FAS 123R and other regulations demand improved record keeping
The perfect storm of option-accounting began in 2002 with the Sarbanes-Oxley Act. Once the floodgates were open, a number of other challenges arose: the Financial Accounting Standard (FAS) 123R in 2004, stock option backdating scandals in 2006 and the final IRC Section 409A regulations in 2007. One of these challenges is particularly prescient right now, FAS 123R, which requires that the fair value of stock options granted to employees be recorded as an expense. As a result, equity compensation expenses moved from a pro forma footnote to a line item in the income statement. And now, the use of the Black-Scholes formula for valuation has come under question and the use of estimated forfeiture rates and ‘true-ups’ is a requirement.
In light of the current environment, auditors are using much higher standards and CFOs are struggling to integrate stock option administration, tax and accounting reporting as well as good corporate governance practices. During the first audit season under the new FAS 123R regulations in 2004, many companies found themselves with insufficient record keeping, making calculating stock option related expenses difficult, time consuming and subject to error. Transactions were not recorded properly or well documented and there was little or no audit trail.
CFOs, stock plan administrators and those responsible for maintaining compliance filings now realize that in order to satisfy the higher levels of scrutiny and comply with the new stock option expensing requirements, they can no longer rely on error-prone, manual spreadsheets. Instead, they are looking to implement automated FAS 123R solutions capable of simplifying the process while providing critical information faster and with greater accuracy and accountability. More specifically, financial executives now require systems that enable all participants to rely on the same set of consolidated records and be capable of combining stock plan administration, stock option expensing and corporate governance management.
As SEC scrutiny of insider transactions increases and rules governing management of equity plans become more complex, companies are looking to gain a greater understanding of how FAS 123R applies to them. Many are evaluating new systems or approaches to make management of programs more efficient. But before doing so they should consider the following steps that may help to simplify FAS 123R compliance and to satisfy their auditors.
First off, organizations should ensure they are properly recording and documenting the actions of the board, the company and each employee relating to option grants, exercises and cancellations. Since option records and equity compensation expense reports will later reflect these actions and the supporting documents, you want to avoid any inconsistencies that may show up in an audit. The stock option scandals revealed in 2006, uncovered examples of option grants that pre-dated board meetings or board meetings that were allegedly held but never documented. This led to incorrect financial statements and tax reporting errors. Such problems could have been avoided if companies had properly integrated their legal documentation with their stock option records. Companies can avoid these types of problems by properly recording, retaining and managing the legal documentation at each step in the process.
Organizations should also consider consolidating all transactions that relate to stock option administration, valuation and expensing, and legal compliance in a single, integrated system. This is particularly important because stock option data tends to come from a number of different areas within a company including legal, finance and human resources. When each department retains and manages its own information, it can lead to errors, inconsistencies and missing documentation as well as duplicate effort and wasted time.
As an example, imagine a situation where the HR department is using one date for an employee termination and the related option cancellation while the finance department is using a different date to determine when to stop expensing the option. Consequently, organizations should create a single, consolidated repository for all legal documents and data related to stock option records and make it available to all members of the equity compensation team.
The next consideration involves the automation of your organization’s stock option administration and equity compensation expensing. This typically involves large numbers of transactions, even if it only involves a single stock option grant. On the administration side, you need to record information related to the date of hire, the option grant, the vesting schedule and any exercises and cancellations. On the expensing side, you need to record how the valuation inputs were determined for each grant date, expense the fair value every period and later true-up when the option is cancelled.
Every time a transaction is recorded, there is the potential for error. Over the course of hundreds of transactions and many years, the risk of error increases. The best way to reduce the level of potential errors is to let your computer do the work. When you automate, you know you are tracking, calculating and reporting similar transactions the same way every time.
Finally, an automated system will create an audit trail showing who made the changes and when. Based on this higher level of reliability, auditors are more comfortable with automated systems and typically can sample fewer records during an audit, which can save considerable time and expense.
Now that the new regulations require companies to include stock option-related compensation expenses in the income statement, auditors are even more careful when reviewing how each variable used in the valuation model is determined. As a result, companies must be able to document that they followed a reasonable process to determine each variable. The key variables are fair market value, exercise price, volatility, expected term, interest and dividend rates, and forfeiture rates – with greater scrutiny being applied to volatility and expected term. In its published ‘Questions & Answers’ dated October 17, 2006, the Public Company Accounting Oversight Board stated, ‘The expected term and expected volatility assumptions have the highest risk because they involve the greatest amounts of judgment and have a significant effect on the estimated fair value.’ Companies unable to demonstrate how they determined a variable as well as why it was changed or did not change for future grant dates will be subject to greater scrutiny. If the valuation and expensing variables are properly documented, based on a reasonable process, and supported by an integrated system, it will provide greater confidence and raise fewer red flags.
The final and perhaps ultimate goal of stock option administration is to produce a clear and concise set of reports that provide the necessary information for a company’s quarterly and annual financial statements. More specifically, your company will want to prepare a standard set of reports that it can use each quarter to generate the stock option-related expense items. Using the same system for generating stock plan administration and option expensing reports will help to avoid inconsistency and increase accuracy.
Taking the time to evaluate and improve your current internal processes for administration, expensing and reporting is the best way to ensure future compliance and expedite your next audit. With option expensing hitting the bottom line and a brighter spotlight on stock option granting practices, companies need to implement better systems to ensure expedient and accurate processes for stock plan administration.
