Coalition Calls For Option Expensing 'Field Test'

January 26, 2004 ( - The International Employee Stock Options Coalition (IESOC) is asking the Financial Accounting Standards Board (FASB) to offer a field test of various stock option valuation methods before making them mandatory.

The need for a field test is necessitated by the “widespread recognition” that an accurate method for valuing employee stock options does not currently exist.   Thus, in order to “safeguard the integrity of financial statements,” IESOC Chairman Rick White, head of the pro-employee stock option group, said in a letter to FASB Chairman Robert Herz. “Field testing makes sense.”

“If the board ultimately proposes mandatory expensing of all options on the face of the income statement, we believe it has an obligation – before adopting a new accounting standard – to consider multiple valuation methods, test them, and evaluate their accuracy and reliability,” the IESOC said.

To assist to the development of a field-testing program, the IESOC said it would work with FASB to construct and implement the tests.   These test should include at least 100 companies, the big four accounting firms and other consultants, the letter went on to outline.

The IESOC, which operates the Web site , ultimately has not given up the goat on its fight to preserve current stock option valuation methods.   In the letter, White says stock options do not constitute an expense because no cash payment or outflow of corporate assets is made.   “The cost of stock options is borne by stockholders through potential dilution, and this expense is already accounted for, and disclosed to investors, in diluted earnings per share,” the IESOC said.

Under current stock option valuation methods, companies can voluntarily elect to expense stock options.   FASB though, has said previously, US companies will have to expense employee options starting in 2005, instead of disclosing the estimated costs in their financial footnotes as current rules allow (See  FASB: Option Expensing Begins in 2005 ).

Previous Tests

Stock option valuation model fielding testing is not a new idea, and the FASB toyed with it last autumn.   In all, FASB enlisted the aid of six companies that sit on the 33-member standards advisory council to participate (See Six Companies Take Option Expensing For a Test Drive ) in a program that would assess the potential costs and benefits from expensing stock options using two separate methods.   To be considered was the Binomial option pricing model, which tends to be a bit more sophisticated than its more widely used cousin the Black-Scholes method, based on its inclusion of more pricing variables than Black-Scholes’ five.

Ultimately, FASB determined shareholder interests would be better served if companies decided the method that was best in valuing their stock options.   Under guidance handed down from the FASB, companies can decide which of the two methods is most applicable to their organization’s stock options (SeeFASB Deflects Option Valuation Method to Companies).

This suggestion from FASB raised some concerns among analysts and corporate accountants. 

Analysts are concerned that such a flexible approach could lead to a race by companies to find the lowest acceptable number and, therefore, the lightest possible hit to earnings.  In response to the charge, the FASB has agreed to fix its gaze on determining an objective for the final option expensing proposals due in February on how to best measure how much stock options are worth at the time they are granted.  “There won’t be room for manipulation if we state clearly the objective,” Edward Trott, a FASB member, said at the meeting held by the User Advisory Council – a group established by the board to increase analysts’ participation in the accounting standard-setting process.

Corporate accountants, on the other hand, have been critical of Black-Scholes’ methods for valuing options.  Specifically, concerns abound that stock options will overvalued due to assumptions that both the option and the stock trade in liquid markets and that the risk-free interest rate and the stock’s price volatility remain constant during the option’s life.  This premise tends to not hold true with the long durations typical of stock options (See  Black-Scholes Overvalues Stock Options ).