ESOARS in Flux; FAS 157 Tempest; PCAOB

An innovative but fledgling security meant to establish market values for employee stock options may have hit a critical speed bump on the road to viability.

Zions Bank developed the security it calls “ESOARS” during implementation of Financial Accounting Standard No. 123R, Share-Based Payment. FAS 123R requires companies to expense employee stock option grants as a charge to earnings. Zions designed the instrument to be sold via auction as a way to track the value of a particular stock option grant, to establish a FAS 123R book value.

The Securities and Exchange Commission studied ESOARS and determined they generally met the requirements of a market-based instrument that could benchmark employee stock option values to comply with FAS 123R. But investor advocates, especially the Council of Institutional Investors, say the product was flawed, skewing values downward and softening the blow to earnings.

Now the Emerging Issues Task Force of the Financial Accounting Standards Board has stepped into the picture, issuing a draft proposal that seems to contradict the SEC view.

The EITF published its views on how an entity should determine whether an instrument is indexed to its own stock for purposes of complying with derivative accounting rules. That proposal illustrates an example that looks a lot like Zions’ ESOARS and says that such an instrument “is not considered indexed to [the company’s] own stock.”

According to EITF, that’s because the instrument does not contain an exercise contingency, and so the settlement consideration will not equal the difference between the fair value of a fixed number of the entity’s equity shares and a fixed strike price.

The question of whether the ESOARS instrument is or is not indexed to the company stock is critical, Zions Vice President Evan Hill says, because that spells the difference between treating the instrument as equity or as a liability—which would kill any incentive for companies to use it.

Zions CFO Doyle Arnold sent a letter to FASB protesting EITF’s view. Classifying the instrument as a liability undercuts the whole purpose for ESOARS “by adding noise and distorting reported earnings as stock price volatility increases volatility of reported earnings,” Arnold wrote. “Feedback we have received from senior management at public companies is that this is not a trade-off that they are willing to make.”

Hill says the security needs to be treated as equity by accounting rules to fulfill the requirements of FAS 123R. “The best way to have a market-based tracking instrument is for the tracking instrument to have the same treatment as the security it’s tracking,” he says.

Jeff Mahoney, general counsel for the Council of Institutional Investors, says the whole question of how to account for ESOARS shouldn’t be addressed, because the security itself is flawed. “The EITF and FASB would compound the SEC staff’s error if they were to grant Zions an exception from fundamental accounting principles,” he says. “The exception, if granted, would permit Zions to mischaracterize a clear financial liability as an equity instrument.”

Committee on Auditing Industry Speaks Up

A Treasury Department advisory committee has published its first pass at a package of recommendations on ways to fortify the auditing profession, offering a range of ideas on training and education, firm operations, and workouts for troubled firms.

According to Donald Nicolaisen, co-chair of Treasury’s Advisory Committee on the Auditing Profession, the report offers a set of recommendations that “ultimately will determine how well our work went. On balance, I’m very pleased with the progress that’s been made.”

The draft report offers ideas on how talent should be recruited into the auditing profession; how young auditors should be educated and trained; how firms should strengthen their ability to detect and prevent fraud; and how firms should make investors aware of auditors’ duties in that area. The draft also offers ideas for how firms that run into litigation or other legal trouble should be managed to avoid a sudden collapse such as Arthur Andersen experienced when Enron failed in 2001.

The report does not call for outright liability protections or other kinds of indemnification, as some audit advocates had suggested (and as investor advocates protested).

Nicolaisen says no single recommendation is most noteworthy, but he sees great potential for recommendations around recruiting minorities into the auditing profession to have a big consequence.

He says the workout recommendations for troubled firms are important as well. “It’s a recommendation that would enable a firm to remain in business if its insolvency were to be threatened,” he explains. Insolvency of another large audit firm like Andersen would be a nightmare for Corporate America, given the dwindling number of firms able to meet the demands of increasingly complex, global audits.

Nicolaisen says nearly a dozen issues still remain under discussion before a final recommendation is complete. “We wanted to at least expose to the public those recommendations that had reached maturity,” he says.

The advisory committee’s list of issues for “observation and further deliberation” include partner rotation, retention, compensation, workload compression, teaching accounting at the high school level, visas, outside capital and the firm business model, litigation, transparency, engagement partner signatures, and expansion of the auditor’s report. The committee plans to continue discussing those issues and offer further recommendations when they are concluded.

Attacks on Fair-Value Accounting Continue

As the credit crisis drags on, sniping continues between critics and advocates of fair-value accounting over the extent to which those accounting rules may play a role in the market’s current predicament.

Fitch Ratings recently published a report saying fair values in financial reports, compared with values based on historical costs, are helpful to analysts and investors “when they represent realistic and reliable indications of the net present values of future cash flows.” It followed a report by the International Banking Federation that said investors would get better information if financial institutions were permitted to use a combination of fair value and historical cost, depending on the financial instrument to be valued.

The compliance catfight surrounds implementation of Financial Accounting Standard No. 157, Fair Value Measurement, which took effect with the opening of the 2008 fiscal year for many companies. While FAS 157 doesn’t require any new use of fair value, it maps out a standard approach for measuring it that relies heavily on market data, along with judgments and assumptions where data may not be readily available.

The standard itself has been controversial enough; its arrival just as the credit markets plunged into turmoil, where multitudes of instruments have no clear market value, has only fanned the flames. The rap on FAS 157’s “Level 3” valuations—which rely on modeling and judgments in the absence of market activity—has led to concern in some circles that they would be overused as a crutch where market transactions have evaporated.

Dina Maher, senior director at Fitch, says in some places just the opposite has occurred. “We’ve found some implementation has been almost overly conservative as a result of turmoil the last couple of months,” she says. “We don’t believe it’s wrong to use models. We believe there should be fulsome, transparent, robust disclosures around the use of them. Issuers need to be willing to give more than the minimum required disclosures.”

Fisher

Donna Fisher, senior vice president with the American Bankers Association, says the international banking community sees fair value as useful when valuing an asset or liability that is actively traded. But where an entity plans to hold an instrument, establishing its fair value every reporting period leads to recognition of income and expenses that simply aren’t real, she argues. “We happen to be in an expense environment now where the values go down, but when the values go up, you have revenue, and that’s not real revenue,” she says. “Unless you’re going to sell that loan, you’re not going to get that revenue.”

PCAOB Seeks Standing Advisory Group Nominees

The Public Company Accounting Oversight Board is trolling for some new talent to accept two-year terms as members of the Standing Advisory Group.

Created in 2003, the SAG meets three times annually to advise the PCAOB on auditing concerns and priorities, to help guide the Board’s standards-setting process. The Board wants to seat a diversified group representing accounting, auditing, corporate finance, corporate governance, and investing in public companies to get a variety of views and perspectives. The Board turns over roughly half of its advisory group annually.

Prospective members can be nominated by themselves or others. The deadline for nominations is June 19, with appointments announced in October and new terms beginning in January.