Using Lattice Models to Value Employee Stock Options Under SFAS 123(R)
New York State Society of Certified Public Accountants
The CPA Journal
SFAS 123(R) requires that employee stock options (ESO) be measured at fair value. While either the Black-Scholes or the lattice option-pricing model is acceptable under the standard, the lattice model is better suited to the unique characteristics of ESOs. The use of a lattice model has broad implications. Auditors and corporate executives must understand the variables that are used to calculate the fair value of ESOs. Lattice models are option-pricing models that involve constructing a binomial tree representing different paths that might be followed by the underlying asset during the life of the option. SFAS 123(R) requires that companies use observable market prices of identical or similar equity or liability instruments to value share-based compensation cost, when such measures are available. The unique features of ESOs and the flexibility of the lattice model lead to a more accurate measure of fair value.