In an effort to improve consistency in the application of standards relating to audits of the fair value of options granted to employees, the Public Company Accounting Oversight Board staff has issued a set of guidelines.Presented in a question-and-answer format, the guidelines point out risk factors that auditors should be aware of in their consideration of the process for developing a fair value estimate, significant assumptions used in option-pricing models, and the role of specialists in fair value measurement.

PCAOB spokesperson Mike Shokouhi said that as early as last year, the board recognized the need for the guidelines. "During the course of our discussions with auditors and other professionals in the industry, this is a topic that has come up, and it was noted by our previous chief auditor, Douglas Carmichael, at last year's Standing Advisory Group meeting, when we set the agenda for the next year," Shokouhi said.

Lillian Ceynowa, the director of the American Institute of CPAs' Center for Public Company Audit Firms, expressed the institute's support, but remained relatively reticent on the issue. "We support the efforts of the PCAOB in its issuance of audit guidance for the profession in this very important area," she stated, without additional detail.

The guidelines follow a Staff Audit Practice Alert that was issued in July in response to reports of questionable practices relating to the granting of stock options, including the "backdating" of grants. Dozens of public companies are being investigated for engaging in the practice.

Though the alert offered no guidelines, it increased awareness of certain issues relating to Accounting Principles Board Opinion No. 25, which was superseded by Statement 123 (revised) of the Financial Accounting Standards Board.

PCAOB chief auditor and director of professional standards Tom Ray acknowledged that auditors were developing their audit approaches in accordance with the general principles established in existing auditing literature, but that perceived inconsistencies had justified guidelines that would help auditors understand how to implement the principles.

FASB Statement 123(r) requires companies to recognize as compensation cost the grant-date fair value of the award. The Securities and Exchange Commission staff subsequently issued guidelines on the valuation of share-based payments for public companies. As these complex share-option instruments have no market values available, valuation involves option-pricing models.

A long history

The guidelines follow over 15 years of controversy, as FASB wrestled with the standard that would eventually put stock-option compensation on the balance sheet, rather than merely disclosing its estimated value and bottom-line impact in footnotes.

Corporations resisted, predicting disaster for high-tech companies that have traditionally used stock options to compensate employees. While companies claimed that the fair value of the instruments could not be determined at grant date, investors and regulators maintained that the values could be reasonably estimated, and that any number would be more accurate than zero.

Auditing the estimating process is intrinsically as complex as making the original estimates. After hearing concerns from auditors and seeing inconsistent practices, the board decided to develop guidelines.

The guidelines prescribe a three-step process, in which auditors first obtain an understanding of the process used to estimate the value of employee stock options; then assess the risk of misstatement; then perform testing for the consistency of the process, the reasonableness of the pricing model and the assumptions behind it, and the accuracy of data.

The guidelines note that compensation cost based on fair value measurements of stock options has a high inherent risk of misstatement, and that auditors should be aware of how changes in assumptions and models can affect fair value.

The guidelines also call for specific response from an auditor when an assumption reduces the fair value below what it would have been had the company based the assumption on unadjusted historical information, and when a historical period has been excluded from the valuation model.

Statement 123(r) requires companies to adopt whatever pricing model is most appropriate, with the Black-Scholes-Merton and the lattice, or binomial, option-pricing models being the most likely choices. The guidelines warn the auditor to be alert to circumstances in which the Black-Scholes-Merton formula might not be appropriate.

Frequent changes of the pricing model, the guidelines said, might indicate a fraud that would require a response by the auditor.

Auditing the Fair Value of Share Options Granted to Employees can be downloaded at www.pcaob.org.

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