Employee Stock Option Valuation: New Source of Litigation Risk for Auditors

By Cindy W. Ma, Algis T. Remeza, and Daniel LaGattuta

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In 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.

For 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.

FASB 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 behavior.

The 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 analysis. The 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.

Another 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.

Unfortunately, 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 double counting.

While 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.

The 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.

Similarly, 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.

Another 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 approach.

The 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.