A Bid for Fair Value

Market-based option pricing may lower expenses for share-based payments, but is it worth the cost?

September 2007
from Journal of Accountancy

The expensing of stock options has been a reality for public companies for two years now thanks to FASB Statement no. 123(R), Share-Based Payment. While the standard settled whether to record expenses for stock-based compensation on earnings statements, it did not solve the problem of how to accurately value those costs.

The consensus of academic research is that options are worth significantly less than the value generated by the Black-Scholes-Merton model. This perception prompted Zions Bancorporation to develop a market-based pricing technique, which it calls Employee Stock Option Appreciation Rights Securities (ESOARS).

ESOARS take advantage of the market-value alternative to option-pricing models allowed by paragraph 22 of Statement no. 123(R). They are derivative securities designed to provide a market basis for estimating the fair value of stock options granted to employees. Zions, which recently received SEC approval to use ESOARS, plans to use these securities itself and to market them for other companies.

[READER NOTE: This article has been excerpted from the Journal of Accountancy. Read the full article with useful sidebars and practical tips here.]

Zions developed ESOARS with an eye toward solving some of the problems that delayed FASB’s imposition of fair value accounting in Statement no. 123(R). Experts had competing views on how to value options, with many arguing that options were not “valuable” and others arguing they could not be valued. In particular, many have argued that option-pricing models (such as Black-Scholes) overstate the value of employee stock options because they assume the abilities to trade and short sell, and ignore the effect of the continued employment requirement, all of which reduce the options’ value to a risk-averse, underdiversified employee.

What Are ESOARS?

ESOARS are derivative securities whose value depends not only on the price of the underlying share of stock, but also the vesting and exercise patterns of the underlying stock options to which they are tied. Page 7 of Zions’ (PDF) Sept. 22, 2006, submission to the SEC states: “The net realized value is calculated as the difference between the trading price per share of Zions’ common stock at the time employees exercise their ESOs [employee stock options] and the exercise price of the reference options, multiplied by the number of shares of common stock obtained by ESO holders on exercise. Payments to ESOARS holders will be made quarterly.”

But it is not so simple. Unlike an option that has one exercise date, the issuer must pay out to the ESOARS holders quarterly and based upon the percentage of reference options exercised during that quarter. Although the payout to the initial ESOARS offerings will be in cash, Zions has indicated that payouts on future offerings could be in company stock. Whether the payout is in the form of cash or company stock will affect whether the security is treated as a liability or equity for accounting purposes.

Consider the following example of how the security works:

  • The number of ESOARS sold equals 100,000, which is 10 percent of the 1 million reference options.
  • The exercise price of those options is $20.
  • The average market price of the company’s stock during the fourth quarter of 2007 is $25.
  • Five percent of reference options are exercised during the fourth quarter.

Under these circumstances the payout to all ESOARS holders would equal 100,000 units x five percent exercised x ($25 market price – $20 exercise price) for a total of $25,000. The ESOARS would remain outstanding, with the holders continuing to receive payments in future quarters when and if the remaining 95 percent of reference options are exercised.

The Benefit to Corporations

The benefit to the corporation, ostensibly, is a more-accurate measure of the cost of the options. In practice, this may mean a lower measure of the cost. Based upon the results of the initial auction, conducted on June 28–29, 2006, Zions estimates the value of the options granted at $8.57 per option, whereas the Black-Scholes model yields a per option value of $12.65. Thus, the accounting expense is substantially reduced using the market-based approach. Zions expects auction prices to increase somewhat over time as more investors enter the market and become familiar with the securities. As some evidence of it, in Zions’ second auction, which was conducted from May 4–7, 2007, the price per option was $12.06 (Zions has not disclosed the equivalent cost under the Black-Scholes model, although in the most recent year available, 2006, they valued their average option at $15.02).

While research indicates the market value for ESOARS is likely to stay below a Black-Scholes price, that will not always be the case, says Evan Hill, a vice president of Zions who helped develop the security. “You could have a situation with an ESOARS issuer who has been extremely aggressive on Black-Scholes,” says Hill. He says the price disparity between the two is likely to vary by company.


Zions Bancorporation has broken innovative ground with ESOARS. The SEC letter makes it likely, but not certain, that these securities can be used to determine the cost of employee stock options, and it is likely the cost established by these auctions will be lower than that established by option-pricing models. Some risk and substantial cost are also involved. The risk of course, is that future auctions may not meet the conditions set forth in the SEC’s letter, while the costs include those associated with the issuance of securities and the possibility that the corporation sells the securities at a substantial discount to fair value. Decision makers should tread carefully in determining whether the benefits involved exceed the costs.

Rate this article 5 (excellent) to 1 (poor).
Send your responses here.

Steven Balsam, CPA, Ph.D., is professor of accounting and Merves Research Fellow, Fox School of Business, Temple University in Philadelphia. Balsam is a contributing writer of the Journal of Accountancy. His views as expressed in this article do not necessarily reflect the views of the AICPA or the Journal of Accountancy.