Statement by SEC Staff:
Remarks Before the 2005 AICPA National Conference on Current SEC and PCAOB Developments


Alison T. Spivey

Associate Chief Accountant
Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 5, 2005

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the SEC staff.


Good afternoon. It is a pleasure to be here.

As you know, following the FASB's issuance of Statement 123R last December, OCA staff, together with staff in the Division of Corporation Finance, set out to try and address some of the questions about valuation and the interaction of Statement 123R and certain SEC rules and regulations in Staff Accounting Bulletin No. 107 (SAB 107). Shan has already provided insight on several areas discussed in SAB 107, and I plan to focus on certain valuation issues, specifically the expected volatility and expected term assumptions and the use of market instruments.

Before I jump into the detailed valuation discussion, I would like to share a personal observation regarding one part of the process that led to the issuance of SAB 107. Our team worked closely with the Commission's Office of Economic Analysis (OEA) in this effort. For those that are not familiar with OEA, this office serves as the chief advisor to the Commission and its staff on economic issues associated with the SEC's regulatory activities. The economists in this office are highly distinguished professionals, and it has been a privilege to learn from them. Working with OEA on the SAB was like receiving valuation tutorials from well-renowned PhDs in a small group setting. I came away from that experience having not only learned a great deal, but also gained an appreciation of the importance of valuation issues in accounting today.

As the FASB continues to consider issues related to the role of fair value in accounting, questions regarding the relevancy and reliability of fair value measurements will undoubtedly be a focal point of that debate. In order to properly join this debate, I believe that accounting professionals would benefit from trying to increase their awareness and understanding of economic and valuation issues and the various techniques and models available to measure fair value.

Expected Volatility Assumption

Turning to share-based payment valuations, let me first touch on the expected volatility assumption. Statement 123R defines volatility as the measure of the change in a financial variable, such as a company's share price, during a period.1 Although Statement 123R does not require a specific method to be used, it does provide a list of factors to consider when estimating expected volatility.2 The staff has been asked whether exclusive reliance on a particular factor would be acceptable in estimating expected volatility. SAB 107 does include the staff's thoughts on when exclusive reliance on either realized historical volatility or current implied volatility would be appropriate. I would like to give you a few additional thoughts on these two measures of volatility based on questions we have received since the SAB was released.

Implied volatility reflects the market's consensus regarding changes in a company's share price during the term of an option. Since employee options have terms that usually extend for several years or more, we understand that some companies may be hesitant to use an implied volatility measure derived from traded options that typically have terms of 2 years or less. SAB 107 expresses the staff's view that, holding other factors constant, the current implied volatility of a traded option with a term of one-year or more would typically not be significantly different from the implied volatility that would be derived from a traded option with a longer term. In fact, the staff stated in SAB 107 that it will not object to a company exclusively relying on the implied volatility derived from a traded option with a remaining maturity of at least one year, assuming other criteria provided in the SAB are also met. In addition, SAB 107 also notes that implied volatility based on a traded option with a remaining maturity of six months or more could be considered as long as a company also considers other relevant information in estimating expected volatility.

Of course, historical realized volatility is one source of relevant information to consider when developing an estimate of expected volatility. Since companies are more familiar with calculations of historical realized volatility, I am not going to go in to a lot of detail on this topic. However, I do want to mention that we are aware that there are many methods available out there for companies to utilize in computing historical volatility.

When evaluating the alternative methods, we would encourage companies to keep in mind the objective as stated in Statement 123R - to ascertain the assumption about expected volatility that marketplace participants would likely use in determining an exchange price for an option.3 The staff expects companies to make good faith efforts to determine an appropriate estimate of expected volatility as one of the key assumptions used in determining a reasonable fair value estimate.

We have become aware of two methods for computing historical volatility that we believe will not meet this expectation. The first method is one that weighs the most recent periods of historical volatility much more heavily than earlier periods. The second method relies solely on using the average value of the daily high and low share prices to compute volatility. While we understand that we may not be aware of all of the methods that currently exist today and that others may be developed in the future, we would like to remind companies to keep in mind the objective in Statement 123R when choosing the appropriate method.

Of course, many companies will likely conclude that exclusive reliance on either historical or implied volatility is inappropriate. In those circumstances, companies would have to consider the information that is available to assist in estimating expected volatility. As you might expect, this consideration would likely be highly subjective. All available information should be carefully evaluated, and there is no “magic formula” for assigning probabilities to that information for an individual company or industry group. Again, I suggest that companies keep in mind the objective of estimating expected volatility stated in Statement 123R, which is to determine the assumption about expected volatility that marketplace participants would be likely to use in determining an exchange price for an option.4

Expected Term Assumption

I would now like to discuss the expected term assumption that is needed to use a closed-form option pricing model, such as the Black-Scholes-Merton model.5 When developing an estimate of expected term for input into a closed-form model, Statement 123R notes that there may be several different sources of information available, such as a company's historical data, industry averages, or academic research.6 When the SAB was being developed, the staff understood that there were minimal sources of publicly available information that could assist companies in determining the period of time that an employee share option would remain outstanding. Some companies might have appropriate historical information available to develop this estimate, but others might not have historical data available for the term of the option being valued. Still others might believe that historical information is not representative of future employee exercise patterns due to, for example, an expectation of a more volatile stock price over the term of the employee option.

In order to address the concern raised that publicly available information does not currently exist and historical data might not, in all cases, provide appropriate information, SAB 107 states that the staff will not object to the use of a “simplified” method for estimating expected term for “plain vanilla” options, as those options are described in the SAB. This alternative is available for all public companies. In addition, the staff would not object if a company applied the simplified method in the financial statements for the pre-IPO years included in the initial registration statement filed with the Commission.

SAB 107 states the staff's belief that more detailed information about employee exercise behavior will, over time, become available. In fact, I have recently become aware of an effort underway to gather and analyze data with the purpose of making the results of this analysis publicly available. Personally, I am encouraged by these developments and the continuing public dialogue in this area.

Market Instruments

Another subject of recent discussion at the Commission relates to the use of market instruments to value employee share options. Statement 123R states that the best evidence of fair value for employee share options is observable market prices of identical or similar instruments in active markets.7

In Statement 123R, the FASB did not attempt to consider the appropriate design of an instrument that might be specifically created for the purpose of obtaining a market-based value of employee share options. Since the issuance of SAB 107, we became aware of efforts underway to design and sell a market instrument for the purpose of providing a value for employee share options. This past September, our former Chief Accountant, Don Nicolaisen, issued a statement expressing his views on the use of market instruments to estimate the grant-date fair value of employee share options. His statement is accompanied by a memo from our Office of Economic Analysis on the economic perspectives of these instruments. Chairman Cox also issued a statement commenting on the use of appropriate market instruments for estimating the fair value of employee share options.

We are not currently aware of any instruments that have been sold in the market for the purpose of valuing employee share options. As a result, the discussions we have had about these types of instruments have been theoretical in nature. As Mr. Nicolaisen stated in his September statement, we believe that it should be possible to design instruments whose transaction prices would be a reasonable estimate of the fair value of underlying employee share options.

Rather than try to discuss all of the views expressed in the September statements, I am going to focus my remarks on two possible approaches to market instruments in order to provide you with some perspectives on what we have been considering. For further information on market instruments beyond what I am about to cover, please visit the Commission's website.

Statement 123R states that the objective of accounting for share-based payment transactions with employees is to record the cost of employee services to the company.8 In order to determine the cost to the company, the purchaser of a market instrument would need to step into the shoes of either the employer or the employee.

If the purchaser of a market instrument assumes the role of the employee, then the instrument would be intended to be designed such that the purchaser would pay an amount based on the value that the purchaser would expect an employee to receive from the option. One possible approach would be to design an instrument that would result in a payoff that tracked the payoff of an underlying pool of employee stock options.

Another approach might be to design an instrument that replicates the restrictive terms included in employee share options. However, we do not believe that the value that a third-party investor would assign to an instrument with the same restrictive terms would represent the fair value of the employee share option consistent with the measurement objective of Statement 123R. That is, it does not seem possible to replicate an employer-employee relationship or the effects of that relationship in a transaction with a third party.

An additional point related to instruments containing restrictive terms is that the investor may be motivated to pay as little as possible for the instrument, while, at the same time, the employer might be motivated to sell the instrument at the lowest possible price in order to obtain a lower value for purposes of recording compensation cost in its financial statements.

On the other hand, if a holder of a market instrument assumes the role of the employer, then that holder would be expected to assume the risks associated with the future exercise of the options by the employees. The holder of the instrument would be free to manage those risks however it deems appropriate, through hedging strategies, transfers to another third party, or some other means. I would expect that an independent third-party that enters into this transaction would strive to maximize the transaction price received from the employer. The counterparty, or the issuer of the stock options, is laying off its obligation to a third party and therefore would likely seek to minimize the transaction price.

Of course, all of the discussion so far has centered on whether the design of an instrument could provide an estimate of fair value for employee share options. The marketing plan for the instrument is an equally important consideration because marketplace participants will need information about the terms of the awards as well as other information that would be useful to appropriately determine a fair value estimate.

Once an instrument has been designed, marketed, and sold for an amount that represents the fair value of an employee share option, the accounting for that instrument under Statement 123R would need to be considered. All of these questions are very interesting, and since September we have continued to gather information and learn more about the potential for market instruments to provide a fair value for employee share options. I am hopeful that the public dialogue on this issue will continue so that the issues can be worked through and we can reach the next stage in the evolution of employee share option valuation.

This concludes my remarks. Thank you for your time today.


1 Statement 123R, paragraph A31.
2 Statement 123R, paragraph A32.
3 Statement 123R, paragraph B86.
4 Statement 123R, paragraph B86.
5 Statement 123R, paragraph A18.
6 Statement 123R, paragraph A29.
7 Statement 123R, paragraph A7.
8 Statement 123R, paragraph 9.