Abstract

http://ssrn.com/abstract=1140361
 
 

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The Effect of Using a Lattice Model to Estimate Reported Option Values


Brian Bratten


University of Kentucky - Von Allmen School of Accountancy

Ross Jennings


University of Texas at Austin - Department of Accounting

Casey M. Schwab


University of Georgia

July 2013

McCombs Research Paper Series No. ACC-02-09
AAA 2009 Financial Accounting and Reporting Section (FARS) Paper
Contemporary Accounting Research, Forthcoming

Abstract:     
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

Accepted Paper Series


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Date posted: June 4, 2008 ; Last revised: September 8, 2013

Suggested Citation

Bratten, Brian and Jennings, Ross and Schwab, Casey M., The Effect of Using a Lattice Model to Estimate Reported Option Values (July 2013). McCombs Research Paper Series No. ACC-02-09; AAA 2009 Financial Accounting and Reporting Section (FARS) Paper; Contemporary Accounting Research, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1140361 or http://dx.doi.org/10.2139/ssrn.1140361

Contact Information

Brian Bratten (Contact Author)
University of Kentucky - Von Allmen School of Accountancy ( email )
Lexington, KY 40506
United States
Ross Jennings
University of Texas at Austin - Department of Accounting ( email )
Austin, TX 78712
United States
512-471-5340 (Phone)
512-471-3904 (Fax)
Casey M. Schwab
University of Georgia ( email )
Athens, GA 30602
United States
706-542-3596 (Phone)
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