As discussed in SC 8, option-pricing models require six inputs, four of which are assumptions that require significant management judgment:

The two remaining inputs—exercise price (applicable only for options and defined by the terms of the award) and the fair value of the underlying stock on the measurement date (based on observable market prices in the case of publicly-traded securities), are not discussed in this chapter. For nonpublic entities, an enterprise valuation may be necessary to determine the fair value of the stock (see FV 7.3.2), and a practical expedient for determining the fair value of the stock is available (see SC 6.2).

ASC 718, Compensation—Stock Compensation, explicitly requires that the assumptions used in an option-pricing or equity valuation model be reasonable and supportable. The assumptions should also reflect the substantive characteristics of the award and all other relevant facts and circumstances.

Additionally, as described in ASC 718-10-55-27, the assumptions used to estimate an award’s fair value should be determined in a consistent manner. A change in either the valuation technique or the method of determining the appropriate assumptions to use in a given valuation technique is generally considered a change in accounting estimate, which, under ASC 250, is applied prospectively. While a change in accounting estimate, unlike a change in accounting principle, does not require an explicit assertion of preferability, inherent in any accounting estimate is the notion that the underlying assumptions represent the most appropriate assumptions for the particular circumstances. Thus, changes in valuation techniques or the development of assumptions should generally only be made when they will result in an improved estimate of fair value.

SAB Topic 14 provides helpful interpretive guidance for SEC registrants related to the application of ASC 718, acknowledging that there may be a range of reasonable judgments in developing assumptions for option-pricing models. SAB Topic 14 also provides registrants with certain simplified alternatives for developing the expected term and expected volatility assumptions, subject to certain conditions. These alternatives are discussed in SC 9.3.1 and SC 9.4. ASC 718-10-30-20A through ASC 718-10-30-20B provides a similar, but slightly broader, practical expedient for determining the expected term for nonpublic companies. If a company cannot or chooses not to use the simplified alternatives, then it should develop its assumptions starting with consideration of its own relevant historical data and adjusting that data, if necessary, for its future expectations.

An option's expected term and the expected volatility of the underlying stock are usually the most difficult assumptions for a company to develop because the same underlying data often could support a range of possible estimates and be segregated and analyzed in a variety of ways. Even the more straightforward assumptions with typically narrower ranges (i.e., risk-free interest rate and the expected dividend yield) can involve choices and approximations, and therefore judgment.

Management should consider all relevant factors when developing its assumptions. Lattice or Monte Carlo models generally require additional and more detailed assumptions than the Black-Scholes model because the Black-Scholes model reduces several separate assumptions to a single value. However, the key concepts and data used to support these assumptions are the same for both types of models.

ASC 718-10-55-23 and SAB Topic 14 acknowledge that there is likely to be a range of reasonable estimates for expected term, volatility, dividend yield, and the resulting fair value. ASC 718 requires that if a best estimate cannot be made, management should use the mid-point in the range of equally likely reasonable estimates.