Accounting may derail market for employee stock options

Deseret News (Salt Lake City), Jul 23, 2007 by Judith Burns Dow Jones Newswires

WASHINGTON -- A Zions Bancorp. push to value employee stock options using a market-based approach may be delayed pending resolution of a basic accounting question: Are financial products that track the value of such options an equity instrument or a liability?

The decision on accounting treatment could spell the difference between success or failure for Esoars, or employee stock option appreciation rights securities, a new financial product offered by Zions, a Salt Lake-based bank holding company. Esoars buyers don't get options, but an instrument whose value depends on the stock price, the options price, and whether employees exercise their options.

Stock options, which give holders the right to buy company stock in the future at a preset price, typically are valued using pricing models designed for exchange-traded stock options. Questions about valuing employee stock options have become more pressing as companies now must deduct the cost of options they grant. Securities and Exchange Commission Chairman Christopher Cox has encouraged competition and innovation, dismaying critics who think market experiments will yield low-ball valuations of employee stock options.

Zions, which held the first-ever Esoars auction this year, tracking options granted to its employees, hopes to offer the service to other companies that issue such options. Broader adoption could be put on hold while accounting questions are put to the Financial Accounting Standards Board's emerging issues task force, comprised of accounting, business and investor representatives.

While critics have focused on whether auctions are a valid way to value stock options, a sleeper issue is how to account for such financial instruments, a seemingly technical question that could make or break the market for such products.

"We are in talks with FASB to try to get our Esoars instruments treated as equity," said Zions vice president Evan Hill.

Deeming such products to be equities would be the best possible result for Zions, although it may delay trading until 2008. However, if standard-setters decide such products are a liability, they likely would be categorized as derivatives, dealing a one-two punch that could boost costs and volatility and raise valuation questions anew, making the tracking instrument far less appealing to companies looking for new ways to value employee stock options.

The reason: derivatives must be marked to market, generally each quarter. While the accounting for employee stock option grants wouldn't change under such an approach, companies would have to reassess any tracking instrument used in valuing those options. That might require frequent auctions, or reverting to options-pricing models, defeating the purpose of using Esoars-type products. Another downside is that as a liability, any increase in the value of the tracking securities would be treated as an expense, reducing earnings.

"I don't see it as deal killer, I see it as a deal complicator," said Hill. He predicted that some companies wouldn't object to using Esoars, even if they must be accounted for as a liability but acknowledged others might decide that "it's just more headache than it's worth."

Zions vice president James Livingston declined to comment on whether Zions is accounting for Esoars as an equity or liability, as did a spokesman for its outside auditor, Ernst & Young LLP.

SEC officials aren't jumping in, said Hill. "For them, it's a FASB question." SEC spokesman John Nester declined to comment.

FASB's emerging issues task force agenda committee may consider whether to add discussion of Esoars-type instruments to a task force meeting on Sept. 11. Task force chairman, Russell Golden, declined to comment on the matter.

FASB created the task force to resolve pressing issues quickly, but its process isn't super-speedy. It typically votes on adopting a consensus view, and then it seeks public comment before finalizing it and sending it to the FASB for ratification. Thus, even if the task force takes up the matter in September, the earliest it could finish would be at its November meeting; any delays might defer a ruling until 2008.

Although the task force has weighed in previously on tracking securities, it has not directly addressed products linked to the value of employee stock options rather than to company stock. A key hurdle: tracking securities that are solely indexed to a stock qualify for equity treatment, and yet Esoars are dually indexed, depending on the value of the stock and whether employees exercise their options.

Another potential wrinkle: while employee stock options and tracking securities generally get accounted for as equity instruments, such treatment may not apply if payments are made in cash. Zions has said Esoars holders may be paid in stock, cash or some combination, which might raise questions about whether the securities qualify for treatment as equity instruments.