Black-Scholes Valuations

CORPORATE ACCOUNTING

Accounting for stock options has been one of the most controversial topics in the field of accounting during the last few decades. The principal debate was whether compensation expense should be recognized for stock options and the periods over which it should be allocated.

FAS 123 (R) became effective for public companies for annual and quarterly reporting periods beginning after June 15, 2005 (December 15, 2005 for small business issuers.) For nonpublic companies, the new standard applies to fiscal years beginning after December 15, 2005. FAS (R) applies to all new grants after the effective date and the unvested portion of outstanding grants as of the effective date, which will be valued based on the assumptions and methods used at the time the grants were initially made. Under FAS 123 (R) an explicit expense is required to be recognized in the income statement for stock options. Basic provisions of FAS 123 (R) allow:

• Use of lattice-based option-pricing models (to include Black-Scholes),
• Use of a binomial model

In 2006, The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) agreed that the fair value at the grant date should be estimated at the grant date using an option pricing model. The majority of public and private companies apply the Black-Scholes model. However, many companies have publicly disclosed the use of a binomial model in SEC filings.

Balance Sheet Footnote

The footnote alternative is what almost all companies used until expensing became mandatory.

This footnote required the company to:

• report the numbers of outstanding options
• place a value on them
• indicate what effect this valuation would have on the company’s earnings

In general, these footnotes contained the following:

• a statement that describes information about the plan or plans such as:

  • number of plans

  • eligibility

  • expiration

  • exercise plan

• a chart showing options granted, exercised and expired
• information about how the options are valued (either by an intrinsic method OR by Black-Scholes; if by Black-Scholes, the values for the five factors are given)
• a chart showing the effect on company net income and net income per share of common stock