ESOARS Challenged; FIN 48 Guidance; More

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n influential voice among institutional investors has asked the Securities and Exchange Commission to delay its approval of a market-based approach to valuing employee stock options, so the proposed security can be studied and any concerns about its validity be shared.

In a Feb. 5 letter to SEC Chief Accountant Conrad Hewitt, the Council of Institutional Investors’ general counsel, Jeffrey Mahoney, said he doubts that an option-based security that would sell for a substantially lower price than the value established by an accepted valuation model is a valid marker for the value of the underlying option. He asked Hewitt to allow investors 30 days to study the instrument.

Hewitt recently wrote to Zions Bancorp saying the SEC generally approved of Zions’ proposal to auction a new type of derivative—called employee stock option appreciate rights securities, or “ESOARS”—that would be based on an employee stock option grant. Zions held such an auction last summer based on an option grant of its own, and now plans to market the security-auction process to other option-granting companies so that the sale of the underlying security would establish a market-based value for expensing purposes.

CII is concerned that the Zions approach may result in valuations distinctly lower than the values established by accepted option-valuation models, resulting in a lower expense deducted from earnings. Hewitt said in his letter to Zions that he thinks it would be noteworthy—but not an obstacle to acceptance—if ESOARS prices ultimately establish values that differ from values produced by accepted methods, such as the Black-Scholes model.

Nicolaisen

Mahoney points out that Hewitt’s predecessor chief accountant, Donald Nicolaisen, held a different view. Mahoney points to a 2005 statement within which Nicolaisen said that if a market-based instrument produced a significantly different valuation, “questions would arise about whether the instrument itself and the marketing of the instrument were sufficient to achieve a true fair value exchange price.”

Mahoney says he’s looking for an opportunity to study the instrument more carefully to see if investors would agree that the Zions derivative adequately captures all the nuances of the stock option grant.

“The ongoing stock option backdating controversy is a constant reminder that the financial accounting and reporting for employee share-based awards is an area in which there is a high risk of intentional misapplication of accounting requirements,” Mahoney writes. He says investors won’t realize the full benefits of showing stock options as an expense unless regulators and others assure the full implementation of expensing rules.

Zions Vice President Evan Hill says the auctions will be open and visible to any individuals interested in observing them. “Once we have had a few ESOARS auctions, I am confident the Council of Institutional Investors will see that ESOARS [will] help bring accurate, market-based numbers into financial statements and suits the very interests their letter seeks to address,” he says.

Hill says Zions can’t predict whether the market for ESOARS will produce values in line with accepted valuation models. “We can only structure the securities to accurately reflect the cost to the company granting the ESOs, give the market adequate information to value the ESOs, then run an open auction with sufficient bidder participation to ensure a fair market value is attained,” he says.

“We feel we’ve developed a product, and a system that will take that product to market that will achieve what the SEC is looking for,” Hill says. “As we have auctions the Council of Institutional Investors will have the opportunity to observe that and see that as well.”

FIN 48 Guidance On ‘Ultimately Settled’ Positions To Come

Tthe Financial Accounting Standards Board plans to issue more guidance on its controversial new tax-disclosure rule saying that a company can assume its tax positions are “ultimately settled” once a tax authority has examined the tax records, found nothing questionable, and doesn’t expect to revisit the return—although at least one FASB member may dissent from that view.

The Board met last week to hash out how it would define the term “ultimately settled” as it is used in Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes, which took effect for calendar-year companies with the first quarter of 2007. Companies lobbied FASB in an onslaught of unsolicited comment letters to delay the effective date of FIN 48, or at least offer more guidance on some of the issues that are causing confusion. The Board rejected the idea of a delay, but agreed to explain what it means by “ultimately settled.”

That phrase is important because FIN 48 requires companies to disclose uncertainty in their tax positions with tax authorities with a heightened level of transparency, until such positions are ultimately settled. Companies have questioned whether that means, for example, after a tax return is examined, after a legal challenge is settled, or after a statute of limitations passes.

FASB staff offered the Board three options for how to define “ultimately settled.” First, it could mean only after a tax position could not be reopened for any reason other than fraud or misrepresentation of material facts, the staff suggested. The phrase also could mean the point after which a taxing authority has examined a position during the current examination process and prior dealings with the taxing authority would suggest it is highly unlikely that the tax authority would come back and revisit the issue.

Ultimately, the Board settled on the staff’s third recommendation: that the position is ultimately settled when it has been examined by taxing authorities, they did not examine the specific position in question, and it’s unlikely that the tax authority will revisit it.

Seidman

“In this case, if the audit is closed and it is viewed as highly unlikely that the taxing authority would reopen the year for audit or for any specific positions within that year, the IRS has essentially decided not to proceed with any claim against any future cash against the entity,” board member Leslie Seidman said. “So it is in the best interest of investors to de-recognize any liability that has been recorded, because the likelihood of any future cash flow has essentially been reduced to zero.”

Herz

Chairman Bob Herz agreed with Seidman, adding that he thought the definition was most appropriate because it reflects the economic reality of how companies view their tax liabilities and “it’s operational.”

Trott

Board member Ed Trott said he favored the narrowest view because he senses companies are looking for the guidance only to ease the burden of applying some judgment that the original interpretation requires. He indicated at the close of the Board’s meeting that he may issue a dissenting comment when FASB publishes its staff guidance.

The Board expects to issue the guidance as soon as possible and expose it for a 30-day public comment period.

PCAOB Advisory Group Reviews New Audit, Fraud Ideas

The Public Company Accounting Oversight Board is summoning its Standing Advisory Group to a Feb. 22 meeting to discuss the Board’s new approach to internal control auditing and to look for ideas on how to improve fraud detection in the audit process.

The PCAOB published an agenda for the SAG that focuses largely on the PCAOB’s proposed new auditing standard that would govern the audit of internal control over financial reporting. Separately, the Board has slotted time for the advisory group to consider ways that the audit process can take cues from forensic accounting practices to enhance the likelihood that an audit will catch fraud.

In its briefing paper to prepare for the meeting, the PCAOB asks the advisory group to consider the characteristics that distinguish an audit of financial statements from a forensic audit and the lessons or best practices from forensic accounting that could improve the quality of financial statement audits.

The PCAOB recently issued a reporting advising audit firms to pay closer attention to how the plan and carry out audits with regard to fraud risks.