Business Valuations Used in ESOPs

Federal Rules and Regulations Governing ESOPs

Business valuation reports of employer’s securities owned by ESOPs are subject to review by plan fiduciaries, government agencies, and IQPAs auditing the ESOP’s financial statements. Each of these readers have their own responsibilities to the participants and beneficiaries of the plans. This article will examine the federal rules and regulations governing ESOPS, the responsibilities of the report readers, and the use of the report as audit evidence.

Introduction

Business valuation reports of employer’s securities owned by Employee Stock Ownership Plans (ESOP) are subject to review by plan fiduciaries, government agencies, and independent qualified public accountants (IQPA) auditing the ESOP’s financial statements. Each of these readers have their own responsibilities to the participants and beneficiaries of the plans including compliance with the Employee Retirement Income Security Act of 1974 (ERISA), generally accepted accounting principles (GAAP), and general accepted auditing standards (GAAS). To provide these readers with sufficient information, the business valuator’s responsibility is to provide an independent valuation conclusion in a detailed report that will provide sufficient information so that the readers can comply with their obligations. This article will not address the valuation methods appropriate for an ESOP engagement but will examine the federal rules and regulations governing ESOPS, the responsibilities of the report readers, and the use of the report as audit evidence.

ESOPs and Government Agencies

ESOPs are statutorily defined qualified employee pension benefit plans designed to invest primarily in the employer’s securities, thus providing a means for employees to have an ownership interest in the company for which they work. As with other employee benefit plans, ESOPS are subject to the rules and regulations of ERISA. The Department of Labor (DOL) and the Internal Revenue Service (IRS) are responsible for federal government oversight of operating and reporting practices of employee benefit plans. As part of its oversight, the DOL’s Division of Accounting Services (DAS) conducts reviews of auditors’ workpapers to confirm the quality of the audits of employee benefit plans’ financial statements. The IRS administers the taxation of contributions and benefits as well as the deductibility of employer contributions to the ESOP. Both agencies are concerned that participants in the ESOP are neither disadvantaged by what the plan pays for sponsoring-company shares nor disadvantaged by what they receive upon their termination from the plan.

Plan Fiduciaries

Fiduciaries include plan trustees, plan administrators, and members of a plan’s investment committee. The primary responsibility of fiduciaries is to run the plan solely in the interest of participants and beneficiaries for the exclusive purpose of providing benefits and paying plan expenses. Fiduciaries must act prudently and follow the terms of plan documents to the extent that the plan terms are consistent with ERISA. Fiduciaries who do not follow these principles of conduct may be personally liable to restore any losses to the plan, or to restore any profits made through improper use of plan assets.

ERISA, Title I, Section 103, requires employee benefit plans to file annually Form 5500, Annual Return/Report for Employee Benefit Plan (Form 5500). Plans with 100 or more participants at the beginning of a plan year are generally required to include an audit report issued by an IQPA stating whether the plan’s financial statements are presented fairly in conformity with GAAP. If the auditor reaches this conclusion, they will issue an unqualified opinion. Form 5500 must be filed by the last day of the seventh month after the plan year ends. A two-and-a-half-month extension can be requested. A penalty can be assessed of up to $2,259 a day for each day a plan administrator fails to file a complete and accurate report. A Form 5500 filed without financial statements that include an unqualified opinion will be considered incomplete and subject the fiduciaries to the penalties.

Fiduciaries are also responsible for the plan’s financial statements to be in compliance with GAAP, which requires investments owned by employee benefit plans to generally be stated at fair value. Fiduciaries face the risk of a material misstatement associated with the valuation of securities that do not have a market price such as the closely held stock of an employer security. The ESOP’s purchase of an employer’s stock should be for no more than adequate consideration which is defined by ERISA as “fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan in accordance with regulations promulgated by the Secretary.” ERISA does not define fair market value; however, the IRS and DOL refer to Revenue Ruling 59-60 which defines fair market value as the price at which the asset would change hands between a willing buyer and a willing seller when the buyer is not under any compulsion to buy and the seller is not under any compulsion to sell and both parties have reasonable knowledge of relevant facts. Internal Revenue Code Section 401(a)(28)(C) requires that employer securities not readily tradable on an established market be valued, at least annually, by an independent appraiser.

FASB ASC 820 requires that the financial statements disclose the valuation techniques and inputs that the reporting entity uses to arrive at fair value, such as: the valuation methods used, the cost of capital applied, long-term growth rates, price multiples used in the market approach, and the discount for lack of marketability that was applied.

In Donovan v. Cunningham (716 F.2d 1455 [1983]), the court ruled that fiduciaries cannot solely rely on the good faith of a third-party valuation to establish the value of the shares or on the price from a prior valuation report because the facts on which that valuation was based may have changed. A trustee’s duty is to use judgment in conjunction with the valuation conclusion of the analyst to make the final determination of value. The judge ruled that an “independent appraisal is not a magic wand that fiduciaries may simply wave over a transaction to ensure that their responsibilities are fulfilled. It is a tool and, like all tools, is useful if used properly. To use an independent appraisal properly, ERISA fiduciaries need not become experts in the valuation of closely held stock; they are entitled to rely on the expertise of others. However, as the source of the information upon which the experts’ opinions are based, the fiduciaries are responsible for ensuring that that information is complete and up to date.”

Auditors

The auditor’s responsibility is the expression of an opinion on the fairness, in all material respects, of the ESOP’s financial statements conformity with GAAP. Under the AICPA Code of Professional Conduct, an auditor’s independence is considered impaired if it assumes management responsibilities. Since the fiduciaries are responsible for ensuring that the financial statements are in compliance with GAAP, this includes determining the value of the employer stock; the auditor cannot provide this given their duty to remain independent in this process.

To arrive at an opinion, the auditor plans and performs the audit to obtain reasonable assurance about whether the statements are free of material misstatement. The auditor complies with GAAS by exercising professional judgement and maintaining professional skepticism through the audit. In addition, the auditor identifies and assesses the risks of material misstatements of the financial statements and obtains an understanding of internal controls relevant to the audit. Audit procedures are then developed and performed in response to those risks and control understandings, which enables the auditor to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base their opinion.

A frequent error discovered in the DOL’s review process of auditor’s workpapers is the insufficient review and testing of investment valuation assumptions. Receiving a confirmation from a trustee, custodian, or investment manager is not adequate audit evidence.

The AICPA’s Employee Benefit Plan Audit Quality Center created a checklist to assist auditors in documenting audit procedures evaluating whether the appraisal can be used as audit evidence in accordance with GAAS. If the auditor’s expertise does not include business valuations, the auditor should use the work of a specialist. The specialist can either be someone within the auditor’s company or an external specialist to aid in the completion of the checklist. The following are some items in the AICPA checklist:

1. Read the minutes of the meetings of the ESOP’s board of trustees to verify that they have reviewed and approved the valuation estimates. This process includes the selection of the independent appraiser.
2. Evaluate the competence, capabilities, and objectivity of the appraiser. This would include determining whether the appraiser’s specialties include ESOP valuations and if the analyst has an understanding of and experience with the accounting requirements of GAAP as it relates to employee benefit plans.
3. Assess the valuation methods used were properly applied and whether calculations were performed correctly. This includes an understanding of the appraiser’s rationale for the valuation method selected, and whether all necessary premiums and discounts are appropriately applied.
4. Determine the relevance and reasonableness of significant assumptions used by the valuator and any limiting conditions, including whether the significant assumptions appear reasonable and appropriate for GAAP financial reporting purposes. Procedures generally include reading the minutes of the board of trustees’ meetings, internal and external financial information of the employer’s company, and discussions with the appraiser and plan management.
5. Evaluate whether information produced by the employer is sufficiently reliable for the analyst’s purpose. Test the accuracy, completeness, and relevancy of the underlying data. Tests may include verifying the source of the data as well as recomputing and reviewing information for internal consistency.
6. Assess the reasonableness of any forecast used by the analyst, including assumptions and expectations used, the company’s past earnings, economic and industry conditions, and other factors as applicable.
7. Review prior period assumptions used in the valuation methods and forecast to see how they compare with the past results.
8. Test the reasonableness of the valuation by applying the underlying data to develop the auditor’s own estimate to compare to the appraiser’s valuation.

If the auditor concludes from the procedures that the valuation conclusion is acceptable as audit evidence, then an unmodified audit opinion will be issued with no reference to the work of the business valuator.

If the auditor concludes that the business valuation is not adequate for the auditor’s purposes, and the auditor cannot resolve the matter through additional audit procedures, the expression of a modified opinion may be required causing an incomplete filing of Form 5500. In this situation, there will be a reference to the business valuator to provide the reader of the financial statements an understanding of the modification to the auditor’s opinion. In such circumstances, the auditor may require the permission of the business valuator before making such a reference.

Business Valuator

Business valuators are not fiduciaries under ERISA. Their responsibilities are to act in good faith and comply with the appropriate business valuation standards. A detailed report that complies with the business valuation standards is appropriate communication to provide the fiduciaries and the auditor with the information and documentation needed to do their assignments. The analyst should consider these actions to aid in the process to timely file a complete Form 5500.

1. Meet with the plan’s fiduciaries and auditor to develop a timetable of when the valuation report is needed.
2. Include in the report’s curriculum vitae the analyst’s experience with ESOP valuations and the analyst familiarity with the GAAP requirements of employee benefit plans.
3. Provide in the report the reasoning for all methodologies applied, the logic for choosing the selected method, and, if applicable, the rationality for any weights applied among the methods to arrive at the conclusion. Enough data should be disclosed so the auditor’s specialist can develop their own conclusion to determine the reasonableness of the analyst’s opinion.
4. Explain any material difference in the valuation conclusions from prior years, including a discussion of the reasoning for any adjustments in forecasts, the cost of capital, growth rates, discounts, and changes in weights used.
5. Include a summary of the required financial statement disclosures.
6. Meet with the fiduciaries prior to finalizing the report to explain the methodology, estimates, and assumptions used. Provide sufficient time to allow them to understand and approve the conclusion.

Summary

In other valuation engagements, the business valuator may find themselves in an adversarial relationship with another analyst. This analyst may not only be looking to discredit the valuation conclusion but promote their own theories and opinions. In the case of an ESOP engagement, the auditor’s specialist has no valuation conclusion to advocate. Their role is only to determine if the analyst’s valuation conclusion is reasonable, conforms to GAAP, and provides the auditor with sufficient information that will be acceptable as audit evidence under GAAS.

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Michael A. Kowler, CPA, ABV, CVA, is a retired partner of Buchbinder Tunick & Company LLP, a regional CPA firm. He was responsible for the firm’s business valuation practice while also providing auditing, tax, and litigation support services. His practice included audits of employee benefit plans and closely held businesses. He was the firm’s internal audit specialist for ESOP client audits. Mr. Kowler was a presenter at the Maryland Institute of Certified Public Accountants’ (MICPA) inaugural business valuation conference and has spoken on various business valuation topics before the Howard County Chapter of the MICPA, the bar associations in various counties in the State of Maryland and before several law firms located in the District of Columbia and Maryland.

Mr. Kowler can be contacted at mkowler@outlook.com.

Andrea Gianni, CPA, a partner of Weaver & Tidwell, has more than 20 years of public accounting experience helping clients fortify their internal controls, optimize efficiencies, and ensure compliance. She provides audit, review, compilation, and attestation services to labor unions, not-for-profits, employee benefit plans, and commercial clients. In addition, she has experience with various information returns, such as Forms 990 and 5500.

Ms. Gianni can be contacted at (240) 200-1422 or by e-mail to andrea.gianni@weaver.com.