How an ESOP Works

An ESOP is a form of a defined contribution benefit plan. The company sponsoring the plan makes contributions of cash or shares of its stock directly to an ESOP trust set up for the benefit of the company's employees. If the contribution is in the form of cash, the trust uses the cash to purchase shares of the sponsoring company's stock, often from a large stockholder who wishes to cash-out. Subsequently, the trust distributes the shares to the accounts of a specified employee group. These shares are referred to as "allocated shares." The manner and timing of the allocation depend on how the trust is financed.

Financing Arrangements and Stock Allocation. ESOPs may be leveraged or unleveraged. Unleveraged plans are the simplest: The company just transfers stock or cash to the ESOP trust. The amount of the contribution is normally determined on the basis of some predetermined criteria, such as a percentage of earnings. After the contribution is made, the ESOP distributes the shares to the individual employee accounts. This setup involves no special financing arrangements.

If the company establishes a leveraged plan, the ESOP trust borrows the cash necessary to purchase the securities. The trust invariably pledges the stock as collateral and the company offers some degree of guarantee regarding the loan. The pledged shares are known as "suspense" shares. Cash to repay the loan comes from two sources: dividends received by the trust on suspense shares and cash contributions by the company. Various arrangements are made regarding the cash contribution by the company. The contributions may be a level amount each year or they may be variable. In the latter case, the contribution is dependent on some specified performance measurement basis such as reported profits or operating cash flow.

The debt service payments cause the release of shares from collateral. Companies use two formulas to determine the number of shares to release. The first, called the principal and interest method, releases shares based on the ratio of the current year's debt payment to the total payments required over the life of the loan. The second method, referred to as the "principal only" method, uses the ratio of the current year's principal payment to the total principal as the basis for releasing shares. Because a larger portion of early debt payments goes toward interest, this method causes a slower rate of release. The trust must allocate the released shares to the employee accounts within a year of release. A nondiscriminatory formula specifies the allocation to individual accounts. Typically, the formula uses the wages and years of service of the individual employees to make the allocation.

When a company's stock has a ready market, the shares allocated to the employee's account are issued when the employee leaves the firm. If the company's shares do not have a ready market, the company must stand ready to repurchase the shares at their fair market value. In this case, the company has issued a "put option" to the employee; i.e., it has agreed to purchase the stock at a later time at a price yet to be determined. Determining this price can be difficult and expensive and is subject to strict regulation. Indeed, this provision is one of the main deterrents to the creation of ESOPs by smaller, closely held companies.

Control Issues. Employees gain voting rights when the ESOP allocates shares to their accounts. Until then, the trustee exercises the voting rights of shares held by the trust. Because allocation will cause some loss of control, a number of companies have chosen to issue non-voting, mandatorily-redeemable preferred stock to their ESOPs. Another tactic is to restrict ownership of voting stock to existing stockholders, employees, and the ESOP. This provision forces redemption of the shares issued by the ESOP when employees leave the firm.

Taxation Issues. Current tax laws favor the establishment of leveraged ESOPs. So long as contributions do not exceed 25% of total employee compensation for the year, company cash contributions for both principal and interest are tax deductible. The cash contributions may be an outright grant or in the form of dividends on stock held by the ESOP. In addition, the IRC offers lenders, such as banks, a significant incentive to provide loans to ESOPs. The tax code exempts from the income of the lender 50% of the interest revenue received from a loan to an ESOP. These tax breaks have had their intended effect: ESOP trusts are more numerous and larger than they would be otherwise, and the overwhelming majority are leveraged.

Accounting Pronouncements for ESOPs

Until recently, Statement of Position (SOP) No. 76-3, Accounting Practices for Certain Employee Stock Ownership Plans, governed the accounting for ESOPs. For the 1970s, SOP No. 76-3 was adequate enough: ESOPs then were comparatively simple affairs. In the 1980s, however, financial managers began to structure ESOPs using more complicated financial instruments. Congress also added complexity by issuing more intricate tax laws.

By the mid-1980s it became clear to accounting policy-setters that SOP No. 76-3 was inadequate. From 1985 to 1993, the EITF of the FASB issued 12 consensus positions dealing with ESOP issues. Concurrently, a task force of the AICPA's AcSEC worked on the issue, resulting in the release of SOP No. 93-6, Employers' Accounting for Employee Stock Ownership Plans, in November 1993. This SOP supersedes SOP No. 76-3 as well as many of the earlier EITF positions.

Balance-Sheet Issues

ESOP debt may be categorized into three groups: 1) direct loans, 2) indirect loans, and 3) employer loans. Under a direct loan, a financial institution makes the loan directly to the ESOP. This type of loan, however, usually requires a guarantee by the employer. An indirect loan treats the employer as a conduit. A financial institution makes a loan to the employer who, in turn, makes the loan to the ESOP. The third category - employer loans - encompasses those situations where the employer makes the loan to the ESOP trust, but there is no associated outside loan.

SOP No. 93-6 reaffirmed the earlier position taken in SOP No. 76-3 and strengthened in EITF 89-10 that ESOP debt should be shown as an obligation of the plan sponsor. Applied to the three categories of debt, this provision would require the plan sponsor to recognize a liability for loans falling in the first two categories. Loans from the employer to an ESOP trust that are not associated with outside loans should not be included in the employer's balance sheet. These recognition provisions are not retroactive. Recognizing the ambiguity of SOP No. 76- 3 in this area, EITF 89-10 made the requirement effective only for ESOP loans made after January 19, 1989. SOP No. 93-6 does not change this provision.

If the company uses the proceeds of the debt to purchase stock in the open market, the company records a credit to cash and a debit to treasury stock. Both SOP No. 936 and EITF 89-10 require the company to record the subsequent issue of the stock to the ESOP by crediting treasury stock and debiting a contra-equity account entitled "unearned ESOP shares." If the ESOP trust acquires unissued shares, the company credits the common stock accounts for the current value of the shares issued and debits unearned ESOP shares. As the name implies, subsequent recognition of compensation expense will reduce the balance in the unearned ESOP shares account. It also will be reduced if the firm releases shares instead of cash to pay dividends on allocated shares.

For control or tax purposes, some companies issue preferred stock to their ESOPs. When the ESOP is endowed in this manner, the law subjects the employer to a form of put option. The company must either buy back the preferred stock when a vested employee leaves or, if the common stock is marketable, provide common stock in lieu of cash. If the buy- back is to be in the form of common stock, EITF 89-11 permits the preferred stock to be classified in shareholders' equity. If the buy- back is to be a cash transaction, the preferred stock is considered to be more of a debt instrument. EITF 89-11 requires the preferred stock be classified between liabilities and shareholders' equity, a location sometimes referred to as the "mezzanine" section of the balance sheet. Furthermore, EITF 89-11 requires the contra-account, unearned ESOP shares, to be classified in the mezzanine as well.

Income-Statement Issues

The two primary issues are the measurement of total compensation expense associated with an ESOP plan and the periods to which the expense should be assigned.

Unleveraged Plans. Accounting for unleveraged ESOPs is straightforward. When the company commits to a contribution of cash or stock to the ESOP, the company should record compensation expense. The amount of the expense is equal to the cash or the fair value of the shares committed at the date of commitment. The number of shares committed to be released under unleveraged plans is normally determined by reference to a formula using pretax income, operating cash flow, or some other performance measure. AcSEC apparently views the commitment as more of a bonus whose value is appropriately measured at the time of determination.

The contribution of shares may come from previously unissued stock or treasury stock. If treasury stock is used, any difference between its cost and its market value should be recorded as an adjustment to additional paid-in capital.

Shares acquired by the ESOP trust must be allocated to participants' accounts by the end of the ESOP's fiscal year. Once the company has made the commitment to contribute shares to the ESOP, the shares in substance belong to the participants. The company, therefore, must charge retained earnings for dividends on shares held by an unleveraged ESOP trust, whether allocated or not. The trust distributes the dividends on unallocated shares when the accounts receive their stock allocation.

Leveraged Plans. For leveraged plans, the firm measures compensation expense on the basis of the fair value of the shares committed to be released. Unlike unleveraged plans, however, the average value of the shares in the period of commitment should be used to measure compensation cost. AcSEC's logic is that the shares committed to be released for compensation are not associated with work on any particular date. The compensation is for work done throughout the period, and the average value of the shares is a more appropriate measure of the cost of this work than is the value of the stock on any particular day.

Dividends paid on leveraged ESOP shares are recorded differently, depending on whether or not the shares have been allocated. Prior to allocation, the employer has control over how dividends on unallocated shares will be used, and their use determines the accounting. When they are used for debt service, the liability for the debt or accrued interest should be debited. If they are added to participant accounts, they should be charged to compensation expense.

Once the shares have been allocated, the employer no longer has control over the dividends on those shares. The shares belong to the participants, Therefore, any dividends on these shares should be charged to retained earnings. The resulting dividend payable may be satisfied by payment of cash, contribution of additional shares, or by the release of ESOP shares.

Use of Fair Value. The use of fair value is a departure from earlier pronouncements, and the requirement probably represents the most controversial aspect of SOP No. 93-6. Previously, companies had to use the original cost of the shares to the ESOP trust as the measurement basis for compensation expense. The sponsoring company, therefore, knew the total compensation expense over the life of the. ESOP agreement when the company originally endowed the trust with shares. Under the new requirement, each period's compensation expense will be a function of the market price of the shares committed to be released that period. Compensation expense will fluctuate with the price of the stock, and future expenses are less predictable for the sponsoring company.

AcSEC adopted fair value in SOP No. 93-6, accounting largely in an effort to have ESOP accounting conform to APB Opinion No. 25, Accounting for Stock Issued to Employees. This opinion requires the expense associated with stock transfer agreements to be measured at the first date the number of shares employees will receive is known. For an ESOP, this date occurs when the shares are committed to be released to the employee accounts.

SOP No. 93-6 defines the fair value for an ESOP share as "the amount the seller could reasonably expect to receive for it in a current sale between a willing buyer and a willing seller." For companies whose shares have an active market, recent prices give ample evidence. The determination of fair value is more difficult for nonpublicly traded companies. Without market prices, these companies rely on independent valuation experts to supply the necessary information. The use of these experts increases the cost of the ESOP to the company. Their use also reduces the quality of the financial accounting information because of the unavoidable subjectiveness of their evaluations.

Earnings-per-Share Issues

When common shares are committed to be released, an exchange of ESOP shares for employee services is assumed to occur. Therefore, shares committed to be released should be considered as outstanding shares for earnings-per-share calculations. Shares that have not been committed to be released (suspense shares) are not considered outstanding.

Because of control considerations, companies will often issue convertible preferred stock to their ESOPs. Such stock normally carries a high dividend rate, usually well in excess of the common dividend rate. In addition, such stock normally contains provisions that prevent it from remaining outstanding indefinitely. Typical of these provisions is what is called a "guaranteed floor feature." This provision guarantees the employee will receive common stock, or a combination of cash and common stock, equal to a specified minimum value for each share of preferred stock when the employee retires.

The unique features of the convertible preferred stock issued to ESOPs will affect EPS calculations. Since the passage of time is the only precedent to the issuance of additional common shares, AcSEC held that convertible preferred stock held by an ESOP should be considered a common stock equivalent. The guaranteed floor feature may also affect the number of shares in the denominator. If the minimum value of the preferred stock exceeds the fair value of the common stock to be issued on conversion, the participants may be entitled to additional shares. These additional shares should also be considered outstanding in the "if converted" calculations. For purposes of this calculation, the current fair value of the common shares should be utilized in both the primary and fully diluted EPS calculations.

Dividends may be paid on allocated or unallocated preferred ESOP shares. The treatment of these dividends in EPS calculations, depends on the way the dividends are used. Dividends on unallocated shares may be added to participants' accounts, or used to service ESOP debt, In both instances, no adjustment to net income in the EPS calculation is necessary. If they are added to participants' accounts, an adjustment to the EPS calculation is not necessary because this use of dividends is discretionary at the time the ESOP is established. When dividends on unallocated shares are used for debt service, EPS adjustments are not necessary since these dividends are not treated as dividends for accounting purposes.

Dividends on allocated shares added to participants' accounts are no different than any other dividend on convertible stock and should be included in the EPS calculation using the "if converted" method. If the dividends on the allocated shares are used for debt service, however, net income in the EPS calculation may need to be reduced. Because of the higher dividend rate on preferred stock, fewer common shares would be required, after assumed conversion, to replace dividends used for debt service. This will leave more common shares for compensation. This additional compensation cost is a nondiscretionary adjustment, and accordingly should be deducted from net income in the EPS calculation.

Required Disclosures

SOP No. 93-6 expands the disclosures required for ESOPs. The disclosures can be categorized into three different areas: a description of the plan and its operation, the accounting policies used for ESOPs, and any contingent liabilities that exist because of the type of security issued to the ESOP.

The description of the plan should contain information describing the employee groups covered, the basis for releasing suspense shares, and how dividends on allocated and unallocated shares are used. Specific data about the operation of the plan should include the cost charged to compensation expense and the number of shares that have been allocated, committed to be released, or still in suspense as of the end of each fiscal year presented. These disclosures must be made for all ESOP shares regardless of whether they are accounted for under SOP No. 96-3 or an earlier pronouncement. The fair market value of suspense shares also must be disclosed but only for those shares being accounted for under the new SOP.

The accounting policies section should specify the method of measuring compensation cost (i.e., whether SOP No. 936 or an earlier pronouncement is used). The section also should disclose the classification of dividends on the various categories of ESOP shares, and the treatment of ESOP shares in earnings-per-share calculations.

Mandatorily-redeemable preferred stock requires special disclosures. Because such stock requires the sponsor to repurchase the preferred stock in the future, a contingent liability is created that should be disclosed in the notes to the financial statements.

Effective Dates and Transition Requirements

SOP No. 96-3 is effective for fiscal years beginning after December 15, 1993. It requires the above accounting prospectively for all securities placed in trust since December 31, 1992, but not yet committed to be released.

The provisions of the SOP are not required, but may be elected, for shares acquired before December 31, 1992.

If application of the provisions of the SOP to the old shares is not elected, two methods of accounting for ESOP shares by the same company will result.

Things are somewhat more complex if the company does elect to apply the new SOP to old shares. Prior to SOP No. 936, companies could use the "shares allocated" method described in EITF 89-8 or some other method. These other methods are ones that companies used before EITF 89-8 and then were grandfathered by the EITF position. For shares previously accounted for under the shares allocated method, the required prospective application of SOP No. 93-6 will not require any entry at the time of adoption. However, if some other method of accounting for ESOP shares had been used, and prospective application of the new standard is elected, a cumulative effect of accounting change should be recorded. The amount of the adjustment is the difference between the cumulative amount of expense that would have been recorded under the shares allocated method (shares committed to be released times the cost per share, less cumulative dividends on ESOP shares) and the cumulative amount of expense that was recorded under the alternative method. The financial statements of previous years should not be restated.

An Example

The Exhibit presents the accounting for a hypothetical leveraged ESOP. In the example, the cash payments on the debt occur in the year the cash payments are promised. If the cash payments occurred in a later period, the same expense amounts would be recorded for each year. What matters for expense recognition is when the commitment to make the payment occurs; the date of the actual cash payment is irrelevant.

Some Warts Remain

The accounting and disclosures provided by the SOP are not perfect. For example, by not insisting that all plans adopt the accounting mandated for new stock acquisitions, the SOP effectively permits several methods to be used to account for the stock held by ESOPs. Other complaints can be made, but on balance the SOP represents progress. ESOP accounting now conforms with the general principles laid down in APB 25, Accounting for Stock Issued to Employees. The SOP also eliminates some of the inconsistencies that existed between the accounting for leveraged plans and unleveraged plans. These gains alone represent major improvements in ESOP accounting.

William R. Cron, PhD, and Randall B. Hayes, PhD, CPA, are both professors at Central Michigan University.

EXHIBIT

AN EXAMPLE OF A LEVERAGED ESOP

On 1/1/x1 ABC Company establishes an ESOP for its employees. The ESOP then borrows $600,000 at an 8% interest rate, which it uses to purchase 30,000 shares of common stock at the existing price of $20 per share. These shares are placed in trust and subsequently released based on the "principal and interest" method. The debt will be repaid with payments of $232,820 in three years. The amortization schedule for the debt is:

Amortization Table:

Date Payment Interest Principal Balance

1/1/X1 $600,000

12/31/X1 $232,820 $48,000 $184,820 415,180

12/31/X2 232,820 33,214 199,606 215,574

12/31/X3 232,820 17,246 215,574 -0-

Because one-third of the total payments are made each year, one-third of the stock(10,000shares)is committed to be released each year. The stock pays a dividend of $1 per year, and dividends on allocated shares are used for debt service. Share prices at various dates are as follows:

1/1/x1 $20

12/31/x1 25

12/31/x2 32

12/31/x3 35

Based on the above information,the following entries would be made:

1/1/x1:

Unearned ESOP Shares 600,000

Loan Payable 600,000

To record the purchase of the shares for the ESOP trust and the issuance of the debt.!

Year-end entries for the next three years will be:

12/31/x1 12/31/x2 12/31/x3

Interest Exp. 48,000 33,214 17,246

Note Payable 184,820 199,606 215,574

Cash 232,820 232,820 232,820

To record the repayment of the debt with cash and dividend payments.!

Dividends 10,000 20,000

Div.Pay. 10,000 20,000

To record dividends owed on shares allocated to participants' accounts.!

Camp.Expense 250,000 310,000 330,000

Dividends Pay. 10,000 20,000

Unearned ESOP Shs. 200,000 200,000 200,000

Additional Paid-in Capital 50,000 120,000 150,000