FASB Addresses Option Pricing Models and “Out of the Money” Stock Options
 
September 10, 2004
 
Mark A. von Bergen- Portland
David Wang - Portland

This is an update to the Public Companies Alert published by Holland & Knight on August 24, 2004. We will issue additional alerts on this topic as events unfold.

At its September 1, 2004 board meeting, the Financial Accounting Standards Board (FASB) addressed the topics of option pricing models and “out of the money” stock options.

FASB Drops Stated Preference for “Lattice Model”

In its March 2004 statement titled “Share-Based Payment:  an amendment of FASB Statements No. 123 and 95,” FASB  proposed that companies expense the fair value of stock options and other equity awards to employees.  To estimate the fair value of such awards, FASB recommended (but did not explicitly require) that companies utilize a “lattice model” instead of closed-form option pricing models such as the Black-Scholes formula.  According to the FASB proposal, “a lattice model is preferable because it offers the greater flexibility needed to reflect the unique characteristics of employee share options and similar instruments.”

At its September 1, 2004 board meeting, FASB reversed course.  Heeding a warning from its staff members that “some accounting firms have told their clients that the explicit preference for a lattice [model] is effectively a requirement,” the board tentatively decided to eliminate stated preferences from its proposal.  According to at least one of the board members, because there likely will be an “evolution in the methods that we use to estimate fair value,” FASB should be wary of adopting policies that might inhibit such development in the future.  Other board members agreed that a policy requiring (or even expressing a preference for) use of a particular type of pricing model would effectively close the door on future option pricing models that might in fact prove more robust and, hence, preferable to those that currently exist.

If this recent modification is adopted in FASB’s final statement, companies likely will remain free to continue using Black-Scholes (or other option pricing models of their choice) in order to meet the anticipated stock option expensing requirements, so long as the model(s) chosen meet certain qualitative criteria described in the FASB proposal.

FASB Stands Firm on “Out of the Money” Stock Options

At the same meeting, FASB refused to exclude or give special treatment to “out of the money” stock options.  An option is “out of the money” when its exercise or strike price is greater than the current market value.  Critics argue that the FASB proposal will force companies to record expenses for outstanding stock options that are unlikely ever to be exercised.  FASB was not swayed by these arguments.

For more information e-mail Mark von Bergen or David Wang at mark.vonbergen@hklaw.com or david.wang@hklaw.com, respectively, or call toll free, 1-888-688-8500.