP shares committed to be released, compensation expense recognized is based on fair value of shares.
* For ESOP shares used to fund other employee benefits -- such as 401(k) matching contributions -- the accounting treats compensation expense as if the employer hadn't used an ESOP.
* Interest cost reported on ESOP debt.
* Dividends on unallocated shares effectively charged to compensation expense.
Earnings Per Share
* Only ESOP shares committed to be released considered outstanding.
Mr. Akresh is a director in Coopers & Lybrand's Human Resource Advisory Technical Services Unit in New York. He co-authored two research studies on retiree health benefits for Financial Executives Research Foundation. Mr. Cosloy is a partner in Coopers & Lybrand's Human Resource Advisory Group in New York.
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|Title Annotation:||includes related article; employee stock ownership plans|
|Author:||Cosloy, Barry I.|
|Date:||May 1, 1994|
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