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What is Black-Scholes and how does it fit AASB 2?

Ian Wood · July 1, 2020 ·

When it comes to the term “option valuation”, you can’t read anything on this topic without seeing the name “Black-Scholes” mentioned.

Fischer Black and Myron Scholes published an article in 1973 entitled “The Pricing of Options and Corporate Liabilities”, in which they laid out their formula for risk neutral portfolio management that effectively separated the option from the risk of the underlying security. This formula was then coined the “Black-Scholes options pricing model” by Robert Merton, and together Merton and Scholes received the 1998 Nobel Memorial Price in Economic Sciences for their work (Black unfortunately died in 1995).

While the use of the formula has been expanded on and adapted for many different applications such as used by investment banks and hedge funds, the formula itself is still very useful in determining a value for an option given a set of inputs.

The Black-Scholes formula relies on one risky asset – usually the share over which the option has been issued – and one riskless asset, which is usually a zero-coupon government bond yield rate.

The variables that are needed to input into the Black-Scholes model are:

The share price on the grant date, or issue date
The exercise price of the option
The time to expiry (in years)
The risk free rate
The volatility of returns of the share price
The dividend yield of the share

These variables are all quite easily determined for any exchange listed company, as they are publicly available, or can be quite easily calculated based on publicly available information.

One limitation of the formula is that it assumes the option to be a European option, or one that can only be excercised at the end of the option life. This contrasts to American options, which usually can be exercised at any time during their life.

While Black-Scholes is formulaic and relatively easy to calculate, when is it an appropriate valuation technique for AASB 2?

AASB 2 and Black-Scholes

AASB 2 requires that for the valuation of share options, factors such as the typical long lives of options issued by companies, and the ability to exercise the options at any time during their life (American options), might preclude the use of the Black-Scholes formula which does not allow for the possible early exercise of options.

However, where the options have relatively short contractual lives, or they must be exercised within a short period of time after the vesting date, those factors may not apply and the Black-Scholes formula may produce a value that is substantially the same as a more flexible option pricing model.

We usually find that where the company does not pay dividends, then the value of the option will be very much the same regardless of which model is used. The reasoning behind this is that the option holder will want to hold their cash for longer and earn a rate of return on that cash, rather than invest it in the share and subject themselves to market risk.

Even where the option may be an American style option, in some instances a Monte Carlo simulation can be used to determine the expected exercise of the option, and this time period can then be used in a Black-Scholes formula to calculate the value of the option.

How does Black-Scholes work for performance rights?

Performance rights usually do not require the employee or recipient to pay anything in return for the issue of a share. In this most basic form, the performance right can be considered to be a zero exercise price option, and the value can then be calculated using an option valuation methodology.

If there are no market conditions e.g. share price hurdles, or Total Shareholder Return (TSR) hurdles then the Black-Scholes model may be an appropriate way to value those performance rights issued by the company.

If there are market conditions such as share price hurdles or TSR hurdles, then another valuation methodology may be more appropriate. Even in these circumstances, the valuation technique will start with the basis of treating the performance right as a zero exercise price option, and then incorporate the specific terms and conditions to derive the value.

As the performance right is a zero exercise price option, then the value of the performance right for a non-dividend paying share will be the same as the share price on the date of issue. As a consequence, the time to expiry and volatility will have no influence on the valuation of the performance right.

When is the best time to use Black-Scholes?

Black-Scholes is a good starting point for valuing options, as it is simple and doesn’t require too much complicated computing in order to get a result.

While this starting point can give you an indication of an option’s value, if there are any market conditions or any element of the conditions of the option that require more customisation of the valuation technique, then Black-Scholes can quickly become unsuitable as the primary valuation model.

Unsure whether Black-Scholes is an appropriate valuation model?

Contact us at Value Logic to help you out with your valuation, and give yourself peace of mind that your valuation will be correct.

Why does AASB 2 require option and performance right valuations?

Ian Wood · June 1, 2020 ·

AASB 2 Share-Based Payment and its predecessors have now been in force for over 15 years, so the requirement to record any issue of shares, options and performance rights to employees and consultants as part of their remuneration is not new.

For equity settled share based payment transactions, the key is that the entity shall measure the goods or services received at the fair value of the goods and services received, unless that fair value cannot be estimated reliably. If the entity cannot estimate the fair value of the goods or services received, the entity shall measure their value by reference to the fair value of the equity instruments granted (para 10).

Typically, the services received will be employment services. As the valuation of employment services is variable and can be difficult to estimate due to that variability from company to company and person to person, the better source of valuation is the equity instrument issued in return for the services.

Option and performance right valuation

The value of the equity instrument is measured at the measurement date, or grant date of the option. This value is based on market prices if available, and if not available, the entity shall use a valuation technique to estimate what the price of those equity instruments would have been on the measurement date in an arm’s length transaction between knowledgeable parties. The valuation technique has to be consistent with generally accepted valuation methodologies for pricing financial instruments and must incorporate all factors and assumptions that participants would consider in setting the price (para 16-17).

What does this typically mean for a company that needs to value these equity instruments?

If the company issues shares, and that company is publicly listed, then the value is typically taken from the share price on the grant date – this is the day that the equity instruments are issued, or approved by shareholders if shareholder approval is required for their issue.

If the company has issued options or performance rights, then it is usually the case that similar options or rights are not listed on the stock exchange, and as such there is no reference to a market price for those instruments. This is where a valuation technique is required to determine a value for the equity instruments issued – typically options or performance rights.

Treatment of vesting conditions

Equity instruments issued in return for services will usually have a vesting or performance condition attached to them, although this is not always the case as they may vest immediately.

If there is a vesting condition, then the type of condition will determine whether that vesting condition is required to be taken into account when the option or right is valued.

Vesting conditions that aren’t market conditions, are not taken into account when estimating the fair value of the options or rights at the measurement date. Instead, the performance conditions are taken into account by adjusting the number of instruments included in the measurement of the instruments.

For example, the performance condition might be that the employee has to remain an employee for three years for the options to vest. The value of the options does not get adjusted for this requirement, but the total number of options expected to vest may be adjusted. Historically the company might have an employee turnover rate of 30% over three years. Applying that data, the company may include in their measurement of the share based payment 70% of the options issued, on the basis that 30% are not expected to vest within the three years.

When do vesting conditions affect the valuation?

Where the performance conditions are market conditions, then those performance conditions are taken into account when calculating the value of the equity instrument issued.

Market conditions are performance conditions that are related to the market price of the entity’s equity instruments, such as:

attaining a specified share price or a specified amount of intrinsic value of a share option; or
achieving a specified target that is based on the market price of the entity’s equity instruments relative to an index of market prices of equity instruments of other entities

Examples are that the share must exceed a certain price by a certain date, or the total shareholder return for the company’s shares has to exceed the total shareholder return of an index to which the company belongs, or a general index such as the ASX200.

These conditions will then be taken into account when valuing the options or performance rights issued, and will require a valuation technique that is able to take into account these performance or market conditions when calculating a value.

Which valuation technique should I use to meet the requirements of AASB 2?

The valuation technique that is used is dependent on the terms and conditions of the options or performance rights issued.

The valuation technique should fit the options, and you should not be trying to make the options fit a particular valuation technique.

The simplest way to work out which valuation technique should be used, is to first work through the terms and conditions of the options or performance rights, and the features of the company’s shares.

Once you have determined the terms and conditions, then you will know which valuation technique will be the most appropriate for your situation.

And if you need to value options or performance rights and you aren’t sure how you should go about valuing those instruments, then contact us at Value Logic to help you out meeting the requirements of AASB 2 and ensuring that your period end audit will be smooth sailing.

Government Review of Employee Share Schemes

Ian Wood · June 18, 2013 ·

As part of the Government’s update to the National Digital Economy Strategy, on 12 June 2013 they have announced a review of the regulatory arrangements for employee share schemes which will see consultation by December 2013.

Due to concerns raised by several industry sectors about the current tax arrangements that apply to share and option schemes offered by start-up firms, the government will review the situation and address the barriers faced by start-ups including:

developing guidance to reduce the administrative burden of establishing an ESS (meaning the cost of valuing shares and options)
adjusting the valuation methodology of options
examining the point at which share options are taxed for start-up companies

While the document that contains this announcement is focused on the digital industries, with a particular focus on high-tech start-ups, it is equally applicable to other industries that contain start-up ventures.

As those who have implemented employee share or option schemes would know, there is a balance that is required between providing the employee meaningful value and reward through equity incentives in the company they work for, and ensuring that the tax outcomes for the employee do not leave them worse off than if they had not received any equity incentive.

One aspect of the review that will be followed very closely will be any changes to the valuation methodology of options, particularly when it comes to the taxation outcomes.

Currently the Income Tax Assessment Act 1997 and Regulations provide the ability to value options using a Black-Scholes method that has very concessional factors, such as volatility of 10%. Should the variables in the valuation method be changed, this may result in higher taxation values than currently exist.

A government review 2 years ago raised a possible increase in the assumed volatility to 20%. An increase of this nature could result in much higher taxation values for options, depending on the ratio of share price to exercise price at the time of issue, and the length of time to expiry for the options.

Given the importance of any potential changes to the ESS rules, Value Logic will be involved in the discussion and consultation with the government.

If you have any concerns or views on the potential changes to the ESS rules, please contact Value Logic or Treasury to make your concerns known.

Need help reporting your ESS to the ATO?

Ian Wood · June 18, 2013 ·

With companies due to provide ESS Statements to their employees and the Australian Taxation Office (ATO), it is now time to start preparing the information required to meet the reporting requirements.

Listed below are 5 tips on issues, and items to consider when preparing that information.

1. Recognising that an ESS interest has been provided to employees

This might sound like a simple task, but with the level of complexity in some share based payments, it is important to recognise whether employees have received an ESS interest.

More importantly, it is necessary to determine what the interest is – whether it is a share, option, performance right, or some other form of equity can make a big difference in the way it is reported, when it is reported, and how it is valued.

It is also vital that an employer recognises when an ESS interest has been provided to employees to identify what type of scheme applies to the interest, and when that interest must be reported to the ATO.

In some cases, that interest might not be reported in the year in which it is issued, and therefore adequate records must be kept in order to identify when the taxing point might occur.

2. Working out if a taxing event has occurred

As important, or even more important, than recognising whether an ESS interest has been provided, is determining whether a taxing event has occurred within the financial year.

There are 4 types of taxing events:

(a) Taxed up-front scheme – eligible for reduction

Generally, all ESS interests are taxed up-front except in limited circumstances.

To be eligible for a reduction, the following conditions must be met for the ESS interests:

The employee is employed by the company or a subsidiary when the ESS interest is acquired;
The ESS interests relate to ordinary shares;
The predominant business of the company is not acquisition, sale or holding of shares;
The ESS is operated on a non-discriminatory basis in relation to at least 75% of the permanent employees who have completed 3 years of service;
There is no real risk of forfeiture of the ESS interest;
You are not permitted to dispose of your ESS interest before the earlier of 3 years, or when you cease employment; and
No employee holds more than 5% beneficial interest in the shares of the company immediately after the acquisition of the ESS interest.

(b) Taxed up-front scheme– not eligible for reduction

Unless any of the special conditions above are met, then most ESS interests will fall into this category.

This will be especially so where the ESS is operated for only a select group of employees such as senior management and executives, and directors.

(c) Deferral schemes

An ESS will have a deferred taxing point where the following conditions are met:

If the interest is a share:

points 1, 2, 3 and 7 from the conditions above apply; and
at least 75% of the permanent employees with at least 3 years of service are, or have been, entitled to acquire ESS interests under the scheme; and either
there is a real risk of forfeiture; or
the market value of the ESS interests acquired are less than $5,000 and the amount was salary sacrificed.

If the interest is a right to acquire an interest in a share:

points 1, 2, 3 and 7 from the conditions above apply; and
there is a real risk of forfeiture.

(d) Discount on ESS interests acquired pre 1 July 2009

Where ESS interests were acquired before 1 July 2009 under the previous ESS rules, and the cessation time under those rules occurs during the financial year, the market value of those interests at the cessation time must be reported.

3. Getting the acquisition date correct

Where ESS interests are taxed upfront, the relevant date for determining which income year they fall into, as well as the value of the ESS interest, is the acquisition date.

The acquisition date is different under tax law to the date used for accounting purposes when reporting the expense in the financial statements.

The important aspect of acquisition date for tax purposes is when the share or right actually came into existence and hence was “acquired”, as this is the date on which the interest will be valued.

Commonly, shareholder approval is given at an Annual General Meeting, but there is a delay in the share registry issuing the interests to the employees.

This delay can see a significant change in the market value of the underlying share price, and this in turn can see a dramatic change in the amount that needs to be included in the assessable income of the employee.

A more thorough discussion of when is the correct “acquisition date” can be found on the Value Logic website.

4. Calculating the correct value of the discount to report

For taxed upfront schemes, the value that must be reported is the discount provided to the employee.

The discount = (market value – amount paid by employee) x number of interests received

The key information that must be determined includes:

Number of interests with taxing event in current year
Correct acquisition date on which to value the share or right
Correct price of share /option/right at the taxing point/acquisition date
The market value of options/rights, either market value or as determined by the formula in the Regulations.

Determining the value of a right (including options and performance rights) is especially vital, as most often these interests are not quoted on a stock exchange and therefore a market price cannot be readily found.

5. Reporting to employees and the ATO by the relevant dates

Employees

An ESS statement must be prepared and provided to employees if:

The employee acquired ESS interests under a taxed upfront ESS at a discount during the financial year
A deferred taxing point for ESS interests acquired under a tax-deferred ESS has arisen or could have arisen in the financial year.

The ESS statement must be provided to employees by 14 July after the end of the financial year.

Australian Taxation Office

Where an ESS statement has been provided to an employee/s, an Employee Share Scheme (ESS) Annual Report must be provided to the ATO by 14 August after the end of the financial year.

Where an employee has not quoted a Tax File Number and receives a discount on ESS interests acquired, the employer is required to withhold tax at the top marginal rate.

Reporting the amount withheld to employees is important to allow the employee to lodge their tax return with the correct information, and give the employee a chance to obtain a refund if the amount withheld is more than their tax liability.

CONCLUSION

Given the impact that receiving an ESS interest can have on an employee’s taxable income, it is vital that the correct details are reported to employee and to the ATO.

Amendments can be made to reports that have been lodged, so if any errors are detected there is an opportunity to correct them.

However, in the interest of keeping good relations with employees, clear and timely communication and advice is the key.

Tips for employee option and performance right valuation

Ian Wood · July 2, 2012 ·

With 30 June signalling the end of financial year and the beginning of the reporting season, thoughts now turn to working out the value for share based payments made during the year to meet the requirements in AASB 2 Share Based Payment.

Through Value Logic’s experience, the valuation of most options and performance rights encounter common issues which can be resolved with some careful advice and analysis of the situation.

At Value Logic we provide efficient turnaround for option valuation and performance right valuation to help companies with preparation of their accounts and ensuring that the auditors have adequate time to sign off before reporting deadlines. We also consult with companies prior to establishing plans and issuing equity interests to ensure that there are no unforeseen valuation issues which may produce unexpected results at reporting time.

What type of interest has been issued?

To report the correct value for share based payments requires the correct valuation technique. Of course, which valuation technique is appropriate is dependent on what type of equity interest has been issued, and the terms and conditions attaching to that equity interest.

An option with no vesting or exercise conditions, and an underlying share that does not pay dividends might be valued using the Black-Scholes model. A similar option whose underlying share does pay dividends might be valued using a modified version of the Black-Scholes model, or a Binomial model.

Options or performance rights with vesting or exercise conditions that are linked to market conditions, e.g. Total Shareholder Return relative to the ASX 200, could be valued using a Monte-Carlo Simulation model.

Vesting or exercise conditions

Vesting or exercise conditions can only be taken into account to value options or performance rights if they are a market condition. Examples of market conditions include measuring a share’s Total Shareholder Return against the ASX 200, or requiring a specific share price in order for the equity interest to be exercised.

Vesting conditions such as a condition of continuing employment, or a requirement to achieve a certain net profit, are taken into account when working out the number of options which are estimated to vest, rather than the value of the option.

When is the grant date?

The date on which the equity interest is to be valued is defined in AASB 2 Share Based Payment as the grant date. This date is the date on which the terms and conditions of the equity interest are agreed upon between the employer and the employee. This date can be a later date where shareholder approval is required for the issue of the equity interest.

Getting the correct date is important as it determines the share price used in the valuation. Where there are significant fluctuations in the underlying share price, this can significantly influence the valuation that results.

The grant date also affects the period over which the option or performance rights vest, and hence the allocation of the expense to each financial period. This may have a significant impact on the expense that is required to be recognised in each given financial period.

Share price volatility

Along with the time to expiry, the volatility is the other biggest influence on the value of an option. As the volatility has such a big influence on the valuation, it is important that the correct volatility is used.

AASB 2 requires the use of the expected future volatility of the share price over the life of the option or performance right. As it is the volatility expected in the future, an expectation of future volatility must be derived. Where a share price’s volatility is not expected to vary from its historical average, the historical volatility may be used as a guide.

Some cases when past volatility is not sufficient as a measure include:

low trading volumes
changes in business structure for the entity
changes in economic conditions and stock-market performance
the company is unlisted.

The key factor is to understand all the circumstances and use best judgement as to when another company’s share price volatility or an index’s volatility might be a better proxy.

Don’t confuse accounting valuation requirements with tax valuation requirements

Commonly it is assumed that the valuation techniques and requirements of AASB 2 are the same requirements found in the Income Tax Assessment Act 1997.

One of the key differences is that the tax legislation requires the valuation to ignore any vesting or exercise conditions when valuing the equity interest.

As the regulations provide a valuation methodology that uses a highly concessional version of the Black-Scholes model, the tax valuations quite commonly turn out lower than the corresponding accounting valuation.

This highlights the importance of getting both valuations performed so that employees are adequately advised of their tax obligations.

Conclusion

While the use of a valuation model may seem relatively simple, the selection of the correct inputs is vital to obtaining a valuation that correctly measures the fair value of equity interests issued as Share Based Payments.

If you have any questions or require any valuations, contact Ian Wood at Value Logic for further assistance.