Monday, October 23, 2006

Peek-a-Boo I See You (and your Black-Scholes assumptions)

Fred Whittlesey
Compensation Venture Group, Inc.

I try to stay on top of what has become an almost-daily flow of news affecting executive and equity-based compensation. But I'll admit that I hadn't seen the Public Company Accounting Oversight Board's ("PCAOB" which apparently is sometimes pronounced "peek-a-boo" in accounting circles) new statement, issued 17 October, regarding the valuation of stock options, when I wrote the preceding blog post here 21 October. This is both a bit prescient and humorously ironic.

After more than three years of effort by many public companies to arrive at a "more accurate" valuation of employee stock options, as required by FAS123 and now FAS123R, PCAOB has caught wind that perhaps some companies may be aggressively using certain assumptions that lower the reported value of options granted, thus lowering expense and increasing reported profit.

Wow! I guess no one from PCAOB has been attending the many professional conferences over the past few years where accountants, actuaries, and others have been presenting their ideas on how best to accomplish this. Hardly a well-kept secret, this one.

What I find interesting is that the Board's Statement indicates that such practices may constitute fraud. As I said on 21 October, it continues to amaze me that widely-publicized broadly-practiced methods of calculating and reporting hypothetical "expenses" related to stock options now fall into the category of "fraud". I'm neither a lawyer nor accountant but I don't think one needs to be either to have observed that hundreds of companies have over the past few years reduced their option valuation assumptions and significantly lowered the reported expense accordingly.

This is why I advise all of my clients that the methods and numbers used for financial reporting, while required by the FASB and the SEC, should never, ever, ever be used for compensation analysis and planning purposes. When such tactics reduce reported expense and artificially inflate profit, they have an even more nefarious effect: reducing the "value" of stock options granted to employees and executives. And if the "value" of each option has been reduced then, as the logic goes, we need to grant more options to them. Which of course again raises expense. But these increases often go, this time, to the executive population rather than the broader employee population. Clever.

No one in the investment community is fooled by artificially low Black-Scholes values and no sophisticated investor accepts financial statements as published - they are reworked through extensive financial modeling, based on cash flow, not hypothetical profit - to determine a company's value. These analysts drive the market so there is a significant check-and-balance system around companies' reported option expense. No such system yet exists, however, for executive compensation. Despite improvements in disclosure, heightened investor attention to the topic, and the growing sophistication of Compensation Committees of Boards of Directors, these option valuation games can indeed be damaging to the corporate governance process. That can only be fixed by recognizing that the real money spent on "managing" option expense is an expensive financial reporting exercise and that real compensation decision-making treats that as only one input, and a minor one at that.

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