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

50 Pages Posted: 4 Jun 2008 Last revised: 24 Jun 2015

Brian Bratten

University of Kentucky - Von Allmen School of Accountancy

Ross Jennings

University of Texas at Austin - Department of Accounting

Casey M. Schwab

Indiana University - Kelley School of Business - Department of Accounting

Date Written: July 1, 2013

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.

Keywords: stock options, valuation models, SFAS 123R, fair values

JEL Classification: M41, M43, G12, G13, J33

Suggested Citation

Bratten, Brian and Jennings, Ross and Schwab, Casey M., The Effect of Using a Lattice Model to Estimate Reported Option Values (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. Available at SSRN: https://ssrn.com/abstract=1140361 or http://dx.doi.org/10.2139/ssrn.1140361

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

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States

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