The Last Battle over Options?

FASB issues draft for expensing options, unleashing the valuation-methodology debate. Next up: Black-Scholes vs. binomial.
Craig Schneider and Tim ReasonMarch 31, 2004

At 8:46 this morning, the Financial Accounting Standards Board fired the first shot in what is most likely the last battle of the war over expensing stock options. The standards board issued its long-expected and hotly debated proposal that stock options be expensed on the income statement, based on value calculated at the grant date.

Actually, Intel’s CEO Craig Barrett — the flag bearer of anti-expensing forces — may deserve credit for the first shot. Barrett took half of the opinion page of The Wall Street Journal this morning to rail against FASB’s plans and warn that it would create a “truly mouth-watering scenario” for class-action lawyers.

In the press release accompanying FASB’s proposal, its chairman, Robert Herz, says: “We expect the proposal will draw interest from a broad spectrum of respondents.” That’s sure to be an understatement. Few accounting changes have such a contentious history–in 1995, a proposal to expense stock options drove some in Congress to threaten to put an end to FASB, and Congress has again being threatening to throw its weighing around on the issue. (See “Who Rules Accounting?.”)

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All other forms of equity-based compensation, including performance-based options, have required expensing up to this point. But for the last decade, broad-based options became the compensation strategy of choice. They were especially popular for cash-strapped technology startups, which used the promise of a high-flying market to attract and retain employees. In the process, they were able to record stock options as a simple expense in the ledger footnotes with no impact to earnings.

That immunity is set to change, assuming that FASB doesn’t reverse its position following the public comment period that ends in June and that the Securities and Exchange Commission approves the final standard. Ahead of the exposure draft, over 400 companies have decided to expense their stock options. In 1994, the FASB board backed off a similar proposal. On the other hand, the proposal’s time might have come — making Herz’s comment that “we welcome all input” merely obligatory.

In the past year, FASB has publicly hashed out many of the details that are likely to draw fire from opponents. For example, when anti-expensing critics shifted their argument to the inaccuracy of the traditional valuation model, Black-Scholes, FASB proposed that the binomial model could be used instead.

Through a series of deliberations, the board has decided to prominently feature the binomial model as an alternative to Black-Scholes. The binomial model, which has been around for nearly as long, was selected early in FASB’s standard-setting process as the best choice for the new standard, largely because of its flexibility.

Unlike Black-Scholes, which is generally understood to overstate the value of employee stock options, the binomial 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. Black-Scholes, which is a formula rather than a framework like the binomial, can only take into account the 10-year term of the option and doesn’t have the flexibility to adjust for such other factors as forfeiture restrictions.

In any event, FASB’s position on the use of the binomial as an alternative to the popular Black-Scholes is unlikely to put an end to the controversy over the issue of valuation methodology, and much else still needs to be worked out. Yet to be determined, for instance, is how the standard will be adjusted for small and medium-sized businesses. FASB plans to discuss issues related to the proposed Statement at the inaugural meeting of the Small Business Advisory Committee on May 11 in Norwalk, Conn. Stay tuned.