Companies, particularly those in the high-tech sector, have been up in arms for years over the possibility that they will have to begin expensing stock options granted to employees. And now that the Financial Accounting Standards Board (FASB) has finally issued a set of proposed regulations that would require stock options expensing by 2005, the din from Corporate America is deafening.
But indeed, it may be corporate finance departments that should be howling. The problem is a small preference expressed by the FASB that will make their lives much more difficult, but should at the same time reduce the impact on corporate earnings from the switch to expensing.
In its proposal issued March 31, the FASB encouraged companies to shift to a different, and much more complicated, method of valuing employee stock options. The reason: Lattice-type valuation models, like the binomial method, are more accurate because they take into account more variables than the Black-Scholes formula that most companies use now. Although the regulations don't demand that companies make this change, analysts predict that the preference the FASB expressed is likely to be enough to make most go binomial. Certainly, they say, external auditors may demand it.
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That will mean a much tougher job for finance departments, experts say. "The Black-Scholes model is something you can program into a handheld calculator. It's just a formula," says Ron Rudkin, a vice president at consulting firm Analysis Group/Economics. "A lattice model is something that iterates and requires a computer program." Rudkin says it takes a lot of effort to modify a standard binomial model to account for the distinctive features of employee stock options, such as early exercise and forfeiture. With this model, companies must come up with the statistics on such items as employee turnover and employee exercise of options, as well as assumptions about things like future volatility and Treasury yields. And because the binomial requires more inputs, "that also means that it's going to be harder to justify to an auditor," says Edward Ketz, an accounting professor at Pennsylvania State University's Smeal College of Business.
To handle the conversion, big companies may choose to rely on consultants or accounting firms. For example, Analysis Group/Economics can provide companies with its custom binomial model, or it will do the valuation work itself. Companies could also turn to the firms to which they outsource stock options administration. Transcentive Inc. of Shelton, Conn., which provides such services, says its Web-accessed software already provides companies with the option of using either the Black-Scholes or binomial methods. Rudkin says companies looking for assistance should be sure that a company's binomial model takes into account all the potential special features of employee stock options and can allow the inputs to vary over time, as the FASB is requiring.
Rudkin adds that if FASB's rules go through, many experts expect companies to switch from "vanilla-type options" to more complicated options. For example, a company might tie either the exercise price or vesting period of an option grant to internal measures of performance like market share or growth in earnings per share. Or it might index the option to the performance of the S&P 500 or another stock index that captures the performance of the company's peers. Options with such features "have enough complexity that you can't really deal with them with a Black-Scholes model–you need something with the flexibility and power of a lattice model," Rudkin says.
There is a silver lining in this cloud, though. Experts say that the binomial model's valuations are not only more accurate, because they take into account all the special features of employee stock options, but they also usually produce lower valuations than the Black-Scholes theorem. That translates into a smaller impact on corporate earnings. Philip Peterson, a senior vice president with Aon Consulting in Chicago, says Aon has found that the binomial model can cut the cost of employee stock options by between 5% and 20%. "A very nice benefit of increased accuracy is lower cost," says Rod Parsley, a consultant with Analysis Group/Economics. "It's more often than not going to be worth it to figure out how to adopt the binomial approach."
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