CEP Financial Modeling & Forecasting 3 — Questions and Answers
Question 1: When modeling the expected term of employee stock options for Black-Scholes purposes, which SEC-approved simplified method is commonly used by companies without sufficient exercise history?
- Average of vesting period and original contractual term (Correct answer)
- Weighted average of grant date and earliest vesting date
- Option contractual term minus one year
- Median of historical exercise dates
Correct answer: Average of vesting period and original contractual term
The SEC simplified method calculates expected term as the average of the vesting period and the full contractual term of the option.
Question 2: A company uses a binomial lattice model to value stock options. Compared to Black-Scholes, a key advantage is the lattice model's ability to:
- Require fewer computational steps
- Incorporate early exercise behavior at each node (Correct answer)
- Produce a closed-form analytical solution
- Ignore dividend adjustments
Correct answer: Incorporate early exercise behavior at each node
Lattice models evaluate early exercise decisions at each node, making them more accurate for American-style options where early exercise is possible.
Question 3: For a performance share unit (PSU) tied to a non-market condition (e.g., EPS growth), compensation expense should be:
- Fixed at grant date regardless of probability of achieving the target
- Adjusted each period based on the expected number of shares to vest (Correct answer)
- Recognized only when the performance target is certified as met
- Based on the intrinsic value at the end of each reporting period
Correct answer: Adjusted each period based on the expected number of shares to vest
For non-market conditions, ASC 718 requires expense to be updated each period based on the probability-weighted estimate of shares expected to vest.
Question 4: Which of the following best describes the 'expected dividend yield' input's effect in the Black-Scholes model?
- Higher dividend yield increases option value by raising the risk-neutral drift
- Higher dividend yield decreases option value because dividends reduce the ex-dividend stock price (Correct answer)
- Dividend yield has no impact on call option value
- Higher dividend yield increases time value of the option
Correct answer: Higher dividend yield decreases option value because dividends reduce the ex-dividend stock price
Dividends reduce the stock price on ex-dividend dates, lowering the expected future stock price and therefore decreasing call option value.
Question 5: Under the modified retrospective approach allowed by ASU 2016-09 for excess tax benefits, these benefits are now recorded:
- In additional paid-in capital (APIC)
- Directly in retained earnings
- In income tax expense within the income statement (Correct answer)
- As a deferred tax asset on the balance sheet only
Correct answer: In income tax expense within the income statement
ASU 2016-09 requires excess tax benefits and deficiencies from share-based awards to be recognized in income tax expense in the income statement.
Question 6: A stock option grant has a 4-year graded vesting schedule (25% per year). Under the graded vesting attribution method, expense in year 1 versus year 4 would be:
- Equal each year because total expense is the same
- Higher in year 1 because more tranches are actively vesting (Correct answer)
- Higher in year 4 because the stock price is higher
- Lower in year 1 due to higher forfeiture probability
Correct answer: Higher in year 1 because more tranches are actively vesting
Under graded vesting attribution, year 1 is the heaviest because all four tranches are simultaneously being expensed; each subsequent year has fewer active tranches.
Question 7: Which equity award type creates a potential book-tax timing difference requiring deferred tax accounting because the tax deduction occurs at vesting while book expense is recognized over the service period?
- Incentive Stock Options (ISOs) at exercise
- Non-Qualified Stock Options (NQSOs) at grant
- Restricted Stock Units (RSUs) at vesting (Correct answer)
- Employee Stock Purchase Plan (ESPP) at enrollment
Correct answer: Restricted Stock Units (RSUs) at vesting
RSU book expense is recognized ratably over the vesting period, but the tax deduction equals the market value at vesting, creating a deferred tax asset during the vesting period.
CEP Financial Modeling & Forecasting 3
When modeling the expected term of employee stock options for Black-Scholes purposes, which SEC-approved simplified method is commonly used by companies without sufficient exercise history?