Yes, Yet Another Article on the “Settlement” But With a Twist

Analysis of Unaudited Financial Statements—Who and How?

There has been much discussion within the ESOP community about the “settlement” and its reverberations. As readers are likely aware, the settlement in question refers to the 2014 settlement agreement between GreatBanc Trust Company and the United States Department of Labor (DOL). The terms of the settlement include, among other things, an agreement concerning fiduciary engagements and process requirements for employer stock transactions. The settlement provides pause for thought for all trustees and their advisors, as the agreement can be viewed as a “playbook” that, if followed, could serve as evidence that the trustee fulfilled its fiduciary duty by engaging in a prudent process in connection with an ESOP transaction. This article discusses the appropriateness of trustees relying on unaudited financial statements following the settlement agreement.

The Settlement and Its Implications—Revisited

[su_pullquote align=”right”]Resources:

ESOP Valuation Basics

Hot Topics in ESOP Valuations

ESOPs: Nuts & Bolts

Legal Considerations for ESOPs

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There has been much discussion within the ESOP community about the “settlement” and its reverberations.  As readers are likely aware, the settlement in question refers to the 2014 settlement agreement between GreatBanc Trust Company and the United States Department of Labor (DOL).  The terms of the settlement include, among other things, an agreement concerning fiduciary engagements and process requirements for employer stock transactions.  The settlement provides pause for thought for all trustees and their advisors, as the agreement can be viewed as a “playbook” that, if followed, could serve as evidence that the trustee fulfilled its fiduciary duty by engaging in a prudent process in connection with an ESOP transaction[1].

Knowledge of the terms of the settlement should not be limited to just trustees, however.  Attorneys, certified public accountants, and valuation professionals frequently serve as advisors to trustees, and thus must develop a thorough understanding of the settlement’s terms.  There are eleven policies and procedures laid out in this settlement agreement.  One of these procedures relates to the reliance on financial statements in determining the fair market value of the stock to be purchased by the ESOP.

Financial Statements Are Not Audited—Now What?

Section E of the settlement agreement provides that the trustee request that the plan sponsor present the trustee and its valuation advisor with audited unqualified financial statements prepared by a CPA for the preceding five years (or as far back as possible to the extent that financial statements apply).  An unqualified audit opinion suggests that, in the independent auditor’s judgment, a company’s financial records and statements are fairly and appropriately presented and are in accordance with Generally Accepted Accounting Principles (GAAP).  This is also known as a “clean” opinion.

In the event the plan sponsor provides the trustee or its valuation advisor with unaudited financial statements, the trustee is required to determine whether it is prudent to rely on the unaudited financial statements.  Furthermore, the trustee is now required to document its basis for reasonable belief that it is prudent to rely on the unaudited financial statements and explain in writing how the trustee accounted for risk, if any, posed by using unaudited financial statements.  As indicated in Section E (3) of the settlement agreement, “If the trustee does not believe that it can reasonably conclude that it would be prudent to rely on the financial statements used in the valuation report, the trustee will not proceed with the transaction.”  These requirements also hold true in the event that audited financial statements with a qualified opinion (an independent auditor’s opinion that suggests the information provided was limited in scope and/or the company being audited has not maintained GAAP) are provided to the trustee.

Trustees typically rely upon their advisors to provide meaningful feedback for the related decision-making processes and relevant services to ensure adherence with matters of compliance, such as the policies and procedures laid out in the settlement agreement.

An assessment of reasonableness of unaudited financial statements requires professionals who are skilled at the analysis of financial statements.  The assessment process involves: (a) a careful analysis of the plan sponsor’s financial statements provided for the transaction; (b) well prepared and meaningful inquiries addressed through dialogue with management and the plan sponsor’s key financial personnel; and (c) investigation of any material issues identified in the course of the analysis and interviews.  Advisors can use a targeted checklist to aid them in the assessment and to structure the specific activities.  The checklist can also be used as a framework to communicate the results to the trustee, should the trustee require a formal report from an advisor.

Aspects of the unaudited financial statements that are assessed as part of the process—and included in the checklist—include but are not limited to:

• Level of current and historical financial statement reporting
  • Review, compilation, internally prepared
  • Prior periods subject to audits, occurrence of step down engagement[2]
  • Specified elements audits
• Plan sponsor’s industry and regulatory requirements, including third-party reporting and examinations required by authoritative agencies
  • Government, regulatory agency, financial institution compliance (covenants)
• Capital structure and ownership, including the plan sponsor’s phase in its life cycle, start up, and exit strategies
  • Consolidations of subsidiaries or variable interest entities
  • Existence of equity instruments and incentive plans—options, warrants, etc.
  • Life cycle considerations—infancy, adolescence, maturity[3]
• Composition and qualifications of the plan sponsor’s accounting and financial reporting personnel
  • CPA, education, industry experience, years of service
  • Job description and performance evaluations
• Accounting and operating systems, including aspects of integration
  • ERP, MRP, proprietary application, out of the box applications
• Plan sponsor’s accounting policies, including unique accounting practices
  • Basis of accounting—GAAP, income tax, cash, contractual
  • Departures from GAAP
  • Revenue recognition for multiple deliverables, foreign currency exchange, other comprehensive income items, financial statement derivatives, etc.
  • Consolidation process, especially with varying fiscal periods and eliminations
• Unusual accounting transactions or arrangements
  • Business acquisitions, prior period adjustment, going concern/management’s plans, subsequent events, impairment of assets, discontinued operations, etc.
• Internal controls over the financial reporting and recordkeeping environment, including close, cut off, and reconciliation processes
  • Do external accountants propose significant adjusting entries?
  • Were all general ledger accounts reconciled to supporting ledgers, schedules, or calculations?
  • Were un-reconciled differences investigated and resolved?
• Revenue recognition and streams
  • Deferred revenue, existence of bill and hold transactions, effects of warranty policies, existence of multiple deliverables
• Expenditure and capital expenditure recognition
  • Physical inventory counts for inventory and fixed assets
  • Accounts payable closes, items incurred but not reserved for
• Debt service and liquidity management, including credit facilities
• Related-party transactions and potential variable interest entities
• Compensation including effects of equity-based arrangements
  • Change in control bonuses, deferred compensation, stock based compensation, commissions, etc.
• Accounting estimates, including allowances, reserves, accrued benefit obligations and compensated absences, and impairment evaluation
  • Requirement for actuarial calculations, i.e., benefit obligations, post retirement
  • Goodwill and identifiable intangible asset (customer lists) impairment
  • Inventory or work in process—slow moving, excessive, obsolete, net realizable value
  • Accounts receivable—bad debts, discounts
  • Cost justified discounts/incentives
  • Deferred compensation, accrued vacation
  • Valuation allowance for net operating losses
• Application of fair value measurements
  • Specialists utilized as part of management’s determination of fair value
• Accounting for income taxes and uncertain income tax positions
  • Factors jeopardizing to plan sponsor tax status
  • Nexus[4]
  • Income tax positions
• Instances of fraud or misappropriation of assets
• Contingencies and commitments, including litigation, licensing, and lease arrangements
• Concentrations, including geographic, customer, and vendor
  • Major customer, supplier, source of labor, financing
• Risks and uncertainties, including transactions involving elements of volatility
  • Market, regulation, international, technology, etc.

In Conclusion

The policies and procedures laid out in the settlement agreement require ESOP trustees to determine the reliability of unaudited financial statements for purposes of the valuation analysis.  The ESOP trustees, working in conjunction with their advisors, can meet this requirement by implementing an effective assessment process.  This process can be significantly enhanced by development of a checklist that incorporates the critical aspects of the plan sponsor’s unaudited financial statements that we have discussed.  Such a checklist could also be an effective communication tool between the trustee and an advisor coordinating the assessment process.

This article was previously published in MHP ESOP Insights, February19, 2015.  It is re-printed here with permission from the author.

[1] As indicated in the DOL agreement concerning fiduciary engagements and process requirements for employer stock transactions, the policies and procedures apply whenever the trustee serves as a trustee or other fiduciary of any employee stock ownership plan subject to Title I of ERISA (ESOP) in connection with transactions in which the ESOP is purchasing or selling, is contemplating purchasing or selling, or receives an offer to purchase or sell, employer securities that are not publicly traded.

[2] A step down in the level of financial statement service (e.g., audit to review or review to compilation).

[3] Typically ESOPs tend to be implemented for mature companies that generate steady cash flows to support the ESOP benefit payments; under this scenario, reference is being made to potential subsidiaries or affiliates in which the parent (ESOP) holds an interest.

[4] A causal connection to taxing jurisdictions where taxable income of an entity can be attributed, recognized, and measured.  Evaluations of nexus require the determination of whether income taxes are attributable to the entity based on the laws and regulations of the taxing authority.

Michael R. Lenkowski, CPA, MSA is a Senior Manager in the Accounting and Tax Group at Meyers, Harrison & Pia, LLC. He has more than 14 years of experience in public accounting. Mr. Lenkowski specializes in audit, tax, and accounting services for privately held businesses. His industry experience includes, but is not limited to, manufacturing, distribution, retail, construction, professional services, investment companies, nonprofit independent educational institutions, and not for profit agencies and foundations. Mr. Lenkowski’s expertise in equity structure, equity awards, organizational planning, and succession planning helps address businesses needs by providing innovative and feasible strategies focused on compliance and tax savings.

Mr. Lenkowski can be contacted at (203) 789-1040 or by e-mail to mlenkowski@mhpcpa.com.