FASB Deflects Option Valuation Method to Companies

October 7, 2003 (PLANSPONSOR.com) - The Financial Accounting Standards Board (FASB) has determined companies should decide which methodology is best when valuing stock options.

The latest move comes after six companies that sit on the 33-member standards advisory council agreed to participate last month (See  Six Companies Take Option Expensing For a Test Drive ) in a program that will 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, according to a Dow Jones report.

Under the guidance handed down most recently from the FASB, companies can now decide which of the two methods is most applicable to their organization’s stock options.   However, this suggestion has 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 ).