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

AuthorLouis P. Le Guyader,Thomas O. Meyer
Date01 January 2021
Published date01 January 2021
J Corp Acct Fin. 2021;32:7–12. wileyonlinelibrary.com/journal/jcaf © 2020 Wiley Periodicals, Inc. 7
Employee stock options and the flawed use
of the BlackScholes option pricing model
Louis P. Le Guyader | Thomas O. Meyer
Department of Accounting and Finance,
College of Business, Southeastern
Louisiana University (SELU), Hammond,
Louis P. Le Guyader, Department of
Accounting and Finance, College of
Business, Southeastern Louisiana
University (SELU), Hammond, LA.
Email: louis.leguyader@selu.edu
This article studies a well-known, and flawed, use of the BlackScholes model
in reporting. It achieves two principal goals. First, it reports our critical analy-
sis into the topic resulting from the combination of our fieldsexpertise in
it. Second, we report our study into an as-yet undocumented example of that
flaw. The flawed use of BlackScholes 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 BlackScholes models versus the legal formulation of ESO contract
terms; and the alteration of the modelsinputs 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 fieldsdisagreements on the use
of the BlackScholes class of option pricing models for reporting.
Black-Scholes option pricing model, employee stock options, US GAAP compensation costs
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
BlackScholes 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 BlackScholes 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 ConferenceNew 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;16. wileyonlinelibrary.com/journal/jcaf © 2020 Wiley Periodicals, Inc. 1

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