Valuing employee stock options under SFAS 123R using the Black–Scholes–Merton and lattice model approaches

In 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payments (SFAS 123R), requiring all entities to recognize as expense the fair value of stock options issued to employees for services provided. Because employee stock options cannot be traded publicly, their fair value must be estimated using a model, with the Black–Scholes–Merton (BSM) and lattice models being the most appropriate alternatives.This teaching note provides an overview of employee stock options, followed by a discussion of the BSM and lattice valuation models, including their application and limitations. A project which has been used in financial accounting courses is also presented. The conceptual discussion coupled with illustrated examples will help students enhance their understanding of fair value estimation of and accounting for employee stock options under the recently adopted SFAS 123R.