Executives from three large California technology companies—Cisco, Qualcomm and Genentech—recently put forth a proposal to expense stock options using a new method that they claim is more accurate than those proposed in FASB's expensing draft.
Though the executives—including Qualcomm Treasurer Richard Grannis, Cisco CFO Dennis Powell, and Genentech CFO Louis Lavigne, Jr.—noted that they are opposed to expensing options and "believe investors would be better served by significantly enhanced disclosures," the trio
acknowledged that FASB remained committed to expensing and hence developed its own approach to valuation that "addresses the unique attributes" of employee stock options.
According to the presentation delivered to FASB (available from box at right), the method—titled the Fair Value Index Adjusted Method—allegedly addresses the weaknesses of Black-Scholes and binomial "lattice" models.
Critics have argued that Black-Scholes typically overstates the fair value of employee stock options, and the authors argue that lattice models are more flexible but "are very costly to design, complex, and out of reach of smaller companies." The presentation also notes that lattice models don't fully account for all ESO attributes, and that they "produce a wide range of subjective outcomes based on subjective inputs that can be manipulated."
In addition, the companies' proposal noted that ESOs differ "significantly" from freely tradable options, and that any valuation model must take into account a variety of unique issues, including non-transferability, non-hedgability, blackout-period restrictions, risk of forfeiture, and more.
SNAPSHOT
The image below is a "snapshot" from the PowerPoint presentation delivered to FASB, as posted at the Web site of Financial Executives International. The complete document can be downloaded via FEI by clicking the image below:
As a result, the authors of the alternative proposal argued that neither Black-Scholes nor lattice models were appropriate.
Their own Fair Value Index-Adjusted Method, however, was pitched as a "practical solution" to those weaknesses, some of which are charted at left.
The proposed method is based on grant date fair value as required by FASB's exposure draft, and apparently uses a Black-Scholes framework "as a starting point." However, the method adjusts the results using a "company-specific volatility index" using S&P 500 Index volatility as a benchmark.
According to the executives' plan, there are numerous benefits to this, including "individualized volatility for every listed company" that is easy to compute. The plan would also avoid "subjectivity and inaccuracy of using long-term historical volatility," which would help certain tech companies avoid big stock swings—like during the stock market bubble—which could in turn keep volatility estimates and option costs low.
High-tech companies, whose stocks can be volatile, have long led the battle against mandatory options expensing, believing they would be the most heavily affected by it. According to a recent Bear Stearns study, counting options as a compensation expense would have trimmed net income for technology companies by 60 percent last year.
According to a Reuters report, the proposal is gaining moderate approval in high places. “I recommend that FASB consider it as an acceptable alternative … and that FASB should consider re-exposing the exposure draft and defer the implementation for a year,” said Fred Cook, member of FASB’s options valuation group.
Cisco, Qualcomm and Genentech hope to at least delay FASB’s current legislation from going into effect as early as January 2005, if not change it altogether.
SEC Chief Accountant Donald Nicolaisen has hinted that he supports a delay in finalizing the standard, saying he is sensitive to companies’ concerns about the effective date, “given the potential need for further implementation guidance.”
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