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A Brief Understanding Of Backdating Stock Options

Reports that the SEC is investigating companies for backdating employee stock options have started to surface over the past two years. According to CNET Erik Lie and Randall Heron published a paper “on July 14 [2006 which] estimates that 18.9 percent of unscheduled grants to top executives from 1996 through 2005 were backdated or manipulated. The pair estimates that 29.2 percent of firms manipulated grants to top executives at some point between 1996 and 2005.(1)” This transgression of good faith affects a company’s taxes and financial statements. The Sarbanes-Oxley Act of 2002 (SOX) requires companies to report the amount of outstanding stock options as a direct expense that should be deducted from income; however, this has not discouraged companies from the practice of backdating.

Backdating Stock Options for employees usually results in immediate gains for the employee. For example, if an employee is granted an at-the-money (par value) stock option today, and the stock is worth $20, the employee will have to wait for the price to increase before any money can be earned. If the at-the-money option is backdated to a time when the stock price was $15 dollars, the employee has automatically earned $5 per option. When options are issued at par value, there is no reporting or tax implications until the options are exercised. Failure to report in-the-money stock options “results in an understatement of compensation expenses and an overstatement of net income. Therefore, option-backdating practices present significant problems for corporate CEOs, CFOs, and their auditors under SOX.(2)”

When this type of practice occurs, analysts and investors are presented with misleading information. Stock options are one way to align employee interests with those of investors; however some people find the practice to be too alluring, and they think stock options should be eliminated. SOX established limits regarding the reporting of stock options (a form must be filed with the...