Audit procedures on the use of fair value of share-based compensation.

Abstract

In October 2006, the Public Company Accounting Oversight Board released a series of "staff questions and answers" to pro vide guidance to CPAs who audit estimates of fair value of employee stock option arrangements. This article examines some of the complexities in auditing the fair value of stock option transactions.

Introduction

In 2006, the Financial Accounting Standards Board (FASB) established a framework for measuring fair value with the issuance of Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). This pronouncement and the underlying requirements it places on independent auditors to properly apply its provisions to fair value reporting and disclosure will greatly affect financial statement reporting and the role of auditors in the United States. In addition, two years ago, when the FASB issued Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (SFAS 123(R), revised 2004), it allowed corporations flexibility in their use of valuation models to measure the fair value of stock option arrangements.

SFAS 123(R) is not included in the scope of SFAS 157. Employee stock option arrangements are not publicly traded instruments, and therefore the fair value of such options are not easily determinable and must be estimated using an option pricing model, such as Black-Scholes-Merton or the Lattice model [3]. The compensation expense recognized on the income statement and the value of the stock options on the balance sheet are based on reasonable estimates using "forward-looking information," and can be material in amount [2].

On October 17, 2006, the Public Company Accounting Oversight Board (PCAOB) issued a series of "questions and answers" (Q & A) to provide direction to CPA firms auditing public company estimates of the fair value of employee stock option arrangements [4]. Using the PCAOB Q & A and other audit procedures, this article examines some of the major complexities in internal control procedures employed in auditing the fair value of a corporation's stock option transactions. Specifically, it addresses:

(a) understanding the process used by an entity to develop the estimated fair value of employee share options,

(b) testing of an entity's share-based payment database and activity,

(c) comparing the two fair value estimate models,

(d) testing procedures used to estimate fair value, including the assumptions employed and the appropriateness of the adopted model used, and

(e) testing the recording and proper classification of the resulting compensation expense and financial statement presentation and disclosures.

In addition, the auditor's use of internal or external fair value specialists will be discussed throughout.

Developing an Understanding of a Corporation's Process Used to Develop Fair Value of Employee Share Options

In the Q & A, the PCAOB Staff noted that in AU 328.09 (Auditing Fair Value Measurements) auditors are required to obtain a thorough understanding of the company's process for determining fair value measurements and disclosures, as well as the relevant controls sufficient to develop an effective audit approach [1, 5]. Specifically, in examining a public company's process for accounting for share-based compensation transactions, documentation of such understanding might include (but is not limited to) the following inquiries of management and its board of directors. The PCAOB Staff note that the auditor should document:

* The terms and conditions of the existing policies granting employee stock options, paying close attention to terms allowing exercise prices that are not equal to the market price on the grant date (as well as terms that delegate option award issuance authority to management).

* The extent the company uses third-party specialists in determining its fair value measurements and disclosures.

* The process for approving and communicating option awards to employees, ensuring that the company determines that the grant date used is consistent with FAS 123(R). Their understanding of the general terms of the stock compensation plan, reviewing contractual terms, settlement alternatives, number of options available, and other relevant terms must be examined.

* The process for tracking stock option awards granted, exercises, forfeitures, cancellations, and option expirations, along with the company's process used to review plan documents and the accounting for each individual grant.

* The process the company uses to measure and record the stock compensation expense, including those personnel authorized to record such entry.

* The process for identifying and effectuating modifications to existing award terms or conditions, including those authorized personnel. The PCAOB Staff noted that the previous year's fair value estimates should be examined to ensure consistency of methods and assumptions employed.

The PCAOB Staff noted that AU 328.23 provides three approaches for testing fair value measurement, including [1, 5]:

1. Testing management's significant assumptions, the valuation model, and the underlying data related to the fair value estimate,

2. Developing independent fair value estimates for corroborative purposes, or

3. Reviewing subsequent events and transactions.

In the Q & A, the PCAOB Staff stressed that the first approach is the more practical method for auditing fair value of employee share options, given that calculating independent fair value estimates (second approach) is not often practical and the "limited usefulness" of testing subsequent events (third approach) [5].

Therefore, auditors should examine and document the significant management assumptions used in determining fair value, the selection of the option pricing model (SFAS 123(R), paragraphs A13-A15), and the expertise and experience of those individuals responsible for determining such estimates [2].

The PCAOB Staff reiterated that some corporations develop assumptions that affect fair value data either internally, by employing their own specialists to prepare the fair value estimate, or externally, by engaging third-party specialists for determining fair value estimates. Referring to AU 328.12, the PCAOB Staff writes that auditors should document the extent to which management uses such specialists, either internally or externally [1]. The PCAOB Staff also cited AU 324 (Service Organizations) when a company engages outside service organizations, and the impact this has on the audit process [1].

Whether fair value assumptions used by management were developed internally or externally, the PCAOB Staff expects auditors to first determine the process used to develop and apply such fair value assumptions, including the processes used to monitor any changes in management's assumptions. In doing so, the controls over the process in which fair value estimates are derived should be examined, including any internal controls over the data. Auditors should also examine the segregation of duties between those responsible for authorizing and carrying out the underlying transactions involving the fair value of stock options with those responsible for preparing the respective valuations.

The PCAOB Staff stated that auditors should test the integrity of change controls and security procedures for the valuation model adopted, as well as controls that ensure consistency, timeliness, and reliability of data inputs in the valuation model. As the auditors test fair value measurements and disclosures, the PCAOB Staff expects the auditors to perform procedures to "evaluate whether management's assumptions are reasonable and to evaluate the source and reliability of the evidence supporting management's assumptions" [5]. In doing so, each auditor performing such high level attestations is required to possess relevant "special skill or knowledge," and be a member of the audit engagement team.

If a public company engages an external fair value specialist, the auditor should determine the objectivity of the specialist, as well as ascertain the necessary skill sets of the specialist. Because fair value estimates prepared by such external valuation specialists could materially impact the public company's results of operations and financial position, the auditor should first test the objectivity of such specialists. In doing so, the auditor should request a copy of the engagement letter disclosing the objectives and scope of the work involved, including if the specialist provides other services. The auditor should also ascertain if there is a relationship between the external specialist and the company that could impair the specialist's objectivity and compromise the integrity of the work performed. Other items the PCAOB Staff believe the auditor should consider about the external valuation specialists include:

* Access to appropriate records and files;

* Confidentiality of the public company's information;

* Documentation of the specific assumptions and methods employed by the external specialist used in the adopted valuation model; and

* Consistency of methods used in the current period with those used in the prior period.

If the auditor is unable to confirm whether or not the external valuation specialist has a relationship with the corporation that could potentially cause impairment of the specialist's objectivity, a confirmation letter from the external specialist attesting to his or her independence would be required.