ESOP accounting: past, present and future. (employee stock ownership plans)by Wise, Bret W.
The past two years have seen a wave of leveraged employee stock ownership plans (ESSOPs) Sweep through the corporate community. Although ESOPs have long been a popular and versatile financing tool for closely-held businesses, recently there has been a significant trend to establish ESOPs by major public companies.
In response to the growing interest in ESOPs, Wall Street has developed innovative financing techniques and new forms of ESOP securities providing sponsors with greater flexibility as well as significant cash flow benefits. in many cases, these new ESOP structures also produce a favorable effect on net income and earnings per share (EPS). The FASB and the SEC have taken an interest in the accounting issues raised by the more complex ESOP arrangements. Among the possible accounting changes being considered that would dramatically affect sponsors' accounting for ESOPs in the future are:
* Measuring expense by the fair value of shares allocated;
* Charging dividends on unallocated shares to expense;
* Consolidation of ESOPS; and
* Changes in the way shares are reflected in EPS calculations.
REASONS FOR THE ESOP MOVEMENT
The increased interest in ESOPs is founded on several attractive features. Favorable tax treatment given ESOP lenders in certain circumstances has allowed ESOPs, and their sponsors through the ESOP, to borrow at reduced interest rates. Other provisions in the tax law allow a deduction for dividends paid on ESOP shares, which has been a particularly attractive feature to public companies. Although Congress has recently taken steps to limit some tax-related ESOP benefits, the growth of ESOPs has continued into 1990.
Many employers believe that employee productivity may be enhanced by giving employees a share in the company ownership. others in the corporate community believe that unfriendly takeovers may be thwarted when a large share of the company ownership is in the hands of employees. A landmark court decision in January, 1989 (Shamrock Holdings v. Polaroid) greatly strengthened companies' ability to use ESOPs as a defensive tactic against hostile takeovers.
Several companies have used ESOPs to finance leveraged buyout (LBO) transactions. One of the largest ESOP financings ($1.75 billion) was put together b;, the Avis Corporation in its 1987 LBO in which Avis became 100% employee-owned. And in a vivid example of East meeting West, some economists believe that ESOPs are a viable vehicle for transferring ownership of state-owned businesses in Eastern Europe to private hands.
Many companies are redesigning employee benefit plans to contain the cost of pension and other postretirement benefits, such as retiree medical insurance. Incorporating benefit plans into an ESOP ties employees' retirement benefits more closely to the market performance of the company's stock. For example, Ralston Purina, Boise Cascade, and Whitman have recently begun to utilize ESOPs to fund postretirement medical benefits for current employees.
Although there are many reasons for the popularity of ESOPS, companies have discovered that the recently developed technique of issuing convertible preferred stock to the ESOP, rather than common stock, can produce a positive impact on net income and EPS. Existing accounting standards, issued in 1976, do not address some of the newer ESOP funding arrangements. As a result, the FASB's Emerging Issues Task Force (EITF) has addressed many ESOP-related questions (see the Accounting Standards Executive Committee (AcSEC) of the AICPA has added a project to its agenda to explore the fundamental accounting issues underlying ESOP arrangements.
EXISTING ACCOUNTING FOR ESOPS
ESOPs were conceived in the 1950s. Until recently, however, ESOP structures were relatively simple, typically involving only common stock of the employer and often leveraged with mortgage-type (level payment) debt with terms of 10 years or less. As the popularity of ESOPs increased in the late 1980s, the nature of ESOP arrangements became more complex. The increased complexity generated differing interpretations of the accounting literature, which was written in simpler times.
In 1976, the AICPA issued Statement of Position (SOP) 76-3, Accounting Practices for Certain Employee Stock Ownership Plans, " to address certain accounting issues relating to leveraged ESOPS. The primary recommendations of the SOP are:
* An obligation of an ESOP should be recognized as a liability by the sponsoring company when the sponsor guarantees the obligation or commits to make future contributions sufficient to service the ESOP debt. This liability is offset by a corresponding reduction in equity; both the liability and the offsetting debit to equity are reduced as the ESOP debt is paid.
* Contributions or commitments to make contributions to the ESOP are recognized as compensation expense and interest expense by the sponsor.
* All of the sponsor's shares held by the ESOP are treated as outstanding in the sponsor's calculation of EPS, regardless of whether those shares have been allocated to participants' accounts.
* Dividends paid on shares held by the ESOP are charged directly to retained earnings by the sponsor.
The ESOP structure has evolved since 1976. Sponsors now are issuing equity, securities to ESOPs with complex conversion, redemption, and dividend features and are financing ESOPs with other than mortgage-type debt. Some of these features were not anticipated in the SOP. For example, in a leveraged ESOP arrangement:
* The sponsor max, issue convertible preferred stock to the ESOP and use dividends to service the ESOP's debt, reducing the sponsor's required contributions.
* The ESOP loan may provide for variable payments rather than level payments.
* The sponsor may not guarantee the ESOP debt.
* The terms of convertible preferred stock issued to an ESOP may be structured to avoid classification as a common stock equivalent for purposes of EPS calculations.
* The plan man, provide ESOP participants with a guaranteed value for the convertible preferred stock upon their retirement or termination.
These arrangements raise a number of accounting issues, many of which have been addressed by the EITF (see Exhibit 1). Three controversial issues addressed by the EITF in 1989 are: expense recognition for leveraged ESOPS, treatment of ESOP debt by the sponsor, and ESOP issues affecting the calculation of EPS.
The SOP recommends that contributions or commitments to make contributions to an ESOP should be recognized as compensation and interest expense by the sponsor. Many companies have interpreted this to allow an employer to expense contributions made to the ESOP on a cash basis.
At the time the SOP was issued, borrowings of ESOPs were primarily in the form of mortgage-type debt or debt with level principal payments. In addition, the tax law at that time required that ESOP shares be allocated to participant accounts based on principal payments on the related ESOP debt. As a result, the sponsor recognized compensation expense equal to the cost of the shares allocated to participants as ESOP debt principal payments were made.
in recent years, the financing of ESOPs has evolved to include nonlevel debt, such as increasing debt service payments over the term of the debt. In addition, current tax law requires that ESOPs with debt terms in excess of 10 years allocate shares based on both principal and interest payments. As a result, ESOP shares purchased using borrowings in excess of 10 years are now allocated in part based on interest payments.
For example, assume that an ESOP borrows $100 million at 9% to be repaid over 15 years with level annual principal and interest payments. In the first year, the trustee makes the annual debt service payment of $12.4 million, consisting of $3.4 million principal and $9 million interest. Because the ESOP has repaid one-fifteenth of its total debt service (principal and interest), the trustee is required to allocate shares with a cost of $6.7 million (one-fifteenth of the shares) to participants. However, the ESOP has only paid for shares with a cost of $3.4 million, as represented by the principal payment on the ESOP debt. The difference of $3.3 million represents the cost of ESOP shares that have been allocated to participants before the debt used to purchase the shares has been paid.
Some companies have interpreted the SOP to allow expense recognition on a cash basis. in the example above, recognizing expense on a cash basis results in $12.4 million of expense in the first year, essentially deferring compensation expense on $3.3 million of shares allocated, for which principal payments have not been made. This perceived deferral of expense was the primary factor that prompted the EITF to address expense recognition by leveraged ESOPs. The EITF interpreted the SOP to require a sponsor to:
* Account for the financing and compensation elements of a leveraged ESOP separately;
* Recognize interest expense as incurred by the ESOP;
* Recognize compensation expense equal to the cost of shares allocated for the period; and
* Recognize dividends used to service ESOP debt as a direct reduction of retained earnings.
This approach is commonly referred to as the shares allocated method. in simple terms, the consensus requires a sponsor to recognize interest expense as incurred and to recognize the cost of the shares (compensation expense) when the shares are allocated to participants. In the example above, the sponsor would recognize expense of $15.7 million in the first year consisting of $9 million interest and $6.7 million compensation for the cost of shares allocated. The shares allocated method results in 3.3 million additional expense in the first year of the ESOP as compared to expense recognized on a cash basis. A more complex example of the shares allocated method, including the effects of dividends.
Recognition of ESOP Debt
The SOP provides that the obligation of an ESOP should be recognized as a liability by the sponsor when the sponsor guarantees the obligation or commits to make future contributions sufficient to service the ESOP debt.
Questions have arisen in practice as to whether the ESOP's debt should be recognized in the sponsor's balance sheet when the sponsor does not guarantee the debt. In june 1989, the EITF concluded that the debt of an ESOP should be recorded as a liability of the sponsor in all circumstances except when the ESOP has the ability and intent to satisfy the debt from sources other than dividends on the sponsor's stock, contributions from the sponsor, or the sale or exchange of the sponsor's securities. Considering the structure of most ESOP arrangements, this consensus effectively requires all ESOP debt to be recorded as a liability in the sponsor's balance sheet.
Earnings Per Share Issues
The recent trend of issuing other than "plain vanilla" common shares to ESOPs has created several EPS issues.
A security frequently used in ESOP arrangements today is high-yield convertible preferred stock. The use of this security is advantageous to companies because dividends are charged to retained earnings, effectively reducing the expense the company must recognize in its income statement. However, for EPS purposes the preferred dividends reduce income available to common shareholders.
Convertible preferred stock held by an ESOP usually carries a dividend rate in excess of the common dividend rate and is typically convertible into a fixed number of shares of common stock. The sponsor may, however, guarantee that upon termination or retirement the employee will receive common stock, cash, or a combination of stock and cash, with a value equal to a specified minimum value for the convertible preferred stock. This provision is commonly referred to as a guaranteed floor feature.
Questions have arisen regarding the treatment of the convertible preferred stock held by an ESOP in EPS computations, including:
* Should convertible preferred shares be considered common stock equivalents in the calculation of primary EPS?
* How does the assumed conversion of the convertible preferred shares impact fully diluted EPS?
* What effect does the guaranteed floor feature have on EPS?
The EITF addressed these issues in the fall of 1989. On the first issue, the EITF concluded that the convertible preferred should not be considered a common stock equivalent unless the yield of the preferred stock at the date of issuance is less than 66 2/3% of the corporate Aa bond rate (the yield test in FASB Statement 85).
The second issue arises when the dividend rate on the convertible preferred stock exceeds, the dividend rate on the common stock. Thus, if the convertible preferred stock held by the ESOP were converted to common stock, the sponsor would be required to make additional contributions to meet the ESOP's debt service requirements. These additional contributions would be charged to expense instead of retained earnings.
The EITF concluded that, in calculating fully diluted EPS under the if-converted method, net income should be reduced by the excess of the preferred dividends over common dividends assuming conversion of the preferred shares. For example, assume that the ESOP holds 100,000 shares of convertible preferred stock which has an $8 per share annual dividend. The preferred stock is convertible into 100,000 shares of the sponsor's common stock which paid a dividend of $3 per share. In calculating fully diluted EPS, the sponsor would be required to assume conversion of the preferred shares into common shares and to reduce net income available to common shareholders by $500,000 (100,000 shares x $5) for the difference between the preferred and common dividend rates.
The existence of a guaranteed floor feature further complicates the application of the if-converted method in calculating fully diluted EPS. if the market price of the common stock is less than the guaranteed value of the convertible preferred stock, the employer has a contingent obligation to issue additional shares of stock or to pay the shortfall in cash (depending on the provisions of the ESOP) when the employee retires or otherwise leaves the company. Many ESOPs allow the company to choose whether it will satisfy the guaranteed floor feature in cash or stock.
A question arises as to how a sponsor should reflect the guaranteed floor feature in its fully diluted EPS calculations. Specifically, if the market price of the common stock is less than the guaranteed floor price, should the company include the additional shares that would be required to satisfy the floor feature in the number of shares outstanding for fully diluted EPS calculations?
The EITF concluded that fully diluted EPS calculations should include the number of common shares based on the stated conversion rate for unallocated shares and the number of common shares equivalent to the guaranteed value for the preferred shares allocated to participants (but not less than the number of shares based on the stated conversion rate). EPS amounts for prior periods should be restated if the number of shares issued, or contingently issuable, subsequently changes because of market price fluctuations. The EITF reached this consensus in part because only participants can exercise the guaranteed floor feature (i.e., the guaranteed floor feature does not attach to the convertible preferred shares until allocated to participants).
The EITF also concluded that if the sponsor is either required to, or has the ability and expressed intent to satisfy the guaranteed floor feature in cash, the stated conversion rate should be used for all shares and no additional issuance of shares related to the guaranteed floor feature need be assumed.
The impact of convertible preferred stock, including the existence of a guaranteed floor feature, on EPS computations.
The guidance of the EITF has provided a level of consistency in practice on a short-term basis. However, as ESOP structures change and become more complex there is a growing need to reconsider the fundamental accounting model for ESOPS.
THE FUTURE OF ESOP ACCOUNTING
AcSEC initiated a project in 1989 to reconsider the SOP and other accounting issues related to ESOPS, including those addressed by the EITF. Some contentious issues which may be addressed by AcSEC are:
* Measurement of compensation expense;
* The treatment of dividends on unallocated ESOP shares;
* Consolidation of ESOPs in the financial statements of the sponsor; and
* The treatment of ESOP shares in the computation of EPS.
Measuring Expense: Cost or Fair Value?
The SOP (as interpreted in EITF Issue 89-8) provides that the cost of shares held by an ESOP should be charged to expense in the period allocated to participants. The cost basis was considered the appropriate measurement principle when the SOP was written because ESOPs were viewed as similar to defined contribution pension plans, where the risks and rewards of ownership of the assets rest with the employee, not with the employer.
Under the cost approach, an employer that sets aside shares today in a leveraged ESOP will recognize expense in future years (when the shares are allocated to participants) at today's cost basis. Some accountants believe that the employer retains the risks and rewards of ownership related to the unallocated shares and, thus, the employer should recognize compensation expense equal to the fair value of the shares in the period allocated to participants. This argument rests on the premise that the fair value of the shares allocated represents a more meaningful measure of the economic benefit provided to the employee and the sacrifice made by the employer.
To illustrate, assume the facts, except that the shares appreciate in value at a rate of 10% per year. In year 5, the per share value would be $161 versus $100 at the inception of the ESOP. Under the cost basis approach, the compensation component of ESOP expense in year 5 would be measured by the cost of the shares allocated of $5.6 million (56,334 shares at $100 per share). On the other hand, if expense is measured based on the fair value of the shares allocated, the compensation element would be $9.1 million (56,334 shares at $161 per share).
This same example may be used to demonstrate how the risks and rewards of ownership with respect to unallocated shares may rest with the sponsor. Assume that the ESOP has been formed to provide for a portion of the employer's match for employee 401(k) savings plan contributions. Further assume that in year 5 the employer is required to provide $10 million in benefits under the 401(k) match arrangement. in these circumstances (where the market price of the ESOP shares has increased to $161 per share), the sponsor would provide $9.1 million of the benefits through the ESOP and make an additional contribution to the 401(k) savings plan of $900,000. If instead the share value had dropped to $50 per share in year 5, the allocation of shares in the ESOP would satisfy only $2.8 million (56,334 shares at $50 per share) of the obligation, requiring an additional contribution by the sponsor of $7.2 million. Clearly in these circumstances the risks and rewards of ownership of the unallocated shares rests with the sponsor.
Fair value expense measurement would have a dramatic impact on the expense recognized by many sponsors of ESOPs. To demonstrate the effect of fair value expense treatment refer again to Exhibit 3 and assume appreciation in the value of the stock of 10% per year. The following table provides the expense recognition on a cash basis, using the shares allocated method, and using the shares allocated method but measuring compensation expense by the fair value of shares allocated (amounts in thousands).
A decrease in value of the sponsor's shares would likewise decrease the expense recognized under the fair value approach as compared to the cost basis approach.
ESOPs are analogous to variable stock compensation plans for which sponsors measure compensation expense based on the fair value of shares issued in accordance with APB Opinion 25, Accounting for Stock Issued to Employees. " The measurement of expense for stock or stock options issued to employees has been controversial for some time and, as a result, the FASB added a project to its agenda in 1984 to readdress the accounting for employee stock compensation plans. The FASB has tentatively agreed that Opinion 25 should not be retained, but has been unable to agree on a new measurement approach. FASB decided in 1988 to consider stock compensation issues in conjunction with its broader project on accounting for financial instruments. This project will not be completed for several years.
It is likely that a change to fair value expense recognition would be strongly opposed by the business community. Many public companies believe that a fair value approach would introduce too much volatility into reported earnings. This would be especially true for high-tech and rapidly growing companies that experience significant share value growth. Critics believe that a fair value method of measuring ESOP expense is inappropriate because the cash flow consequences to the company are determined when shares are issued to the ESOP. These companies argue that ESOPs are similar to restricted stock compensation plans in which the number of shares to be granted to employees is fixed when the ESOP is established; thus, the sponsor's expense measurement should be based on the original cost of the shares.
Currently there is substantial disagreement as to the appropriate measure of expense for ESOP shares. Many who favor a cost approach believe that the effect of changes in fair value can be adequately dealt with through disclosure. TheN, also believe that financial statement users will not understand the earnings fluctuations produced by fair value and question whether this approach provides useful new information. Because of the need to educate users, they believe that ESOP accounting should not move to fair value until the FASB has made more progress on its financial instruments project. However, because of the evolution of ESOP structures, others believe that the cost approach disguises the economic differences among ESOPs and feel that the time has come for fair value expense measurement.
Treatment of Dividends
one of the more controversial issues in ESOP accounting has been the treatment of dividends on shares held by an ESOP. The SOP requires that dividends on all shares held by an ESOP should be charged to retained earnings. In a leveraged ESOP arrangement, this results in a portion of the cost of benefits provided to employees being charged to retained earnings rather than as an expense. Assume that Company A and Company B provide identical benefits to their employees and that Company A funds the benefits from working capital while Company B funds the benefits through an ESOP. In this situation, Company B would report higher net income because the portion of the benefits funded via dividends on ESOP shares would be charged directly to retained earnings.
To illustrate this concept, refer to year 5. In year 5, the sponsor would recognize expense under the shares allocated method of $7.8 million (consisting of the compensation element of $5.6 million, interest of $8.6 million, less dividends on unallocated shares of $6.4 million). By contrast, if dividends on unallocated shares used for ESOP debt service were charged to expense, the sponsor would recognize expense of $14.2 million (consisting of compensation of $5.6 million and interest of $8.6 million).
One unique feature of ESOPs is that the tax law allows a deduction for dividends paid on ESOP shares. The tax benefit from dividends on shares held by the ESOP is credited directly to retained earnings under APB Opinion 11 and is treated as a reduction of income tax expense under FASB Statement 96. Thus, under Statement 96, a sponsor excludes from its income statement that portion of its ESOP contribution made in the form of dividends, but is able to recognize the tax benefit of the dividends in net income. Some accountants believe that dividends on ESOP shares should be charged to expense consistent with the treatment under the tax law and the treatment of the related tax benefit under Statement 96.
Irrespective of the inconsistent tax treatment, some believe that dividends on unallocated ESOP shares are more analogous to compensation expense than to a distribution to shareholders. Those in this camp would point to EITF Issue 86-27, in which the EITF concluded that dividends on unallocated shares should be charged to expense. Further, in the case of preferred stock with a stated dividend rate held by an ESOP, an argument has been made that the dividends on the preferred stock are simply a contractual payment to fund the ESOP debt and not a distribution to shareholders. Lastly, proponents of the consolidation concept, discussed below, contend that expense treatment of dividends on unallocated ESOP shares is consistent with the consolidation approach.
Consolidation of ESOPs
In some respects, current ESOP accounting represents a quasi- consolidation approach. The sponsor is required to record a liability, for the ESOP debt with a corresponding reduction in shareholders' equity, frequently referred to as deferred compensation or guarantee of ESOP debt. The effect of this treatment is consistent with consolidation of the ESOP, in which case the sponsor would record the ESOP debt and a reduction of equity for unallocated shares held by the ESOP (i.e., treasury shares) in the consolidated financials.
On the other hand, the present ESOP accounting model treats all shares held by the ESOP as outstanding for EPS calculations. Many believe that the treatment of all ESOP shares, including unallocated shares, as outstanding, creates excessive dilution of EPS. Further, under existing accounting, dividends on all shares are charged to retained earnings. Some believe that charging dividends on unallocated shares to retained earnings is not appropriate because the IRS now permits dividends on all shares to be used by the sponsor to service ESOP debt.
Thus, the present ESOP accounting model is internally inconsistent. The model requires the debt of the ESOP to be recorded by the sponsor, with a corresponding reduction in equity, consistent with the view that the ESOP is a non-independent entity, similar to a subsidiary or grantor trust. However, the model requires all shares to be treated as outstanding for EPS and dividend purposes, consistent with the view that the ESOP is an unrelated, independent entity.
The FASB has been at work on a major project involving consolidations since 1982. FASB Statement 94, issued in 1987, requires consolidation of all majority-owned subsidiaries, except in certain limited circumstances. The FASB expects to issue a discussion document later in 1990 in which the Board will set forth its preliminary views on the concept of a reporting entity. Many believe that consolidation of ESOPs is a logical step that would provide a more consistent framework for addressing the ESOP accounting issues that have arisen in recent years.
Earnings Per Share Issues
One question that will be reconsidered by AcSEC is whether unallocated shares should be treated as outstanding for EPS purposes. As noted, the SOP requires all ESOP shares to be considered outstanding for EPS computations, If AcSEC concludes that consolidation of ESOPs in the financial statements of the sponsor is appropriate or that dividends on unallocated shares should be charged to expense, it would be consistent to treat only allocated shares as outstanding in EPS calculations. Interestingly, a minority of the AcSEC members in 1976 favored 'such treatment. The EITF concensus on issue 86-27 also requires this treatment when an employer terminates a defined benefit pension plan and rolls the proceeds into an ESOP.
Some sponsors believe that treating all shares as outstanding does not recognize the economics of ESOP arrangements. Further, they believe that including all shares in EPS calculations produces less-meaningful and potentially misleading EPS amounts. In particular, many public companies opposed the EITF conclusions on EPS issues. Some financial analysts agree with these views and have ignored the adjustments made to reported EPS of companies with large ESOPs.
Under existing accounting, the cost of ESOP shares is charged to expense when the shares are allocated to participants. Inherent in this concept is an assumption that the risks and rewards of unallocated shares have not passed from the sponsor to the employee. To those who believe that the sponsor effectively controls the ESOP, it seems inconsistent to treat these same shares as outstanding for EPS purposes.
Consideration of only allocated shares as outstanding in EPS calculations could have a positive impact on reported EPS. Assume that a sponsor of a common stock ESOP has net earnings of $100 million per year and 10 million common shares outstanding. Assume further that the sponsor issues one million common shares to the ESOP which will be allocated over 15 years using the share allocation. The sponsor would report the following EPS, assuming that 1) all ESOP shares are outstanding and 2) only allocated ESOP shares are outstanding:
In year 16, EPS would be the same under either method because all ESOP shares would be allocated and considered out-standing. Treating only allocated ESOP shares as outstanding removes the excessive EPS dilution in the early years of the ESOP. As the shares are allocated to employees, the shares are reflected as outstanding, consistent with the economics of the ESOP arrangement.
A NEW ESOP ACCOUNTING MODEL
A variety of ESOP issues continue to develop in practice. These issues, along with diverse views on the appropriate approaches to use in accounting for them, have prompted AcSEC to reconsider the way businesses report ESOP arrangements. It seems likely that AcSEC will conclude that the current ESOP accounting model requires a major overhaul. One possible approach would be to;
* Measure compensation expense based
* the fair value of shares allocated;
* Expense interest as incurred on ESOP debt;
* Charge dividends on unallocated shares to expense instead of retained earnings; and
* Treat only allocated shares as outstanding for EPS purposes.
This model is essentially a consolidation approach based on the premise that the risks and rewards of unallocated ESOP hares rests with the sponsor. The model is internally consistent with respect to the treatment of ESOP shares for expense measurement, recognition of dividends, and PS calculations. Further, this model would result in consistent treatment for different types of plans, such as non-leverd ESOPs, leveraged ESOPs, and 401(k) savings plans.
A change in practice of this magnitude would have a material effect on the financial statements of many companies. Many ESOP sponsors and others are certain to consider fair value expense measurement too revolutionary a change from present practice. A worthwhile alternative would be to adopt the above model but retain cost basis expense measurement and require disclosure of the fair value of shares allocated. This approach would be more acceptable to the corporate community nd, thus, could be implemented in a relatively short time frame. This compromise would improve financial reporting of SOPs by providing a more conceptually sound and consistent model in the short- term while the FASB continues its work on he financial instruments project.
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