The Effect of Using a Lattice Model to Estimate Reported Option Values
University of Kentucky - Von Allmen School of Accountancy
University of Texas at Austin - Department of Accounting
Casey M. Schwab
University of Georgia
July 1, 2013
AAA 2009 Financial Accounting and Reporting Section (FARS) Paper
Contemporary Accounting Research, Vol. 32, No. 1, pp. 193-222
McCombs Research Paper Series No. ACC-02-09
Statement of Financial Accounting Standards 123R suggests that lattice valuation models may improve the estimates of reported employee stock option values relative to the more commonly used Black-Scholes model. However, lattice model critics have expressed concerns that managers may use lattice models’ flexibility to opportunistically understate option values. In this study, we investigate a sample of firms that recently adopted a lattice model to value employee stock options to provide evidence on this issue by identifying the determinants of lattice model adoption and examining the effect of lattice model use on reported option values. We report three main results. First, we find that firms are more likely to adopt a lattice model when it is more likely to produce lower values than the Black-Scholes model and when managers have incentives to lower stock option expense. Second, we find that firms adopting a lattice model increase understatement of reported option values more than firms that continue to use the Black-Scholes model and that the incremental understatement is due to use of the lattice model. Third, we conduct several tests to examine whether the valuation effect of lattice model use is consistent with efforts to correct for documented shortcomings in the Black-Scholes model and find no evidence that this is the case. Taken together, the evidence in this study suggests that firms adopt and implement lattice models primarily to lower reported option values.
Number of Pages in PDF File: 50
Keywords: stock options, valuation models, SFAS 123R, fair values
JEL Classification: M41, M43, G12, G13, J33
Date posted: June 4, 2008 ; Last revised: June 24, 2015
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