PCAOB Answers More Expensing Questions

As auditors prepare for the 2006 year-end audit season—the first in which stock options will be fully expensed and listed on the balance sheet for all to see—the Public Company Accounting Oversight Board published new “frequently asked questions” guidance to help them through the process.

Tom Ray, chief auditor of the PCAOB, published the 28-page document to help auditors apply existing auditing standards to stock option valuations. So far that exercise has been a walk on eggshells for public companies and auditors alike, since until now stock option expenses were only shown as a footnote disclosure, and how investors will react to more public disclosure is yet unknown.

Expensing became the law of the land in late 2004 when the Financial Accounting Standards Board adopted Financial Accounting Standard 123(R), Share-Based Payment, in late 2004. It became effective for most companies beginning in 2006 following an order from the Securities and Exchange Commission to delay the effective date for six months—In March 2005, the SEC issued guidance directed at management in Staff Accounting Bulletin No. 10.

The PCAOB already issued an audit alert in July that focused on an auditor’s role in assessing the proper accounting of backdated stock option grants, following the revelation of the widespread use of the possibly illegal practice. The current question-and-answer guidance, however, looks more broadly at auditing valuation issues, not just the effective dates and how those were recorded.

What The Current Guidance Says

In the current guidance, the PCAOB staff says auditors should rely on AU Sec. 342, Auditing Accounting Estimates, and AU Sec. 328, Auditing Fair Value Measurements, because they apply most directly to topics such as stock options, where no liquid market naturally exists to serve as a basis for making valuation judgment. The staff also advises auditors to pay attention to AU Sec. 316, Consideration of Fraud in a Financial Statement Audit, because option valuation carries a risk of intentional misstatement of estimates to achieve fraudulent outcomes.

PCAOB advises auditors to start by gaining an understanding of the process a client used to develop its fair-value estimate and to assess the risk of misstatement related to the stated value. The guidance also advises auditors to make an honest assessment of whether they have the necessary skills and knowledge to plan and perform the audit.

Ma

The Q&A says auditors should test the company’s estimated value by evaluating the consistency and reasonableness of the company’s valuation model, as well as the reasonableness of its assumptions surrounding volatility and term. Those are the two major valuation assumptions that can move the ultimate expense up or down, depending on how liberally or conservatively the company has estimated them, says Cindy Ma, vice president at NERA Economic Consulting.

Ma says the Q&A offers the market a little more guidance than it already had in FAS 123R and SAB 107, but not a great deal more. “They provide a good overall approach as to what auditor should do, but auditors have already been doing that,” she says. “It is still a very subjective approach to deal with the expected term and volatility issues.”

Bishop

Keith Bishop, a partner at the law firm Buchalter Nemer, says it’s still akin to auditing into a crystal ball. “The new accounting for auditing stock options involves a high degree of judgment of things that haven’t happened yet,” he contends. “That means auditors are going to have a tough time, essentially auditing how people’s procedures look into the future. It’s not a precise, quantitative calculation.”

Q&A

An excerpt from the PCAOB’s recently issued Q&A on the duties associated with auditing the fair value of employee share options follows.

In general, when auditing the fair value of employee share options, the auditor

should:

Obtain an understanding of the process used to develop the

estimated fair value of employee share options;

Assess the risk of misstatement related to the fair value of

employee share options; and

Perform testing on the company's estimated value of employee

share options.

Testing includes:

– Evaluating the consistency of the process,

– Evaluating the reasonableness of (1) the company's model

and (2) the assumptions used in the model, such as

expected term and expected volatility, and

– Verifying the accuracy and completeness of the data

underlying the fair value measurements.

The auditor also should evaluate whether he or she possesses the necessary

skills and knowledge to plan and perform the audit procedures.

Source

PCAOB Staff’s Q&A: Auditing The Fair Value Of Share Options Granted To Employees (Oct. 17, 2006)

Still, that calculation has become a tighter process, because companies are putting more effort into making sound assumptions and estimates now that the numbers have a bigger role in the financial statements, says Thomas Welk, a partner with the law firm Cooley Godward.

Welk

Before FAS 123R, “companies didn’t need to pay too close attention to their assumptions as long as their assumptions were conservative, because it was just a footnote disclosure,” Welk says. “Now that it’s not just a footnote disclosure, companies probably want to pay closer attention to their assumptions because they want more accuracy in their numbers.”

Bishop says the audit process for stock options is simply going to require much more audit work. “Auditors are going to be spending a lot more time on equity than they ever did,” he says. “It really lays bare the fact that auditors are going to have a tough time looking at the estimates.”

Is Guidance Too Grainy?

Frederick Lipman, director for the Association for Audit Committee Members and a partner at the law firm of Blank Rome, says the guidance is too granular and is likely to set off a “mini 404” experience, referring to the criticisms of Sarbanes-Oxley Section 404 implementation and the huge increase in audit activity that has resulted.

Lipman

“The number of steps that are being mandated and the amount of effort that goes into the auditing of equity-based plans will definitely drive up the cost of equity-based plans for all companies, and may even cause them to reconsidering using equity-based plans,” he says.

Lipman says the guidance reflects “no attempt to use a top-down, risk-based approach. The staff seems to have no conception of cost versus benefits. I’ve got to believe this is overkill.”