Accounting & Tax

Will ESOARS Fly?

Will a new method for valuing stock options put companies on the ''road to fair value''?
Karen M. KrollApril 12, 2007

The push toward fair-value accounting continues its fitful progress as a new method for valuing stock options wins approval but also raises concerns.

In January, the Securities and Exchange Commission signed off on the approach, dubbed ESOARS (Employee Stock Option Appreciation Rights Securities), which uses an auction process to assign a value to the options. The high bidder owns the option and receives a payment from the company for the ESOARS when the employee exercises the option.

In February, early press reports that the ESOARS formula produced option valuations just half those generated by the Black-Scholes-Merton model raised an alarm. Jeff Mahoney, general counsel with the Council of Institutional Investors (CCI), wrote a letter to the SEC requesting that the commission defer further approvals of companies’ use of ESOARS for 30 days.

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Evan Hill, a vice president at Zions Bancorporation, which developed the ESOARS approach, says the CCI “got spooked by the media.” He contends that several glitches, including timing (the auction was held not on the grant date but on a date when the stock price was lower than the strike price) and technical difficulties, marred the test auction. Those problems, he says, have been resolved.

Still, Mahoney isn’t the only one questioning the ESOARS approach. Cindy Ma, a vice president at NERA Economic Consulting, says that in a market-based approach, investors have to determine a value for the ESOARS. Given that investors would not have as much information as the company itself, she says, they would “likely apply a higher risk discount or ascribe a lower value to the instrument.”

The SEC has acknowledged that some aspects require improvement and that each ESOARS auction would need to be reviewed. Nevertheless, while agreeing that more work is needed, Jack Ciesielski, publisher of The Analyst’s Accounting Observer, says, “I think we’re on the road to fair value.”