In the United States, SFAS 123 required firms to report employee stock option (ESO) expense either in its financial statements proper or in a financial statement. Many firms based their expense estimates on the Black- Scholes option pricing formula (Section 7.9.1). However, many of these firms included a management disavowal of the reliability of the ESO expense calculation in their financial statements.
Blacconiere, Frederickson, Johnson, and Lewis (BFJL; 2011) studied these reliability disavowals. Their interest was in whether the disavowals were informative about reliability or whether they indicated opportunistic behaviour by the managers involved. Informative disavowals would bring to investors’ attention that management really believed ESO expense was unreliable. Opportunistic disavowals were not necessarily indicative of low reliability, but rather designed to benefit the manager. For example, the manager may wish to reduce political backlash to high ESO compensation by calling the value of that compensation into doubt.
a. What are the problems of using the Black- Scholes option pricing model to estimate ESO expense?
b. Does a finding that management disavowals are associated with high unreliability of ESO estimates mean that reporting ESO expense is not decision useful for investors? Explain.
c. The authors found that firms with high implied share price variability were more likely to disavow than firms with low implied share price variability. The implied variability of share price applies to firms with traded stock options outstanding (i. e., options not issued as ESOs). Given the market price of the traded options, and estimates of the other inputs into the Black- Scholes formula (Section 7.9.1), the formula can be solved for the variability of share price implied by the model. This variability estimate is often regarded as a superior input to Black- Scholes than past share price variability for valuing ESOs since it is more forward looking. Does this finding suggest that management disavowals of reliability are informative or opportunistic? Explain.
d. Under SFAS 123, firms are required to disclose the values they use for the various inputs to the Black- Scholes formula, including the input for share price variability. For each firm in their sample, the authors compared this variability input with the firm’s actual share price variability over a five- year period following the disavowal. They found that, on average, management’s share price variability input exceeded actual variability following the disavowal. Does this finding suggest that management disavowals of reliability are informative or opportunistic? Explain.