Valuation of executive stock options and the FASB proposal: An extension

Abstract

I N Foster et al. (1991), we use the Black and Scholes option-pricing model to estimate the value of executive stock options (ESOs) in a study on the materiality of ESO compensation expense. In this issue of The Accounting Review, Jennergren and Nislund (1993) address a potentially important issue regarding the materiality of ESOrelated expense. If the employment of the option recipient is terminated, ESOs may be either forfeited or exercised prematurely. The Black and Scholes continuous-dividend model used in Foster et al. relies on four parameters: the exercise price, the variance rate of return on the optioned stock, a risk-free interest rate, and a continuous-dividend rate. Jennergren and Ndslund's valuation procedure allows for the possibility of premature cancellation by adding one additional parameter, X, which is defined as the rate per unit time that ESOs are cancelled prematurely. They modify the Black and Scholes model for X, thus rendering it appropriate for ESOs that are not exercisable until maturity (i.e., European options). The central concern, however, is the more typical plan for ESOs, those that are exercisable prior to maturity (i.e. American options). Jennergren and Naslund suggest a numerical method, adjusted for X, to estimate the value of such options. In concept, X must be constant through time, follow a Poisson process (i.e., apply to a large group of employees), and be fully diversifiable. In practical applications, X must also be observable. We believe that X is difficult to estimate and is unstable through time. Moreover, we suspect that X is unique to each employee position and possibly to each employee. Such issues must be resolved empirically before X could affect accounting policy. Finally, we feel that X and the related numerical method are likely to be incompatible with the Financial Accounting Standard Board's (FASB) policy-setting precedents.