ESOARS Approval Challenged; Lease Accounting

Armed with a private, independent valuation analysis, the Council of Institutional Investors has lobbied the Securities and Exchange Commission to rescind its endorsement of a derivative instrument invented by Zions Bancorp to establish market values for stock option grants.

Jeffrey Mahoney, the CII’s deputy chief counsel, recently met with officials of the SEC’s Office of the Chief Accountant to present the findings of a study the Council commissioned to examine more closely whether Zion’s employee stock option appreciation rights (ESOARS) adequately tracks the underlying stock option to establish a reliable value. The analysis, conducted by Compensation Valuation Inc., concluded that the Zions derivative and auction process does not fulfill the conditions necessary to establish a reliable market value.

Zions first auctioned its derivative last summer to test its theory that the derivative would establish a book value for stock option grants and meet the requirements of Financial Accounting Standard No. 123R, Share-Based Payment. The Financial Accounting Standards Board, which adopted FAS 123R in 2004 to require expensing of stock options, and the SEC have challenged the market to come up with a way to establish a market value for stock options beyond the use of theoretical models. Zions is the first to get the SEC’s approval for its approach, which relies on a “Dutch auction” to make the security available for sale.

The CVI analysis determined that the auction process fails to meet the conditions necessary to determine a true market price. While the tracking security is “imperfect but not unreasonable,” its combination with the auction mechanism, surrounding conditions, and incentives produce a “predictably downward-biased result,” CVI said in its 10-page report.

“Difficulties arise from restrictions placed on participants in the ESOARS auction, from the small size being offered, and from incentives of the seller,” CVI said. Other poor conditions included “a contingency to eliminate competitive bidding, delays in payments to security holders, mandatory account-holding by winning bidders post-auction with Zions’ brokerage arm (Zions Direct), and pre-auction consideration of each bidder’s Zions Direct balance, which affects the maximum bid allowed.”

CVI also raised concerns about an unsupported secondary market and undefined third-party valuations. “Not surprisingly, these factors preclude the ESOARS auction mechanism from satisfying the basic requirements for liquidity and price discovery and make it highly likely that the ESOARS auction price will significantly understate the true cost of [stock options] to the firm,” the report says.

Mahoney says the Council shared the CVI analysis with a wide range of valuation and accounting experts before taking it to the SEC. The consensus, he says, was that Zions’ auction “did not create a true market value and therefore was in violation of the spirit of the principles-based valuation guidance in Statement 123R.”

Mahoney says the SEC staff indicated they were still working through issues with Zions. SEC spokesman John Heine declined to comment on any further SEC analysis of the derivative beyond what the Commission has already published, which provides general support for the instrument and permits its use as a benchmark for establishing a FAS123R value.

Zions Vice President Evan Hill won’t comment on specific aspects of the CVI analysis because he’s due to meet with SEC officials again soon to answer questions about it. However, he says the CVI analysis is largely based on Zions beta test auction conducted last June, to which the SEC had already recommended changes that Zions implemented before it conducted a subsequent auction. He also says criticisms asserting that the auction restricts participation are focused on provisions that must be in place to meet rules for trading securities.

SEC staff economists clearly are wrestling with how to allow a market-based valuation approach to evolve while still meeting the current requirements of the standard. In a recent speech, SEC Chief Economist Chester Spatt puzzled aloud as to how accounting policy can reward innovative approaches.

Spatt

“To the extent that the goal of accounting policy is to replicate a particular measurement objective, how can innovative ways to define or reach that objective be encouraged?” Spatt said. “Indeed, from the perspective of a registrant it is plausible that the goal is to minimize the expense being measured, rather than measuring the expenses more accurately. This suggests potential tension between designs that are of interest to registrants and those that measure the expense more accurately, especially if the out-of-pocket cost of implementing that market-based approach exceeds that of implementing the model alternative.”

Turner

Lynn Turner, former chief accountant for the SEC, says the ultimate yardstick of an employee stock option’s value is visible when the options are exercised. “It will be very interesting to see how this value compares over time to the amount of actual cash executives put in their pockets and actually realize as compensation when they exercise their options,” he says. “It will also be interesting to see what value corporations place on their options and take as a deduction on their corporate income tax returns. A question will be whether or not Zions will use this same lower value for purposes of the corporate income tax return that they are using to tell their investors what they are worth in the financial reports.”

Hill acknowledges the questions have been raised, but contends that such debates are better focused on the requirements of U.S. Generally Accepted Accounting Principles rather than how Zions will implement them. “We’re looking for the number required by FAS 123R,” he says. “The security we designed is to value a vested stock option to meet the requirements of 123R. If the Council of Institutional Investors means what they say in the press, we’re after the same objective. We want to have increased accuracy in financial reporting. We’re trying to help companies understand the real cost of granting stock options to their employees. We feel the market does a better job of that than a model does.”

Lease Accounting Changes Hit Lease-Dependent Industries Hard

A recent analysis of financial statements for lease-heavy retail companies shows that the growing momentum for reform in lease accounting rules will result in material changes to key measures of fiscal health—especially profitability, financial leverage, debt coverage, and cash flow.

The Financial Accounting Standards Board has launched what it expects will be a long-term project to overhaul lease accounting rules with the stated intention of getting more off-balance-sheet lease obligations into the financial statements. Current lease accounting rules, largely contained in Financial Accounting Standard No. 13, Accounting for Leases, establish precise tests for distinguishing between capital leases, which appear on the balance sheet as long-term liabilities, and operating leases, which are expensed periodically as lease costs are incurred.

The Georgia Tech Financial Analysis Lab examined fiscal year 2006 and 2007 results for 19 large retailers, known for their extensive use of leasing to establish retail and warehouse sites, to determine how such a change in accounting principles might affect financial results. The lab made pro forma adjustments to the balance sheets, income statements, and cash flow statements, extrapolating information from the companies’ own reports.

The study found an increase in EBITDA (earnings before interest, taxes, depreciation, and amortization) because of reductions in income from continuing operations and earnings per share. The analysis also uncovered an increase in financial leverage and a decline in debt coverage measures. Profitability measures, such as return on assets and return on equity, took a hit, but operating cash flow and free cash flow increased.

Mulford

Charles Mulford, director of the Georgia Tech lab, says he undertook the study expecting to find a decline in earnings and leverage, but he was surprised by changes in EBITDA and operating cash flow. He says the results will be of particular interest to companies that establish compensation agreements or debt covenants based on EBITDA.

“If lenders are using EBITDA in their debt covenants, they’re going to have to revise those debt covenants,” he says. “And what does this do to a compensation agreement for an officer? Should he or she get a raise just because the accounting is changed?”

Mulford says the analysis focused on retail companies because their use of leasing is so strong, but the results would hold true for other types of operations as well, especially in the airline industry. “EBITDA will always go up, but it depends on the extent to which a company uses operating leases,” he says.