FAS 123R: accounting for stock options; Tips for an increasingly complex task.

With apologies to Baskin-Robbins, stock options seem to be available in at least 31 flavors. Consider the following varieties: premium options (strike price above grant date stock price); purchased options (employee pays a fraction of the strike price at grant); indexed options (strike price varies based upon an index); and options with performance conditions (e.g., vesting or share award depending on growth in earnings per share).

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These compensation measures were designed to align employee performance with the company's success. The result, however, is a tremendously complex world for those faced with accounting for these instruments.

WHAT GAAP IS APPLICABLE TO STOCK OPTIONS?

FAS 123R, Share Based Payment, provides the accounting guidance for a broad spectrum of compensation instruments, including equity shares, equity share options, other equity instruments or liabilities that are based, at least in part, on the price of the issuer's shares.

FAS 123R revised FAS 123, replaced APB 25 and amended FAS 95. However, it did not modify the accounting promulgated by Emerging Issues Task Force 96-18, impacting equity awards to non-employees, or SOP 93-6, relating to employee stock ownership plans.

FAS 123R requires companies to recognize the cost of employee services received in exchange for share-based payments based on the respective grant date fair value of the award. This objective is consistent with FASB's theme that the "economic consequences," or fair value, of transactions be reflected in financial statements. Subsequent to FAS 123R, both the SEC and the PCAOB issued guidance concerning the implementation of FAS 123R (see Staff Accounting Bulletin No. 107, www.sec.gov/interps/account/sabl07.pdf, and PCAOB Audit Practice Alert No. 1, www.pcaobus.org/Standards/Staff_Questions_and_Answers/2006/07-28_APA_1.pdf).

Still, as many companies complete their first year of compliance with the new standard, questions abound.

KEY IMPLEMENTATION ISSUES OF FAS 123R

One of the first steps is determining the most suitable valuation model. There are two primary models in use: the Modified Black-Scholes model and the binomial lattice model.

The MBS model uses a pre-established equation to determine an estimated fair value. Conversely, a binomial lattice model provides a framework for computing the fair value using discounted cash flows.

Under the two models, FAS 123R generally requires--at a minimum--the consideration of: the exercise price of the option, the expected term of the option, the current price of the underlying share, the expected volatility of the price of the underlying share, the expected dividends on the underlying share and the risk-free interest rate.

For purposes of FAS 123R, the Black-Scholes model is modified to use the "expected term" of the option as opposed to its contractual term, if different. This is permitted due to the differences between employee stock options, which generally may be exercised anytime after vesting, and options that are traded on the open market, which are typically not exercised prior to expiration (FAS 123R Sec. A26).

This modification raises an important consideration relative to the model decision: What are the key inputs to the valuation of an option, and how is the valuation sensitive to these factors? Some general guidelines include:

When Input Increases, Input Difficulty to Determine Option Value: Current Market Price Low Increases Strike Price Low Decreases Risk-Free Rate Medium Increases Dividend Yield Medium Decreases Expected Term High Increases; due to longer

time to realize gains

without downside Expected Volatility High Increases; due to higher

potential for market

price appreciation

The decision is driven, in part, by how these inputs are determined. In general, many small- to middle-market companies have utilized the MBS model. However, large companies, such as Google and Oracle, are employing the MBS. In practice, this model appears to be simpler and more cost effective, which is in part due to existing familiarity with the prior valuation practices typically applied under FAS 123.

However, some studies have found that the MBS results in higher fair values and consequent expenses when compared with a lattice model [Rudkin, Ronald. April 2006. Valuation of Employee Stock Options and Other Equity-Based Instruments: Short Term and Long-Term Strategies for Complying with FAS 123R and for Optimizing the Performance of Equity-Based Compensation Programs under the New Standard. Pg 1; and Plank, Jeffery. Wynn, Bruce. Expensing Stock Options under FAS 123(R)].

As for the lattice model, FAS 123R suggests it "more fully reflects the substantive characteristics of a particular employee share option" (FAS 123R Sec. 15). The explanation is that lattice models have the capacity to vary the fair value inputs over time, whereas the MBS utilizes constant values for the life of the instrument.

This capacity causes the SEC's Staff Accounting Bulletin No. 107 to note that the lattice model must be used in certain situations. For example, if an option exercise is dependent upon a certain level of share price increase (performance condition), only the lattice model is able to take the requisite underlying market conditions into account. Some examples of companies that have employed this model include Cisco Systems Inc., Procter & Gamble and Qualcomm. However, some companies may judge the benefits of this sophistication to be counter-balanced by the commensurately higher implementation and audit costs.

It's worth noting that it is permissible to switch between models in appropriate circumstances. In SAB 107, the SEC noted it would not consider this type of event to be a change in accounting principle.

VALUATION INPUT ESTIMATION: BEST PRACTICES

Even though the fair-value estimate should reflect assumptions utilized by marketplace participants, both FASB and the SEC have noted that it is not realistic to expect the models to reliably predict actual future events (See FAS 123R Sec. A12 and SAB 107).

Of all the inputs, the two most difficult to estimate are Expected Term and Expected Volatility. At least one reason for this expectation is that these inputs are to be estimated on a forward-looking basis. In other words, while historical experience is generally the starting point for these estimates, the experience should be modified to reflect any current assumptions indicating that future conditions may be different.

Here are some recommendations concerning factors to consider in estimating these values (note that FAS 123R and SAB 107 both list other relevant factors):

Expected Term

* Examine historical exercise patterns, the post-vesting cancellation period, the vesting length, blackout dates and patterns of the stock price.

* Aggregate awards into homogeneous groups. For example, the behavior of grants to executive management may be distinct from awards to managers. (For an example, see Oracle's 2006 10-K filing, www.oracle.com/corporate/investor_relations/10k-2006.pdf).

* Note that SAB 107 sets forth a simplified method for "plain vanilla" options based upon the following formula: one half of the combined total of the vesting term plus the original contractual term. However, it is anticipated that this method may only be applied relative to option grants made before Dec. 31, 2007.

* In any event, the lower bound of the expected term is the vesting period.

Expected Volatility

* Determine the implied volatility of publicly traded company options or relevant comparables, but do not use indexes. The latter approach may be particularly relevant for emerging companies. (For example, see the recent S-1 filings of Aruba Networks, www.secinfo.com/dr6nd.vFg.5.htm, and Veraz Networks, www.secinfo.com/dr6nd.vd8.w.htm).

* Focus on those options that have similar terms and strike prices to ensure consistency. It is also preferable if the traded options have an active market. If not, consider aggregating weekly trading volume.

* Consider if historical volatility is a reliable indicator of long-term volatility in light of mean reversion tendencies (FAS 123R Sec. 58.).

* Note that SAB 107 addresses circumstances in which exclusive reliance on either historical or implied volatility is appropriate.

In addition, it's necessary to compute the number of options that are expected to vest. In other words, there is a certain probability that a percentage of options will be forfeited. Although this variable does not impact the valuation of an individual option, it does directly impact total compensation expense incurred. This estimation is a change from FAS 123, which permitted the inclusion of all options in the original estimation. When making this estimate, carefully consider factors affecting the probability of exercise, including the employee turnover rate, which may in turn be impacted by the expected stock price.

WHAT ELSE?

Other hot issues to be aware of related to FAS 123R:

* The determination of the grant date has received a lot of attention. One key criteria of FAS 123R is that the employee has to benefit from changes in the stock price beginning on the grant date.