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PCAOB Advises on Employee Stock Options

The Public Company Accounting Oversight Board staff has issued guidance for implementing the existing auditing standards related to a company's accounting for the fair value of employee stock options. In general, when auditing the fair value of stock options, the auditor should obtain an understanding of the process used to develop the estimated fair value of the stock options, assess the risk of misstatement related to their fair value and perform testing on their estimated value. The testing should include evaluating both the consistency of the process, the reasonableness of the company's model and the assumptions used in the model, and should verify the accuracy and completeness of the data underlying the fair value measurements.

Auditors should also evaluate whether they have the necessary skills and knowledge to plan and perform the audit procedures. The staff guidance does not illustrate how the auditor should test the design and operating effectiveness of internal controls related to stock option compensation cost and disclosures in an integrated audit.

There are essentially two options pricing models. The Black-Scholes-Merton model was developed for exchange-traded share options and assumes option exercises occur at the end of an option's contractual term. The lattice, or binomial, model was developed to accommodate dynamic assumptions of expected volatility and dividends over the option's contractual term.

The staff advised auditors to be alert to circumstances in which the selection of the Black- Scholes-Merton formula might not be appropriate. For example, the Black-Scholes-Merton model would not generally be an appropriate valuation model for a share option in which the exercisability is conditional on a specified increase in the price of the underlying shares because the model is not designed to take into account that type of market condition.

When a company changes options pricing models, auditors should evaluate management's reason for the change. The staff noted that frequent changes in the valuation model might indicate a risk of fraud, requiring an auditor response. In addition, according to Staff Accounting Bulletin No. 107, changing a model from period to period for the sole purpose of lowering the fair value estimate of a stock option would not meet the fair value measurement objective of Financial Accounting Standard No. 123R.

The staff also provides guidance on how auditors should assess the options valuation models. For example, when the Black-Scholes-Merton model is used, the staff details a number of procedures that auditors should apply to the expected term assumption. Among other things, auditors should obtain an understanding of the company's process for estimating expected term, including the extent to which the company evaluates relevant factors in the accounting literature. Auditors should also verify that the expected term is at least equal to the vesting period of the stock option grant. It is also important to verify that the company has taken into account the contractual term of the option and the effects of post-vesting employment termination behavior, in addition to employees' expected exercise behavior. Auditors also must evaluate whether adjustments that the company has made to the historical exercise behavior are reasonable and supportable.

Auditors must evaluate whether the chosen model has appropriately calculated the fair value estimate for the options. If the company is using the Black-Scholes-Merton model, auditors should verify that the company is using the correct formula and recalculate the fair value. If the company is using a lattice option-pricing model, auditors should obtain evidence that the model is functioning properly.

FAS 123R requires that the valuation method consider the expected dividends of the underlying shares for the expected term and the risk-free interest rate. With respect to dividends, the staff advised auditors to evaluate whether the company has both the intent and the ability to pay the dividends embodied in the expected dividend assumption. As for the risk-free interest rate, if Black-Scholes-Merton is used, auditors should verify that the company used a traded zero-coupon U.S. Treasury bond with a remaining term equal to the expected term measured on the grant date. Auditors also should verify that the company properly calculated the yield based on the traded price. If the company's lattice model uses a yield curve, auditors should verify that the company properly calculated the yield curve and accurately entered the yields into the lattice model.

FAS 123R allows the aggregation of individual awards into homogenous groups for estimating the fair value of the options granted to each group. If the company segregates the employees into more than one group, such as executives and non-executives, auditors should evaluate whether the rationale supporting the determination of the groups is adequate, as well as the reasonableness and completeness of the groups. The underlying data on which the groups are based should also be tested.

The guidance also discusses the role of a specialist in auditing estimates of the fair value of stock option grants. As part of understanding of the process the company uses to determine fair value, auditors should consider the extent to which management employs specialists. When auditors are evaluating whether management's assumptions are reasonable, they should evaluate any assumptions developed by a specialist employed by management. Similarly, the qualifications of the specialist performing the service should be evaluated.

Laura Phillips, the PCAOB's deputy chief auditor, reported that the staff is closing in on the revisions to Auditing Standard No. 2. She believes the audit process can be improved, but emphasized the importance of taking the time to get it right. Ms. Phillips also noted that it is not unusual for standards to be amended over time as practices improve. The staff is challenging every aspect of Auditing Standard No. 2, she said, with particular attention to any sections that may encourage work that will not benefit the audit.

The inspection staff is looking at how well firms are applying the May 2005 guidance on Auditing Standard No. 2, she said. The revisions to the standard will add to the rule text the guidance that has been most helpful. The PCAOB has told auditors not to wait to implement the improvements, she added. When asked about the timetable for the revisions, Ms. Phillips said the staff hopes to affect the 2007 audit process. The staff expects the same volume of comments on the revisions as it received on the original proposal, she said. Once the board adopts the revisions, they will require SEC approval. Mr. Goelzer predicted that the proposal would be out within the next 30 days. It must be out this fall to meet the desired timetable, he said.

Audit Committees

Amy Goodman, with Gibson, Dunn & Crutcher LLP, outlined ways in which the audit committees can meet their responsibilities. She suggested that committees prepare an agenda and a schedule for each year which includes items in the committee's charter. Committees must make time to focus on different risks and reporting issues, she said. They should identify the groups with whom to have an ongoing relationship, such as the outside auditor, and establish a rapport between the committee chair and the audit partner.

The committee should have a list of audit-related and non-audit items for approval, and should make sure that controls are in place to ensure that the items do not exceed the budget. The audit committee should be the "boss" of the internal audit function, she said.

Some audit committees find it useful to meet with the disclosure committee at least once a year. The audit committee may also wish to meet with the general counsel, particularly if the general counsel serves as the chief compliance officer. Many companies view "whistleblower" programs as part of their overall compliance program, she said. Audit committees may want to make sure that hot lines are in place and help determine how the complaints are handled. If there are allegations of financial impropriety, the audit committee should know about it.

Ms. Goodman said the audit committee should also coordinate with other committees, such as the executive compensation committee, particularly in light of the recent stock option backdating issues. Audit committees should consider outside expertise as needed, including educational and training advice which is particularly important for new directors.