Pricing Model Management: Evidence from Employee Stock Option (Un)Fair Valuation

This paper examines the reliability of valuation models used in fair value accounting. Departing from earlier literature focused on input estimates, we study management of the valuation model itself, detected in the ad hoc adjustments made by preparers to generally accepted models. Our analysis is based on a unique sample of listed ESOs in an IFRS context for which detailed disclosure is available. We find evidence of model management, with a material median understatement compared to a generally accepted benchmark model, which is designed to control for ESO-specific characteristics and input estimates. Furthermore, we identify three levers for model management: non-tradability of the option, transaction costs incurred to hedge the option, and to a lesser extent dilution. Based on option pricing literature, a close examination of the arguments used to justify these ad hoc adjustments suggests that they lead to unreliable estimates. By highlighting valuation model reliability as a relevant concern for fair value measurement, as distinct from the issue of input estimate reliability, this study has direct consequences for preparers, auditors, and standard setters.