A n option is a derivative financial instrument that specifies a contract between two parties for a future

transaction on an underlying asset at a pre-determined strike price. The value of an option is primarily derived from the intrinsic value difference between the strike price and the value of the underlying asset, plus a premium based on the time remaining until the expiration of the option.

Share options are important to today’s financial market and businesses. Not only because share options are widely listed in stock exchanges as investment vehicles, but also because companies use options for business purposes such as currency hedging and employee remuneration.

This article focuses specifically on the valuation of share options for IFRS 2 Share-based Payment and covers pricing models, valuation practices and relevant accounting requirements.

Impact of IFRS 2In 2005, the International Accounting Standards Board introduced IFRS 2 to address the issue of accounting for remuneration paid to employees in the form of equity or derivatives of equity.

Before IFRS 2, employee stock options affected only a company’s profit and loss if options were exercised, and the impact was solely based on the options’ intrinsic values.

Under IFRS 2, in order to correctly recognize employee stock options on a company’s financial statement, both a valuation exercise and accounting exercise are required.

The valuation exercise is required in respect of the fair value of the employee stock options at the date they were granted, and an accounting exercise is required in respect of the extent to which the grant-date fair value is

charged to the company’s profit and loss.

Employee stock optionAn employee stock option is a call option on the common stock of a company, granted by the company to employees as part of an employee’s remuneration package.

The primary objective is to align employee interests with the company and give employees an incentive to behave in ways that will boost the company’s stock price.

Two key advantages of employee stock option schemes are (1) they provide an incentive to employees without any cash flow implications to the company, and (2) there is no upfront cost of participation and employees only exercise when there is an appreciation in the value of the company.

Option pricing modelA number of well established valuation models are available to estimate the fair value of share options. While no particular option pricing model is regarded as theoretically superior to others, the Black-Scholes-Merton model and the binomial tree model are the two most widely used.

Black-Scholes-Merton modelThe Black-Scholes-Merton model is an example of a closed-form model, which is characterized by the use of an equation to produce an estimated fair value.

In 1973, Fischer Black and Myron Scholes achieved a significant breakthrough when they determined the premium for a stock option in terms of parameters that are directly observable or may be estimated using historical data. The ideas were groundbreaking and eventually led to Scholes and Robert Merton winning the 1997 Nobel economics prize.

While the theory behind the Black-

Scholes-Merton formula is complex, applying the formula is relatively straightforward. Typically, the Black-Scholes-Merton model is better suited to value short-term, exchange-traded share options than long-term, tailor-made share options.

Binomial tree model In contrast to the Black-Scholes-Merton closed-form model, the binomial tree model is a lattice, producing an estimated fair value based on the assumed changes in prices of a financial instrument over successive periods of time.

First developed in 1979, the binomial tree model uses an iterative procedure, allowing for the specification of nodes, or points in time, during the time span between the valuation date and the instrument’s expiration date.

The model reduces possibilities of price changes, removes the possibility for arbitrage, assumes a perfectly efficient market and shortens the duration of the instrument. Under these assumptions, it is able to provide a mathematical valuation of the instrument at each point in time specified.

The key difference between a lattice model and a closed-form model is flexibility. A lattice model can explicitly use dynamic assumptions regarding the term structure of volatility, dividend yields and interest rates.

Furthermore, a lattice model can incorporate market conditions that may be part of an options’ design. Thus valuation specialists believe that the binomial tree model provides a more accurate estimate of a share option’s fair value.

Valuation inputsIn the process of estimating the fair value of a share option, despite the valuation model adopted, a minimum of six inputs (expected life, current share value, exercise price,

Unveiling valuation of options for IFRS 2 Share-based PaymentAlex Leung and Ross Wang examine models, practices and accounting requirements in the use of share options for remuneration

IFRS 2

46 November 2012

Alex Leung is senior director of business and financial instruments and Ross Wang is manager of business and financial instruments in the valuation and advisory services unit of CBRE.

A PLUS

November 2012 47

Change in fair value

Incr

ease

Dec

reas

e

Exercise price

Expected life

Current share value

Expected volatility

Increase in parameter

Table 1 - Relationship between value of parameters and value of share options Table 2 - Expense amortization table

Tranche Vesting Period

expected volatility, expected dividend yield and risk-free interest rate) have to be taken into consideration (see Table 1).

Expected life of the option: The expected life of an option is largely determined by its remaining contractual life to maturity: the longer the remaining contractual life, the more chance that the intrinsic value of the option will increase and, thus, the more valuable the option. Nevertheless, the expected life of an option is also influenced by a number of factors such as the length of the vesting period, past exercise history, the employee’s position within the organization and expected volatility of the underlying shares.

Current share value: If the underlying company is listed in an active market, the public quoted price is the price indicator of the current share value. In general practice, the closing price of the underlying shares as at valuation date is adopted as the current share value. For an unlisted company, however, a separate valuation on the underlying company is required. Typically, a full-scale business valuation on the equity interest of the company has to be performed before the valuation specialist determines other option pricing model inputs. Such a situation is common for the valuation of pre-IPO share options.

Expected volatility: Share price volatility measures the level of share price fluctuation during a given period. As much of the value of a share option is sourced from its potential for appreciation, share price volatility has a significant impact on the estimation of the share option’s fair value. Expected share price volatility can usually be determined with reference to the historical volatility of the underlying share price over the same as the

expected life of the option. In addition, the time range adopted for the historical volatility must be consistent with the expected option life. If long-term historical volatility is adopted, valuation specialists must make appropriate adjustment to price observations for normalization to avoid any outlier effect.

Expected dividend yield: If the holder of a share option is not entitled to a dividend on the underlying shares, the expected dividend will have a negative impact on the value of the option. Other things being equal, the higher the dividend yield, the less valuable the option. This parameter usually can be determined with reference to the firm’s prevailing dividend policy, dividend payout history, industry peers’ practice or management’s reasonable estimation.

Risk-free interest rate: The risk-free interest rate affects the price of an option in a less intuitive way than expected volatility or expected dividends. IFRS 2 specifically states that the risk-free interest rate should be the implied yield available at the date of grant on zero-coupon government issues. However, it may also be necessary to use an appropriate substitute in some special circumstances, if there are no comparable government issues or the overall economy has high inflation.

Expensing the employee stock optionUnder IFRS 2, for an employee stock option without any vesting conditions, the expense shall be recognized at the grant date. If a vesting condition is attached to the employee stock option, the expense shall be spread over the relevant vesting period.

It is worth mentioning that for employee stock options that mature over several financial reporting periods, a valuation is required only at the grant date. Subsequent

corrections to the annual expense figure may normally be caused by a change in the number of options, but not by a change in the fair value of the options.

Example: A company granted an employee stock option scheme to its employees on 30 June 2012. Four tranches of employee stock options with different vesting periods were granted. The assessed fair value of each tranche was $10,000 as at the grant date. The financial year of the company is from 1 January to 31 December. The expense of the employee stock option could be allocated in the way as shown in Table 2 (see above).

ConclusionTraditionally, share options are represented by standard European and American options. Nevertheless, along with the development of financial markets, a series of new options, such as Bermudan options, Asian options, barrier options and other exotic products have become more common.

The growing complexity of share options calls for more advanced valuation models and techniques. Besides the Black-Scholes-Merton and binomial tree models, valuation specialists have also adopted the trinomial tree model, finite difference method and Monte Carlo simulation method to tackle heavily structured share options.

As issuing employee stock options could result in significant profit and loss impact, companies are advised to assess the fair value of options at an early stage.

1

2

3

4

Total

Nil

1 year

2 years

3 years

$10,000

$5,000

$2,500

$1,667

$19,167

$5,000

$5,000

$3,333

$13,333

$2,500

$3,333

$5,833

$1,667

$1,667

Risk-free interest rate

Expected dividend

yield

Financial year

2012 2013 2014 2015