FASB Allows Companies To Select Options Valuation Model

After showing its initial preference for a particular form of stock option valuations models, the Financial Accounting Standards Board last week decided back off, lest companies conclude that model was a requirement.

That's according to numerous industry press reports, including a recent article in The Wall Street Journal. However, closer review of the FASB proposal shows that the Board had already clearly stated that the choice of valuation models was up to the companies themselves.

In the original FASB proposal (available in box at right), several valuation techniques were considered appropriate to meet "the criteria required by this Statement for estimating the fair values of employee share options and similar instruments."

Those included both a "lattice" model, an example of which is a binomial model, and a closed-form model like the commonly utilized Black-Scholes-Merton formula.

According to the FASB proposal, the selection of a valuation model "will depend on the substantive characteristics of each arrangement and the availability of data necessary to use the model."

A Preference That Can't Be Switched

The proposal did show a preference for a lattice model. When the proposal was released, FASB spokesperson Sheryl Thompson told Compliance Week that the Board was favorably inclined to a lattice model because it can be designed to accommodate variable factors such as dividends and volatility over the option's contractual term. "The lattice model provides a greater number of data inputs and allows for a more precise, or higher-quality number," she said.

However, the proposal also went out of its way to note that "Although a lattice model may be preferable because of its ability to more fully capture and better reflect the characteristics of a particular employee share option or similar instrument in the estimate of fair value, it may not be practicable to use such a model."

Kothari

In fact, MIT professor S.P. Kothari told Compliance Week that Black-Scholes is not necessarily as "closed" as the name closed-model suggests. That's because the formula can be adjusted to take into account the actual selling behavior of employees. "The usual way Black-Scholes valuation of options is done is by reducing the expiration from ten years, to something like four years," said Kothari, who heads MIT's Department of Economics, Finance & Accounting. "Historically employees have been exercising in three or four or five years. Once you make that adjustment to Black-Scholes, I think it is fairly straightforward to implement."

Nevertheless, there was some concern—especially among high tech companies—that the Board was explicitly endorsing a lattice model. That endorsement may have been implied in the fact that—while companies have latitude in choosing which model they wish to employ—FASB cautioned that the valuation technique selected should remain constant.

Specifically, the Board noted that the model can only be changed to what the Board considers a more accurate one, meaning from Black-Scholes to a lattice model. Not vice versa. Therefore, a company initially implementing the lattice model cannot later switch to a closed-form method.

"Once an entity changes its valuation technique to a lattice model, it may not change to a less preferable valuation technique," noted the proposal.

Crooch

As a result, the FASB last week clarified that it was not requiring companies to utilize a lattice model. "We didn't want to hog-tie individuals to a particular model," FASB board member Michael Crooch told CFO Magazine. Crooch serves as the Board collaborator on the equity-based compensation project.

The Board will next meet today, September 8, to discuss further. The conversation is expected to focus on employee share purchase plans and disclosures, as well as other topics.

Details on the FASB proposal, as well as related columns and guidance, are available from the box above, right.

NOTE: Please note that this is a summary of a proposed FASB proposal, and should not be construed to be a complete or final rule, nor should it be construed to be legal guidance. Please refer to the FASB's Web site for updated and final rule information.