More private companies are using employee stock ownership plans (ESOPs) these days, but risk managers are not getting enough information to do proper financial statement analyses, according to recent Financial Accounting Standards Board (FASB) advisory discussions.
Information is not being fully disclosed about loans plan sponsors offer to ESOPs, members of the Private Company Council (PCC) recently told the FASB. Items like the terms, conditions, and interest rates on the loans being made, for example, are not clearly documented, and monetary shortages are coming to light too late.
“I did have that thought as I was auditing a plan this year ‘where are they going to get this money to pay these people that have left already?’” Candace Wright, partner, EisnerAmper’s Audit & Assurance Services Group, said. “And they owe it,” she said. “The fair value is set at that point and so it’s a real actual liability.”
The discussions come as use of ESOPs are projected to increase in the next 10 years. Currently, there are about 6,500 ESOPs in the US as of 2022, according to the National Center for Employee Ownership. Of that number, 5,887 are related to privately held companies, and 580 are related to public companies.
For privately held companies, ESOPs are popular because they can be used as a business strategy to provide the company with liquidity as well as pass a portion of ownership to employees, the PCC said at a December 14, 2023, meeting. “But I think when you have that it really creates risk to the capital and cash part of the balance sheet because in essence it’s a ‘put’ from the employee back to the company and you really need to be monitoring that and be aware of that,” Robert Messer, chief financial officer-chief risk officer at American National Bank of Texas, said. “So I think it’s something that does merit more attention.”
ESOPs can be complicated. “And there’s some sort of cash settlement piece to it that has a really big impact because as the wealth is being transferred there seems to be some conditions or loans out there that ultimately are going to impact one side of the equation or the other,” said David Hoagland, executive credit officer, commercial real estate, community development corporation, and housing capital corporation for U.S. Bank. “So more disclosure from a lending standpoint – while we do have access to management which helps – but certainly for other stakeholders that don’t have that kind of access it gets to be fairly complicated and could be large.”
The PCC is a 12-member body that works with the FASB to amend U.S. Generally Accepted Accounting Principles (GAAP) for privately held companies. The FASB sets GAAP for public and private companies and not-for-profit organizations. GAAP compose the gold standard for filing financial statements in annual and quarterly reports.
Flagged by the Risk Management Association
The ESOPs topic surfaced as an emerging issue because the Risk Management Association (RMA) suggested in October that the PCC or the FASB consider the topic. A suggestion was that ESOPs’ repurchase obligations should be recognized in the plan sponsor’s financial statements, a FASB staff member said. “Or, if not recognized, at least at a minimum disclosed in some type of five-year maturity table such as those given about debt disclosures,” staff said. Additionally, for cash settled warrants issued to departing shareholders, “additional information is needed such as the terms and conditions of those agreements and disclosures on the future effects of cash flows.”
Observing that he thought ESOPs had “trended down quite a bit,” FASB Chair Richard Jones asked the PCC “how common are these ESOP plans for private companies? Is it something you see all the time? is it something you rarely see?”
“I think we’re going to start seeing them a little bit more over time especially as more people start to retire and move on there’s a lot of transitional issues coming through and that will start showing up in terms of people don’t have anybody under a succession plan,” David Finkelstein, a director at SingerLewak, LLP, said. “So ESOPs may be a better one to keep a company alive and continue to thrive and move on whereas just shutting the doors even on a profitable company,” he said. “So I think we’re going to start seeing more ESOPs, probably more complex ESOPs, and more ESOP type transactions over the next 10 to 20 years.”
The emerging popularity around ESOPs could be stemming from the interest rate environment, valuations, and tax implications, others said.
“There are tax implications – positive ones on pass-through entities to doing an ESOP and that’s making it very interesting because most private companies are pass-through entities,” David Pesce, head of surety at Munich Re Specialty Insurance, said. “So I do expect to see a big increase in this because they’re running out of time – management that wants to retire is running out of time and they ran into a wall on private equity investment for purchase and sale so ESOP is the route they’re looking at.”
This article originally appeared in the December 28, 2023, edition of Accounting & Compliance Alert, available on Checkpoint.
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