by Glenn Cheney

Norwalk, Conn. -- The Financial Accounting Standards Board has pretty much decided to loosen the rules on calculating the fair value of employee stock option compensation. It’s not an easy thing to calculate and, at best, the final answer is an estimate -- close, but not precise.

FASB said that close is better than nothing, and to help financial statement preparers get as close as possible, the board has tentatively decided to let them choose the formula that fits them best. The current standard requires the use of the Black-Scholes Model, but a proposed change that is expected later this year would allow other models.

The alternate model, in most cases, will likely be a binomial lattice methodology.

The International Employee Stock Options Coalition, however, said that the binomial model has never been used in the preparation of public company financial statements, and therefore it and other models should be subjected to comprehensive field tests before FASB passes down a final standard that allows their use.

However, the ESOC doesn’t like the whole idea of stock option compensation being measured at fair value and entered on the balance sheet as an expense. In some companies, that would tip balance sheets in a direction that would make them look less profitable. The current standard only requires that the effect of such expensing be shown in financial statement footnotes.

Concerned that a new measurement model would make a bad situation worse, the coalition sent a letter to FASB requesting that a field test be implemented and studied before any decisions are made.

“Basically, we are saying that real testing is necessary because of the intractable and unsolved problem of valuation,” said Jeffrey Peck, lead consultant for the coalition and a partner with lobbying firm Griffin, Johnson, Madigan & Peck. “FASB and many others have looked at the valuation issue for the last 10 years, and no one has come up with a more accurate model than Black-Scholes. Before we put these numbers in the face of the income statement — and we would argue that they are materially inaccurate numbers — FASB ought to be most concerned about getting it done right, not getting it done quickly. The appropriate and sensible thing to do is run actual field tests on the various methods to find out if they are accurate or not.”

The ESOC letter said that many coalition members are eager to participate in field testing and that the coalition would be glad to assist in the development, implementation and analysis of the study.

“Given the widespread recognition that an accurate and reliable method for valuing employee stock options does not exist, we respectfully suggest that investors, issuers and all stakeholders in the financial reporting system would be well-served by such testing,” the letter stated.

FASB board member Michael Crooch emphasized that FASB is following all necessary administrative procedures and due process as it works towards new steps.

“It’s very important to understand that we are following our administrative procedures and are trying to take into consideration all of the comments that we get. Our goal is to get the best accounting that’s out there so that we can have high-quality financial statements. We continue to take our steps.”

  “All board members have [received] the letter, though it has not been discussed specifically at a public meeting,” Crooch said. “They have read it and understood it, but at this point there has not been any discussion of or decision on any field test.”

“We have done field visits with 17 companies, trying to determine concerns, data problems and those kinds of things without asking companies to go through a full-blown field test,” Crooch said. “Part of that was because we wanted to be sure we could get the information without companies having to incur significant costs to change things if they had to.”

Crooch said that the research was conducted at companies, or companies were invited to FASB headquarters. When visits were not possible, discussions were held by video-conference. In most cases, a board member was involved in each visit, along with technical staff. FASB staff is reviewing and summarizing the results of the field research, and the board will soon review them.

The binomial lattice model has existed for years. It allows greater data input that results in more accurate estimates, but it requires substantial computational power. Developments in information technology have made binomial calculation viable. Financial analysts have used the model, but, given the required use of Black-Scholes, it has not been widely implemented by companies.

The proposal that FASB is likely to produce will allow companies to make a good-faith choice of measurement methods. There are many besides Black-Scholes and the binomial lattice, but Crooch said that FASB has not been researching them as thoroughly.

FASB spokesperson Sheryl Thompson said that no field test was necessary because the issue had already been subjected to “the ultimate field test” — seven consecutive years of crunching stock option numbers for financial statement footnotes, with some companies exercising the option to expense the compensation on their balance sheets.

Peck countered that FASB had not done a test to determine whether implementation in the footnotes has proved accurate. He also said that FASB expects most companies to opt for the binomial model, which has not been permitted and, therefore, not been tested.

“Most, if not all, companies have been using Black-Scholes, so the ultimate field testing has been the result of apples that have been used for the last seven years,” Peck said. “The only problem is that they are encouraging people to use oranges in the future.”

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