Magazine article The CPA Journal

Employee Stock Ownership Plans: New Accounting for These Fables

Magazine article The CPA Journal

Employee Stock Ownership Plans: New Accounting for These Fables

Article excerpt

An employee stock ownership plan (ESOP) places the stock of a company in the hands of its employees. While the employees end up with a financial stake in their company, the reason a plan is created in the first place may have little to do with altruistic concepts of employee ownership or even employee compensation. Aided by Federal and state legislation in 1984 and 1986, companies have found ESOPs can be useful in achieving a host of different objectives. Companies have used ESOPs to prevent hostile takeovers, raise investment capital, take a company private, restructure debt, produce tax refunds, buy out owners, and sell or acquire subsidiaries. An ESOP can be a virtual Swiss Army knife in the hands of a creative management team.

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 of 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. …

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