Christopher Cox, the new chairman of the Securities and
Exchange Commission (SEC), fought against expensing employee stock options as a member of Congress. When Cox told a Senate committee considering his nomination as SEC chair that he supported options expensing, he squelched any remaining hopes that the new requirement might be overturned. Now companies are settling down to prepare for options expensing, which is turning out to involve a considerable amount of work, some of it coming in unexpected areas.
"The challenge for [companies] is to pull off integration of a new standard in an environment where they're still struggling with Sarbanes-Oxley," says William Dunn, a partner in the global human resources solutions practice at PricewaterhouseCoopers LLP. Dunn notes that expensing employee stock options requires the concerted efforts of a great many different departments, including human resources, treasury, finance, tax, accounting and share plan administration. "It's hard to get all of the parties focused on a strategic path," he says.
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Of course, companies have been putting a value on stock options all along, but that number used to end up in a footnote in their financial statements. Now that the options value is due to land on the balance sheets as an expense, companies are taking a much more rigorous approach to valuing options. And while the early chatter around expensing centered on which valuation model companies would choose, the focus has shifted to the data that companies feed into those models. "The inputs matter more than the model," says Bernard Pump, a partner with Deloitte Financial Advisory Services LLP who specializes in valuations. "That has been a real benefit of [Financial Accounting Standard] 123(r), the higher level of diligence and more serious review that most companies are doing of their inputs."
One piece of data that's likely to look different this time around is the input for volatility. FASB's guidance on implementing the new expensing requirement puts a premium on forward-looking data and says companies with traded securities should use the implied volatility on those securities. However, companies using implied volatility, which has been trading near 10-year lows, should be prepared for big changes from the historical volatility previously used.
A low volatility would temper the value placed on a company's stock options, but that effect could be reversed if volatility rises next year. "You don't want to be too aggressive with your valuation, because then you have nowhere to go but up," says PwC's Dunn. "Most companies have been using a combination of the two, forward-looking and historic [volatility], just as a way to neutralize that effect."
But some valuation experts argue that if a company has traded options, their implied volatility is the number to use. "In theory, today's implied volatility is the market's best forecast of future volatility," says Daniel Abrams, a managing partner at FAS123 Solutions LLC in Teaneck, N.J. Abrams says, though, that companies might want to adjust for "market imperfections" in the volatility data by looking at more than a single day's volatility. "Depending on how actively traded the options are, we're taking a trailing month's worth of data," he says.
David Roberts, president and CEO of Equity Methods, a valuation consulting company in Scottsdale, Ariz., says the expected term of a company's options will be the most highly scrutinized input. "Just looking at a typical historical holding period doesn't take into account the unexercised options," Roberts says. "If you have a lot of unexercised options, you could have a bias in the calculation that extends or potentially shortens your term."
In the end, the tax aspects of expensing may be the biggest headache for companies. Daniel Coleman, a manager in Deloitte's valuation practice, estimates that half of the work companies are doing on FAS 123(r) relates to the tax aspects, while the valuation accounts for just a third or so, with financial reporting making up the remaining work.
The tax work arises from the disparity between when the company awards a stock option and when it can recognize a tax deduction for that stock option. Companies will have to record a deferred tax asset when they grant an option, and then, when the option is exercised, forfeited or expires unused, they will have to reconcile the actual deduction with that deferred tax asset. Accountants say this presents particular problems for stock options already granted but not yet exercised, since companies may not have been tracking all the necessary data. And they note that software used by stock plan administrators isn't able to cope with all the situations companies are likely to face.
"None of the software products that are in the market now completely capture what's required around the tax benefits in FAS 123," Coleman says. "I don't think there's any off-the-shelf solution that will automatically spit out a complete answer."
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