| 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 optio'’s 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 midsized 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.
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