If you are a registered user please log in to see more postings.

The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

Sep 9

Written by: Jack Ciesielski
9/9/2005 7:08 PM 

Since May, the investor and accounting community has been all ears over Cisco's plans to develop tradeable derivative instruments that establish a value for employee stock options - instruments whose values could then be substituted for "modeled" values in complying with Statement 123R, the much-reviled FASB standard requiring compensation expense recognition for employee goodies paid in options. The concerns of investors: those values could be severely understated, and consequently water down stock compensation expense.

Cisco floated their plan with the SEC to see if it would hold water should the values become an integral part of their financial statements. It would be a departure from Statement 123R; to go into expensive, risky waters without SEC arbitration could be a recipe for trouble.

In doing so, Cisco put the SEC into an awkward spot: the idea had no distinct heritage in GAAP - and as the final arbiter of public company financial statements, the SEC had to make a judgment as to whether such values would be legitimate enough ("robust enough", for the more politically correct) to be used in financial statements employed by the public at large. No public hearings, but plenty of publicity - and high stakes for the Commission. If the gambit was approved, and found to be lame after its real-world deployment, it would be too late - the flood gates would already be wide open. The approach would be embraced by at least the tech sector.

Today, the SEC made their decision: keep those gates closed, thank you. For now.

Don Nicolaisen, outgoing SEC Chief Accountant, issued a statement to that effect this afternoon. The crux:

"...Broadly speaking, my staff and I, with help from OEA, have become comfortable that it should be possible to design instruments whose transaction prices would be a reasonable estimate of the fair value of underlying employee stock options using either of the methodologies that seek to track returns to holders of options or the obligations of the issuer of those options. Further, while I recognize alternative views and new facts are possible, at this point, we have significant doubts based on OEA's views, as to whether it would be possible to design an instrument that would achieve the measurement objective of Statement 123R by relying on similar contractual terms and conditions. That is primarily because of the difficulties inherent in replicating the employer-employee relationship in an issuer-investor arrangement.

While various strategies have been considered and I encourage further efforts in the future, we are not aware of any instruments that have actually been sold in the market in an effort to obtain an observable market price for use in valuing employee stock options. Without actual market information, I do not believe at this point that it is possible to definitively conclude that the strategies that have been considered, or others that could be developed, would produce an estimate of fair value that complies with Statement 123R. For example, if an instrument were designed that my staff and I believed could produce an appropriate value in a market-based transaction, but the actual transaction price proved to be significantly different from the price that would be expected based on broadly accepted modeling techniques, questions would arise about whether the instrument itself and the marketing of the instrument were sufficient to achieve a true fair value exchange price. These questions may dissipate over time should market-based transactions become common, but early users would have to address and resolve such questions to their satisfaction and to that of their auditor before the transaction price could be used as the only basis to measure the fair value of the applicable employee stock options. In addition, appropriate disclosures would be required to be included in filings regarding the approach used to estimate the fair value of employee stock options." [Emphasis added.]

And the crux of Chairman Cox's take on the matter:
"As our previous staff guidance has stated, it will be rare when there is only one acceptable choice in estimating the fair value of employee stock options. Indeed, many valuation approaches and measurement techniques are currently under study, or in various stages of development and implementation. The Commission's approach has been, and remains, the encouragement of robust efforts in the private sector to design market instruments that have the potential to accurately measure the cost of employee stock option grants to the issuer. Because so little empirical data is available, the views expressed today are necessarily tentative and subject to ongoing assessment.

"Over time, as issuers and accountants gain more experience in valuing employee stock options for financial reporting purposes, particular approaches may begin to emerge as best practices, and the range of potential methodologies will likely narrow. For now, however, it is not our intention to narrow the field and to limit experimentation, but rather to welcome it.

"Today's incremental advancement of this cause comprises two documents: an overview by the Chief Accountant, and a brief progress report by the Office of Economic Analysis, setting forth their analysis to date of candidate instrument designs that have come to their attention in the last six months.

"As the OEA memorandum makes clear, the use of an appropriate market instrument for estimating the fair value of employee stock options has some distinct advantages over a model-based approach. Most importantly, the instrument's price could establish the issuer's true cost of the option grant, by having it priced by the market.

"We remain committed to the promotion of competition between different approaches. Ideally, that competition will also lead to further innovation in models used to value employee stock options. I thank the professional staff of the Commission for their diligent work on this subject thus far, and pledge the continuing support of the SEC in evaluating the wide range of proposals that we expect will be submitted for our review."

[There was an additional release by Chief Economist Chester Spatt, which was the foundation for the conclusions of Nicolaisen and Cox. More on that in subsequent posts.]

Put the two together and what have you got? A pause, I think. For now, 123R will be implemented as it stands. Will there be option-derivative instruments developed and traded anyway? I think there's a pretty good chance of it. If the interested companies ever want to embed those values in their financials, they're going to have to move forward with the development of those instruments and markets - even with the Catch-22 of having to prove why they're better than modeled values when they differ. Even if the preparers couldn't prove it, however, they could still be presented in "pro forma earnings" computations as being more "real" - and they might be able to get some investors and analysts to buy into it all of the time.

Another consideration: Nicolaisen is retiring next month. Will his successor be as skeptical of the proposal? Stay tuned. Experimentation is sure to continue.