An institutional investor group is voicing concern over the U.S. Securities and Exchange Commission's recent decision to grant preliminary approval to Zions Bancorp's plan to use an auction-based system to determine the fair value of employee stock option grants.

The Zions auction system is the first market-based valuation method to pass muster with the SEC. In 2005, Cisco Systems proposed its own market-based plan, but the agency declined to approve it. Cisco and other technology firms, which historically have issued a significant number of stock options, contend that commonly used mathematical methods, such as the Black-Scholes model, overstate option values.

However, some investors warn that companies may use market-based methods to improperly reduce their reported compensation costs. In a Feb. 5 letter to the SEC's chief accountant, the Council of Institutional Investors (CII) urged the agency to delay approving other market-based valuation methods for at least a month to give investors more time to analyze Zions' plan.

"The ongoing stock-option backdating controversy is a constant reminder that the financial accounting and reporting for employee share-based awards is an area in which there is a high risk of intentional misapplication of accounting requirements," CII General Counsel Jeff Mahoney wrote to the SEC.

Investors advocates have long urged U.S. regulators to require companies to expense options so shareholders could get a better sense of the total cost of executive and employee compensation. In December 2004, the Financial Accounting Standards Board (FASB) heeded these concerns and mandated option expensing in its Statement of Financial Accounting Standards 123R. While option valuation information had typically been available in financial statement footnotes, the new rule sought to improve transparency and give investors a better sense of the economic impact of option grants within GAAP financials.

Statement 123R applies to the first fiscal year that started after June 15, 2005, which means that investors are just starting to see corporate disclosures that address option expensing. To date, about 60 companies have made 123R disclosures.

Under Statement 123R, companies have significant leeway in the models they use to calculate option values. Issuers also have flexibility in the assumptions they make about the various factors, such as expected option-term length and stock price volatility, that are used as inputs for these models. Recent financial filings indicate that companies are using varying assumptions and deriving significantly different values. In some cases, companies are reporting a lower options expense than one might calculate with a standardized methodology and inputs. (Next Tuesday's blog post will offer more on how these assumptions vary and their impact on reported option values)