Are The FAS 123R Storm Clouds Hovering Overhead?

May 22nd 2008
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Gary Levine - The weather has been a bit steamy here in the Boston area. Everyone is talking about the heat and humidity this month … the old “it’s so much worse than dry heat.” Unfortunately, the weather is not that predictable here in New England and it’s not uncommon for the forecasters to make mistakes.

Let’s hope it’s not that way for your spreadsheets.

Does sweat start to bead on your brow when you realize the auditors are coming in next month and you haven’t had time to check and re-check the formulas in your stock option spreadsheets? Or when you try to figure out which is the most recent version of the spreadsheet? Do you get a cold chill when you realize that because of all the new FAS 123R regulations, your auditors are going to be putting your valuation assumptions under greater scrutiny than last year? Have you discussed in advance what they are going to want to see?

Since Financial Accounting Standard (FAS) 123R moved equity compensation expense from a pro forma footnote to a line item in the income statement, CFOs and controllers have felt a storm brewing. I’ve referred to it in other articles as the “Perfect Storm” when thinking about SOX, FAS 123R, option backdating, and new executive compensation disclosures.

Since your goal is to make the annual audit as painless and brief as possible, have you thought about how you are going to put it all together? If it’s your first time, how would you begin to comply with FAS 123R and satisfy the auditors? Well, there are a few general steps that you can take to create auditable stock option records, comply with FAS 123R, and ensure the perfect storm by-passes your next audit.

First, organize all your legal documents. Before anything else, start properly recording and documenting the legal actions of the Board, the company, and each employee as they relate to option grants, exercises, and cancellations. Because your option records and equity compensation expense reports will later reflect these actions and the supporting documents, you want to avoid any inconsistencies that may show up in an audit.

Second, centralize your records. Consider consolidating all transactions that relate to stock option administration, valuation and expensing, and legal compliance in a single, integrated system. This is particularly important as stock option data tends to come from a number of different areas within a company, typically in documents most commonly related to legal, finance, and human resources. When each department retains and manages its own collection of information, it can lead to errors, inconsistencies, and missing documentation – in addition to duplicate effort and wasted time.

Third, automate the transactions. Over the course of hundreds of transactions and many years, the risk of error increases. The best way to reduce potential errors is to let your computer do the work. When you automate, you know you are tracking, calculating, and reporting similar transactions the same way, every time. It saves time and it creates an audit trail showing who made the changes and when. Based on this higher level of reliability, auditors are more comfortable with automated systems and typically can sample fewer records which will save audit time and expense.

Fourth, determine the variables. Now that the new regulations require companies to include stock option-related compensation expense in the income statement, auditors are even more careful when reviewing how each variable used in the valuation model is determined – particularly fair market value, volatility, and expected life. You must be able to document that you followed a reasonable process to determine each variable. If the valuation and expensing variables are properly documented, based on a reasonable process, and supported by an integrated system, it will provide the auditors with greater confidence and raise fewer red flags.

Fifth, prepare your reports. The final and perhaps ultimate goal of stock option administration is to produce a clear and concise set of reports that provide the necessary information for a company’s quarterly and annual financial statements. More specifically, your company will want to prepare a standard set of reports that it can use each quarter to generate the stock option-related expense items. Using the same system for generating both the stock plan administration and valuation and expensing reports will help to avoid inconsistency and increase accuracy. To ensure a smooth audit, prepare the list of reports in advance and organize them in a format that is easy to review.

If you would like a few more details or a visual chart that lays out these actions and describes the documents, click here to read a white paper I recently authored regarding setting up a Framework to Create Auditable Stock Option Records and Comply with FAS 123R.

Gary D. Levine, President and CEO
Two Step Software, Inc.


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