Making a Market for Stock Options

A proposal by Cisco Systems, which create a new derivative that would help the company value its employee stock options, has ''a lot of potential,'...
Ed ZwirnMay 16, 2005

The Securities and Exchange Commission seems to find itself in FASB territory once again, at least on the matter of expensing options.

Last month the commission pushed back the effective date (for some companies) of Statement 123R, the Financial Accounting Standards Board’s revised rule on stock-option expensing. Now SEC officials are apparently engaging in discussion with Cisco Systems Inc. over a proposal that would drastically change the way the options are valued.

Cisco’s proposal, which would involve the company’s sale of a derivative — on the open market, with the same terms as the employee stock option — has “a lot of potential,” said SEC Chairman William Donaldson, according to Bloomberg. In an interview with, Cisco spokesman John Earnhardt confirmed that the company had taken up direct discussions with the SEC staff.

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Earnhardt also observed that Statement 123R, the Financial Accounting Standards Board’s revised rule on expensing options, specifies that “the fair value of an equity share option…shall be measured based on the observable market price of an option with the same or similar terms and conditions, if one is available.”

FASB spokesman Steven Getz, though he would not comment on the merits of the Cisco proposal, does note that 123R already provides guidance (specifically, in paragraphs A7 and A8) on how a market price would be used, if such a price existed. Getz also adds that it would be within the SEC’s purview to favor the Cisco valuation proposal over the Black-Scholes and fair-value methods already approved by FASB.

(For his part, deputy editor Ron Fink writes that Cisco’s idea sounds as if it depends on a poorly performing derivative instrument to minimize the option value and, therefore, the expense.)

The standards board is also in the midst of clarifying an issue related to 123R that could have a huge impact on the bottom line of companies with a “large retirement-age population,” according to Roberta A. Fox, a compensation analyst with Hewitt Associates.

“Employee Compensation: Classification of Freestanding Financial Instruments,” discussed last week and on the agenda for Wednesday’s meeting, centers on the accounting treatment for employee stock options that are still on the books more than 90 days after an employee leaves a company. Normally, observes Fox, such options may be exercised anytime between three and five years later, but at the time of the employee’s departure, the company is certain only that the stock-option grant &#8212 which under 123R must be expensed on the grant date — will no longer be subject to the standard as of day 91.

“A lot of clients are unaware” of the issue, maintains Fox. To illustrate further, she points to a hypothetical option on a stock worth $30 on the date at which a $30 option was granted. According to Fox, FASB statement EITF 00-19 “says I have to mark the option to market” after day 90. This would mean another $30 of expense if that same stock later hit $60. “It’s a pretty big nut,” she warns, because most companies that grant options have exercise periods that extend more than 90 days past an employee’s departure.

Other items on the board’s agenda this Wednesday:

• Electronic waste obligations: The board will discuss the issues raised in the comments received on proposed FAS 143-a, “Accounting for Electronic Equipment Waste Obligations,” and whether to proceed to a final staff position.

• Segment reporting: Possible finalization of proposed FAS 131-a, “Determining Whether Operating Segments have ‘Similar Economic Characteristics’ under Paragraph 17 of FASB Statement No. 131.”

• Minimum revenue guarantees: The board will discuss whether to add a project that considers whether the provisions of FASB Interpretation No. 45 apply to a guarantor’s accounting for a minimum revenue guarantee granted to a business or its owners.