The continuing brouhaha over a new accounting rule that would require expensing of employee stock options could amount to a tempest in a teacup, if an alternative valuation model is embraced by regulators and proves to be as accurate as advertised.

To be sure, corporate lobbyists continue to complain about the rule to legislators, the Securities and Exchange Commission (SEC), and the accounting standards-setter, the Financial Accounting Standards Board (FASB). The anti-expensing argument, if anyone needs reminding, is twofold. First, say the critics — the most vociferous of which hail from the high-tech industry — a rule requiring expensing is inappropriate because the traditional valuation method, known as Black-Scholes, produces wildly inaccurate results. And even if it didn't, goes the gripe, imposing such a requirement would be a mistake because it would limit entrepreneurial companies' ability to attract, motivate, and retain key employees. That limitation, add the critics, would curtail their ability of those companies to innovate, depriving the nation of a key economic edge.

Some experts contend, however, that the alternative method for valuing these employee incentives is not only far more accurate than Black-Scholes, but also could significantly reduce the added expense that companies would have to report. And that obviously could go a long way to undermine the argument against expensing options.

FASB has yet to issue its rule, but its exposure draft (anticipated in a matter of days) is expected to embrace the alternative "binomial" valuation method, to one degree or another. The binomial method is more robust than Black-Scholes, though both techniques need to be adjusted to take into account an essential fact: Employees rarely hold the options they're granted for the entire length of their typical 10-year term.

More Flexible but Less Familiar
Unlike Black-Scholes, the binomial method divides the time from the option's grant date to the expiration date into small increments. Since the share price may increase or decrease during any interval, the binomial model takes into account how changes in price over the term of the option would affect the employee's exercise practice during each interval. The binomial model can also consider an option grant's lack of transferability, its forfeiture restrictions, and its vesting restrictions — even for options with more-complicated terms such as indexed and performance-based vesting restrictions.

Consultants who favor the binomial method contend that this flexibility is critical. "You need to look at the value that employees attach to a specific set of compensation requirements," explains Ron Rudkin, a vice president of the Boston-based Analysis Group. "You can't do that with Black-Scholes," says Rudkin. "It just doesn't have the flexibility."

As a result, the new method produces a much lower estimate of the value of the same grant, according to a study by Analysis Group. Anywhere from 28 percent to 56 percent lower, in fact, compared with the cost estimated under a Black-Scholes model modified to reflect the length of time the options are likely to be held.

To be sure, adjusting the binomial model for this purpose isn't easy. For one thing, the new model is far less familiar than Black-Scholes, so users must spend considerable time figuring out how to use it. "Black-Scholes is so widely used that there are lots of software packages, for laptops and handheld computers, to run the model," says Rebecca McEnally. A vice president of the Association for Investment Management and Research (AIMR) — an analyst group that advocates expensing options — she is also an advisor to the International Accounting Standards Board (IASB), FASB's counterpart outside the U.S. The binomial method "is not quite as easily adopted," says McEnally.

Here's a complication: Projecting the exercise practices of employees involves assumptions based on historical figures. But if companies change the design of their plans — as many are considering, in light of pressure to adopt benchmarks tied more closely to performance — then it may take some doing to convince the SEC and auditors that the use of historical data is appropriate. What's more, companies that have divested a large segment of their business might find that employees exercise their options much earlier than expected.

As a result, says Susan Eichen of Mercer Consulting, "it's difficult for auditors to verify the expected life assumption for all the factors." Rudkin of Analysis Group agrees. "I think there will be a rather steep learning curve," he says.

If FASB embraces the binomial model, however, companies may have little choice but to climb aboard. The model is already in use at a handful of companies, including American International Group and Washington Mutual Inc.; by publication time, neither could be reached for comment. And at this point, how many others would become early adopters is anyone's guess.

Yet precedent suggests more than a few would do so. Following earlier far-reaching and controversial changes in accounting rules — including the elimination of goodwill amortization and the new treatment of intangible assets in mergers and acquisitions under FAS 141 and FAS 142 — many companies changed their accounting to conform before they were required to do so.

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