SEC's “Simplified Method” for Estimating Stock Option Cost is Ripe for Manipulation

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Call me cynical, but I am wary of accommodations that permit companies to freely choose between their best estimates and something less.  Even significant restrictions on the ability to elect a simplified approach may not be effective in preventing manipulation. Witness, for example, the  abuse of the short-cut method for demonstrating hedge effectiveness under FAS 133 by Fannie Mae et. al.  Accommodation may result in relief that is elected in good faith by many, but for some, it's just another opportunity to manage financial reporting.  The latest example is SEC Staff Accounting Bulletin 110, and the related earlier SAB 107.

Background

FAS 123R requires a company to estimate the grant-date fair value of its options, which in turn necessitates estimation of the expected exercise date of the options.  For companies that did not have access to adequate historical data about employee exercise behavior in order to make a realiable estimate of when options will be exercised, the SEC issued SAB 107 in March 2005, permitting use of a simplified approach until December 31, 2007.  The simplified approach was further restricted to options that meet criteria collectively referred to as “plain vanilla,” and essentially allowed companies to assume that the exercise date of an option would be halfway between its vesting date and the expiration date.

SAB 107 made the the simplified approach available only through December 31, 2007 – at which time the SEC staff expected companies to have sufficient historical data with which to more precisely estimate the expected exercise date.  As the Dec. 31, 2007 deadline in SAB 107 approached, the SEC staff was persuaded the detailed information about exercise behavior was still not readily available for many companies. Accordingly, SAB 110 was issued on December 12, 2007 to allow the continued use of the simplified method—provided a company concludes that its own historical share option exercise experience does not provide a reasonable basis for estimating expected term.

The Earnings Management Tactic

By the way, I am not a big fan of FAS 123R, because grant-date valuation often understates the actual costs of stock options.  It would make more sense to value the options on the date they are effectively 'issued' to employees, which is the vesting date.  But given that grant date valuation is the law of the land, I suppose that it is theoretically correct to base the valuation on the expected exercise date as opposed to the expiration date.   

Having said that, valuation based on assumed exercise at the expiration date -- as opposed to estimating an earlier exercise date -- would yield higher measures of compensation cost; and, especially given the concerns that the SEC has expressed in SABs 107 and 110, result in greater consistency of measurement.  It would also remove one very significant element that management could manipulate -- which is a big reason why companies lobbied for using the expected exercise date in the first place.  The simplified approach temporarily permitted by SAB 107 and extended by SAB 110 sweetens the deal.

Here's how the earnings management game works. Assume that (1) management of a company desires to minimize reported compensation cost, and (2) the expected exercise date of options is on the later side of the halfway point between vesting and expiration.  In this case, one would expect management to try their best to convince their auditors that they are unable to reliably estimate the exercise date -- that's because the simplified approach would produce lower compensation cost.  But, if the expected exercise date were on the earlier side of the midpoint, we would see just the opposite kind of self-interested rationalization: management trying to convince their auditor that their SWAG is practically as good as carved in stone.

Finally, why is the SEC making more work for itself?  Unlike SAB 107, there is no specific expiration date of the simplified approach in SAB 110.  The SAB 110 release states that once relevant detailed external information about exercise behavior becomes widely available for companies to make more refined estimates of expected term, the staff will no longer accept use of the simplified method.  In the interim, I suppose the SEC will be selectively asking companies to justify why they continue to use the simplified approach.  That's not a good use of anyone's time. 

If a company cannot make a reliable estimate of the exercise date, the SEC should require them to assume exercise at expiration.  That should get their attention -- and protect investors by cutting the legs out from under an obvious earnings management opportunity.

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Comments

[David Harper]

Hi Tom

Can I compound the confusion (only because this is one area I did a lot of work in; I've valued options for 123R reporting)?

Many people forget that the use of "expected life" rather than contractual term (for most ESOs, that would be 10 years), was proposed in the original exposure draft as a deliberate band-aid to fix the non-transferability issue. Specifically, most ESOs are not liquid; they rightly deserve an illiquidity discount if valued using an Black-Scholes (which assumes the ESO can be traded). FASB did believe that the contractual term was the correct input, but they allowed for expected life to approximate a discount for illiquidity.

I believe the illiquidity discount is both significant but yet almost impossible to calibrate (20-50%?). If you believe the options deserve an illiquidity discount, then IMO, using an estimated life is a really blunt means to reduce the option value, and not inappropriate. I mean, that's what FASB did, in my understanding. I do agree with you, however, that estimating expected exercise date is not hard to do; when companies claim this, they are teasing. Many studies have been done, and except for a few, it's pretty much the same: if the options are in the money, 85+% are exercised within 18 months of vesting (i.e., they do not hold much longer than they must). The majority: cashless exercise within one year.

Finally, I hear you on the games companies can play. But I am sympathetic, also, to what i would hear from tech companies in the Valley back when this debate was raging. There was an earnestness to this problem: if the stock is volatile (tech company), grant date valuation can grossly overstate the actual cost if a volatile stock doesn't end up in the money (last i checked, forfeitures reverse but valuation impairments do not. I mean, with "grant date fair value" you are stuck with the charge like cement shoes). So, a company can incur a large expense that doesn't materialize.

The application of an option pricing model is somewhat hilarious, really, you calibrate six fine inputs to produce a fine number. Kludge for nontransferability that's not built into the model; assume historical volatility is predictive (it's not, it's stochastic in the worst way). All these bands aids in order to get a precise number: 39.5% and it's *totally* a fat thumb in the air! But bottom line, since the valuation is imprecise (or gives a false appearance of precision), I do agree with your ultimate prescription for conserservatism. I am just broadly troubled by the fair value of these derivatives, having actually used the models...

[Jeff Watson]

Excellent commentary and right on point with the vesting date valuation versus grant date valuation issue. One thought that kept coming to my mind as I read the blog was how the FASB/SEC are suppose to be trying to simplify the accounting rules with all of the special projects they have going on. The FASB/SEC talk about simplifying the rules for preparers and investors, but then they go and make rules that are more cumbersome and complicated but provides little benefit to the investor. It makes me wonder how much money the Big Four or some of the companies are spending or what promises are being made to get these accounting rules pushed through so quickly.