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The author responds.

Crow's letter reveals two misconceptions common among valuation professionals concerning the valuation of ESOs that we sought to correct in our article. First, the letter suggests that there has to be symmetry in valuation: The value of an ESO to a company must equal the value to an employee. Second, if these values are somehow different, the writer claims that the value to the employee is the relevant value for accounting purposes. Neither claim is accurate.

The value of an ESO as measured by an employee will generally be less than the value as seen by the company. The difference arises because restrictions prevent employees from selling or hedging their ESOs, forcing them to bear the risk of ownership. As a result, an employee's valuation reflects risk aversion and other necessarily subjective preferences. Furthermore, the value of an ESO will be different for each employee; indeed, it can even be worthless to some. For this reason, some valuation professionals, who seek to justify low values to attract clients, readily adopt this perspective. But it is fundamentally inconsistent with accounting guidance and fair value principles.

For financial accounting purposes, the value of the ESO is the value from the company's perspective and not from that of the employee. Readers of financial statements want to understand how the company is performing, not how others perceive its performance. This concept was repeatedly discussed at FASB's Option Valuation Group meetings, and met with broad consensus agreement.

In a discussion memo dated December 15, 2003, FASB stated that the value of an ESO as measured by a company is the "fair value" that the company would be required to pay a hypothetical market participant to assume the company's ESO obligations. That is the company's perspective. In particular, "[t]he market participant is hypothetical and does not represent the biases of a particular participant, such as an employee whose personal wealth is concentrated in the employer's equity instruments, but rather reflects the notional consensus of the market." Indeed, if a company used employees' valuations, the resulting estimates would not represent fair value, because they would be the values to individual employees rather than to the marketplace.

Crow argues that ESO valuation asymmetry cannot exist because a company would never issue an ESO if it costs more than it is worth to an employee. This line of reasoning ignores why ESOs are issued in the first place. ESOs are structured to incentivize employees to raise their efforts to increase the profitability and performance of the company. A company expects that the difference between the employees' and employers' valuation of an option would be exceeded by the increase in the employees' productivity resulting from the option grant.

Crow's misinterpretation of accounting guidance is similarly matched by his mischaracterization of the evolution of SFAS 123. The fact that current accounting standards do not require companies to expense ESOs on their income statements does not imply the ESOs are worthless. In 1995, political pressures caused FASB not to require employee stock option expensing. Under SFAS 123, companies can voluntarily value the ESOs according to a Black-Scholes formula or a binomial model.

Such fundamental misconceptions as Crow's are all too common among valuation professionals. The issues involved in valuing ESOs are surprisingly subtle. It is important that a valuation professional possess not only valuation experience, but a truly correct understanding of accounting and the "spirit" of SFAS 123.

Cindy W. Ma, PhD, CFA, CPA

NERA Economic Consulting

Editor's note: NERA is a Mercer Inc. company, part of the Marsh & McLennan Companies. NERA, Mercer Inc., and Marsh & McLennan are unaffiliated with Mercer Capital. Ma and coauthor Algis T. Remeza participated in discussions with FASB on employee stock option valuation issues; Ma is a member of FASB's Option Valuation Group.
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Title Annotation:Inbox: Letter to the Editor
Author:Ma, Cindy W.
Publication:The CPA Journal
Date:Oct 1, 2004
Words:627
Previous Article:Common misconceptions about employee stock options.
Next Article:Public accountability: an interview with New York State Comptroller Alan Hevesi.

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