by Glenn Cheney

Norwalk, Conn. -- In a surprise loosening of probable new rules and a shift toward principles-based accounting, the Financial Accounting Standards Board has tentatively decided not to specify a valuation model for the measurement of stock option employee compensation.

The tentative decision is one of the final decisions in a project that is likely to require — for the first time — the expensing of stock option compensation. The project has been very controversial, meeting resistance from the corporate sector, which believes that such compensation cannot be measured accurately. Current rules allow companies the option of keeping the cost of stock option compensation off the balance sheet, reporting its financial effects only in footnotes.

If FASB retains its decisions to date, expensing would be required, but companies would be allowed to choose “the most appropriate” valuation formula. Two of the most popular are known as the Black-Scholes model and the binomial model.

Alfred King, senior vice president at consultant Valuation Research Corp., said that the decision is good and that the choice of model by a given company will have little effect on the bottom line. His company has tested various models on several financial reports.

“There are probably 50 different options pricing models, but let’s not make a mountain out of a mole hill,” King said. “They all are dealing with the same basic variables, and they’re all developed by academics who go tweaking little refinements. You’re just not going to get a very different answer if you use any of the 50 methods. For plain-vanilla options, they’ll all give you the same answer. When there are complex modifications to plans, it may be difficult to handle it with Black-Scholes, but others can handle it.”

FASB spokesperson Sheryl Thompson said that the board has expressed a preference for the binomial model, but the only requirement will be that companies use a method that adheres to fair-value objectives in arriving at the true expense of stock option compensation.

“Companies will need to do their homework on this,” Thompson said. “They will need to choose the appropriate options pricing model that adheres to the fair-value objectives that the board has been pursuing in this project. That model must reflect theoretical merit and be accepted by the financial community.”

The high-tech sector has been especially resistant to any requirement that stock option compensation be expensed under any existing pricing model. Though many companies have voluntarily started expensing such compensation, many more continue to protest that the true value of stock options cannot be calculated accurately or consistently, and therefore should not be reported on balance sheets. They warn that the impact of expensing stock option compensation will make companies appear less profitable and therefore will discourage the use of stock options as compensation.

The Association for Investment Management and Research has been advocating the expensing of stock option compensation. Vice president of
advocacy Rebecca McEnally  praised the move to allow companies to decide which models best suit their situation.

“It’s probably better to not specify a particular model in the rules, because we hope that, as time passes, technology will continue to improve,” McEnally said. “We’ll get better at this and we’ll learn how to do it and explain it in ways that are better for investors, so it won’t discourage the development of new models. But it is essential that companies tell us what model they are using and tell us what the key inputs are. If they do that, then [investors] can see whether the model was a good choice and whether the valuation is reasonable.”

Financial Executives International apparently agreed that the ongoing use of various models would allow companies to explore better techniques.

In June of this year, in a letter to FASB chair Robert E. Herz, the FEI wrote: “We [believe] that it is important that the board carefully consider the guidance it provides on measurement in order that it not forestall or preclude the development and use of more sophisticated and precise valuation techniques that emerge. We believe that this may be best accomplished, given the current state of valuation models, by not prescribing a specific model but, rather, by setting forth attributes of models that are consistent with achieving the fair-value objective.”

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