Chapter 7 — Share-Based Payment Awards and Other Compensation Arrangements

7.2 Employee Stock Ownership Plans

7.2.1 General

7.2.1.1 Background

An ESOP is a qualified defined-contribution employee benefit plan designed to invest primarily in the stock of the sponsoring entity (referred to hereafter as the “sponsor”). ESOPs are “qualified” in the sense that the sponsor receives certain tax benefits because the plan meets the ESOP requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code of 1986 (IRC) as either a stock bonus plan or a combination of a stock bonus plan and a money purchase pension plan. Further, an ESOP:

Is organized through a trust fund and is generally funded through contributions made by the sponsor.
Must hold qualified common stock of the sponsor or noncallable preferred stock that is convertible into qualified common stock of the sponsor.6
May issue debt to fund the acquisition of shares of the sponsor. Loans owed by an ESOP may be entered into with the sponsor or with a third party. See Section 7.2.1.2 for further discussion of the difference between a leveraged ESOP and a nonleveraged ESOP.

The sponsor may make contributions to the ESOP through various means. It may issue its shares to the ESOP; make contributions of cash to the ESOP so that the ESOP can purchase the sponsor’s shares in the market; or make principal and interest payments on debt owed by the ESOP, resulting in the release of shares that serve as collateral on the ESOP’s debt. The shares held by an ESOP are either allocated or unallocated. Allocated shares represent shares held by an ESOP that have been assigned to the accounts of individual employee participants (referred to hereafter as “participants”). Allocated shares are generally subject to vesting requirements. Shares held by an ESOP that have not been assigned to individual participant accounts represent unallocated shares. As of the end of an ESOP’s fiscal year, generally only leveraged ESOPs have unallocated shares.

Participants do not pay taxes on allocated shares until they receive a taxable distribution from the ESOP. Upon termination of employment, participants may be able to “roll over” their vested shares into another qualified plan to defer taxation on the distribution. In some ESOPs, the vested shares of participants are repurchased by the sponsor or by the ESOP as of the date on which the participant’s employment is terminated. If the shares of common stock or convertible preferred stock held by an ESOP are not readily tradable, by law the sponsor must typically provide a put option that gives participants the right, but not the obligation, to sell vested shares at an amount generally designed to represent fair value (see further discussion in Section 7.2.4.2.1). Any unvested allocated shares of a participant that terminates employment are redesignated as unallocated shares and subsequently allocated to other participants.

Dividends paid on the sponsor’s stock may be distributed or allocated in various ways, including:

Dividends on allocated and unallocated shares held by an ESOP may be used to repay a loan owed by the ESOP. In these situations, the ESOP generally pays the dividend equivalent on allocated shares in additional shares of stock.
Dividends on allocated shares could be paid to participants in cash or through an allocation of additional shares with a value equal to the cash amount of the dividends.
Dividends on unallocated shares could be paid to participants in cash or through the allocation of additional shares of stock on the basis of a specified allocation formula (typically, the participant’s account balance).

ASC 718-40 addresses the accounting by sponsors of all ESOPs. Entities may sponsor other types of stock ownership plans that do not meet the definition of an ESOP because those plans do not meet the requirements for an ESOP in ERISA and the IRC. Those arrangements are subject to the accounting specified in other Codification subtopics.

Changing Lanes

The guidance in ASC 718-40 was codified from AICPA Statement of Position (SOP) No. 93-6, which superseded the previous guidance in SOP 76-3 (as interpreted by EITF Issue 89-8). Sponsors were required to apply SOP 93-6 to all shares acquired by an ESOP on or after January 1, 1993. While sponsors were encouraged to prospectively adopt SOP 93-6 for shares acquired by ESOPs before January 1, 1993, sponsors that did not elect to adopt SOP 93-6 for all shares owned by an ESOP would continue to apply the guidance in SOP 76-3 to the grandfathered ESOP shares (see ASC 105-10-70-2(c)). The guidance in SOP 76-3 was not codified, in part, because it was no longer expected to be widely applicable. Section 7.2.3.4 discusses the application of SOP 76-3 to leveraged ESOPs. The remaining guidance below is based on the requirements of ASC 718-40.

7.2.1.2 Leveraged Versus Nonleveraged ESOPs

For accounting purposes, it is important to distinguish between leveraged ESOPs and nonleveraged ESOPs. This is because the accounting and EPS requirements in ASC 718-40 differ significantly for the two different types of ESOPs. A leveraged ESOP is an ESOP that enters into a loan arrangement to acquire shares of the sponsor. A nonleveraged ESOP is an ESOP that does not enter into loans to acquire shares of the sponsor.

A leveraged ESOP may enter into a loan with a third party or with the sponsor. A loan entered into between an ESOP and a third-party lender is referred to as a direct loan. When an ESOP enters into a loan directly with a third party, the repayment of the loan is generally guaranteed by the sponsor. A loan entered into between an ESOP and the sponsor, with a related outside loan between the sponsor and a third-party lender, is referred to as an indirect loan. If an ESOP enters into a loan with the sponsor and the sponsor does not obtain a related loan with a third-party lender, the ESOP is considered internally leveraged and the loan between the ESOP and sponsor is an intercompany loan.

Loans with third parties must be reflected as debt on the sponsor’s balance sheet regardless of whether they are direct loans or indirect loans. Loans between a sponsor and an ESOP may not be reflected as assets or liabilities on the sponsor’s balance sheet. Thus, when an ESOP is only internally leveraged, the accounting relevant to leveraged ESOPs applies but no liability related to the ESOP’s debt is reflected on the sponsor’s balance sheet.

7.2.2 Nonleveraged ESOPs

7.2.2.1 General

In accordance with ASC 718-40-25-19, a sponsor of a nonleveraged ESOP reports compensation cost in each financial reporting period on the basis of the contributions that are required for the period under the terms of the plan, regardless of whether those contributions are made in cash or stock. When contributions are made in stock, the fair value of the stock contributed is used to measure compensation cost. Tax law requires sponsors to allocate the amounts contributed to individual participant accounts as of the end of the ESOP’s fiscal year. While the participants are generally subject to vesting requirements, any vesting requirements (and any forfeitures resulting from a failure to meet these requirements) have no impact on the prior compensation cost recognized by the sponsor. Any forfeited account balances are reallocated to other participants and could only indirectly reduce the subsequent-period compensation cost because of the reduction in the required contributions for that period.

Under ASC 718-40, if a nonleveraged ESOP does not hold shares related to the reversion of assets from another terminated employee benefit plan, the sponsor will not need to recognize any unearned ESOP compensation expense (contra-equity) account in a manner similar to how such accounts are recognized by sponsors of leveraged ESOPs. However, such a situation does not obviate the need for sponsors to estimate and accrue compensation expense during interim periods. Example 1 in ASC 718-40-55-34 through 55-38 illustrates the journal entries that must be recorded by a sponsor of a nonleveraged ESOP that holds common stock.

The impact of a nonleveraged ESOP on the sponsor’s calculation of basic and diluted EPS is relatively straightforward. ASC 718-40-45-1 and ASC 718-40-45-9 contain the EPS accounting requirements for nonleveraged ESOPs.

ASC 718-40

EPS

45-1 Dividends on preferred stock held by an employee stock ownership plan shall be deducted from net income net of any applicable income tax benefit when computing both basic and diluted earnings per share (EPS) if that preferred stock is considered outstanding (that is, if the employee stock ownership plan shares are allocated).

EPS

45-9 All shares held by a nonleveraged employee stock ownership plan shall be treated as outstanding in computing the employer’s earnings per share (EPS), except the suspense account shares of a pension reversion employee stock ownership plan, which are not treated as outstanding until they are committed to be released for allocation to participant accounts. If a nonleveraged employee stock ownership plan holds convertible preferred stock, the guidance in paragraphs 718-40-45-6 through 45-8 for leveraged employee stock ownership plans shall be considered.

As noted in the guidance above, the calculation of basic and diluted EPS by a sponsor of a nonleveraged ESOP is affected by dividends paid on any convertible preferred stock held by the ESOP, the outstanding shares of common stock held by the ESOP, and the application of the if-converted method when the ESOP holds convertible preferred stock. In addition, any redemptions of convertible preferred stock and the redemption provisions of common stock or convertible preferred stock held by the ESOP could also affect EPS.

Connecting the Dots

Unlike an entity that accounts for leveraged ESOPs, an entity that accounts for nonleveraged ESOPs would consider all shares of common stock or convertible preferred stock held by the ESOP to be outstanding shares in the calculation of EPS. The only exception applies to suspense account shares of a pension reversion ESOP, which are not treated as outstanding until they are committed to be released for allocation to participant accounts (referred to hereafter as “suspense pension reversion shares”).7 The EPS treatment of outstanding shares is considered the same, regardless of whether those shares are fully vested or remain subject to vesting requirements. The forfeiture of allocated shares would only affect future financial reporting periods to the extent that the sponsor’s required contributions are less because of the reallocation of forfeited shares.

7.2.2.2 Dividends

7.2.2.2.1 Dividends on Common Stock

Dividends paid on shares of common stock held by a nonleveraged ESOP that are not considered suspense pension reversion shares are charged to retained earnings. The payment of such dividends will generally have no impact on basic or diluted EPS unless they are paid in additional shares of common stock (i.e., unless they increase the outstanding shares of common stock held by the ESOP). If the sponsor has multiple classes of common stock or participating securities and is required to apply the two-class method, the shares of common stock held by the ESOP that are not considered suspense pension reversion shares will be treated in the same manner as other outstanding shares of common stock of the same class issued by the sponsor to other investors. See Section 7.2.4.4 and Chapter 5 for further discussion of the two-class method.

Connecting the Dots

Because all shares of common stock held by a nonleveraged ESOP are considered outstanding regardless of vesting requirements, the unvested portion of participants’ allocated shares are not considered participating securities.

7.2.2.2.2 Dividends on Convertible Preferred Stock

Section 3.2.2 discusses the general requirement to adjust net income (loss) for dividends on preferred stock to arrive at income available to common stockholders, which is the numerator in the calculation of EPS. ASC 718-40-45-1 explains that this general requirement applies to all shares of convertible preferred stock held by a nonleveraged ESOP, other than any suspense pension reversion shares. Dividends on outstanding shares of convertible preferred stock should include undistributed earnings of the sponsor if the outstanding shares of convertible preferred stock held by the nonleveraged ESOP meet the definition of a participating security. For example, if the shares of convertible preferred stock allocated to participants (whether vested or unvested) contain rights to participate in dividends with common shareholders, the allocated shares of convertible preferred stock held by a nonleveraged ESOP would meet the definition of a participating security. See Section 5.3 for further discussion of the definition of a participating security.

7.2.2.3 Outstanding Shares

7.2.2.3.1 Common Stock

All shares of common stock held by a nonleveraged ESOP that are not considered suspense pension reversion shares are considered outstanding, and the sponsor must include such shares in the denominator of both basic and diluted EPS on a weighted-average basis. The treatment of such shares is the same as that for outstanding shares of common stock owned by investors. See Section 7.2.4 for additional considerations related to situations in which a nonleveraged ESOP holds shares of common stock that are redeemable at the option of the participant or upon the occurrence of events outside the control of the sponsor.

Connecting the Dots

Given the recognition guidance in ASC 718-40 that applies to nonleveraged ESOPs, any vesting requirements associated with allocated shares of common stock held by an ESOP have no bearing on the impact of those shares on basic and diluted EPS.

7.2.2.3.2 Convertible Preferred Stock

A sponsor’s basic EPS will be affected by shares of convertible preferred stock held by a nonleveraged ESOP as a result of the payment of dividends (see Section 7.2.2.2.2), redemptions, and remeasurement adjustments under ASC 480-10-S99-3A. Redemptions of preferred stock are addressed in Section 3.2.2.6. That guidance applies to redemptions of convertible preferred stock held by a nonleveraged ESOP even if the redeemed shares remain in the ESOP for reallocation to other participants. See Section 7.2.4 for additional considerations related to situations in which a nonleveraged ESOP holds shares of convertible preferred stock that are redeemable at the option of the participant or upon events outside the control of the sponsor.

A sponsor’s diluted EPS will be further affected by the application of the if-converted method to the weighted-average number of shares of convertible preferred stock held by a nonleveraged ESOP. The if-converted method should be applied to all shares of convertible preferred stock held by a nonleveraged ESOP that are not considered suspense pension reversion shares. Section 4.4.1 discusses the general requirement to apply the if-converted method to convertible preferred stock in the calculation of diluted EPS. ASC 718-40-45-6 through 45-8 (excerpted in Section 7.2.3.1) further describe how the if-converted method is applied to convertible preferred stock held by a leveraged ESOP. ASC 718-40-45-9 explains that this guidance is also relevant to the accounting for a nonleveraged ESOP that holds convertible preferred stock. See Section 7.2.3.3.2 for further discussion.

Connecting the Dots

Given the recognition guidance in ASC 718-40 that applies to nonleveraged ESOPs, any vesting requirements associated with allocated shares of convertible preferred stock held by an ESOP have no bearing on the impact of those shares on basic and diluted EPS.

7.2.3 Leveraged ESOPs

7.2.3.1 General

The sponsor’s recognition and measurement of transactions involving leveraged ESOPs is more complicated than the accounting for nonleveraged ESOPs. The additional complications arise because a leveraged ESOP borrows money to acquire shares of common stock or convertible preferred stock of the sponsor and initially holds those shares in a suspense account. In contrast, a nonleveraged ESOP generally only holds common shares or convertible preferred shares that have been allocated to participants.

The shares held in the suspense account by a leveraged ESOP are referred to as suspense shares. Suspense shares are shares that have not been released, committed to be released, or allocated to participant accounts. Such shares generally collateralize the debt of a leveraged ESOP. The ESOP typically repays amounts on the borrowed funds as it receives contributions from the sponsor and dividends on the shares held. As the ESOP’s debt is repaid, suspense shares are allocated to participant accounts.

ASC 718-40-25-10 specifies that the sponsor must initially report the issuance of shares, sale of treasury shares, or acquisition of shares in the market by a leveraged ESOP as outstanding shares, with a “corresponding charge to unearned [ESOP] shares, a contra-equity account.” As shares are committed to be released, the contra-equity account for the unearned ESOP shares is credited with an offsetting debit to compensation cost, dividends payable, or other liabilities, depending on the specific purpose for the release of shares. Compensation cost is measured at the fair value of the shares as of the date the shares are committed to be released; any difference between the fair value and the original cost of the shares that is credited to the contra-equity account for the unearned ESOP shares is recognized as an adjustment to APIC. At any point in time, a leveraged ESOP will hold shares of common stock or convertible preferred stock that are considered suspense shares. Such shares are reflected in the sponsor’s balance sheet as unearned ESOP shares, a contra-equity account.

The above discussion serves as a high-level overview of the recognition and measurement guidance for leveraged ESOPs. For the specific recognition and measurement requirements applicable to leveraged ESOPs, sponsors should look to the accounting guidance in ASC 718-40.

ASC 718-40 contains the following guidance relevant to the EPS accounting for sponsors of leveraged ESOPs:

ASC 718-40

EPS

Issuance of Shares or the Sale of Shares to an Employee Stock Ownership Plan

45-2 Paragraph 718-40-25-10 states that an employer shall report the issuance of shares or the sale of treasury shares to an employee stock ownership plan when they occur and shall report a corresponding charge to unearned employee stock ownership plan shares, a contra-equity account. That account should be presented as a separate item in the balance sheet.

EPS

45-3 For purposes of computing basic and diluted earnings per share (EPS), employee stock ownership plan shares that have been committed to be released shall be considered outstanding. Employee stock ownership plan shares that have not been committed to be released shall not be considered outstanding.

45-4 Employers that use dividends on allocated employee stock ownership plan shares to pay debt service shall adjust earnings applicable to common shares in the if-converted computation for the difference (net of income taxes) between the amount of compensation cost reported and the amount of compensation cost that would have been reported if the allocated shares had been converted to common stock at the beginning of the period.

45-5 Prior period EPS shall not be restated for changes in the conversion rates.

Convertible Preferred Shares

45-6 The number of common shares that will be issued on conversion of the convertible shares held by an employee stock ownership plan that have been committed to be released shall be deemed outstanding in the if-converted EPS computations for diluted EPS if the effect is dilutive. Convertible preferred shares held by the employee stock ownership plan that have not been committed to be released shall not be considered outstanding and, accordingly, would be excluded from the if-converted computations for diluted EPS.

45-7 When participants withdraw account balances containing convertible preferred shares from an employee stock ownership plan, they may be entitled to receive common shares or cash with a value equal to either the fair value of the convertible preferred shares or a stated minimum value per share. Accordingly, if the value of the common stock issuable is less than the stated minimum value or the fair value of the preferred, participants may receive common shares or cash with a value greater than the value of the common shares issuable at the stated conversion rate. In determining EPS, the employer shall presume that such a shortfall will be made up with shares of common stock. However, that presumption may be overcome if past experience or a stated policy provides a reasonable basis to believe that the shortfall will be paid in cash. In applying the if-converted method, the number of common shares issuable on assumed conversion, which shall be included in the denominator of the EPS calculation, shall be the greater of the following:

The shares issuable at the stated conversion rate
The shares issuable if the participants were to withdraw the shares from their accounts.

45-8 Shares issuable on assumed withdrawal shall be computed based on the ratio of the average fair value of the convertible stock (or, if greater, its stated minimum value) to the average fair value of the common stock.

The calculation of basic and diluted EPS by a sponsor of a leveraged ESOP differs significantly from the EPS accounting by a sponsor of a nonleveraged ESOP because, unlike shares held by nonleveraged ESOPs, all shares held by leveraged ESOPs are not considered outstanding for EPS purposes. This difference exists because the unallocated shares serve as collateral on the loan obligation of a leveraged ESOP. According to ASC 718-40-45-3, shares held by a leveraged ESOP that have been either allocated or committed to be released (on the basis of the debt service payments) should be considered outstanding in the calculation of EPS. Shares that have not been committed to be released should not be included in the calculation of either basic or diluted EPS. As with the accounting for nonleveraged ESOPs, the vested status of a leveraged ESOP’s outstanding shares is not relevant to the sponsor’s calculation of basic and diluted EPS.

7.2.3.2 Dividends

7.2.3.2.1 Dividends on Common Stock

Dividends paid on shares of common stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1) are charged to retained earnings. The payment of such dividends will generally have no impact on basic or diluted EPS unless they are paid in additional shares of common stock (i.e., unless they increase the outstanding shares of common stock held by the ESOP). If the sponsor has multiple classes of common stock or participating securities and is required to apply the two-class method, the shares of common stock held by the ESOP that are considered outstanding will be treated in the same manner as other outstanding shares of common stock of the same class issued by the sponsor to other investors. See Section 7.2.4.4 and Chapter 5 for further discussion of the two-class method.

Connecting the Dots

Generally, all dividends paid in cash on all shares of common stock held by a leveraged ESOP are used for debt service and the ESOP allocates additional shares of common stock to participants as a substitute payment of dividends on allocated shares. Provided that the monetary value of the additional allocated shares equals the cash amount of the dividends, the only additional impact on EPS that will result from the payment of dividends in additional shares of common stock is the additional number of outstanding shares of common stock that are included in the denominator.

Because all shares of common stock held by a leveraged ESOP that are allocated (including committed-to-be-released shares) are considered outstanding regardless of vesting requirements, the unvested portion of shares of common stock allocated to participants is not considered participating securities. Although atypical, if dividends on unallocated shares of common stock are paid to participants or added to participant accounts, the sponsor must treat those dividends as additional compensation expense in accordance with ASC 718-40-25-16. In these circumstances, the sponsor should consider whether the two-class method should be applied to its undistributed earnings.

7.2.3.2.2 Dividends on Convertible Preferred Stock

Section 3.2.2 discusses the general requirement to adjust net income (loss) for dividends on preferred stock to arrive at income available to common stockholders, which is the numerator in the calculation of EPS. ASC 718-40-45-1 explains that this general requirement applies to all shares of convertible preferred stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1). Dividends on outstanding shares of convertible preferred stock should include undistributed earnings of the sponsor if the outstanding shares of convertible preferred stock held by the leveraged ESOP meet the definition of a participating security. See Section 5.3 for further discussion of the definition of a participating security.

Connecting the Dots

Generally, all dividends paid in cash on shares of convertible preferred stock held by a leveraged ESOP are used for debt service and the ESOP allocates additional shares of convertible preferred stock to participants as substitute payment of dividends on allocated shares. Provided that the monetary value of the additional allocated shares equals the cash amount of the dividends, the only additional impact on EPS that will result from the payment of dividends in additional shares of convertible preferred stock is the additional number of outstanding shares of convertible preferred stock that are used in the calculation of diluted EPS under the if-converted method (see Section 7.2.3.3.2).

If the shares of convertible preferred stock allocated to participants (whether vested or unvested) contain rights to participate in dividends with common shareholders, the allocated shares of convertible preferred stock held by a nonleveraged ESOP would meet the definition of a participating security. Although atypical, if dividends on unallocated shares of convertible preferred stock are paid to participants or added to participant accounts, the sponsor must treat such dividends as additional compensation expense in accordance with ASC 718-40-25-16. In these circumstances, the sponsor should also consider whether the two-class method should be applied to its undistributed earnings.

7.2.3.3 Outstanding Shares

7.2.3.3.1 Common Stock

Shares of common stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1) must be included in the denominator of both basic and diluted EPS on a weighted-average basis. The treatment of such shares is the same as that for outstanding shares of common stock owned by investors. See Section 7.2.4 for additional considerations related to situations in which a leveraged ESOP holds shares of common stock that are redeemable at the option of the participant or upon the occurrence of events outside the sponsor’s control.

Connecting the Dots

As with nonleveraged ESOPs, the vesting requirements associated with outstanding shares of common stock held by a leveraged ESOP have no bearing on the impact of those shares on basic and diluted EPS.

7.2.3.3.2 Convertible Preferred Stock

A sponsor’s basic EPS will be affected by shares of convertible preferred stock held by a leveraged ESOP as a result of dividend payments (see Section 7.2.3.2.2), redemptions, and remeasurement adjustments under ASC 480-10-S99-3A. Redemptions of preferred stock are addressed in Section 3.2.2.6. That guidance applies to redemptions of convertible preferred stock held by a leveraged ESOP even if the redeemed shares remain in the ESOP for reallocation to other participants. See Section 7.2.4 for additional considerations related to situations in which a leveraged ESOP holds shares of convertible preferred stock that are redeemable at the option of the participant or upon the occurrence of events outside the control of the sponsor.

A sponsor’s diluted EPS will be further affected by the application of the if-converted method to the weighted-average number of shares of convertible preferred stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1). Section 4.4.1 discusses the general requirement to apply the if-converted method to convertible preferred stock in the calculation of diluted EPS. ASC 718-40-45-6 through 45-8 further describe how the if-converted method is applied to convertible preferred stock held by a leveraged ESOP. That guidance explains that, for diluted EPS purposes, the following should be considered:

In the calculation of adjustments to the numerator related to the assumed conversion of convertible preferred stock into common stock, in addition to the adjustment for dividends on the convertible preferred stock that would not have been paid during the period if the convertible preferred stock had been converted into common stock, adjustments are also needed for the difference in tax benefits and compensation cost that would exist if the convertible preferred stock had been converted into common stock. See the examples in Sections 7.2.3.5.3 and 7.2.3.5.4.
Upon withdrawal of account balances, participants may be required, or may have the right, to either convert their shares of convertible preferred stock into shares of common stock or receive a cash amount equal to the conversion value. The amount of cash or the number of shares of common stock received upon conversion may equal the greater of (1) the if-converted value based on the stated conversion terms or (2) a stated minimum amount of the convertible preferred stock. The potential dilution calculated under the if-converted method must be the greater of those two amounts. In addition, the more dilutive of the two-class method or the if-converted method must be applied if the outstanding shares of convertible preferred stock meet the definition of a participating security. See further discussion in Section 5.5.4.

Connecting the Dots

In the calculation of diluted EPS, it is presumed that a contract that may be settled in cash or shares will be settled in shares. This presumption may not be overcome; therefore, a sponsor must apply the if-converted method to calculate the effect on diluted EPS of convertible preferred stock held by a leveraged ESOP. However, the numerator in the calculation may be affected in accordance with the guidance in ASC 260 on contracts that may be settled in cash or stock. (See further discussion in Section 4.7.)

7.2.3.4 Accounting Under SOP 76-3

AICPA SOP 76-3

.11 The Division believes that all shares held by an ESOP should be treated as outstanding shares in the determination of earnings per share. An ESOP is a legal entity holding shares issued by the employer, whether or not those shares have been allocated to employee accounts.

.12 Dividends paid on shares held by an ESOP should be charged to retained earnings. Such dividends should not be included at any time in compensation expense.

As discussed in Section 7.2.1.1, certain sponsors may still be applying the grandfathered guidance in SOP 76-3, as interpreted in EITF Issue 89-8, for shares acquired by leveraged ESOPs before January 1, 1993 (see ASC 105-10-70-2(c)). Under SOP 76-3, the accounting principles for nonleveraged ESOPs are the same as those for leveraged ESOPs. Sponsors that account for a leveraged ESOP in accordance with SOP 76-3 should charge all dividends to retained earnings and all shares held by a leveraged ESOP, regardless of whether they are allocated to participants, should be included in the denominator for both basic and diluted EPS. In EITF Issue 92-3, the Task Force reached a consensus that the tax benefits from dividends on unallocated stock held by a leveraged ESOP, which are recognized in retained earnings along with those dividends, should not be an adjustment to net income in the calculation of EPS. The Task Force noted that this consensus also applies to the application of the if-converted method to convertible preferred stock held by a leveraged ESOP.

The example below illustrates the accounting by a sponsor of a leveraged ESOP with shares of common stock accounted for under both SOP 76-3 and ASC 718-40.

Example 7-8

ESOP Shares Accounted for Under SOP 76-3 and ASC 718-40

Assume the following:

Entity A has sponsored an ESOP that holds shares of its common stock.
The ESOP has three direct loans.
The ESOP has unallocated shares that pertain to all three loans.
Shares of common stock purchased with the proceeds of the first loan were acquired before January 1, 1993, and are being accounted for under SOP 76-3 (as interpreted by EITF Issue 89-8).
Shares of common stock purchased with the proceeds of the second and third loans were acquired after December 31, 1992, and are being accounted for under ASC 718-40.

In the calculation of EPS, the unallocated shares of common stock pertaining to the first loan should be considered outstanding and included in the denominator in the calculations of both basic and diluted EPS. The unallocated shares of common stock pertaining to the second and third loans should not be considered outstanding in the denominator in the calculations of basic and diluted EPS until they have been committed to be released. All allocated shares of common stock held by the ESOP are included in the denominator in the calculations of both basic and diluted EPS. The accounting policies for each block of shares should be disclosed in the financial statements.

7.2.3.5 EPS Examples

ASC 718-40 includes four comprehensive examples illustrating the accounting for leveraged ESOPs. Those examples are shown below.

7.2.3.5.1 Common Stock Leveraged ESOP With a Direct Loan

ASC 718-40-55-4 through 55-8 contain an example illustrating an ESOP that owns common stock and is leveraged through a direct loan. The example addresses the impact on the sponsor’s basic and diluted EPS.

ASC 718-40

Case A: A Common-Stock Leveraged Employee Stock Ownership Plan With a Direct Loan

55-4 This Case illustrates a common stock leveraged employee stock ownership plan with a direct loan. This Case has the following assumptions:

On January 1, Year 1, Entity A establishes a leveraged employee stock ownership plan.
The employee stock ownership plan borrows $1,000,000 from an outside lender at 10 percent for 5 years and uses the proceeds to buy 100,000 shares of newly issued common stock of the sponsor for $10 per share, which is the market price of those shares on the date of issuance.
Debt service is funded by cash contributions and dividends on employer stock held by the employee stock ownership plan.
Dividends on all shares held by the employee stock ownership plan are used for debt service.
Cash contributions are made at the end of each year.
The year-end and average market values of a share of common stock follow.
The common stock pays normal dividends at the end of each quarter of 12.5 cents per share ($50,000 for the employee stock ownership plan’s shares each year). Accordingly, in this Case, the average fair value of shares is used to determine the number of shares used to satisfy the employers’ obligation to replace dividends on allocated shares used for debt service.
Principal and interest are payable in equal annual installments at the end of each year. Debt service is as follows.
The number of shares released each year is as follows.
The number of shares released for dividends is determined by dividing the amount of dividends on allocated shares by the average fair value of a share of common stock (for Year 2: $10,000 divided by $10.25 equals 976 shares). In this illustration, the remaining shares are released for compensation (for Year 2: 20,000 less 976 equals 19,024 shares).
Shares are released from the suspense account for allocation to participants’ accounts based on a principal-plus-interest formula. The released shares are allocated to participant accounts the following year. Shares released and allocated follow.
Income before employee stock ownership plan related charges is as follows.
All interest cost and compensation cost are charged to expense each year.
Excluding employee stock ownership plan shares, 1,000,000 shares are outstanding on average each year.
Entity A follows the guidance in Subtopic 740-10.
Entity A’s combined statutory tax rate is 40 percent each year.
Entity A’s only book-tax differences are those associated with its employee stock ownership plan.
No valuation allowance is necessary for deferred tax assets.

55-5 The following table sets forth Entity A’s employee stock ownership plan-related information. All amounts represent changes (credits in parentheses) in account balances.

55-6 Entity A would record journal entries from inception through Year 5 as follows.

55-7 Assuming Entity A terminates its employee stock ownership plan at the end of Year 2 (when the fair value of the suspense shares is $540,000 [60,000 shares multiplied by $9 per share], the unearned employee stock ownership plan share balance is $600,000, and the unpaid debt balance is $656,000), and assuming the suspense shares are sold to pay down the debt, Entity A would make the following journal entry.

55-8 The following tables set forth Entity A’s tax (assuming no termination) and earnings per share (EPS) computations.

In this example, the leveraged ESOP affects the sponsor’s calculation of basic EPS as a result of (1) the reduction in net income associated with the interest and compensation expense recognized, net of the income tax benefit, and (2) the increase in outstanding shares of common stock for the shares of common stock released and allocated to participants in each financial reporting period. As shares of common stock are released from the collateral on the loan and allocated to participants, compensation expense is recognized in an amount equal to the fair value of the shares allocated and those shares become outstanding for the calculation of basic EPS. Dividends paid on the shares of common stock that have been allocated to participant accounts, which are paid in additional shares of common stock, are recognized in retained earnings and do not affect the numerator in the calculation of basic EPS. However, these additional shares of common stock do increase the outstanding shares of common stock in the denominator in the calculation of basic EPS. Dividends paid on unallocated shares of common stock are recorded as a reduction of debt and accrued interest and have no impact on basic EPS. In this example, there is no incremental impact on the sponsor’s calculation of diluted EPS on the basis of the terms of the leveraged ESOP.

7.2.3.5.2 Common Stock Leveraged ESOP With an Indirect Loan

ASC 718-40-55-10 through 55-19 contain an example illustrating an ESOP that owns common stock and is leveraged through an indirect loan. In this example, the ESOP is used to fund the sponsor’s match of its 401(k) savings plan. The example does not take into account the impact of the leveraged ESOP on the sponsor’s EPS calculations. However, the EPS considerations are discussed after the example.

ASC 718-40

Case B: A Common-Stock Leveraged Employee Stock Ownership Plan Used to Fund the Employer’s Match of a 401(k) Savings Plan With an Indirect Loan

55-10 This Case illustrates a common stock leveraged employee stock ownership plan used to fund the employer’s match of a 401(k) savings plan with an indirect loan. On January 1, Year 1, Entity B established an employee stock ownership plan to fund the employer’s match of its savings plan. All of the assumptions are the same as those outlined in Case A for Entity A, except as follows:

Entity B loaned its employee stock ownership plan $1,000,000 and concurrently obtained a related loan. The terms of both lending arrangements are the same as for Case A’s outside loan.
Entity B uses shares released by the employee stock ownership plan to satisfy its matching obligation of 50 percent of voluntary employee contributions to the savings plan. The average fair value of the shares for each year is used to determine the number of shares necessary to satisfy the matching obligation.
If the fair value of the shares released is less than Entity B’s matching obligation, Entity B contributes additional newly issued shares to the employee stock ownership plan to satisfy the remaining obligation.
Shares used to replace dividends on allocated shares used to service debt do not count toward the employer’s match.
The employee contributions, required employer match, and the number of shares needed to fund the employee match follow.

Note that the number of shares needed to satisfy the employer’s matching obligation is determined by dividing the matching obligation by the average fair value of a share of common stock (for Year 1: $200,000 divided by $10.75 [see above table for average fair values] equals 18,605 shares).

55-11 The 20,000 shares released each year based on debt service payments follow.

55-12 Cumulative share amounts follow.

55-13 Note that dividends on top-up shares are paid in cash. Cumulative shares released include top-up shares.

55-14 The following table sets forth Entity B’s employee stock ownership plan related information. All amounts represent changes (credits in parentheses) in account balances.

55-15 Entity B would record journal entries from inception through Year 2 as follows.

55-16 Note that the journal entry differs from Case A because Entity B receives an additional $10,000 deduction ($4,000 tax benefit) for the 976 top-up shares.

55-17 Assuming Entity B terminated its employee stock ownership plan at the end of Year 4 (when the fair value of the suspense shares is $240,000, the unearned employee stock ownership plan shares balance is $200,000, and the unpaid debt balance is $239,800), and assuming the employer buys back the suspense shares in an amount equal to the debt balance, there will be 17 suspense shares left, which must be allocated to participants. (In this Case the shares are used to partially satisfy the employer’s 401(k) matching obligation.) Entity B would make the following journal entry.

55-18 In this Case, Entity B’s taxes would be computed the same way as Case A. For Entity B the average number of employee stock ownership plan shares outstanding would be as follows.

55-19 This represents the cumulative numbers of shares released at the beginning of the year plus the end of the year (see the table in the preceding paragraph) divided by 2.

Although not specifically discussed in this example, the leveraged ESOP affects the sponsor’s calculation of basic EPS as a result of (1) the reduction in net income associated with the interest and compensation expense recognized, net of the income tax benefit, and (2) the increase in outstanding shares of common stock resulting from the release and allocation of common stock to participants in each financial reporting period. As shares of common stock are released from the collateral on the loan and allocated to participants, compensation expense is recognized in an amount equal to the fair value of the shares allocated and those shares become outstanding for the calculation of basic EPS. Compensation expense includes the fair value of the additional “top-up” shares allocated to participants. Dividends paid on the shares of common stock that have been allocated to participant accounts, which are paid in additional shares of common stock, are recognized in retained earnings and do not affect the numerator in the calculation of basic EPS. However, these additional shares of common stock do increase the outstanding shares of common stock in the denominator in the calculation of basic EPS. Dividends paid on unallocated shares of common stock are recorded as a reduction of debt and accrued interest and have no impact on basic EPS. In this example, there is no incremental impact on diluted EPS on the basis of the terms of the leveraged ESOP.

The total compensation expense recognized (before the effect of income taxes) that reduces the numerator in the calculation of basic EPS is as follows:

Dividends paid on allocated shares of common stock, regardless of whether they are paid in cash or with additional shares of common stock, do not affect the numerator in the calculation of EPS.

The following table shows the average shares of common stock that are released and allocated to participants in each financial reporting period and that become outstanding shares included in the denominator for basic EPS on a weighted-average basis:8

7.2.3.5.3 Convertible Preferred Stock Leveraged ESOP With a Direct Loan

The example in ASC 718-40-55-21 through 55-29 illustrates an ESOP that owns convertible preferred stock and is leveraged through a direct loan. The example includes the impact on the sponsor’s basic and diluted EPS.

ASC 718-40

Case C: A Convertible-Preferred-Stock Leveraged Employee Stock Ownership Plan With a Direct Loan

55-21 This Case illustrates a convertible preferred stock leveraged employee stock ownership plan with a direct loan. On January 1, Year 1, Entity D established an employee stock ownership plan with convertible preferred stock. The assumptions are as follows:

The borrowing, debt service, earnings, and tax assumptions are the same as those for Entity A outlined in Case A.
On January 1, Year 1, the employee stock ownership plan used the proceeds of the debt to buy 80,000 shares of newly issued convertible preferred stock of Entity D for $12.50 per share.
The preferred stock pays dividends quarterly at an annual rate of $1.25 per share ($100,000 each year for the employee stock ownership plan shares). Accordingly, in this Case the average fair value of the shares is used to determine the number of shares used to satisfy the employer’s obligation to replace dividends on allocated shares used for debt service.
All dividends on employee stock ownership plan shares are used for debt service.
The preferred stock is convertible into common stock at 1:1 ratio.
Participants may not withdraw the convertible preferred stock from the employee stock ownership plan. When participants become eligible to withdraw shares from their account, they must either convert to common stock or redeem the preferred shares.
The preferred stock has a guaranteed minimum redemption value of $12.50 per share, to be paid in shares of common stock.
The preferred stock is callable at $13.00 per share.
There is one vote per preferred share.
The year-end and average fair values of a share of preferred stock (fair value is assumed to be greater than or equal to minimum value) follow.

55-22 The shares released each year follow.

55-23 Note that the number of shares released for dividends is determined by dividing the amount of dividends on allocated shares (16,000 multiplied by $1.25 in Year 2; 32,000 multiplied by $1.25 in Year 3; and so forth) by the average fair value of a share of preferred stock ($12.50 in Years 2 and 3). In this illustration the remaining shares are released for compensation (16,000 less 1,600 in Year 2, 16,000 less 3,200 in Year 3, and so forth).

55-24 Additional share information follows.

55-25 The following chart sets forth Entity D’s employee stock ownership plan related information. All amounts represent changes (credits in parentheses) in account balances.

55-26 The journal entries to reflect the accounting for Entity D’s employee stock ownership plan from inception through Year 2 are as follows.

55-27 The tax and EPS calculations for Entity D follow.

55-28 If-converted computation.

55-29 Computations for (1), (2), and (3) follow.

In this example, the leveraged ESOP affects the sponsor’s calculation of basic EPS as follows:

Numerator — Income available to common stockholders is reduced by the interest and compensation expense recognized and dividends paid on shares of convertible preferred stock allocated to participants, net of the related income tax benefits. As shares of convertible preferred stock are released from the collateral on the loan and allocated to participant accounts, the sponsor reports compensation expense equal to the current fair value of the shares. Dividends on allocated shares, which are paid in additional shares of convertible preferred stock, are recognized in retained earnings and reduce income available to common stockholders by an amount equal to the fair value of the additional shares of convertible preferred stock allocated to participant accounts. Dividends paid on unallocated shares of convertible preferred stock are recorded as a reduction of debt and accrued interest and have no impact on the numerator.
Denominator — Because the ESOP holds convertible preferred stock that does not represent a participating security, basic EPS is unaffected because no shares of convertible preferred stock have been converted into shares of common stock.

The following additional adjustments are necessary for the sponsor’s calculation of diluted EPS:

Numerator — Under the if-converted method, the following three adjustments are made to the numerator in the calculation of basic EPS: (1) an add-back equal to dividends paid during the year on allocated shares of convertible preferred stock, net of tax, under the assumption that those allocated shares were converted into common stock; (2) an add-back equal to the tax benefit that would have been received if the allocated shares of convertible preferred stock had been converted into shares of common stock and received dividends on the basis of the dividends paid on shares of common stock during the year; and (3) the additional compensation expense, net of tax, that would have been reported if the shares of convertible preferred stock had been converted into shares of common stock. All of these adjustments are calculated on the basis of the weighted-average outstanding shares during the period.
Denominator — Under the if-converted method, incremental shares of common stock are included under an assumption that the allocated shares of convertible preferred stock have been converted into shares of common stock. The if-converted method is applied to allocated shares of convertible preferred stock on a weighted-average basis. In all years except the final year, the application of the if-converted method is based on an assumption of redemption in shares of common stock on the basis of the minimum stated amount of the convertible preferred stock because this approach is more dilutive than conversion at the stated conversion terms.

7.2.3.5.4 Convertible Preferred Stock Leveraged ESOP With an Employer Loan

The example in ASC 718-40-55-30 through 55-33 illustrates an ESOP that owns convertible preferred stock and is leveraged through an internal loan with the sponsor. In this example, the ESOP is used to fund the sponsor’s match of its 401(k) savings plan. The example includes the impact on the sponsor’s basic and diluted EPS.

ASC 718-40

Example 2: A Convertible, Preferred-Stock, Leveraged Employee Stock Ownership Plan Used to Fund a 401(k) Savings Plan With an Employer Loan

55-30 This Example illustrates the guidance in paragraphs 718-40-25-7 through 25-17; 718-40-30-1 through 30-4; 718-40-35-1; 718-40-40-1 through 40-7; and 718-40-45-3 through 45-8 for a convertible preferred stock leveraged employee stock ownership plan used to fund a 401(k) savings plan with an employer loan. This Example has the following assumptions:

On January 1, Year 1, Entity E established a leveraged employee stock ownership plan with convertible preferred stock.
The employee stock ownership plan borrowed $1,000,000 from the employer at 10 percent for 5 years and used the proceeds to buy 80,000 shares of newly issued convertible preferred stock of Entity E for $12.50 per share.
Debt service is funded by cash contributions and dividends on employer stock held by the employee stock ownership plan.
Dividends on all of the original 80,000 shares held by the employee stock ownership plan are used for debt service.
Cash contributions are made at the end of each year.
The preferred stock pays dividends quarterly at an annual rate of $1.25 per share ($100,000 each year for the employee stock ownership plan’s shares). Accordingly, in this Example, the average fair value of the shares is used to determine the number of shares used to satisfy the employer’s obligation to replace dividends on allocated shares used for debt service.
The preferred stock is convertible at a 1:1 ratio into common stock.
Participants may not withdraw the convertible preferred stock from the employee stock ownership plan. When participants become eligible to withdraw shares from their account, they must either convert to common stock or redeem the preferred shares.
The preferred stock has a guaranteed minimum redemption value of $12.50 per share, to be paid in shares of common stock.
The preferred stock is callable at $13.00 per share.
There is one vote per preferred share.
The year-end and average fair values of a share of preferred stock (fair value is assumed to be greater than or equal to minimum value) follow.
Entity E uses shares released by the employee stock ownership plan to satisfy its matching obligation of 50 percent of voluntary employee contributions to the savings plan. The fair value of the shares at the end of each month is used to determine the number of shares necessary to satisfy the matching obligation. (Accordingly, in this Example, average fair values are used to determine the number of shares needed to satisfy the employer’s liabilities.)
If the fair value of the shares released is less than Entity E’s matching obligation, Entity E contributes additional newly issued shares (top-up shares) to the employee stock ownership plan to satisfy the remaining obligation. The top-up shares are issued at the end of the year. Dividends on the top-up shares are paid in cash.
Shares that replace dividends on allocated shares used to service debt do not count toward the employer’s match.
The employee contributions, required employer match, and the number of shares needed to fund the employee match follow.

Note that the number of shares needed to satisfy the employer’s matching obligation is determined by dividing the matching obligation by the average fair value of a share of common stock (for Year 1: $200,000 divided by $12.50 equals 16,000 shares).
Principal and interest are payable in annual installments at the end of each year. Debt service is as follows.
Shares are released from the suspense account for allocation to participants’ accounts based on a principal-plus-interest formula. The released shares are allocated to participants’ accounts at the beginning of the following year. Shares are assumed to be released ratably throughout the year.
The shares released each year follow.

Note that the number of shares released for dividends is determined by dividing the amount of dividends on allocated shares (12,481 multiplied by $1.25 in Year 2; 26,686 multiplied by $1.25 in Year 3, and so forth) by the average fair value of a share of preferred stock ($12.50 in Years 2 and 3). In this example, the remaining shares are released for compensation (14,205 less 1,248 in Year 2; 16,286 less 2,669 in Year 3, and so forth).
Additional share information follows.
The pre-employee stock ownership plan income, shares outstanding, and income tax assumptions are the same as for Example 1 (see paragraph 718-40-55-3).

55-31 The following chart sets forth Entity E’s employee stock ownership plan related information. All amounts represent changes (credits are in parentheses) in account balances.

55-32 The journal entries to reflect the accounting for Entity E’s employee stock ownership plan from inception through Year 2 are as follows.

55-33 The tax and earnings per share (EPS) computations for Entity E follow.

In this example, the leveraged ESOP affects the sponsor’s calculation of basic EPS as follows:

Numerator — Income available to common stockholders is reduced by the interest and compensation expense recognized and dividends paid on shares of convertible preferred stock allocated to participants, net of the related income tax benefits. As shares of convertible preferred stock are released from the collateral on the loan and allocated to participant accounts, the sponsor reports compensation expense equal to the current fair value of the shares (including the “top-up” shares). Dividends on allocated shares, which are paid in additional shares of convertible preferred stock, are recognized in retained earnings and reduce income available to common stockholders by an amount equal to the fair value of the additional shares of convertible preferred stock allocated to participant accounts. Dividends paid on unallocated shares of convertible preferred stock that are used to repay the debt between the sponsor and ESOP have no impact on the numerator.
Denominator — Because the ESOP holds convertible preferred stock that does not represent a participating security, there is no impact on basic EPS because no shares of convertible preferred stock have been converted into shares of common stock.

The following additional adjustments are necessary for the sponsor’s calculation of diluted EPS:

Numerator — Under the if-converted method, the following three adjustments are made to the numerator in the calculation of basic EPS: (1) an add-back equal to dividends paid during the year on allocated shares of convertible preferred stock, net of tax, under the assumption that those allocated shares were converted into common stock; (2) an add-back equal to the tax benefit that would have been received if the allocated shares of convertible preferred stock had been converted into shares of common stock and received dividends on the basis of the dividends paid on shares of common stock during the year; and (3) the additional compensation expense, net of tax, that would have been reported if the shares of convertible preferred stock had been converted into shares of common stock. All of these adjustments are calculated on the basis of the weighted-average outstanding shares during the period.
Denominator — Under the if-converted method, incremental shares of common stock are included under an assumption that the allocated shares of convertible preferred stock have been converted into shares of common stock. The if-converted method is applied to allocated shares of convertible preferred stock on a weighted-average basis. In all years except the final year, the application of the if-converted method is based on an assumption of redemption in shares of common stock on the basis of the minimum stated amount of the convertible preferred stock because this approach is more dilutive than conversion at the stated conversion terms.

7.2.4 Redeemable Shares Held by an ESOP

7.2.4.1 Scope of Temporary Equity Accounting

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(2) ASR 268 requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date, (2) at the option of the holder, or (3) upon the occurrence of an event that is not solely within the control of the issuer. As noted in ASR 268, the Commission reasoned that “[t]here is a significant difference between a security with mandatory redemption requirements or whose redemption is outside the control of the issuer and conventional equity capital. The Commission believes that it is necessary to highlight the future cash obligations attached to this type of security so as to distinguish it from permanent capital.”

S99-3A(3) Although ASR 268 specifically describes and discusses preferred securities, the SEC staff believes that ASR 268 also provides analogous guidance for other redeemable equity instruments including, for example, common stock, derivative instruments, noncontrolling interestsFN2, securities held by an employee stock ownership planFN3, and share-based payment arrangements with employees.FN4 The SEC staff’s views regarding the applicability of ASR 268 in certain situations is described below.

____________________

FN2 The Master Glossary defines noncontrolling interest as “The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest.” ASR 268 applies to redeemable noncontrolling interests (provided the redemption feature is not considered a freestanding option within the scope of Subtopic 480-10). Where relevant, specific classification and measurement guidance pertaining to redeemable noncontrolling interests has been included in this SEC staff announcement.

FN3 ASR 268 applies to equity securities held by an employee stock ownership plan (whether or not allocated) that, by their terms, can be put to the registrant (sponsor) for cash or other assets. Where relevant, specific classification and measurement guidance pertaining to employee stock ownership plans has been included in this SEC staff announcement.

FN4 As indicated in Section 718-10-S99, ASR 268 applies to redeemable equity-classified instruments granted in conjunction with share-based payment arrangements with employees. Where relevant, specific classification and measurement guidance pertaining to share-based payment arrangements with employees has been included in this SEC staff announcement.

ASC 480-10-S99-3A addresses the classification and measurement of redeemable equity securities. ASC 480-10-S99-3A(3) indicates that the classification and measurement guidance applies to shares of stock held by ESOPs, whether nonleveraged or leveraged. ASC 480-10-S99-3A must be applied by SEC registrants and in filings of financial statements by entities in the process of registering securities with the SEC. The application of ASC 480-10-S99-3A by other nonpublic entities is optional. See Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity for further discussion of which entities are subject to the guidance in ASC 480-10-S99-3A.

7.2.4.2 Classification of ESOP Shares Within Temporary Equity

7.2.4.2.1 Classification of Shares

ASC 480-10-S99-3A(2) requires that equity securities be classified in temporary equity if they are redeemable at the option of the holder or upon the occurrence of an event not solely within the issuer’s control. Thus, shares of common stock or convertible preferred stock held by an ESOP, whether nonleveraged or leveraged, that are redeemable at the option of the participant or upon any event outside the sponsor’s control must be classified within temporary equity.

The shares of stock held by an ESOP may meet the requirements for classification in temporary equity because of various redemption features and terms. As discussed in EITF Issue 89-11, a sponsor of an ESOP is required to provide participants with a put option on their shares of stock when those shares are not readily tradable. EITF Issue 89-11 states, in part:9

Under federal income tax regulations, employer securities (such as convertible preferred stock) that are held by participants in an employee stock ownership plan (ESOP) and that are not readily tradeable on an established market must include a put option. The put option is a right to demand that the sponsor redeem shares of employer stock held by the participant for which there is no market for an established cash price. The employer may have the option to issue marketable securities for all or a portion of that option rather than to pay cash. The provisions of the ESOP may permit the ESOP to substitute for the sponsor as buyer of the employer stock; however, in no case can the sponsor require the ESOP to assume the obligation for the put option.

ASC 718-40-25-2 also discusses this put option requirement and other situations in which sponsors must repurchase shares of stock held by participants that withdraw their shares. ASC 718-40-25-2 states:

Regardless of whether an employee stock ownership plan is leveraged or nonleveraged, employers are required to give a put option to participants holding employee stock ownership plan shares that are not readily tradable, which on exercise requires the employer to repurchase the shares at fair value. Public entity sponsors sometimes offer cash redemption options to participants who are eligible to withdraw traded shares from their accounts, which on exercise requires the employer to repurchase the shares at fair value. Employers shall report the satisfaction of such option exercises as purchases of treasury stock.

In addition to the situations described above, shares of stock held by an ESOP may be redeemable as a result of various other features and terms, including, but not limited to, the following:

Shares of convertible preferred stock held by the ESOP may be redeemable upon the occurrence of a change of control or another deemed liquidation event involving the sponsor.
The sponsor may not have sufficient authorized and unissued shares of common stock to achieve the conversion of convertible preferred stock. For example, upon withdrawal, the holder may be entitled to receive a variable number of shares of common stock on the basis of a minimum stated value without any stated cap on the maximum number of shares of common stock that may need to be delivered. In the absence of a stated cap on the number of shares of common stock that must be delivered, the sponsor does not control the ability to deliver shares of common stock to satisfy such settlement requirements.

Connecting the Dots

The plan documents for an ESOP that holds common stock listed on a stock exchange may contain a stated put option that becomes operable only if the sponsor’s shares of common stock are no longer readily tradable (e.g., the shares are delisted from the stock exchange). In these situations, temporary equity classification of the shares of common stock held by the ESOP is required because it is not within an entity’s control to maintain the readily tradable status of its common stock. However, when the plan documents for an ESOP that holds common stock listed on a stock exchange do not contain a stated put option in the event that the sponsor’s shares of common stock are no longer readily tradable, additional consideration is necessary. In these situations, the sponsor does not control the ability to maintain the listing of its shares of common stock on a stock exchange. If the sponsor’s shares of common stock are delisted, they would no longer be considered readily tradable and put options would be issued to ESOP participants or their beneficiaries. However, an entity is not required to classify those shares of common stock in temporary equity if the sponsor has not yet legally conveyed a put option to the ESOP participants or their beneficiaries and if, upon receipt of a delisting notice or another event that would cause the sponsor’s shares to no longer be readily tradable, the sponsor has the unilateral ability to (1) terminate the ESOP, (2) accelerate the vesting of all shares of common stock held by the ESOP, and (3) distribute all the shares of common stock held by the ESOP participants or their beneficiaries before the sponsor’s shares become no longer readily tradable. That is, if the holder of the shares does not have a current redemption right and the sponsor controls the ability to avoid the holder’s redemption of the shares of common stock back to the sponsor under all circumstances (i.e., the sponsor controls the ability to effect a plan termination, which would avoid its requirement to provide a redemption option to the holders), temporary equity classification of the common stock held by the ESOP is not required. Note that entities must carefully evaluate the facts and circumstances to determine whether ESOP shares must be classified in temporary equity. As part of this evaluation, it may be necessary to legally interpret certain ERISA and IRC provisions related to the requirement to provide put options on shares that are not readily tradable.

In accordance with ASC 718-40-45-9, all shares held by a nonleveraged ESOP are treated as outstanding except the suspense account shares of a pension reversion ESOP, which are not treated as outstanding until they are committed to be released for allocation to participant accounts (see Section 7.2.2.1). Further, in accordance with ASC 718-40-45-3, shares held by a leveraged ESOP that have been either allocated or committed to be released (on the basis of the debt service payments) should be considered outstanding (see Section 7.2.3.1). However, when shares of stock held by an ESOP are redeemable (i.e., subject to a put option or other redemption upon the occurrence of events outside the sponsor’s control), the sponsor must classify all such shares in temporary equity. The SEC’s guidance does not distinguish between allocated and unallocated shares. See Section 7.2.4.2.2 for discussion of classification of the contra-equity account related to unearned ESOP shares. This guidance would also apply to nonleveraged ESOPs with suspense pension reversion shares.

Connecting the Dots

For both nonleveraged and leveraged ESOPs, the vested status of shares of stock held by the ESOP is not relevant to the classification of such shares within temporary equity.

See Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity for further discussion of the classification guidance in ASC 480-10-S99-3A.

7.2.4.2.2 Classification of Unearned ESOP Shares of Leveraged ESOP

When the outstanding shares of stock of a leveraged ESOP must be classified in temporary equity, it is also appropriate to classify all or a portion of the related contra-equity account for unearned ESOP shares in temporary equity. Although not codified, EITF Issue 89-11 states, in part:

The Task Force reached a consensus that when ASR 268 (as presented in Section 211 of the “Codification of Financial Reporting Policies”) requires some or all of the value of the securities to be classified outside of permanent equity, a proportional amount of the debit in the equity section of the sponsor’s balance sheet (sometimes described as loan to ESOP or deferred compensation), if any, should be similarly classified.

7.2.4.3 Initial and Subsequent Measurement

Under ASC 480-10-S99-3A, redeemable equity securities that are classified in temporary equity must be initially measured at fair value. This requirement is generally consistent with the initial measurement guidance related to shares of stock held by an ESOP, whether nonleveraged or leveraged. In addition, ASC 480-10-S99-3A requires that redeemable equity securities classified in temporary equity be subsequently remeasured to their redemption amounts in each financial reporting period unless redemption is contingent on an event outside the sponsor’s and holder’s control and it is not probable that the instrument will become redeemable.

ASC 480-10-S99-3A contains one exception to this general classification guidance that is relevant to shares of stock held by an ESOP that are classified in temporary equity. Paragraphs 12(b) and 16(b) of ASC 480-10-S99-3A and ASC 480-10-S99-4 describe this one exception to the general measurement requirements.

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: [Footnote omitted] . . .

b. For employee stock ownership plans where the cash redemption obligation relates only to a market value guarantee feature, the registrant may elect as an accounting policy to present in temporary equity either (i) the entire guaranteed market value amount of the equity securities or (ii) the maximum cash obligation based on the fair value of the underlying equity securities at the balance sheet date.

S99-3A(16) The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

SEC Observer Comment: Sponsor’s Balance Sheet Classification of Capital Stock With a Put Option Held by an Employee Stock Ownership Plan

S99-4 ASR 268 (see also paragraph 480-10-S99-3A) requires that to the extent that there are conditions (regardless of their probability of occurrence) whereby holders of equity securities may demand cash in exchange for their securities, the sponsor must reflect the maximum possible cash obligation related to those securities outside of permanent equity. Thus, securities held by an ESOP (whether or not allocated) must be reported outside of permanent equity if by their terms they can be put to the sponsor for cash. With respect to ESOP securities where the cash obligation relates only to market value guarantee features, the SEC staff would not object to registrants only classifying outside of permanent equity an amount that represents the maximum cash obligation of the sponsor based on market prices of the underlying security as of the reporting date; accordingly, reclassifications of equity amounts would be required based on the market values of the underlying security. Alternatively, the SEC staff would not object to classifying the entire guaranteed value amount outside of permanent equity due to the uncertainty of the ultimate cash obligation because of a possible market value decline in the underlying security.

This exception should not be applied by analogy. For example, it would not apply when an amount other than the market value guarantee may need to be redeemed by the sponsor for cash or other assets and that redemption could occur upon any event outside the sponsor’s control. If the exception does not apply, the entire carrying amount of the ESOP’s outstanding redeemable shares of stock must be classified in temporary equity.

See Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity for further discussion of the measurement guidance in ASC 480-10-S99-3A.

7.2.4.4 EPS Implications of Remeasurement Adjustments

ASC 480-10-S99-3A covers how the measurement adjustments to the redemption amounts of equity securities classified in temporary equity affect basic and diluted EPS. Generally, the EPS accounting implications are as follows:

Common stock — If the common stock is redeemable at fair value, the redemption amount adjustments have no impact on basic or diluted EPS. If the common stock is redeemable at an amount other than fair value, the two-class method of EPS must be applied and the redemption amount adjustments are treated as dividends in the application of the two-class method. Redemption provisions related to shares of common stock held by an ESOP will often reflect fair value redemptions and have no impact on the calculation of basic and diluted EPS.
Preferred stock — The redemption amount adjustments are treated as dividends in the calculation of EPS, regardless of whether the redemption is at a fair value or non–fair value amount. These deemed dividends reduce income available to common stockholders in the calculation of EPS.

Connecting the Dots

When an ESOP holds convertible preferred stock that is classified in temporary equity on the sponsor’s balance sheet, in the calculation under the if-converted method, the amount of any deemed dividends (along with any tax benefits) from remeasurement adjustments that reduce income available to common stockholders in the sponsor’s calculation of basic EPS will need to be added back to the numerator as part of the numerator adjustments discussed in Section 7.2.3.3.2.

See Sections 3.2.2.4 and 3.2.4.2 for further discussion of the EPS implications of remeasurement adjustments related to equity securities classified in temporary equity.

Footnotes

See definition of “employer securities” in IRC Section 409(l).

An employer that terminates a defined benefit pension plan may avoid part of the excise tax on an asset reversion by transferring the assets to an existing or newly created ESOP, which could be either leveraged or nonleveraged. The reverted assets may be used either to purchase shares of the employer stock or to retire existing ESOP debt. Because the number of shares the ESOP acquires in a pension plan reversion is usually more than the Internal Revenue Service permits to be allocated to participant accounts in a single year, some of the shares are held in a suspense account until they are committed to be released in future years for allocation to participant accounts. The guidance in ASC 718-40 on shares held by leveraged ESOPs applies to suspense account shares.

These calculations are based on the table in ASC 718-40-55-12.

Although not codified, the guidance in EITF Issue 89-11 is still relevant.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.