Employee stock options and the flawed use of the Black–Scholes option pricing model

• Author: Louis P. Le Guyader,Thomas O. Meyer
• DOI: http://doi.org/10.1002/jcaf.22456
• Date: 01 January 2021
• Published date: 01 January 2021

J Corp Acct Fin. 2021;32:7–12. wileyonlinelibrary.com/journal/jcaf © 2020 Wiley Periodicals, Inc. 7

EDITORIAL REVIEW

Employee stock options and the flawed use

of the Black–Scholes option pricing model

Louis P. Le Guyader | Thomas O. Meyer

Department of Accounting and Finance,

College of Business, Southeastern

Louisiana University (SELU), Hammond,

Louisiana

Correspondence

Louis P. Le Guyader, Department of

Accounting and Finance, College of

Business, Southeastern Louisiana

University (SELU), Hammond, LA.

Email: louis.leguyader@selu.edu

Abstract

This article studies a well-known, and flawed, use of the Black–Scholes model

in reporting. It achieves two principal goals. First, it reports our critical analy-

sis into the topic resulting from the combination of our fields’expertise in

it. Second, we report our study into an as-yet undocumented example of that

flaw. The flawed use of Black–Scholes leads to mark-to-model measurements

errors in reporting, most notably in Earnings. Our analysis covers the major

sources of the resulting mis-measurement: the mismatch between the parame-

trization of Black–Scholes models versus the legal formulation of ESO contract

terms; and the alteration of the models’inputs mandated by regulators. These

regulators asserted that the unavoidably incorrect values would be “sufficient”

for reporting. Our study examines the infrequently studied “risk-free rate”

input to demonstrate that resulting mis-measurements are readily quantifiable.

We expect to continue this research into our fields’disagreements on the use

of the Black–Scholes class of option pricing models for reporting.

KEYWORDS

Black-Scholes option pricing model, employee stock options, US GAAP compensation costs

1|INTRODUCTION

In 1995, under FAS123, the FASB adopted the use of

option-pricing models to value share-based compensation

contracts issued to employees (Financial Accounting Stan-

dards Board (FASB), 1995). It reaffirmed this decision in

2004 when it required the expensing of these values under

FAS123 (revised; Financial Accounting Standards Board

(FASB), 2004). Later, the IFRS would follow this lead

resulting in the issuance of IFRS 2 in 2004 (International

Accounting Standards Board (IASB), 2004). The IFRS

adoption of this approach reflected a broader agenda to

attempt a convergence between US GAAP and IFRS to

produce “one single accounting model.”The acceptance of

Black–Scholes models (Black & Scholes, 1973) in both set-

tings was facilitated by the fact that Myron Scholes and

Robert Merton (Merton, 1973) had earned the Nobel Prize

in economics for this model, an award which popularized

its use throughout the world.

The problem with this model choice was that Fischer

Black and Myron Scholes had carefully crafted their model

using the standard format for standardized equity options as

traded in the Chicago exchange markets. Shared-based com-

pensation contracts are both more complex and substantially

different. Further, these compensation contracts had also not

been included in the modeling efforts of Black and Scholes.

There was no doubt that share-based compensation

contracts contained an imbedded equity option. How-

ever, there was every doubt that Black–Scholes was the

appropriate option model to value it. The FASB went

This paper was presented virtually on March 25, 2020, in the American

Business Research Conference—New Orleans, where it was awarded

Best Paper in an Accounting Session.

Received: 17 April 2020 Revised: 21 May 2020 Accepted: 22 May 2020

DOI: 10.1002/jcaf.22456

J Corp Acct Fin. 2020;1–6. wileyonlinelibrary.com/journal/jcaf © 2020 Wiley Periodicals, Inc. 1