New option expensing rulings spawn new options: to expense or not expense stock options is no longer the question, but new rulings have raised significant compliance questions, while simultaneously adding a new source of financial expense--two often-conflicting objectives.

• Author: Roberts, David
• Position: Accounting

An 11-year debate finally ended on Dec. 16, 2004. On that date, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards 123 Revised, FAS 123(R), mandating that companies expense the fair value of their employee stock options on the face of their income statements.

This new mandate, along with the requirements of the Sarbanes-Oxley Act of 2002, further increases the need for veracity and transparency in financial statements. For most companies and auditors, the conservative approach will be the preferred approach. But even with this course of action, there are still questions concerning what exactly this approach is and how to behave conservatively without drastically impairing bottom-line results.

Companies are now faced with a myriad of complex decisions that under the former standard, FAS 123, were given little if any scrutiny by companies or their auditors. Some of these key reporting issues include computing key assumptions (primarily volatility and expected term), choosing an option pricing model and considering overall tax impact. The following gives some insight into these key challenges, providing a high-level overview of some of the most pressing issues around FAS 123(R).

Implicit Preference for Lattice Models

In the initial Expose Draft (ED) related to share-based compensation, FASB stated an explicit preference for lattice models. Subsequently, the board apparently recognized the over-whelming evidence demonstrating why the Black-Scholes-Merton (BSM) formula (the previously accepted model) is a fully inadequate technique for deriving a reasonable estimate of fair value. This view is especially true for companies that have ample historical exercise data that facilitates a more rigorous analysis of employee exercise behavior and its changes due to stock price volatility.

However, two critical and flawed assumptions made by the BSM formula (vis-a-vis lattice) are important to understand:

* BSM values employee options as if everyone in the company exercised on the same exact day. Of course, this hardly corresponds to reality, since employees base their exercise decisions on where the stock price is at a given point in time.

* BSM presupposes that anyone with out-of-the money options would throw them away at the expected term because they have no belief that the options will ever have value.

Clearly these assumptions do not reflect how employee option-holders base their decisions, and as a...