Outside Audit: Cost

Outside Audit: Cost
Of a Stock Option?

FASB to Urge an Approach
That Gives Better Estimate
Of Expenses to Companies

By LINGLING WEI
DOW JONES NEWSWIRES

American International Group Inc. uses it. So do Washington Mutual Inc., Cincinnati Financial Corp. and a handful of other companies. Others may, too, once the stock-option expensing rule kicks in.

"It" is binomial valuation, an approach to be favored by U.S. accounting rule makers in their soon-to-be-proposed guidelines mandating that companies record the value of employee stock options through earnings, beginning in 2005. The value of the binomial approach is that it accounts for the likelihood that changes in a stock's price influence the timing of when employees exercise options. An array of possibilities is factored into binomial valuation, providing what boosters say is a truer cost of options to companies.

Today most companies use the simpler Black-Scholes formula, named after the Nobel Prize winners who developed it, to measure the fair or market value of employee options. Companies have the choice to simply disclose that value in financial footnotes or to deduct it directly from net income. Most do the former.

The battle has raged for a decade around forcing corporate America to recognize option grants as a real income-statement expense, primarily pitting option-heavy companies against shareholder advocates. The U.S. rule-making Financial Accounting Standards Board is on its way to issuing a draft expensing standard this month, specifying how exactly to account for the expenses. The issue that's attracted the most attention is how to determine an employee option's value -- the amount that would go to the bottom line.

FASB has decided not to impose any particular technique. Companies, it says, bear the responsibility to look for the best tool. Still, given the advantages inherent in what FASB calls a "more robust" approach, the board will encourage companies, especially those with large option grants, to switch to binomial from Black-Scholes. And once they make the switch, they won't be allowed to switch back.

"If stock options represent a significant portion of your compensation plan, you should use binomial," says FASB Chairman Robert Herz. "Binomial, if properly done, could produce a more refined estimate" of an employee option's value, though Mr. Herz adds that Black-Scholes still provides a "reasonable" estimate and that switching valuation methods could be onerous for some companies.

Given the valuation flexibility to be permitted by FASB, corporate executives, mindful of the potential blow to earnings, may want to see which tool could produce a lower value for the options. At least for now, many valuation experts say it's impossible to generalize the dollar difference between the numbers derived from the two techniques.

Employee options give workers the right to buy their companies' shares at a fixed price within a specified period. They generally don't vest for a number of years, can't be traded, and pay off only if the stock price rises.

Black-Scholes is designed to price short-term, publicly traded options but has nevertheless won near-universal acceptance by American employers for a decade. The popularity is mainly due to "its relative simplicity, not accuracy," says Stephen Ross, a co-discoverer of the binomial approach and currently a professor of financial economics at the Massachusetts Institute of Technology.

Critics of options expensing say no methodology reliably values an employee option.

But a key advantage binomial has over Black-Scholes is that it takes into account the possibility that changes in the stock price may influence the timing of when employees exercise options, an eventuality that FASB has said companies should make in assumptions about calculating options' fair value.

Employees typically have a price point in mind at which they want to exercise options, says compensation expert Carl Weinberg of PricewaterhouseCoopers's human-resource practice, and the only way to capture the correlation between changing stock price and employees' expectations is "the tree-like binomial approach."

The binomial approach makes use of a "binomial tree" or "lattice" model and contains an array of probabilities relating to stock-price movement and whether exercise is profitable at each stage.

Indeed, it is because of this adjustability that American International Group decided to change its option-pricing tool to binomial from Black-Scholes, and it also began expensing options. In its 2002 annual report the New York insurer switched to binomial and recalculated the fair value of stock options for some prior years. Thus, for example, AIG said in that report, it recorded $195 million of stock options in 2001 and $58 million in 2000 rather than the Black-Scholes-derived values of about $213 million and $85 million in 2000.

Write to Lingling Wei at

Updated March 4, 2004