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Accounting rule change may impact you

November 1, 2003 By    

An accounting rule change may alter the way employee ownership is reflected in your company’s financial statements.

This important change – known as Financial Accounting Standards Board Statement No. 150 – effectively changes the Generally Accepted Accounting Principles that determine the way your company’s financial statements are audited or reported by your accountant. Even if your financial statements are not audited, third parties such as your lender may require these aspects to be applied.

To summarize, the accounting profession will require that company obligations to issue ownership interests or redeem ownership interests from its owners be shown as liabilities on the balance sheet of your company when such obligations become unconditional. These obligations are considered unconditional if there is a transfer of an ownership interest at a specific date or if the transfer is required on the occurrence of a certain event (death, retirement or disability being common examples of redemption “triggers”).

If the event has not yet occurred, but will, a liability needs to be shown as soon as the “triggering” event becomes a certainty.

As I have previously noted, your company should provide, in written agreements between the employee and the company, for the repurchase of any employee-owned, minority, ownership interests in your company when the employment of such owners end. This is recommended so that the company does not end up with minority interests owned by “outsiders.”

Thus, FASB 150 directly impacts the buy/sell or stockholder agreement with a mandatory repurchase statement. Any redemption obligation must be shown as a liability on the balance sheet of the company, whether it is a corporation or an LLC.

The liability is not delayed until the owner dies or becomes disabled or retires, if those are the “triggering” events. Rather, the liability is shown at the time the company agrees to be obligated to redeem upon the happening of those events.

On a much broader scale, a company entirely owned by an employee stock ownership plan – with an obligation to redeem the shares of participants upon such events – no longer has any equity, unless the collective redemption prices are less than the current equity.

This reporting change takes effect Dec. 15, 2004, for nonpublic entities, and after June 15, 2003, for public entities; it takes effect immediately for agreements initiated or modified after May 31, 2003.

Review loan covenants with lenders, as balance sheets will change dramatically. You must educate lenders and other reviewers of financial statements about the changes in the reporting that have nothing to do with any adverse change in the company’s business.

If your loan agreements have financial covenants, then you should know that FASB 150 – if applied to the preparation of your company’s financial statements – will adversely impact financial covenants, such as tangible net worth, debt-to-equity and debt-coverage requirements.

You can change mandatory redemptions to cross-purchase agreements or rights of first refusal or options in order to remove your company from being unconditionally obligated to redeem interests.

If FASB 150 applies to your company’s financial statements, then the company’s repurchase of the ownership interest should be made an option (and not an obligation). If guaranteed liquidity for the minority owner is to be provided, then, perhaps the option could be “backed up” by making the repurchase an obligation of the majority owner of the company, if the company does not elect to repurchase.

As always, I recommend that you talk to your counsel (and, this time, also your accountant) about this important change.

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