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Unformatted text preview: and expensed over the period when an
employee performs related services. Under this method, the company must also
disclose pro forma net income and earnings per share as if the fair value based
method had been used (Wiedman & Goldberg, 2001).
Under the fair value based method, compensation cost is measured at the grant
date and is recognised over the service period, which is normally the vesting
period. The fair value is determined using an option pricing model. Option
pricing models take into account such factors as the grant date, the exercise
price, the expected life of the option, the current price of the underlying stock,
its expected volatility, expected dividends on the stock and the risk-free interest
rate over the expected life of the option. As the fair value of an option includes
not only its intrinsic value but also its time value, the fair value approach
results in a higher expense than the intrinsic value approach (Wiedman &
3.5.2 Overview of Option Pricing Models and Their Drawbacks When
Applying to Stock-Based Compensation Plans
The fair value of stock-based compensation can be measured using option
pricing models. Both IASB and FASB provide companies with the choice of
measuring stock options using option pricing models. We here present a short
introduction to the available models.
The most popular option pricing models are the Black-Scholes and the
binominal models, which provide quite accurate estimates of the value of an
option (www.ei.com./publications/2001/winter1). Companies usually prefer the
Black-Scholes model, which was introduced in 1973 by two financial
academics, Fischer Black and Myron Scholes, and co-developed by Robert
Merton. The Black-Scholes and binominal models are formulas that generate
an expected of value stock option, i.e. an amount which an investor is willing to
pay today for the opportunity to receive the benefits of the increase in value of
the underlying stock during the life of the option (Restaino, 2001).
The a ssumptions m ade i n o ption p ricing m odels a re a s f ollows
• No dividends are paid during the option’s life
European exercise terms are used
Markets are efficient
There are no commissions charged
Interest rate remains constant and known. The Black-Scholes model and standard binominal models were created to be
used for short-term investment instruments, which are publicly traded.
Therefore, they cannot, without modification, be used to value employee stock
options. In fact, these option pricing models can considerably overstate the
value of the employee stock options (www.ei.com/publications/2001/winter1).
Alfred King, Vice Chairman of Valuation Research Corp. in the United States,
said that the Black-Scholes model is good for publicly traded options, but is
inappropriate for employee stock options (Harrison, 2002). A number of
companies, such as Wal-Mart and Commerce Bancorp Inc., have also noted the
drawbacks of the existing option pricing models. In their annual reports the
companies stated that since employee stock options differ from traded options
and since option valuation methods require a lot of subjective assumptions,
which can affect the valuation, the existing option pricing models do not
provide an accurate measurement of the employee stock options’ fair value
The expected dividends of the stock, the expected life of the option and the
expected volatility of the stock require a lot of professional judgement from
accountants. When estimating dividends, accountants should consider the
historical pattern of paying dividends. However, there is a probability that
historical dividend payout will not be sustained. In such cases, accountants
have to find a different way to estimate dividends. The expected life of options
depends on the vesting period. If there is any indication that options might be
exercised earlier, the company should use the average length of time during
which similar grants were outstanding in the past. The expected volatility is the
most complex to estimate. Again, accountants should look at the historical
volatility of the stock (Bushong, 1996).
While publicly traded options are quite short-term, can be exercised at any time
and can be traded freely, employee stock options are of a considerably different
nature. As a rule, employee stock options have a longer life period, can be
exercised after a long vesting period and, most importantly, they are nontransferable (Harrison, 2002).
The non-transferability of employee stock options is an important limitation.
Standard option pricing models assume that options will be exercised at or
30 close to the optimal exercise price. The transferability of options ensures that
they won’t be exercised prematurely. If, for example, the holder of the option
does not want to hold it until the appropriate exercise date, he/she can sell the
option to another investor, who will wait until the optimal time. The
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- Fall '13