SEC Accountant Offers Guidance On Option Assumptions

Companies that are fine-tuning the assumptions necessary to value stock options may want to pay heed to Securities and Exchange Commission Associate Chief Accountant Alison T. Spivey, who recently warned of two methods for setting volatility assumptions that would not pass SEC muster.

To comply with FASB Statement 123R, which requires companies to expense stock options, companies must make certain assumptions—such as volatility, expected option term, and interest rate-and then input those assumptions into their chosen valuation model. Companies have a variety of choices to make about using historical data, to the extent it may be available, or market-based projections.

Spivey

But in an address to the American Institute of Certified Public Accountants last week, Spivey reminded accountants to stick to the objectives stated in 123R, and to make volatility assumptions as if buyers and sellers were operating in an open market. “The staff expects companies to make good faith efforts to determine an appropriate estimate of expected volatility as one of the key assumptions used in determining a reasonable fair value estimate,” she said.

Spivey said the staff has learned of two emerging methods for establishing historical volatility that would not meet that expectation. “The first method is one that weighs the most recent periods of historical volatility much more heavily than earlier periods,” she said. “The second method relies solely on using the average value of the daily high and low share price to compute volatility.”

Spivey said some companies may be operating under the assumption that the SEC would frown on exclusive reliance on either historical or implied volatility. On the contrary, Spivey said, companies are expected to consider the information that is available to assist in estimating expected volatility, and that consideration would likely be highly subjective. “There is no magic formula for assigning probabilities to that information for an individual company or industry group,” she said, harking back to the provisions of 123R to focus on what buyers and sellers might likely assume.

Feinstein

Spivey also reiterated guidance found in Staff Accounting Bulletin 107, that the staff would not regard the current implied volatility of short-term options as significantly different from longer-term options. Steven P. Feinstein, finance professor at Babson College, said it’s significant that the SEC illuminated that point because it will have a significant impact for many companies on the volatility numbers they can plug into their valuation models. “Of all the different initiatives the SEC could be focusing on right now, they see this as a high priority,” he said. “They recognize that these issues have big impact for the market and it’s at the top of the SEC’s agenda.”

The Ongoing Quest…

Spivey reminded attendees at the AICPA event that companies struggling with expected term assumptions can rely on the guidance SEC issued in SAB 107, which says the staff won’t object if companies use a simplified method for estimated expected term for “plain vanilla” options, or options with no special features. “In addition, the staff would not object if a company applied the simplified method in the financials statements for the pre-IPO years included in the initial registration statement filed with the commission,” she said.

Spivey said she recently learned about an effort to gather and analyze historical exercise behavior that would be publicly available. In the fall, Terry Adamson, vice president of Aon Consulting and operations director for the firm’s national employee stock option valuation practice, said the actuary profession was buzzing with activity to try to aggregate data from major brokerage houses to publish standardized tables that would describe exercise behavior.

The tables would read much like standardized tables that already exist for mortality, retirement, resignation and other factors that help set values for pension plans or insurance, for example, Adamson said. Spivey didn’t elaborate but said she is encouraged by the efforts.

In the ongoing quest for a new financial instrument that would better establish a market value for stock options, Spivey offered advice on two possible approaches. “In order to determine the cost to the company, the purchaser of a market instrument would need to step into the shoes of either the employer or the employee,” she said. “One possible approach would be to design an instrument that would result in a payoff that tracked the payoff of an underlying pool of employee stock options.”

Alternatively, Spivey suggested it might be possible to design an instrument that replicates the restrictive terms included in employee share options, but she discouraged it. “It does not seem possible to replicate an employer-employee relationship or the effects of that relationship in a transaction with a third party,” she warned. Restrictive terms like those placed on employees holding options, she said, might motivate investors to pay as little as possible and employers to sell at the lowest possible price to suppress value.

That gap between employee and investor motivations has so far stymied the market in creating a derivative that would meet regulatory standards for creating a baseline value for options. The SEC rejected a proposal earlier this year by Cisco to create a new instrument that would establish an option value because, at least in part, it didn’t adequately replicate the employee-employer relationship. Cisco promised it would go back to the drawing board and try again.

Related coverage and resources are available above, right.