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November 2005
Models for Calculating a Stock Option's Fair Value 
Submitted by: Valeria Molton
FASB Statement No. 123 (Revised 2004), Share-Based Payment , requires companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award, with limited exceptions. Although Statement No. 123 (R) does have several requirements, it does not specify a preference for a particular option-pricing model to use in estimating the fair value. It does specify that if an observable market price is not available for a share option with the same or similar terms and conditions, the fair value of that instrument must be estimated using a model that takes into account, at a minimum:
- The exercise price of the option
- The expected term of the option, taking into account both the contractual term of the option and the effects of employees' expected exercise and post-vesting employment termination behavior
- The current price of the underlying share
- The expected volatility of the price of the underlying share for the expected term of the option
- The expected dividends on the underlying share for the expected term of the option
- The risk-free interest rate(s) for the expected term of the option
Binomial models and the Black-Scholes formula are among the valuation techniques that meet the criteria required by Statement No. 123(R) for estimating the fair values of employee share options and similar instruments. These valuation techniques are based on established principles of financial economic theory and are used by valuation professionals, dealers of derivative instruments, and others to estimate the fair values of options and similar instruments related to equity securities, currencies, interest rates, and commodities. Both of these models can be adjusted to account for the substantive characteristics of share options and similar instruments granted to employees.
The Black-Scholes model is a single formula with six fixed input factors that computes an estimate of an option's fair value. It assumes that option exercises occur at the end of an option's contractual term, and that expected volatility, expected dividends, and risk-free interest rates are constant over the option's term. If used to estimate the fair value of instruments in the scope of Statement No. 123 (R), this model must be adjusted to take into account certain characteristics of employee share options and similar instruments that are not consistent with the model's assumptions (e.g., the ability to exercise before the end of the options contractual term). Because of the nature of the formula, those adjustments take the form of weighted-average assumptions about those characteristics. The Black-Scholes model is easily run on a financial spreadsheet.
In contrast, the binomial model can incorporate multiple and variable assumptions of expected volatility and dividends over the option's contractual term, and estimates of expected option exercise patterns during the option's contractual term, including the effect of blackout periods. Therefore, the design of the binomial model will require more inputs and judgments to be made by management, but may more fully reflect the substantive characteristics of a particular employee share option or similar instrument. The binomial model also requires extensive calculations, which will require very complex computer-based models. This can prove to be both time-consuming and costly for companies, especially in the initial year of adoption of Statement No. 123 (R). Many mid-sized public companies may find it difficult to perform binomial calculations without external assistance. Many companies may not have the data, at least initially, needed for inputs into a binomial model. We expect most nonpublic companies will elect to use the simpler Black-Scholes model.
However, both the binomial model and the Black-Scholes model can provide a fair value estimate that is consistent with the measurement objective of Statement No. 123(R). A cost-benefit analysis should be done when deciding which option-pricing model to use. The simpler Black-Scholes model, with its six relatively easy input factors, may be applicable for most non-public companies. Regardless of the model selected, a company must develop reasonable and supportable estimates for each assumption used in the model. These assumptions, some of which involve significant judgments and estimates, may have a greater impact on the fair value calculation than the model itself.
Published in RSM McGladrey's Insights Newsletter. Congress, Agencies Authorize Procedures To Facilitate Hurricane Katrina Relief Efforts
Submitted by: Courtney Edmonson, Senior Consultant
Reproduced with permission from Federal Contracts Report, Vol. 84, No. 9, pp. 219-220 (Sept. 13, 2005). Copyright 2005 by The Bureau of National Affairs, Inc. (800-372-1033) www.bna.com
The $51.8 billion emergency supplemental funding measure (Pub. L. No. 109-062) signed by President Bush Sept. 8 formally authorized use of emergency procurement procedures for federal agency relief activities related to Hurricane Katrina.
The legislative action came on the heels of directives from the Office of Management and Budget, the General Services Administration, and the Department of Defense authorizing agency heads to use the special emergency procurement procedures to help meet increased demands for disaster-related services.
Under these procedures:
- the micropurchase threshold is increased from $2,500 to $15,000;
- the simplified acquisition threshold is increased from $100,000 to $250,000; and
- the threshold for the commercial items test program is increased from $5 million to $10 million.
Any purchases using these procurement authorities "must have a clear and direct relationship to the support of the current national emergency," GSA's chief acquisition officer, Emily W. Murphy, advised the agency's acquisition staff in a Sept. 6 memo. Murphy directed that use of the increased thresholds should be documented "in writing by a brief memorandum to the contract file specifying the product or service being procured and its relationship to support the response to Hurricane Katrina."
Acquisition Flexibility Supports Efforts
Murphy also pointed out in her memo that "existing laws and regulations provide considerable flexibility for acquisitions that support urgent situations and contingency operations." She specifically listed governmentwide acquisition contracts, multiple award indefinite delivery/indefinite quantity (ID/IQ) contracts, single award ID/IQ contracts, governmentwide purchase cards, and the GSA Schedules program.
Part 6 of the Federal Acquisition Regulation, which addresses competition requirements, "continues to provide the authority to limit competition when the need arises," as long as the additional justification and approval requirements of FAR 13.501(a) are taken into account, Murphy said. "You are encouraged to continue to use small businesses where practicable to meet emergency requirements and to get competition where practicable, even if circumstances require limiting competition to a limited number of sources," she wrote.
Increasing the thresholds will help federal agencies "significantly" in awarding contracts for relief efforts in the aftermath of Hurricane Katrina, according to Acquisition Solutions, Inc., a company that provides acquisition support to the federal government. "Orders up to $15,000 will not require competition at all. Orders up to $250,000 require adherence to simplified procedures outlined in FAR part 13, allowing limited competition," Acquisition Solutions said in an advisory on emergency contracting issued in response to the hurricane.
"Perhaps most significant," according to Acquisition Solutions, is the authority for use of FAR part 13 simplified acquisition procedures for commercial item orders up to $10 million. Commercial items are not limited to products, but can include services as well, the group noted.
Expanded Use of Government Credit Card Questioned
In procurements related to Hurricane Katrina relief efforts, both the emergency supplemental and earlier directives from DOD authorize use of the governmentwide purchase card for commercial transactions of up to $250,000. Contracting officers "may deviate from the requirements" of Defense Federal Acquisition Regulation Supplement subpart 213.301(2)(i)(A) and (C) when using the purchase card to support Hurricane Katrina relief efforts, Domenic Cipicchio, acting director of defense procurement and acquisition policy, said in a Sept. 2 memo to the military services and defense agencies.
However, the authority is controversial, due in part to charges of past abuses associated with the card. Sens. Charles Grassley (R-Iowa), Susan Collins (R-Maine), and Joseph Lieberman (D-Conn.), in a Sept. 8 letter to congressional leaders, objected that raising the limit for emergency micro-purchases using government credit cards from $15,000 to $250,000 amounts to an increase of more than 1,600 percent. They cited the Government Accountability Office's findings last year that "ineffective management oversight and weak internal controls led to misuse and abuse of these cards" (81 FCR 503).
The three senators suggested that, rather than the "staggering increase in micro-purchase authority" included in the spending measure, "a more reasonable limit, perhaps $50,000," could be set. They also recommended requiring that larger purchases using the credit cards be approved in advance by senior level federal officials.
Similarly, Rep. Henry Waxman (D-Calif.) protested that raising the threshold "is an unwise provision that could lead to contract abuse and extensive waste, fraud, and abuse." The increase would "mean that any federal employee with a government-issued credit card could buy up to $250,000 in goods or services in a single purchase. There would be no limit to the number of such purchases," Waxman said in a Sept. 8 letter to the chairman of the House Appropriations Committee, Rep. Jerry Lewis (R-Calif.).
Waxman pointed to the provision in the relief act that gives contracting officers the ability and authority to make federal procurements of up to $250,000 "expeditiously, making the credit card provision unnecessary." Complaining that the federal response to Hurricane Katrina "has been woefully inadequate to date," Waxman warned against compounding "those problems by creating a situation which will inevitably lead to further waste, fraud, and abuse."
Congressional Oversight Called For
Beyond the government credit card issue, there is concern in Congress that there will be little oversight of the $62 billion dedicated to hurricane relief by the two emergency supplemental bills passed in the aftermath of Katrina. Reps. Jim Leach (R-Iowa) and Tom Tancredo (R-Col.) both have introduced legislation aimed at monitoring contracts awarded as part of the Katrina reconstruction effort.
Leach's measure (H. Res. 432) would create a select committee to investigate both the award and performance of contracts designated for the rebuilding of communities destroyed by the hurricane. The resolution would authorize the committee to make recommendations to the House in a number of areas, including:
- bidding, contracting, and auditing standards used in the award of contracts;
- oversight procedures;
- forms of payment and safeguards against money laundering;
- accountability of contractors and government officials involved in procurement;
- penalties for abuses in the award and performance of government contracts;
- subcontracting under large contracts; and
- inclusion of small businesses through subcontracts "or otherwise."
Tancredo said in a Sept. 8 statement that his legislation (H. Res. 435), which also would establish a bipartisan House oversight committee, is necessary because the "federal government has created a situation that is ripe for fraud and abuse. Billions of dollars are being handed out to a place where there is severely compromised infrastructure, where local officials have been incompetent in their early response to the emergency, and where there is little if any oversight in administering the funds."
OMB Exploring Further Needs
Also, the Office of Management and Budget is in the process of determining what legislative changes could be "quickly enacted to facilitate the federal recovery effort in the wake of Hurricane Katrina," according to David Safavian, administrator of the Office of Federal Procurement Policy.
In a Sept. 6 memorandum, Safavian asked federal agency chief acquisition officers and senior procurement executives to identify needs and recommend changes to existing legislative authorities that could be made quickly.
In seeking to expedite the acquisition of "critical services and supplies," Safavian asked that the proposals be submitted immediately for consideration and possible inclusion in OMB's proposed relief legislation. Proposals should be "focused on short-term actions that will facilitate and expedite the aid delivery process" and help ensure that existing "procurement procedures do not present any obstacles to the relief effort," he said.
By Deborah Billings Additional information about emergency contracting practices initiated as a result of Hurricane Katrina is available on Acquisition Solutions' Web site at: www.acqsolinc.com/emergencycontracting , and on the Acquisition Community Connection's Web site at: https://acc.dau.mil/simplify/ev_en.php.
Increased charitable deduction limits.
New tax law just signed by the President temporarily increases limitations on charitable deductions for an individual's cash contributions made between August 28, 2005 through December 31, 2005. It also exempts such donations from the overall itemized deduction limitation for individuals. The limit on corporations is also increased where contributions are made for Hurricane Katrina relief.
Pre-Act law. A tax deduction is allowed for charitable contributions, subject to limitations that depend on the type of taxpayer, the property contributed, and the donee organization.
Individuals. Generally, individuals were allowed a deduction for charitable contributions up to 50% of their adjusted gross income. The limits were reduced to 30% for capital gain property and 20% for certain contributions to private foundations.
Corporations. The limit for charitable contributions made by a corporation were limited to 10% of its taxable income.
Carryovers. Contributions that exceed the applicable percentage limitation may be carried forward for up to five years under Code Sec. 170(d) .
Overall limitation on itemized deductions. For 2005, the total amount of an individual's otherwise allowable itemized deductions (other than medical expenses, investment interest, and casualty, theft, or wagering losses) is reduced by 3% of the amount of the taxpayer's AGI in excess of $145,950 ($72,975 for a married taxpayer filing a separate return). The otherwise allowable itemized deductions may not be reduced by more than 80%. These dollar amounts are adjusted for inflation.
New law. An individual may deduct qualified contributions up to the amount by which his adjusted gross income exceeds his deduction for other charitable contributions. Qualified contributions in excess of this amount are carried forward for 5-years as contributions to which the 50% limit applies.
(Act § 301(b)(1))
A corporation may deduct qualified contributions up to its entire taxable income less other contributions. Qualified contributions in excess of this amount are carried forward for 5-years as contributions to which the 10% limit applies. (Act § 301(b)(2))
The deduction for qualified contributions is not treated as an itemized deduction for purposes of the overall limitation on itemized deductions. (Act § 301(c))
This change can be very beneficial, especially to those who have been considering large contributions but were concerned with either the annual limitations or the itemized deduction phaseout provisions.
Attention Property Owners
Business Personal Property Tax returns for 2006 are due no later then December 31, 2005. The preprinted forms are arriving in the mail this month and must be used to prepare the 2006 returns. Returns submitted to Madison County that are not prepared on the preprinted forms will not be accepted for processing. If Beason & Nalley, Inc. will be preparing your personal property tax returns for you please forward your preprinted forms to our office as soon as you receive them. The returns should include all property owned as of October 1, 2005. Please update your list for any additions as well as deletions for assets you no longer own.
If you have any questions please call our office at 533-1720. If we do not receive a preprinted form for your company we will assume that you have prepared the return in house. Coffee Talk
Don Nalley attended the fall meeting of The UAH Business Advisory Council and he also spoke to Dr. Merle Maddock's Management Accounting class.
Don Nalley attended the RSM McGladrey Combined Netgroup Meeting in Chicago, Illinois.
Tommy Beason represented the Huntsville Chamber of Commerce and Southeast U.S. on a recent trip to the Japan Association Joint Meeting in Tokyo, Japan. The delegation was led by Governor Riley. The group went on to Korea to meet with a major company that is already located in Huntsville, Alabama. They also met with the local newspaper in Seoul that has written articles about Huntsville in the past and is going to publish another one.
Matt Capone, Courtney Edmonson and Cindy Hill attended a two day workshop in Washington D.C. sponsored by Federal Publication Seminars on "Basics of Government Contract Accounting".
Don Nalley attended the fall Board of Advisory for Culverhouse School of Business in Tuscaloosa, Alabama.
Mike Woeber attended the Biotechnology Association of Alabama BioMixer at Brookwood Pharmaceuticals in Birmingham, Alabama. Related Information:
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