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.

In addition, the PCAOB Q & A addresses an inquiry as to how an auditor evaluates the qualifications of a valuation specialist. The PCAOB Staff refers to AU sec. 336.08(a) and (b), which states that auditors should examine and consider the valuation specialist's certification, licenses, and other documented competencies [1, 5]. More specifically, the PCAOB Staff believe the auditors should ascertain the external valuation specialist's knowledge, experience, and understanding of the valuation concepts central to the determination of fair value estimates. In addition, the auditors should evaluate the specialist's knowledge of the relevant laws, regulations, and FASB standards, as well as guidance from the Emerging Issues Task Force (EITF), American Institute of CPAs (AICPA), and the Securities Exchange Commission (SEC).

Testing an Entity's Share-based Payment Database and Activity

Once an understanding of the public company's process for developing estimates of the fair value of employee share options has been documented, the auditor should perform tests of the share-based payment database and recorded activity. A schedule presenting all share-based award activity should be obtained, including:

* The number of options outstanding at the beginning and end of the period;

* Options that are exercisable at the end of the period; and

* The number of options granted, exercised, forfeited, cancelled, or expired during the period.

In addition, exercise prices, including non-vested shares, should be included on the schedule. The schedule should contain options granted, along with the fair value on the grant date and the resulting compensation expense, which is reconciled to the general ledger. The auditor should examine if any patterns or conditions exist indicating any previously identified risks regarding share-based payment. In particular, items the auditor should examine include:

* The existence of a high percentage of grants awarded in a period;

* Arrangements where share-based compensation is a major portion of executive compensation arrangements;

* High variation in grant dates;

* Patterns of significant increases in stock prices subsequent to the grant date; and

* High levels of stock-price volatility.

After a preliminary examination of the current period's schedule, the auditors should use the prior-year working papers to determine that the outstanding stock options at the beginning of the period (on the schedule) for the current period, agree with the outstanding stock options at the end of the previous period. In addition, a sample of stock option awards should be selected from the beginning of the period (each sample should represent one individual issued at a single grant date), with balances based on the total unamortized fair value of those options.

To determine if the options selected remain outstanding, the auditors should obtain appropriate evidence corroborating that the employee is still employed with the entity, and that the option has not been cancelled or forfeited. The auditors should also determine if the terms of each option have been modified during the period, and whether or not each option is exercisable, and they should trace the option to ensure it agrees with the schedule of options exercisable at the end of the period. The PCAOB Staff noted that auditors should test the completeness of the various share-based payment award activities by making inquiries of responsible persons outside of the accounting function, including the corporate secretary and members of the board's compensation committee, and they should read the board's minutes.

Comparison of Two Option Pricing Models

The PCAOB staff writes that in testing the estimated value of employee share options, auditors should [5]:

* Evaluate the consistency of the process;

* Evaluate the reasonableness of the company's fair value model, and assumptions employed in the model, including expected term and expected volatility; and

* Verify both the accuracy and completeness of data underlying the fair value measurements.

Once the awards granted are corroborated for the current period in the schedule discussed above, the fair value of each award must be tested. Auditors are expected to evaluate the reasonableness of the option-pricing model selected by the company for calculating the fair value of employee options. The FASB states in SFAS 123 (R), Paragraph A13, "a lattice model (e.g., a binomial model) and a closed-form model (e.g., the Black-Scholes formula) are among the valuation techniques that meet the criteria required by this Statement for estimating the fair value of employee share options and similar instruments" [2]. The FASB, however, does not offer any preference as to which valuation technique a company may adopt. Initially the Board recommended the lattice model, but removed the preference from the exposure draft after receiving public comment [3]. The PCAOB staff further states that auditors should evaluate if the valuation model selected [5]:

* Is applied in a manner consistent with SFAS 123(R)'s fair value measurement objective;

* Is based on established principles of financial economic theory; and

* Reflects all of the substantive characteristics of the share options granted to employees.

In order to understand the substantive differences in each of the main option pricing models, both the Black-Scholes-Merton and Lattice option pricing models will be briefly discussed, respectively.

A. The Black-Scholes-Merton Option Pricing Model

The Black-Scholes-Merton (BSMOP) model, a closed-form option pricing model, measures the relationship between "call option value and ... factors that determine the premium of an option's market value over its expiration value" [6]. SFAS 123(R), Paragraph 18, specifies six assumptions used to calculate the fair value of share based payment [2]:

1. Expected term of the option;

2. Expected volatility of the price of the underlying share for the expected term of the option;

3. Exercise price of the option;

4. Current price of the underlying share;

5. The risk-free interest rate(s) for the expected term of the option; and

6. Expected dividends of the underlying share for the expected term of the option.

These six variables represent auditable components and are used in both the BSMOP and the lattice models. The BSMOP model assumes that stock option exercises occur only at maturity, with other variables (using weighted-average estimates) such as expected dividends, expected volatility, and risk-free interest rates remaining constant over the option term [5].

The BSMOP model is simpler to apply than the lattice-based models, but it has limitations in that it prevents the ability to consider "varying assumptions" over the option term; further, since most of the inputs used in the BSMOP model remain constant, none of the input data can describe any "unique" features of the employee stock option plans [4]. The BSMOP model was originally developed for valuing exchange-traded options; therefore, it does not take into consideration any differences between traditional exchange-traded stock options and those options granted to employees, possibly causing the value of stock options to be overstated. Baril et al. argue that BSMOP model's use is more appropriate for companies that grant relatively few stock options [4]. Unlike the static assumptions used in BSMOP model, the lattice-based models accommodate multiple dynamic assumptions.

B. The Lattice-Based Model

Because employee stock options cannot be transferred and are subject to vesting requirements and strict forfeiture clauses, more often such share options are exercised prior to their maturity. The lattice-based model takes into consideration many unique assumptions that reflect conditions under which employee options are typically granted, such as early exercise of the option. The most common lattice model is the binomial model (although trinomial and multinomial formulas also exist), where the period of time from the grant date to the maturity date is divided into small increments representing intervals. The lattice model estimates how changes in prices over the term of the option would affect the employee's exercise behavior during each interval. While BSMOP is simpler and more commonly used, the lattice model (binomial) requires considerable technical expertise.

As indicated, the six assumptions discussed earlier are also used in the lattice model, with one exception: the expected term of the option is an output of the lattice model, not an input. Specifically, the lattice model calculates the effects of changes in volatility factors (risk-free interest rate, dividend rate, and estimates of expected early exercise) over the option term, requiring more data analysis in building its assumptions. The PCAOB staff stated that the lattice model "might more fully reflect the substantive characteristics of a particular employee share option" [5].

The PCAOB Staff noted that auditors should be aware of circumstances in which the BSMOP model would not be appropriate, and it offers one specific example: "an exercise condition that is satisfied when the share prices exceeds a specified value for a specified period of days ... [Black-Scholes] is not designed to take into account that type of market condition" [5].

If the company uses the lattice model, the PCAOP Staff recommends that the auditor should evaluate whether the adopted model meets the fair value measurement objective of SFAS 123(R). The PCAOB Staff stated that a company should not frequently switch between valuation models and should demonstrate why a change in valuation technique is warranted. Changing valuation models from period to period to lower compensation expense does not meet the fair value measurement objective of SFAS 123(R). The PCAOB Staff also noted that frequent changes in models might indicate the presence of fraud, and that auditors therefore should determine management's reason for the change.

Testing Procedures Used to Estimate Fair Value: Assumptions Employed and the Appropriateness of the Adopted Model Used

The auditor must assess the reasonableness of each of the six assumptions used in the adopted option-pricing model (explained above). As previously mentioned, if such estimates were developed by either an internal or external fair value specialist, auditors should ensure such specialists possess the skills and experience in valuing share-based payment. For each option selected for audit, the exercise price must agree with appropriate supporting documentation (e.g., board of director's minutes). In addition, documentation should be obtained revealing the expected term of the option, taking into consideration several auditable items.

The expected term of an option is the first one of the six assumptions used in an option-pricing model, as discussed above. Because this is a central input to the BSMOP model, the PCAOB Staff recommends that auditors consider the following procedures [5]:

* Obtain an understanding of the company's process for estimating the expected term of the option, and the extent to which the company evaluates relevant factors in the accounting literature;

* Verify the length of the option's vesting period (option life cannot exceed vesting period);

* Determine if the company has taken into consideration factors impacting employee exercise behavior;

* Verify that the company has considered the term of the option and the effects of employees' post-vesting employment termination behavior, as well as employees' expected exercise behavior (excluding any pre-vesting termination behavior);

* Evaluate whether adjustments, if any, to the historical exercise behavior are reasonable and can be supported; and

* Test the data used in the estimate.

In addition, the PCAOB Staff expects the auditor to examine evidence documenting the average length of time similar options remained outstanding (historical exercise patterns of employees as well as post-vesting employment behavior for similar grants). The PCAOB staff noted that auditors should verify a company's calculations to include options not exercised during the contract term (evaluate whether the company's numbers include all vested options, including those never exercised, ensure mathematical accuracy, and test underlying data upon which the company's calculations were based) [5].

The second assumption audited is the expected volatility of the price of the underlying share for the expected term of the option. In measuring the volatility of the underlying stock price, on average, employees tend to exercise options earlier on stocks possessing higher volatility than those with lower volatility. The PCAOB staff note that auditors should perform the following procedures to evaluate the reasonableness of the expected stock volatility [5]:

* Obtain an understanding of the company's process for estimating expected volatility;

* Evaluate whether the company's process considers all applicable factors in Paragraph A32 of SFAS 123(R) in calculating expected volatility [1];

* Evaluate the reasonableness of the assumptions, supporting information, judgments, and weightings;

* Evaluate consistency of the company's process for estimating expected volatility, while considering the availability of new or different information that would be directly useful for estimating expected volatility;

* In evaluating historical volatility, determine if the company's process looks back over the expected term to consider the extent to which currently available information indicates that future volatility will differ from historical volatility; and

* Test the underlying data used in the estimate.

With respect to the third assumption, the PCAOB Q & A requires audits to consider whether the exercise price of the option agrees with appropriate supporting documentation (e.g., board of director's minutes, option contracts, etc.).

The fourth assumption audited is the current stock price of the underlying shares. For each sample selected, the auditor should determine that the stock price, as of the grant date, of the underlying shares used to calculate fair value was calculated using the closing stock price published in The Wall Street Journal or other source where stock prices are published. If a non-public entity is involved, the current share price can be based on an appraisal of the entity's underlying stock.

The fifth assumption used in fair value estimates is the risk-free rate. The PCAOB Staff noted this is generally less subjective than the expected term and volatility assumptions, and can have a less significant effect on the fair value estimate. For each sample selected, the auditor should evaluate the reasonableness of the risk-free interest rate used for the expected term of the option being considered. The risk-free interest rate is "the yield on a zero-coupon U.S. Treasury bond with a remaining term equal to the option term" [5]. Assuming all other variables remain constant, in general, a higher risk-free rate ultimately increases a share-based option's value (with terms similar to a call option) and, thus, the fair value used in the calculation.

The PCAOB staff noted that if the company uses the BSMOP model, the auditor should verify that the company correctly used as its risk-free interest rate a zero-coupon U.S. Treasury bond with a remaining term to maturity equal to the remaining term of the option (since the grant date) [5]. Auditors should also ensure that the correct yield was calculated, and if the yield was interpolated, auditors should determine if the calculation was correct. If the company uses a lattice model that incorporates a term structure of fixed volatilities, then the auditor should verify that the yield curve is properly calculated over the option contract term, and was accurately entered into the model [5].

The final assumption entered into the models used to estimate fair value is expected dividends. In general, a higher dividend yield used over the option term decreases the value of the option. The auditor should determine that the entity's methodology for determining expected dividends is reasonable. In doing so, the auditor should insure that the company's dividend payment history during a period is commensurate with the expected term of the option. Secondly, the auditor should determine if there is any available company information on plans for future dividends.

In addition, the PCAOB staff notes that in examining the expected dividend yield, auditors should evaluate whether the company has the "intent and ability to pay the dividends" used in such assumptions (by examining sufficient cash levels and observable past dividend trends) [5]. If the company has adjusted its current or historic dividend yield, auditors should also evaluate if such adjustments were reflected in the expected dividend yield (by examining press releases, historic dividend yield rates, etc.) [5].

Testing the Proper Recording and Classification of the Resulting Compensation Expense and Presentation and Disclosure

Once the adopted option pricing model assumptions have been tested, the auditor should determine that the numbers are accurate, complete and relevant. The auditor should obtain a schedule providing the amounts of all share-based payment compensation costs for the current period. The schedule should be tested for mathematical accuracy. The compensation costs determined should be reconciled to the schedule presenting all share-based award activity (as discussed above). The auditor should insure that the journal entries related to share-based compensation expense were made by an authorized person and the amounts recorded are valid, appropriate and authorized, and should investigate unusual journal entries, if any.

In addition, the auditor should obtain a schedule of financial statement disclosures related to employee stock option arrangements, test completeness of the schedule, and insure all proper disclosures agree with beginning balances from the prior period's financial statements. The auditor should also consider whether any subsequent events or transactions occurred involving fair value measurements and disclosures after the balance sheet date, but prior to the completion of the audit.

Conclusion

The implementation of and proper reporting of share-based payment awards under SFAS 123(R) has caused enormous complexities in auditing such transactions. The PCAOB Staff recently issued its Q & A to provide greater direction to auditors who audit public company estimates of the fair value for employee share-based payment award, especially in light of all of the negative publicity surrounding the backdating and other questionable activities related to the financial reporting of share-based payment awards that have recently been published in the news.

References

1. American Institute of Certified Public Accountants (2006). PCAOB Standards and Related Rules. New York, NY: AICPA, 527, 583, 586, 664.

2. Financial Accounting Series. Proposed Statement of Financial Accounting Standards: Share-Based Payment An Amendment of FASB No. 123 and 95. Norwalk, CT: FASB, March 31, 2004, 7, 40, 41, 48, 49.

3. www.aicpa.org/PUBS/JOFA/apr2005/eaton.htm#Black, per 11/20/06, 5, 6.

4. www.aicpa.org/PUBS/JOFA/dec2005/baril.htm, per 11/20/06, 2.

5. www.pcaobus.org/standards/staff_questions_and_answers/2006/stock_options.pdf, per 11/20/06, 3, 4, 8, 9, 12, 13, 14, 17, 18, 24, 25, 26, 27, 28.

6. Siegel, J., Levine, M., Quereshi, A., and J. Shim. (2006). GAAP 2007: Handbook of Policies and Procedures, Chicago, IL: Commerce Clearing House, Inc, 1.15.

Benjamin R. Silliman, Queens College of the City University of New York

Adrian P. Fitzsimons, The Peter J. Tobin College of Business, St. John's University