...fair value of stock option transactions.

Introduction

In 2006, the Financial Accounting Standards Board (FASB) established framework for measuring fair value with the issuance of Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). This pronouncement and the underlying requirements it places on independent auditors to properly apply its provisions to fair value reporting and disclosure will greatly affect financial statement reporting and the role of auditors in the United States. In addition, two years ago, when the FASB issued Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (SFAS 123(R), revised 2004), it allowed corporations flexibility in their use of valuation models to measure the fair value of stock option arrangements.

SFAS 123(R) is not included in the scope of SFAS 157. Employee stock option arrangements are not publicly traded instruments, and therefore the fair value of such options are not easily determinable and must be estimated using an option pricing model, such as Black-Scholes-Merton or the Lattice model [3]. The compensation expense recognized on the income statement and the value of the stock options on the balance sheet are based on reasonable estimates using "forward-looking information," and can be material in amount [2].

On October 17, 2006, the Public Company Accounting Oversight Board (PCAOB) issued a series of "questions and answers" (Q & A) to provide direction to CPA firms auditing public company estimates of the fair value of employee stock option arrangements [4]. Using the PCAOB Q & A and other audit procedures, this article examines some of the major complexities in internal control procedures employed in auditing the fair value of a corporation's stock option transactions. Specifically, it addresses:

(a) understanding the process used by an entity to develop the estimated fair value of employee share options,

(b) testing of an entity's share-based payment database and activity,

(c) comparing the two fair value estimate models,

(d) testing procedures used to estimate fair value, including the assumptions employed and the appropriateness of the adopted model used, and

(e) testing the recording and proper classification of the resulting compensation expense and financial statement presentation and disclosures.

In addition, the auditor's use of internal or external fair value specialists will be discussed throughout.

Developing an Understanding of a Corporation's Process Used to Develop Fair Value of Employee Share Options

In the Q & A, the PCAOB Staff noted that in AU 328.09 (Auditing Fair Value Measurements) auditors are required to obtain a thorough understanding of the company's process for determining fair value measurements and disclosures, as well as the relevant controls sufficient to develop an effective audit approach [1, 5]. Specifically, in examining a public company's process for accounting for share-based compensation transactions, documentation of such understanding might include (but is not limited to) the following inquiries of management and its board of directors. The PCAOB Staff note that the auditor should document:

* The terms and conditions of the existing policies granting employee stock options, paying close attention to terms allowing exercise prices that are not equal to the market price on the grant date (as well as terms that delegate option award issuance authority to management).

* The extent the company uses third-party specialists in determining its fair value measurements and disclosures.

* The process for approving and communicating option awards to employees, ensuring that the company determines that the grant date used is consistent with FAS 123(R). Their understanding of the general terms of the stock compensation plan, reviewing contractual terms, settlement alternatives, number of options available, and other relevant terms must be examined.

* The process for tracking stock option awards granted, exercises, forfeitures, cancellations, and option expirations, along with the company's process used to review plan documents and the accounting for each individual grant.

* The process the...

NOTE: All illustrations and photos have been removed from this article.



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