The Effect of Exercise Date Uncertainty on Employee Stock Option Value

Abstract

The IASC recently recommended that employee compensation in the form of stock options be measured at the 'fair value' based on an option pricing model and the value should be recognized in financial statements. This follows adoption of "SFAS No. 123" in the United States, which requires firms to estimate the value of employee stock options using either a Black-Scholes or binomial model. Most US firms used the B-S model for their 1996 financial statements. This study assumes that option life follows a Gamma distribution, allowing the variance of option life to be separate from its expected life. The results indicate the adjusted Black-Scholes model could overvalue employee stock options on the grant date by as much as 72 percent for nondividend paying firms and by as much as 84 percent for dividend paying firms. The results further demonstrate the sensitivity of ESO values to the volatility of the expected option life, a parameter that the B-S model or a Poisson process cannot accommodate. The variability of option life has an especially big impact on ESO value for firms whose ESOs have a relatively short life (5 years, for example) and high employee turnover. For such firms, the results indicate a binomial option pricing model is more appropriate for estimating ESO value than the B-S type model. Copyright Blackwell Publishers Ltd, 2003.

Expensing stock-based payments: A material concern?

“…Many also question the appropriateness of the models given that options issued to employees have idiosyncratic characteristics relative to traded options (e.g. lack of transferability, performance hurdles and restrictions on the period in which the option can be exercised) (Maris, Maris, & Yang, 2003). The international regulation does (does not) allow the fair value of the options at grant date to be adjusted for market (non-market) based performance conditions.…”

Taxation and the Early Exercise of Call Options

“…Note that there are factors other than tax that can cause the value of an option to differ for different market participants. The literature on Employee Stock Options (ESOs) is a case in point (see, for example, Huddart, 1994; Huddart and Lang, 1996; Carpenter, 1998; and Maris et al, 2003). ESOs must be valued from the viewpoint of the issuer in order to determine the appropriate cost to include in financial statements.…”

“…This means that the basic assumptions underlying Black‐Scholes‐Merton option valuation are not met; the holder of the option is not able to exit her position by selling the option and is generally not able to hedge her position by means of a short position in the underlying stock. ESOs, therefore, must be valued using a lattice approach and modelling the factors that affect early exercise, as is done by Carpenter (1998) and Maris (2003). This differs from the exchange traded options studied in this paper, as exchange traded options (and the underlying shares) are generally tradeable in a liquid market, while the dividend and its tax benefits are generally not tradeable.…”

Accounting Choices and Director Interlocks: A Social Network Approach to the Voluntary Expensing of Stock Option Grants

“…Stock‐based compensation expense has been a widely discussed topic since the 1990s (Aboody et al, 2004; DeChow et al, 1996; Espahbodi et al, 2002; Foster et al, 1991; Fredrickson et al, 2006; Harter and Harikumar, 2002; Jennergren and Naslund, 1993; and Maris et al, 2003). Prior to 2006, firms were given a choice to either adopt a fair‐value‐based method to account for stock option grants as prescribed by the Statement of Financial Accounting Standards (SFAS) 123, or to continue with the intrinsic method of Accounting Principles Board Opinion (APB) No.…”