Changing Valuation Circumstances: Periodically Reanalyzing Assumptions
While most companies utilize the Black-Scholes-Merton (BSM) formula to value their employee stock options, the process by which they develop the input assumptions requires considerable judgment and is subject to ongoing scrutiny by external auditors and regulators. Other research by Equity Methods documents the dangers associated with simple “add water and stir” approaches to estimating input assumptions, such as mechanically running administration system reports without comparing different estimation techniques or testing the representational faithfulness of the historical data.
This Issue Brief raises a related challenge: understanding how changes in the compensation program or company circumstances can cause valuation assumptions to become stale and thus fail to meet the fair value measurement requirements of ASC 718. By periodically reevaluating valuation assumptions (similar to how annual goodwill impairment tests take place), companies reduce external audit risk and ensure their valuations do not over-value or under-value new option grants.
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