Employee stock options and the flawed use of the Black–Scholes option pricing model

Abstract This article studies a well‐known, and flawed, use of the Black–Scholes model in reporting. It achieves two principal goals. First, it reports our critical analysis into the topic resulting from the combination of our fields’ expertise in it. Second, we report our study into an as‐yet undocumented example of that flaw. The flawed use of Black–Scholes leads to mark‐to‐model measurements errors in reporting, most notably in Earnings. Our analysis covers the major sources of the resulting mis‐measurement: the mismatch between the parametrization of Black–Scholes models versus the legal formulation of ESO contract terms; and the alteration of the models’ inputs mandated by regulators. These regulators asserted that the unavoidably incorrect values would be “sufficient” for reporting. Our study examines the infrequently studied “risk‐free rate” input to demonstrate that resulting mis‐measurements are readily quantifiable. We expect to continue this research into our fields’ disagreements on the use of the Black–Scholes class of option pricing models for reporting.