FASB Publishes Options Draft

Updated from 10:03 a.m. EST

The Financial Accounting Standards Board rejoined the battle to put the cost of stock options plainly in view of investors Wednesday, formally releasing a draft of a new rule on equity compensation that is already meeting opposition from the technology sector and in Congress.

The proposal has two main elements: that publicly traded companies be required to use a fair-value method of valuing options from the date they granted to employees, and that the value be subtracted as a business expense on companies' income statements. At present, the cost of stock options must be estimated only in footnotes that append federal filings, where employers are allowed to use a much simpler technique than fair value to reckon the cost.

The bulk of the proposal deals with the methodology behind fair-value pricing of options granted to employees, which, because of their longer exercise periods and non-transferability, act differently from options traded in public markets. FASB decided to prescribe the use of models that consider an option's price relative to the underlying stock and an estimate of the stock's volatility to arrive at a fair-value expense, the most famous of which is the Black-Scholes formula.

The draft reflected a growing FASB taste for methodologies other than Black-Scholes, however, including a formula sometimes known as lattice or binomial pricing, in which more codependent variables are incorporated.

"Board members agree .... that closed-form models may not necessarily be the best available technique for estimating the fair value of employee share options -- they believe a lattice model is preferable, because it offers the greater flexibility needed to reflect the unique characteristics of employee share options and similar instruments," FASB wrote in the draft.

Currently, public companies are allowed to use an "intrinsic value" method of pricing options, which considers only the strike price in relation to the underlying shares. Both the new requirement for fair value pricing and the placing of the expense on income statements have opponents, particularly among tech companies that use options aggressively and worry that the lower reported earnings would result in lower stock prices.

The proposal, which would take effect in 2005, is now open for public debate for the next 90 days. The FASB's first effort to get options onto corporate earnings statements was shot down in 1995 by a coalition of technology companies and federal legislators, which argued making options an expense would harm both share prices and the ability of new companies to attract talent . A similar opposition is coalescing in Washington and Silicon Valley to the current proposal.

Proponents argue that public companies are currently allowed to hide the cost of their options grants from investors, and say more candor in the area would've helped prevent corporate fiascos like Enron and WorldCom from occurring. Others think U.S. accounting standards are out of step with overseas rules.

"The proposal also would achieve substantial convergence in this important area between U.S. and international accounting standards," the FASB noted in a press release. "Reports show that approximately 500 public companies in the U.S. are treating stock options as an expense or plan to do so in the near future. The International Accounting Standards Board and Canada recently issued requirements to expense share-based payments, including employee stock options."

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