BY RICHARD A. CLEAVELAND CPA
SENIOR AUDIT MANAGER

With the issuance of the new accounting pronouncement, Statement of Financial Accounting Standards No. 123 (Revised) Share Based Payments (FAS 123R), many companies will now have to determine whether the benefits from issuing stock options to employees outweigh the cost and effort associated with accounting for those awards. Under existing guidance, companies have been required to calculate the fair value of stock options, with many utilizing the exception for disclosure purposes only in the footnotes to their financial statements. However, now they will have to record that amount in their income statements.

Expensing stock options will undoubtedly have a significant unfavorable impact to the financial statements of some companies and will cause the management of many entities to spend more time explaining to analysts, board members and shareholders what the new expense is and why results of operations don't look as good as might be expected.

In addition, the cost of valuing stock options under the new standard will increase significantly. The statement provides significant guidance on how to determine the fair value of stock options. Included in that guidance are requirements for what type of valuation models should be used and how assumptions should be selected. The Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) both expect companies to use much more judgment in selecting assumptions for valuing the awards than in the past.

The most widely used method of calculating fair value of stock options in the past has been the Black-Scholes option pricing model. Now companies will need to determine if that model is still appropriate or whether a more complex model is needed. The FASB and SEC have clearly stated that they would accept companies continuing to use the Black-Scholes model to value options under the new standard as long as it reflects all substantive characteristics of the options being valued. However, both have clearly pointed out that for more complex options, a different pricing model will be necessary, because there are certain limitations to the Black-Scholes model that prevent it from taking into consideration the characteristics of more complex awards. In fact, the SEC has specifically stated in its guidance that the Black-Scholes model would not be appropriate for valuing "market based" awards. Instead, valuation techniques such as the binomial model and the Monte Carlo model may be more appropriate. Using these other option pricing models, which are much more complex, in many cases will require expertise not normally found within a company's finance/accounting departments. As a result, in using one of these other models, it may be necessary for a company to hire a valuation consultant to assist them in valuing the option, which may result in a higher cost than planned.

Even if companies continue to use the Black-Scholes model for valuing stock options, companies will need to make significant refinement to certain assumptions. To estimate the expected term of an option and the expected volatility of an entity's stock price, companies will need to have detailed records of historical experience and try to estimate whether the future will be similar or different than that experience in estimating the assumptions to be used. Privately held companies, in particular, will find it much more challenging to comply with the new guidance on selecting assumptions in that they will now have to estimate volatility for their stock, even though it is not traded in the public market. Under the new guidance, those companies will now have to calculate a volatility based on publicly traded companies that are within the same industry (calculated value). They will then need to consider whether any adjustments will be needed to that peer public company index to reflect the volatility of their company. The FASB does make an exception for non-public companies for which there is not a comparable public company index, but expects that exception will only be used in "rare circumstances." Finally, the new pronouncement requires that companies estimate future forfeitures of awards and adjust the amount of expense to be recognized based on this estimate. This will require companies to analyze historical forfeiture patterns and adjust it for any future anticipated changes. In addition, going forward, the entity will be required to adjust its estimated forfeiture rate for any changes in forfeiture patterns and adjust the resulting expense recognition accordingly. Keeping the records to track forfeitures adequately will add yet another layer of cost that previously did not exist.

Both the expense required to be shown in a company's financial statements and the cost of determining that expense will cause many companies to reconsider the types of awards they issue to employees. Many companies are already deciding to issue restricted stock instead of stock options to eliminate the cost associated with valuing the stock option. Others may decide to eliminate share-based compensation altogether, concluding that the expense to be recognized and the cost of determining the expense far outweigh the perceived benefit.

There is some good news, however, resulting from the issuance of the new standard. The standard significantly reduces the unfavorable impact of granting market-based awards and performance-based awards. Market-based awards are earned by the employee if the stock price rises above a certain target. Performance-based awards are earned if certain performance targets, such as sales or earnings targets, are reached. These types of awards are very effective in tying an executive's compensation to the performance of the company, thereby aligning his or her interests with those of the shareholders. In the past, many companies refrained from granting these types of awards because they generally triggered what is known as variable accounting. Variable accounting arises because the ultimate number of shares of stock to be granted under the awards are not known up front. Instead, they are contingent upon the market price or performance target being reached. Variable accounting required a company to re-measure its stock options at each reporting period and record the change in value during those periods as expense or income in their income statements. For most companies, where the expectation is that the business will grow and the company's stock price value will increase, variable accounting was viewed adversely, because its impact could result in significant charges to the income statement.

Now with the issuance of FAS 123R, variable accounting for equity awards such as stock options is generally eliminated, and instead a fair value is calculated for these types of awards on the date granted. There is generally no subsequent re-measurement required. As a result, any subsequent increase in sales or a market price will not affect the compensation expense recorded by the company. Under the new pronouncement, a company will now be able to achieve the additional benefits associated with performance - and market-based awards and yet the method of recognizing the award in the income statement is not significantly different from a time-based award. As a result, many companies may revisit the use of these types of awards.

However, as with stock-based awards in general, companies will need to consider the cost and effort associated with valuing market based and performance-based awards. As mentioned previously, these types of awards will require more complex valuation models to be used in estimating their fair value. The cost of the actual award may not be significantly different from a time-based award, but the incremental cost to engage a valuation expert to value such awards may cause the total cost to outweigh the expected benefits to be received.

Publicly traded companies must adopt this pronouncement as of the beginning of their first quarter of their first fiscal year beginning after June 15, 2005. That means that companies having a year-end of September 30 will need to adopt this guidance for the quarter ending December 31, 2005. Calendar year public companies will need to adopt the guidance in the first calendar quarter of 2006. Privately held companies are required to adopt this guidance for fiscal years beginning after December 15, 2005.

In designing stock option awards under this new guidance, companies should consult with their accountants early in the process. In addition, companies should also discuss the other provisions of this new standard, including the effect of transition on existing awards with their accountants to ensure that they are implementing it correctly.

It's still too early to determine the exact effect this pronouncement will have on the practice of issuing stock options. My belief is that larger companies should be able to absorb the incremental cost associated with issuing stock options and continue to grant them, but smaller companies may choose other alternatives.

Amper, Politziner & Mattia’s Public Company Practice continues to grow, as more and more companies recognize the talent, service and value Amper offers to this sector. The firm is now listed as the 9th leading public company auditor in the country in the 2005 edition of “Who Audits America,” an annual ranking by Spencer Harris, Data Financial Press. This is an increase of two places over the 2004 listings.

Whether it’s issues of staffing capacity within the international accounting firms, the additional work now required under Sarbanes-Oxley, or the high levels of talent that regional firms are now attracting, firms like Amper are becoming frequent choices when it comes time to appoint auditors within the public company sector. Audit committees, boards of directors, investors and company management have all developed a level of comfort engaging accounting firms other than international and national firms.

Amper has been representing both public and private companies since 1965 and was named the fastest-growing audit practice among firms in its revenue category by Public Accounting Report. Amper is a member of the Center for Public Company Audit Firms of the American Institute of Certified Public Accountants and is registered with the Public Companies Accounting Oversight Board. The firm is a member of Baker Tilly International, a network of leading independent regional accounting firms throughout the world, allowing Amper to offer the global reach of an international firm while maintaining the personal touch of a regional firm.

53rd Edition, Spencer Harris, Data Financial Press	June 2005
Auditor Cum.Sales Clients $1x25 $26x50 $51x100 to $250 to $500 to $1Bil to $5Bil $5 Bil + 1 PWC $3,169,978 1,017 146 57 94 148 136 131 197 108 2 EY $2,567,694 1,254 218 83 112 205 154 168 218 96 3 DT $2,463,694 889 125 57 86 126 121 121 160 93 4 KPMG $1,790,337 1,013 179 87 123 162 135 102 164 61 5 BDO $55,613 302 128 55 36 44 23 5 10 1 6 GTI $48,756 358 128 56 66 60 31 10 7 0   open $9,860 142 96 8 15 10 8 4 1 0 7 McGP $6,175 96 47 22 15 8 3 0 1 0 8 CCC $5,333 86 35 20 20 9 0 2 0 0 9 Amper, Politziner & Mattia $2,931 23 13 2 2 4 0 0 2 0 10 MAC $2,581 50 16 19 8 6 1 0 0 0 11 BKD $2,544 38 16 4 10 6 2 0 0 0 12 CSDL $1,549 1 0 0 0 0 0 0 1 0 13 RAE $2,198 59 44 2 7 3 3 0 0 0 14 DIXH $1,810 21 6 6 7 0 1 1 0 0