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Financial Accounting Standards Board hears from academics

STANFORD -- When the Financial Accounting Standards Board (FASB) proposed last year that companies report stock-based compensation as expense against income, it unleashed a firestorm of protest.

American business was - and still is - up in arms at the idea. The new accounting rule would be hugely expensive, it was charged, especially for young high-technology firms, which traditionally rely on stock options for employee compensation.

While the FASB has not been dissuaded so far, the board does appear to be backing off. The main roadblock, it discovered, is that there is thus far no answer to a question that arose at FASB hearings throughout the year: How do you determine the value of an employee stock option?

Two assistant professors of accounting at Stanford Business School - Steven J. Huddart and Mark H. Lang - have been studying that issue. They presented their views to the FASB at a one-day roundtable of university professors, compensation consultants, investment bankers and others in April.

"The current FASB proposal is based on option pricing models that were developed to value publicly traded options," Huddart and Lang wrote in Employee Stock Option Exercises: An Empirical Analysis. But option pricing theory for publicly traded options hinges on the notion that options are exercised at predictable points in time, they note, a condition that does not apply to employee stock options.

Noting, too, that previous research on employee stock options has dealt mainly with compensation at the executive level, the two researchers sampled four industrial companies that issue employee stock options extending "deep into the organization" to determine if there had been a time pattern in the exercise of options. Two of the companies are established firms of from 50,000 to 100,000 employees; the others are smaller, emerging companies. All offered fixed stock options, most with 10-year terms. If exercise of options "takes place over a range of time and is predictable based on other factors," Huddart and Lang wrote, it would suggest "modifications to the FASB approach."

Exercise of employee stock options within a certain time frame is, in fact, unpredictable, the two researchers found. "A simple model in which exercise occurs at predictable points in time, while potentially accurate for publicly traded options, is not generally descriptive for our sample," they concluded.

They also found that factors excluded from standard option pricing formulas are strongly associated with employee exercise decisions. Since option valuation hinges on employee exercise decisions, the researchers proposed alternative valuation procedures that take account of these additional factors.

Huddart and Lang called for further study, adding, "We are in the process of conducting additional analysis incorporating knowledge of the details of the option plans, more sophisticated estimation procedures, and detailed data about the employees such as salary and level within the company."

In June, the FASB announced it's going back to the drawing board. While the board has not given up on the idea of charging employee stock options against income, it is postponing implementation until it can come up with a more accurate means of valuation. Huddart and Lang presented their latest findings to a group of academics and chief financial officers from across the United States gathered at the Business School for its annual "accounting camp," July 24-26.


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