Verifying PEO Compliance
ESAC has been accepting and reviewing applications for accreditation and successfully verifying PEO compliance with important financial, operational and ethical standards for over two decades. During this time ESAC has reviewed the financial statements and operations of hundreds of PEOs ranging from new startups to large national companies.
ESAC's comprehensive review and analysis has resulted in some PEO applicants being denied accreditation by ESAC at a time when these same PEOs were licensed or registered in good standing by some states. ESAC also has occasionally terminated the accreditation of a PEO that continued to be licensed or registered by some states. A logical questions is, “Why would ESAC deny accreditation to PEOs that were licensed or registered by one or more states?”
To answer this question, it is important to understand several things about PEO operations and about key differences in ESAC’s accreditation requirements and state registration and licensing requirements, including:
- Accreditation Covers All PEO Entities Under Common Ownership Control: ESAC requires that all PEO entities under common ownership control be accredited regardless of their state of domicile or in what states the PEO entities provide services. States only require registration or licensing of PEO entities doing business in that state, and some of the requirements vary significantly among states. Also, some states do not have a PEO registration or licensing requirement. Therefore, a group of commonly controlled PEOs can have entities licensed in good standing in one or more states with perhaps some licensed and unlicensed PEO entities not meeting ESAC’s requirements. ESAC also prohibits an accredited PEO from providing, using or sharing services with a non-accredited PEO since the non-accredited PEO may not meet ESAC’s ethical, financial or operational standards. ESAC’s board of directors established these requirements in 1995 to ensure that all PEO entities being marketed under an accredited PEO trade name were in fact meeting ESAC’s standards, and this practice has served ESAC well for over 25 years.
- Broad Definition of Controlling Persons Coupled with Diligent Investigation to Identify All Controlling Persons: Ensuring that each PEO is owned and managed by controlling persons with a reliable track record is fundamental for successful PEO compliance monitoring. Therefore, ESAC’s PEO controlling person definition is intentionally broad, and the definition has been broadened over the years as a result of experience gained in investigating applicants for accreditation. Honest controlling persons will identify themselves if they are aware of the requirement. Dishonest controlling persons are likely to attempt to circumvent the requirement. A key to ESAC’s success has been diligent upfront investigation to make sure all true controlling persons are identified and required to authorize an independent background investigation. ESAC has found the states’ controlling person background investigations to be reliable. But in a few cases, state registration and licensing processes have failed to identify a controlling person that would have otherwise led to denial of state registration or licensing and did lead to ESAC’s denial of accreditation.
- Multi-Entity, Multi-State Compliance Monitoring: ESAC’s policy of monitoring compliance of all PEO entities under common control, regardless of the state in which they operate, greatly increases the ability to detect a developing compliance problem much earlier than is possible by monitoring only the entity or entities operating in a given state. Most PEOs operate in multiple states, if for no other reason than their clients have employees in multiple states. And most PEOs have multiple PEO entities under common control. PEOs have multiple PEO entities primarily due to the combination of differences in the risk characteristics and service needs of various clients and the different requirements of various insurance companies and state agencies. Most PEOs only license or register each PEO entity in the state or states in which that entity currently serves clients. Some PEOs also have related non-PEO entities under common control with which the PEO has financial transactions. It has been ESAC's experience that audited financial statements of individual entities may not adequately disclose the existence and nature of all related party entities or verify the appropriate treatment of relevant intercompany financial transactions. Examples of relevant entities that may be under common control include trusts, captives and other entities with which the PEO either provides or receives services or shares assets or liabilities in a manner that may impact the PEO’s financial condition.
- Combined or Consolidated Financial Statements: ESAC has found that for purposes of monitoring PEO solvency and early detection of developing financial problems, a combined or consolidated financial statement or individual financial statements for all PEO entities under common control accompanied by an auditor's combining or consolidating schedule is a more reliable compliance monitoring approach than looking at the financial statements of the individual entities or a consolidated statement of only part of the PEO entities under common control. Without being able to verify the adequacy of net worth and working capital on a combined or consolidated basis for all PEO entities under common control, it is difficult to detect a developing financial problem that may result in an unexpected default by one or more licensed entities in a given state. Likewise, if a PEO entity is owned by a parent non-PEO entity and the PEO entity relies on notes receivable or other financial commitments from the parent entity to meet the PEO’s net worth and working capital requirements, the financial reliability of the parent entity must be verified along with the parent entity’s guaranty of the subsidiary PEO’s financial obligations. ESAC requires that accredited PEOs provide audited financial statements covering all PEO entities under common control on a combined or consolidated basis or provide audited financial statements for each PEO entity accompanied by a combining or consolidating schedule. This requirement facilitates verification of the accredited PEO’s compliance with net worth and working capital standards on a combined or consolidated basis across all PEO entities under common control. ESAC also verifies the compliance of each accredited PEO entity’s compliance with the financial requirements of its states of operation. Some existing state registration or licensing statutes require PEOs to provide audited financial statements for each entity doing business in the state but do not require that all entities under common control meet the state’s financial requirements. This situation significantly limits the state licensing agency’s ability to preemptively detect a developing financial problem.
- Accurate Reporting of Working Capital: PEOs are very much a cash flow type of business. Therefore, reliable financial monitoring of PEO working capital is essential to ensure that there are no errors or omissions in the reporting of current assets and current liabilities. If an auditor is not sufficiently familiar with PEO operations or is only engaged to audit selected PEO entities within a group of PEO entities under common control, the existence and materiality of some important related party transactions may be missed. In such cases, if PEO management has not adequately documented or inadvertently or intentionally fails to disclose relevant related party transactions, the PEO’s current assets and current liabilities will not be properly reported in the audited financial statements in compliance with generally accepted accounting principles (GAAP). If there are multiple PEO entities under common control, the adequacy of working capital needs to be verified on either a combined or consolidated basis since groups of related PEOs almost always share internal staff and other operating expenses. Since these expenses can easily be allocated to make some PEO entities appear profitable and adequately capitalized while other entities are not, it is essential to evaluate solvency of the group of related entities as a whole. Also, it is important to ensure that each item included as a current asset is investigated to make sure its classification complies with GAAP. It also is important to review each specific liability that is not included as a current liability to make sure its classification complies with GAAP. Particular attention should be given to any type of loan or other financial transaction or service provided to or received from any controlling person, trust, captive or any type of “Variable Interest Entity” (as defined by GAAP), a non-PEO entity under common control, or any other PEO entity not included in the audit. Until one can verify that all material aspects of the operations of all PEO entities under common control and all financial or service transactions with controlling persons or other entities are being reported according to GAAP, the working capital and net worth shown on a PEO’s financial statement should not be taken for granted.
- Ensuring Reliable Payment of Key Fiduciary Employer Responsibilities: PEOs assume fiduciary responsibility for the payment of client worksite employee wages, state and federal payroll taxes, most health and workers’ compensation insurance premiums and contributions to employee retirement plans. And by adding clients, PEOs have the ability to aggregate these financial responsibilities rapidly just as banks, insurance companies and securities firms are able to rapidly aggregate client funds. As with many service industries, the clients and the associated cash flow from service fees is by far a PEO’s most valuable asset. Under capitalized PEOs with negative net income can continue to cash flow for significant periods of time by paying today’s bills with tomorrow’s dollars. If the PEO is growing at a sufficient rate, this method of operating can continue for years. But when a PEO and its related entities under common control are operating with negative working capital on a combined basis, a financial default can occur quickly when growth slows down due to a change in market conditions or if there is an unanticipated reduction in cash flow as a result of the loss of one or more large clients, the failure of clients to pay in a timely manner, an increase in the cost of essential but non-controllable services, or the loss of an important source of financing. Certification by an independent CPA of the timely payment of important employer obligations of all PEO entities under common control can help limit the size of a default but may have limited value for early detection of a developing financial problem due to a growing PEO's ability to cash flow. ESAC requires the certification by an independent CPA of all major PEO employer payment obligations by all PEO entities under common control regardless of where they operate. But even more importantly, ESAC closely monitors the earnings, working capital and net worth of all accredited PEO entities under common control on a combined or consolidated basis, with all such entities providing cross guaranties of the other entities’ liabilities. If a parent holding company is providing the financial strength, a parent guaranty of each subsidiary is required and the parent company’s financial strength is monitored appropriately. The frequency of financial monitoring is increased as needed if the combined financial strength of the group of entities under common control declines such that a continuation of similar financial performance would result in the combined entities having negative working capital or a net worth of less than five percent of total liabilities.