Stock Option Valuation: New Source of Litigation Risk for
Cindy W. Ma, Algis T. Remeza, and Daniel LaGattuta
On March 31, 2004, FASB released
the Exposure Draft on Share-Based Payment, an Amendment
of SFAS 123 and 95, requiring companies to expense the
value of employee stock options that they issue. The exposure
draft recommends using a “lattice model” to determine
the value of options for most public companies, and establishes
guidelines for their construction.
response to these guidelines, a slew of “valuation
specialist” providers have quickly sprung up, touting
models that generate the lowest possible stock option valuations.
The opportunity to minimize expenses by “model shopping”
may prove tempting to certain options-issuing companies,
but that path is fraught with dangerous financial pitfalls
that place a great burden on the company auditor.
example, with the prospect of being a codefendant in numerous
class action suits, an auditor’s need for financial
statement accuracy may not align with a company seeking
the lowest possible options valuation estimate. Auditors
may also find themselves held responsible for determining
whether the model chosen by their clients is compliant with
the exposure draft, and whether the option valuation estimates
are accurate. Should the valuation estimates prove inaccurate,
an auditor could be liable for any resulting lawsuit over
earnings misstatements. To avoid these pitfalls, auditors
should know how to recognize design flaws when reviewing
a lattice model for compliance with the exposure draft.
is advocating lattice models because they are part of “well-established
financial economic theory” and are capable of accurately
capturing employee exercise behavior. Lattice models are
intended to address the long-standing criticism that the
Black-Scholes-Merton model fails to incorporate the full
effects of employee early exercise and postvesting termination
exposure draft does not specify how to incorporate employee
exercise behavior, leaving that task to valuation professionals.
Instead, the draft requires that a lattice model and its
input parameters be based on “available information.”
Valuation professionals must therefore prove their assumptions
using hard data, such as past histories of stock option
exercise, employee demographic information, and empirical
intent is to provide sufficient modeling flexibility and
to accommodate all types of situations. The exposure draft
allows for a variety of models, as long as each is consistent
with FASB’s implementation rules, accounting fair-value
concepts, and sound financial economic theory. This flexibility,
however, may place an auditor in the position of not only
needing to verify the checklist of items in the draft, but
of also making sure that valuation professionals are not
violating accounting guidance in more subtle ways.
critical issue that auditors should be aware of is the matter
of perspective. Each item of a company’s financial
statement must be measured from the company’s standpoint.
Therefore, the fair value of a stock option is the fair
value to the employer, which is generally not the fair value
to the employee because of the associated restriction. Valuation
estimates based on the employee’s perspective will
result in lower—and less accurate—numbers than
those based on the employer’s perspective.
this confusion of perspective is a big problem lurking in
some of the valuation models currently being peddled. A
number of models that purport to measure the company value
explicitly adopt the employee’s perspective by applying
a discount to reflect various contractual restrictions such
as “non-transferability” and “non-exercisability.”
Nevertheless, an employee’s valuation influences the
cost to the company, but only through the timing of exercise
or forfeiture. Any further discounts would in effect be
these pitfalls may be dangerous, FASB provides a safe path
to compliance with an easily verified checklist of requirements.
If these requirements are overlooked by valuation professionals,
the responsibility to catch errors is left in the hands
of the auditors. For example, instead of using one constant
interest rate, as in the Black-Scholes-Merton model, the
exposure draft recommends the use of a term structure of
interest rates based on zero-coupon U.S. Treasury bonds
with different maturities. Yet, not all models take this
into account. Similarly, the exposure draft requires that
blackout periods (times when stock options cannot be exercised)
be taken into account, yet some existing models do not consider
these at all. Omissions may be easier to detect, but errors
that are embedded in programming will be much more difficult
to discern, especially when valuations are not well documented.
exposure draft’s requirement of supportable evidence
in the form of data for the valuation models makes economic
sense, but this will be an added responsibility for the
auditors. Creating lattice models requires estimating parameters
and making assumptions about the exercise patterns of employees.
This process can be easily subject to manipulations and
lead to inaccurate valuations.
some valuation consultants have created a one-size-fits-all
model designed for all companies, but, again, this is unlikely
to be supported by data for every company. In general, lattice
models will need to be customized for each company because
of unique characteristics and employee-specific information.
major pitfall concerns bad estimation techniques. A major
challenge for valuation professionals is how to develop
an economically sound, statistically stable, and operationally
feasible approach to derive the valuation input parameters,
using a pool of cross-sectional and time-series company-
and employee-specific data. An even greater challenge for
auditors is verifying the reliability of this estimation
objective of financial accounting is to present the financial
position of the company fairly to shareholders and potential
investors. FASB’s new expensing guidelines attempt
to do just that, but valuation techniques devised to minimize
stock option expenses work against the transparent accounting
goals that inspired the changes in the first place. The
aforementioned temptation to “model shop” for
lower expenses also places a tremendous burden on company
auditors, who face a number of new risks—including
litigation—should the new valuation estimates prove
inaccurate. Auditors who follow the new guidelines and understand
the pitfalls explained above will minimize their legal risks;
otherwise, let the auditors beware.
W. Ma, PhD, CFA, CPA, is a vice president and Algis
T. Remeza and Daniel LaGattuta, PhD,
are senior consultants of NERA (www.nera.com),
an economic consulting arm of Marsh & McLennan Companies.
Ma and Remeza participated in discussions with FASB on employee
stock option valuation issues, and Ma is a member of FASB’s
Option Valuation Group.