Revisiting FAS 150 and the Pros and Cons of Cash Incentive Plans

  

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FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity was issued in May 2003 and required certain financial instruments to be classified as liabilities.

FASB Staff Position FAS 150-3, Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, issued in November 2003, indefinitely deferred the effective date for applying Statement 150 for mandatorily redeemable financial instruments of certain nonpublic entities.

FASB Staff Position FAS 150-4, Issuers' Accounting for Employee Stock Ownership Plans under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, also issued in November 2003, excluded ESOPs from Statement 150, subject to further review:

As defined in AICPA Statement of Position No. 93-6, Employers' Accounting for Employee Stock Ownership Plans, an employee stock ownership plan (ESOP) is "an employee benefit plan that is described by the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC) of 1986 as a stock bonus plan, or combination stock bonus and money purchase pension plan, designed to invest primarily in employer stock." By law, employers with ESOPs must provide the employee with a put option or other redemption feature if the shares are not readily tradable; often, the plan requires that upon death, retirement, or the employee's reaching a certain age the shares must be sold back to the employer at fair value. If the employer must redeem, then the shares meet the definition of mandatorily redeemable shares under Statement 150. Although Statement 150 "does not apply to obligations under stock-based compensation arrangements if those obligations are accounted for under APB Opinion No. 25, Accounting for Stock Issued to Employees, FASB Statement No. 123, Accounting for Stock-Based Compensation, AICPA Statement of Position (SOP) 93-6, Employers' Accounting for Employee Stock Ownership Plans, or related guidance," it includes within its scope a "freestanding financial instrument that was issued under a stock-based compensation arrangement but is no longer subject to Opinion 25, Statement 123, SOP 93-6, or related guidance" (paragraph 17).

Q—Are ESOP shares that are mandatorily redeemable or freestanding agreements to repurchase ESOP shares within the scope of Statement 150?

A—No, ESOP shares or freestanding agreements to repurchase those shares are not within the scope of Statement 150, because those shares are accounted for under SOP 93-6 or its related guidance through the point of redemption. For example, SOP 93-6 provides accounting guidance for dividends on allocated shares, redemption of shares, recognition of expense, and computing earnings per share.

However, ESOP shares that are mandatorily redeemable or freestanding agreements to repurchase those shares continue to be subject to other applicable guidance related to SOP 93-6, for example, EITF Issue No. 89-11, "Sponsor's Balance Sheet Classification of Capital Stock with a Put Option Held by an Employee Stock Ownership Plan." As discussed in Issue 89-11, SEC registrants are required to comply with SEC Accounting

Proposed FSP on Statement 150 (FSP FAS 150-4) p. 1

Series Release No. 268, Presentation in Financial Statements of "Redeemable Preferred Stocks," which requires certain amounts to be classified outside of permanent equity.

Transition

The guidance in this FASB Staff Position (FSP) is effective for financial statements issued after the final FSP is posted to the FASB website. If applying this FSP results in changes to previously reported information, the cumulative effect of the accounting change shall be reported as of the beginning of the first period beginning after the final FSP is posted to the FASB website.

A prior Employee Ownership Update discussed how this applied to ESOPs:

For ESOPs, it now appears that if a company cashes out the shares while they are still in the plan, then pays the employee the cash, that would not require accounting under FAS-150. Companies may have to provide an employee the choice to be paid out in shares, however, although few would choose that. Companies can also write their plans without an mandatory redemption rule. Because employees very rarely want to sell their stock to someone other than the plan or the company, and the company still has a right of first refusal, this would rarely be an issue. The main potential problem would be for larger ESOP S corporations where enough employees would be leaving in any one year and not under a mandatory obligation to sell their shares back to the plan or company. These situations could cause the company to exceed the 75-shareholder limit for S companies.

It is still not clear just when the company must record the liability for distributed shares subject to FAS 150, but it appears the liability would only occur at the point after the employees has left the plan and taken stock that is subject to the mandatory obligation to sell the shares back to the company.

The Update notes that the further review is now on its way and references Project Updates - Financial Instruments with Characteristics of Equity (formerly Liabilities and Equity)—Joint Project of the FASB and IASB:

DECISIONS REACHED AT THE LAST MEETING (March 16, 2009)

The Board continued to discuss an approach for determining whether a financial instrument should be classified as equity. The Board decided that a perpetual instrument should be classified as equity. A perpetual instrument is defined as one that lacks a settlement requirement and entitles the holder to a portion of the net assets of the entity in liquidation. Instruments that are redeemable at the option of the issuer meet that definition because, although the issuer may choose to settle the instrument, it cannot be required to do so.

The Board also decided that puttable and mandatorily redeemable instruments shall be classified as one of the following two types, which should be considered differently in determining classificattion:

1. An instrument that is puttable or mandatorily redeemable upon death or retirement of the holder would be classified as equity. The term retirement is used broadly to include events such as termination, resignation, or ceasing to be a member in a cooperative or partnership.
   
2. An instrument that is puttable at the option of the holder or mandatorily redeemable if specified dates or events other than death or retirement occur would generally be classified as liabilities.

Some Board members expressed reservations about always classifying all instruments of the second type as liabilities, and indicated that they may want to make exceptions when the approach is more fully developed. One example might be an instrument that is puttable or mandatorily redeemable at fair value or an approximation thereof.

SUMMARY OF DECISIONS REACHED TO DATE (As of March 16, 2009)

Classification

The Board decided that a perpetual instrument should be classified as equity. A perpetual instrument is defined as one that lacks a settlement requirement and entitles the holder to a portion of the net assets of the entity in liquidation. Instruments that are redeemable at the option of the issuer meet that definition because, although the issuer may choose to settle the instrument, it cannot be required to do so.

The Board also decided that puttable and mandatorily redeemable instruments shall be classified as one of the following two types, which should be considered differently in determining classification:

1. An instrument that is puttable or mandatorily redeemable upon death or retirement of the holder would be classified as equity. The term retirement is used broadly to include events such as termination, resignation, or ceasing to be a member in a cooperative or partnership.
   
2. An instrument that is puttable at the option of the holder or mandatorily redeemable if specified dates or events other than death or retirement occur would generally be classified as liabilities.
   

The Boards also decided that derivatives on an issuer's own equity instruments should be classified as liabilities or assets. At a future meeting, the Boards will discuss whether derivative instruments within the scope of FASB Statement No. 123 (revised 2004), Share-Based Payment, and IFRS 2, Share-based Payment, would be subject to that classification principle.

NEXT STEPS

The Boards will continue to develop a classification model. Specifically, the Boards will consider (1) which financial instruments, if any, should be separated into equity and non-equity components and (2) initial and subsequent measurement requirements.

The Update also discusses some of the pros and cons of cash incentive plans:

Critics argue that dangling carrots in front of employee owners may be counterproductive. Incentives can easily become entitlements, can encourage people to focus too intently on one aspect of performance or another, and may send a message to people that they have to be bribed to perform. Proponents argue that well-crafted plans provide short-term rewards for employees that help keep them motivated and focused.