Employee Stock Option Valuation: New Source of Litigation Risk for Auditors
Ma, Cindy W., Remeza, Algis T., LaGattuta, Daniel, The CPA Journal
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.
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 fairvalue 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 fail-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. …