The fair value is determined using an option pricing

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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 & Goldberg, 2001). 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 (www.bradley.bradley.edu): 29 • • • • • 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 (Harrison, 2002). 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 transferable o...
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