The Securities and Exchange Commission guidance on the soon-to-take-effect accounting rule requiring companies to expense stock options leaves the door wide open for companies to decide how to establish their costs, but also emphasizes the importance of good disclosure in describing their valuation methods.
Turner
“The key point the SEC staff guidance reiterates over and over is that the standard provides flexibility to companies in determining the fair value of their option grants,” said Lynn Turner, managing director of research for Glass Lewis & Co. and former chief accountant at the SEC. “However, that flexibility should not be abused. Whatever method or valuation approach is chosen, it must be representative of the fair value of the equity given to employees, and there must be transparent disclosure with respect to the accounting and financial reporting.”
The SEC issued Staff Accounting Bulletin No. 107 last week in an attempt to answer questions and continuing debate over the controversial Statement 123R, the accounting rule adopted by the Financial Accounting Standards Board requiring companies to show the cost of employee stock option grants and other share-based payments as an expense on their income statements. FASB finalized the rule in December 2004, and it is scheduled to take effect in the third quarter of 2005.
Opponents of the rule, including a number of technology companies, have taken their case to Congress, where a measure to overturn the rule is languishing in committee. Among the criticisms of the new accounting rule, opponents say there’s too much volatility in the various metrics to establish an accurate cost for stock option awards.
Scott
The SEC and FASB have stated their intention to migrate toward a more principles-based approach to accounting, giving companies room to exercise judgment based on their specific circumstances. Despite outside pressure to dilute or overturn FASB, or at least more clearly define valuation methodology, the SEC guidance in SAB 107 makes no attempt to delay or soften the rule, experts say.
“The SEC has established that it will enforce the rule as written,” said Linda Scott, director of corporate governance from TIAA-CREF. “In other words, it will not use a narrowly defined standard. It will take a principles-based approach and allow companies to choose from among a number of valuation models.”
Nicolaisen
The SEC Office of Economic Analysis weighed in with a seven-page memo dated March 18, 2005, to Chief Accountant Donald Nicolaisen saying that the valuation methods permitted under FASB’s new rule are “conventional and well-known.” The memo continued, “The issues that practitioners will likely face in estimating option values under FAS 123(R) are not unusual and indeed arise in other areas of accounting and finance.”
Reasonable Fair Value
Comforting to corporate finance executives, SEC’s recently issued guidance assures companies that they’ll not be punished if their estimates and assumptions prove in hindsight to be off base.
Lubushkin
“I find it interesting that among the first questions asked and answered is the staff’s views on values reasonably established that are different from values ultimately realized,” said Greg Lubushkin, chief accounting officer at ECC Capital Corporation. “They basically say give it your best shot, consider the guidance and make a good faith estimate. If there are changes in the initial value subsequent to its measurement, no matter how significant, that’s OK.”
Scott arrived at the same conclusion. “The SEC has indicated that it will not object to reasonable fair value, good faith estimates made in accordance with FASB’s rule, even if subsequent events indicate other estimates would have been more accurate,” she said.
Wirtshafter
John Wirtshafter, an attorney McDonald Hopkins who focuses on executive compensation, said the guidance gives companies some flexibility to settle into a valuation methodology over time.
“It reflects some of the realities companies go through as they adopt new rules,” he said. “It tells companies that if changes need to be made, they can make them, but they have to be prepared to explain them.”
Wirtshafter and Turner both noted the staff accounting bulletin gives companies some good guidance about what they need to disclose in Management’s Discussion and Analysis. Turner also noted the SEC addresses accelerated vesting—a tactic some companies are increasingly choosing as the effective date of the rule approaches to get existing options off the books before they become an expense. SEC’s guidance reminds companies to fully disclose their action and their reasoning.
Glass Lewis issued a research report on the SEC guidance saying the flexibility given to companies in choosing valuation methods and assumptions ultimately will be confusing to investors. “The implementation of FAS 123R will likely be a difficult process, but one that will eventually report the very real cost of issuing stock options,” the report said.
A complete version of the SEC's guidance is available from the box above, right, as are other related documents and resources.
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