Companies are slowly—very slowly—considering “binomial” models for valuing stock options, instead of using the more simple Black-Scholes model. That's according to a recent study by Aon Consulting, which found that—as of August 31, 2005—122 public companies had disclosed they were using a binomial model, up from 36 companies that used a binomial model at the end of 2002.
Among the companies making such announcements was ADP, CDW Corp., Procter & Gamble, and Staples.
When proposing new rules requiring companies to show stock options as an expense, the Financial Accounting Standards Board originally stated a preference for a lattice model, of which the binomial model is one example, but left companies the option to choose. Black-Scholes has long been the preferred model because it’s described as easier to use, although experts say it generally produces a higher value for stock options than a lattice model might produce, which creates a greater hit to earnings.
Phil Peterson, senior vice president at Aon Consulting, acknowledges that 122 companies among several thousand doesn’t necessarily indicate a statistically significant increase in the number of companies adopting a binomial approach. “It’s difficult to say based on the information we have here so far what kind of predictive value the information has,” he said. “We do know that a lot of companies are shifting away from Black-Scholes to some kind of lattice model.”
Olsen
Scott Olsen, national leader of the total compensation practice for PricewaterhouseCoopers, agrees that the numbers probably aren't significant at this stage. “Our experience thus far has been that a relatively small percentage of companies are adopting a lattice model,” he said. He estimates 10 percent to 20 percent of companies are choosing that approach.
Olsen said a number of companies have studied extensively how their options would be valued using various lattice models compared with Black-Scholes and determined they would stick with Black-Scholes. “They determined the cost-benefit relationship was not worth the added effort,” he said. “They were not getting a better result, and by ‘better’ I don’t mean lower; I mean more accurate.”
Ma
Cindy Ma, vice president of securities, energy and risk management practices for NERA Economic Consulting, said binomial or other lattice models may continue to gain favor as companies apply more detailed, more accurate data about their employees’ historical exercise behavior.
“The difference between a good model and a bad model is a model of exercise behavior,” she said. “It’s an integral part of the valuation process.”
Brian Prucyk, finance professor at Marquette University, said the numbers in Aon’s analysis seem consistent with what he would expect. “The lattice model is more accurate and more flexible, so I would expect that as firms begin to comply with the standard they will come to see its advantages,” he said. “The only holdback before would have been lack of familiarity.”
The Aon study, as well some recent coverage on valuation issues, can be found in the box above, right.
AICPA Issues Guidance On Auditor Independence, More
The American Institute of Certified Public Accountants has issued two documents that provide new insight into auditor independence rules and auditing variable interest entities.
The AICPA’s Professional Issues Task Force issued a practice alert, “Auditing Procedures With Respect to Variable Interest Entities,” which offers guidance in planning and performing auditing procedures when the audit involves variable interest entities.
“We found there was a lot of guidance on how to account for variable interest entities, but not a lot of guidance on how to audit them,” said Michael Glynn, AICPA technical manager.The Practice Alert, broader that the group’s usual alert, Glynn said, offers a seven-step approach to the audit.
Regarding auditor independence, the AICPA’s Professional Ethics Executive Committee has issued proposed revisions to the group’s code of conduct to further define “other considerations” that might cause an auditor’s independence to become or even seem compromised.
Currently, the code of conduct carries a section called “other considerations” that the committee proposes to expand. The changes would address how members can examine considerations that may impair independence, or even create the appearance of impaired independence.
The proposed revisions are available from the box at right; comments are due Dec. 16.
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