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Bucking pressure from corporate lobbyists and lawmakers, the Financial Accounting Standards Board on Wednesday unveiled a proposal that requires companies to expense employee stock options. The draft rule compels companies to record the value of options on their income statements beginning in 2005. Critics contend that deducting these costs from corporate profits could damage a firm’s bottom line and stock price. Proponents of mandatory options expensing dispute that notion, arguing that better bookkeeping will benefit investors. “Investors understand that stock option grants have an element about them that is akin to an expense, and if investors are not being fooled, who is?” said Tim Leurhman, managing director of Standard & Poor’s Corporate Value Consulting group. A study by consulting firm Towers Perrin tracking the performance of 335 companies that expense options found that, on average, their shares matched those of 900 companies in the S&P 500 and mid-cap 400 indexes. Still, political opposition to FASB’s plan has been vigorous, with many detractors claiming that there is no accurate system for valuing options. “To adopt an admittedly inaccurate accounting standard is a troubling question that deserves examination,” said Rep. Richard Baker, R-La., chairman of a House Financial Services panel recently in hearing to discuss alternatives to FASB’s rule. Baker is sponsoring a bill that would require companies to expense only the options offered to their top five executives. It also would bar the Securities and Exchange Commission from enforcing FASB’s accounting rule until the agency studies its economic impact. While not mandating a particular system for valuing options, FASB in its proposal advises companies to use either “binomial” or “lattice” modeling, as well as the commonly used Black-Scholes model. (A lattice is a way to organize and summarize future share prices.) Companies will have a choice of which valuation method to use, but must stick to whatever system they select. Critics say such techniques are tantamount to using a crystal ball. They also argue that many companies are unfamiliar with the binomial model, making it not only difficult but costly to implement. But experts who favor FASB’s proposal contend that, while no valuation method is perfect, the binomial model tends to be more accurate and flexible than Black-Scholes. “What FASB is saying is that a reasonable estimate is a lot better than no estimate,” said Mark McDade, a partner in the transactional services practice at PricewaterhouseCoopers LLC. “The binomial method mathematically takes into account more circumstances, which should result in a more accurate valuation,” Simply put, the binomial pricing model, developed by economists John Cox, Stephen Ross and Mark Rubinstein in 1976 at the University of California, Berkeley, values options by tracing future share movements according to their probability. The binomial model’s flexibility allows for assumptions that include eight parameters: the price of the underlying stock, instantaneous variance of the asset returns, exercise price, time to expiration in days, risk-free interest rate, up state value, down state value and number of time intervals. This approach also addresses the question of whether exercising an option early is profitable at each stated time period. Black-Scholes, on the other hand, is primarily used for pricing publicly traded options. Developed by the Massachusetts Institute of Technology’s Fischer Black, Myron Scholes and Robert C. Merton in 1973, the equation is credited with laying the foundation for the rapid growth in options and derivatives markets in the 1980s and 1990s. Its creators also won a Nobel Prize in economics in 1997. Although Black-Scholes is by far the most widely used system, it has drawn fire for failing to provide for variation in the underlying economic assumptions. The method values options using six parameters: the price of the underlying stock, instantaneous variance of asset returns, exercise price, time to expiration in days, risk-free rate and dividends paid. Opponents to options expensing also argue that no one has figured out how to obtain market-based prices for non-public companies. McDade disagrees. “In today’s business environment, there are lots of ways of determining fair value,” he said. “Someone has to have an idea as to how much of a check to write for what percentage of the company they get.” FASB acknowledges that some companies, especially private and startup enterprises, will have difficulty estimating the value of employee options. The board said such firms may use “intrinsic value” accounting, which involves valuing an option at zero on the grant date, rather than the fair-value method. Baker has scheduled a hearing April 21 on FASB’s proposal. “With today’s action I fear FASB is beginning to stand for Flatten All Start-up Businesses,” he said. “There is mounting evidence of the terrible impact this rule would have on our economy at the very time we are fighting through a jobless recovery.” Interested parties will have 90 days to comment on the rule. FASB will hold public roundtable discussions on the proposal in late June. Copyright �2004 TDD, LLC. All rights reserved.

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