Editor

Two years ago, the Financial Accounting Standards Board was said to be "moving quickly" on a proposal that would call for listing employee stock options as expenses like any other among the company's profits and losses, rather than in footnotes as a pro-forma expense.

That's how Steve Lawton, vice president for regulatory affairs and general counsel of the Biotechnology Industry Organization, characterized the pace. (See BioWorld Financial Watch, Aug. 19, 2002.)

The idea had BIO and others up in arms. Objectors said that to list employee stock options (ESOs) as expenses would clash directly with the need - especially by biotechnology start-ups - to draw talented young physicians and scientists, since ESOs commonly are used to attract them when hard cash isn't available.

What's more, they said, to count ESOs as expenses might distort the financial statements of small biotechnology firms, since their stocks fluctuate wildly, based on trial results, product approvals and (to a greater extent, arguably, than other stocks) investor whim.

"Quickly" doesn't mean the same in Washington as it does most other places, but FASB might finally be going forward with the proposal. The comment period ended June 30, and BIO is reacting as before to the accounting agency's idea, formally put forth this spring.

Until something else happens, companies may use one of two accounting methods. The first is Accounting Principles Board No. 25, established decades ago, also known as the "binomial method." It allows companies to use "intrinsic value" - that is, the difference between the market price of the stock and the exercise price - when figuring the cost of ESOs.

The other is FASB's Statement 123, adopted in 1995. It recommends the "fair value" method, based on an option-pricing model such as the Black-Scholes algorithm, which many have attacked as being too slapdash. ESOs, critics point out, have no value unless vested. When issued, they're just paper.

Basically, the rules as they stand let companies report ESO costs in the footnotes of their financial reports, without the costs putting a dent in profits - not a good thing, maybe, for highly profitable firms trying to keep their numbers up by hiding what might be considered expenses, but hardly evil for the likes of struggling biotechnology outfits with little, if any, profit to show.

FASB's rule change also would hit employee stock-purchasing plans that allow staffers to allocate a percentage of earnings per pay period to buy shares at a discount, which is a sore point in biotechnology and beyond. The National Center for Employee Ownership estimates 4,000 companies allow more than 15 million employees to make such buys. Firms could still offer the plans under the rule change, but would have to value them using the binomial model.

Corey Rosen, director of the NCEO, composed and posted on the organization's website a "ditty" regarding the FASB debate over ESOs, which goes in part: "But, we complained, who knows what they cost? / The math is uncertain; shareholders get lost. / And if we issue new shares, there is no confusion, / owners just face some extra dilution. / But if we record this terrible guess, / our average worker can only get less. / No more options for them; they really don't matter, / it's CEOs whose wallets need to get fatter."

Walter Moore, vice president of government affairs for Genentech Inc., put the matter more soberly in his testimony last fall before a Senate subcommittee. Moore said the footnote-disclosure method provides more clarity than trying to value ESOs as expenses.

"An investor with a target price can determine the exact dilution in the stock price he or she can expect. Conversely, expensing options will take the focus away from the real cost of options, [which is] dilution. Instead, companies will report a seemingly precise' number in the income statement, which, in fact, is totally subjective, unreliable, and cannot account for scientific and technological breakthroughs or failures."

On board as of last week in favor of FASB's "Share-Based Payment, an Amendment of FASB Statements No. 123 and 95," however, is the General Accounting Office's comptroller, David Walker, who called the issue "critical" and urged FASB to "complete its analysis of comments received on its exposure document on share-based payment and finalize the proposed statement." Walker didn't say FASB should do so "quickly," but that's what he seemed to mean.

Another two years, then?

New ESO rules were expected to take effect by Dec. 31, 2004, but FASB said during a recent hearing that it might need more time to consider thousands of comment letters. The avalanche of protest documents came mostly from technology firms, such as networking behemoth Cisco, but with medical research companies well represented, too.

Voices are at least as loud on the other side of the controversy, with powerful institutional investors from the U.S. and overseas insisting that FASB hold the line and adopt tougher standards, in order to stay in line with such moves being made in various realms of finance around the world.

Ways other than the two standard methods of valuing ESOs are being considered, FASB has said. A professor of finance at the University of California at Berkeley came up with one. So did Integrated Finance Ltd., the investment bank co-founded by Nobel Prize-winning economist Robert Merton. There are rumblings that FASB could delay deciding for another year - which some opponents want.

In Moore's view, "one prudent way of moving forward would be to road test' models through footnote disclosure to discern whether they actually work, rather than mandating whole-scale change and risking what we believe would be severe consequences for small businesses and their employees."

Meanwhile, the battle goes on. There's legislation in the U.S. House of Representatives to mostly derail FASB's proposed changes (under the floated law, ESOs would have to be expensed for only the five highest-paid employees of a given firm), but the Senate has not taken any action, and word is that it's unlikely to, since the Senate Banking Committee's strongest Republican, Richard Shelby from Alabama, and most prominent Democrat, Paul Sarbanes of Maryland, are backers of FASB.

Of course, technology firms - "bio" and otherwise - hope to resolve the matter outside the legislative arena. But valuing ESOs is going to be tricky, Moore warned. An estimate is a shot in the dark.

"At any point in time the volatility of companies even within the same industry can be radically different," he told the subcommittee. "For example, in our industry in 2001, four companies used volatility assumptions in their footnote disclosures that ranged from 44 percent to 63 percent. What is the correct volatility to use? Who knows? Biotech is a stunningly risky business."

No Comments