Option Backdating
Winter Scandals: How
2008
Management
Accountants Can Help
VOL.9 NO.2
B Y Z A B I H O L L A H R E Z A E E , P H . D . , C M A , C PA ; C R A I G L A N G S T R A AT, J . D . ,
C PA ; A N D J O H N M A L L O Y, P H . D . , J . D . , C PA
BACKDATING
OF EMPLOYEE STOCK OPTIONS CAN HAVE A SIGNIFICANT NEGATIVE EFFECT
ON A PUBLIC COMPANY.
MANAGEMENT ACCOUNTANTS ARE
IN A POSITION TO
HELP THEIR COMPANIES ADDRESS A NUMBER OF FACTORS THAT COULD HELP PREVENT
A BACKDATING SCANDAL.
(IRS) rules. Second, subsequent probes can cause a disruption in an implicated company’s operations, including costly internal or external federal investigations,
ineffective corporate governance resulting from the
departure of key directors or corporate officers, and
financial reporting problems caused by late filings,
internal control deficiencies, and restatements. Thus,
option backdating practices are detrimental to a company’s operations, governance, internal controls, and financial reports. Management accountants can assist their
organizations by properly addressing these detrimental
practices and minimizing their effects on corporate governance, internal controls, tax implications, and financial reporting.
ervasive option backdating scandals have
affected many public companies. As of April
2007, more than 264 companies have been
the subject of internal reviews, inquiries by
the Securities & Exchange Commission
(SEC), or subpoenas by the Department of Justice
(DoJ) in regard to option backdating.1 Option backdating occurs when grant dates are managed retroactively
to precede a run-up in underlying shares in order to
maximize the value to benefit executives, directors, and
other key personnel. Such controversial and seemingly
dishonest practices signal poor corporate governance,
ineffective internal controls, and aggressive accounting
policies and practices.
Option backdating practices can have a two-pronged
effect on an organization. First, the ineffective corporate
governance and internal controls that create the incentive and opportunity for option backdating violate
Generally Accepted Accounting Principles (GAAP),
SEC filing requirements, and Internal Revenue Service
P
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
SIGNIFICANCE
OF
E M P L OY E E
STO C K O P T I O N S
Employee stock options (ESOs) are often awarded as
long-term incentive plans to help align the interests of
executive and key personnel with those of shareholders.
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employee as ordinary income, and the fair value
becomes the employee’s basis in the stock for the
determination of any future capital gain or loss upon the
disposition of the stock. Nonqualified stock options
enable the company to recognize a tax deduction equal
to the amount of ordinary income realized by the
employee on the exercise date. The recorded value of
ESOs is a function of market value of underlying stock
on the grant date and the specified exercise price.
When the company’s stock rises, those who have been
granted ESOs receive financial benefits from the good
performance. ESOs are also used to retain executives
and key personnel by requiring a specified amount of
time to pass before the option can be exercised, during
which the company benefits from productive executives and employees.
ESOs give recipients the right to buy shares at a
determined exercise price, usually the market price on
the grant date approved by the company’s board of
directors. When ESO plans are approved, the board of
directors may assign the administration of those plans to
the compensation committee, which officially determines the size and timing of ESO grants. The company’s executives, including the CEO, do not have the
legal right to grant ESOs without the preapproval of the
board of directors. The value of a stock option to the
recipient on the grant date is the difference between
the market price of the underlying stock and its exercise price specified in the option. To use as incentive
plans, companies often grant “discounted,” or “in-themoney,” ESOs where the exercise price is less than the
market price of the underlying stock on the grant date.
There are two types of ESOs: qualified stock
options, which are also referred to as incentive stock
options (ISOs) or statutory stock options, and nonqualified stock options. The accounting methods for recognizing the compensation expense for the different types
are similar, but their tax treatments are quite different.
To be considered qualified options, the strike price
must be at least 100% of the market price of underlying
stock on the grant date, which makes these options “atthe-money” or “out-of-the money.” There is no grantdate tax implication for ISOs and no realization of
income or deduction when employees exercise their
options. The exercise price becomes the employee’s
basis in the stock for future capital gain or loss recognition. The company issuing ISOs does not receive any
tax deduction.
The majority of ESOs are nonqualified with no
grant-date tax implications. When an employee exercises an option, he or she recognizes income for the differences between the fair market value and the exercise
price, which is commonly referred to as the intrinsic
value of the option. The intrinsic value is taxable to the
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
C AU S E S
AND
EFFECTS
Manipulated or allegedly “scandaled” ESOs involve
managing the timing of the grant date to increase the
potential value of the stock options. Timing can significantly affect the value of the options, compensation
benefits, tax treatment, and compensation expenses.
Managing the timing of an ESO grant date can be
achieved in several ways:
◆ The first, most scrutinized scheme is backdating,
which is the practice of intentionally or unintentionally setting the grant date as the day when the
underlying stock price was low.
◆ The second scheme is “spring-loading,” which is
setting the grant date shortly before announcing
good news and/or withholding good news until
after ESOs are granted.
◆ The third is “bullet-dodging,” which involves setting the grant date shortly after bad news is
announced.
Backdating has come under scrutiny by federal
authorities, investors, and the media, but the other
schemes have not received the same kind of attention.
Backdating can occur at any public company. Companies that face a higher risk of potential backdating problems are those that:
1. Set the strike price of the ESOs equal to the stock
price on the backdated grant date,
2. Have lower stock prices on the backdated grant
date than on the actual grant date,
3. Have or had policies giving executives the right to
choose their grant dates,
4. Make numerous option grants during the course of
a year,
5. Have a nonstandard pattern of timing option
grants from year to year,
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confessions to private lawyers conducting an internal
probe. The former CEO of Brocade Communications
Systems was convicted for illegal backdating practices,
sentenced to 21 months jail, and ordered to pay a
$15 million fine.3
Several corporate governance measures influence
backdating. One of the common characteristics of companies implicated in option backdating scandals is
director interlock, where several companies have the
same directors on their board. More than 40% of implicated companies have directors who sit on more than
one board within the group. This suggests that option
backdating practices might have been spread by “word
of mouth, through the conduit of directors sitting on the
boards of more than one company.”4
An organization’s board of directors, particularly the
compensation committee, needs to be actively involved
in:
1. Authorizing and approving ESOs,
2. Setting the grant dates,
3. Getting the approval of shareholders on award
option grants, and
4. Assuring proper use of SEC Form 4.
Executive stock options are long-term incentive
plans designed to align executive interests with those of
the shareholders. Thus, shareholders or their representatives should approve the options or give an advisory
vote regarding overall executive compensation. Any
option grant backdating that reduces shareholder
wealth and is not properly disclosed to the shareholders
is illegal. Shareholders who have suffered losses can
exercise their right to bring lawsuits against the company and its officers and directors engaged in such practices. Shareholder monitoring is an important corporate
governance mechanism for ensuring sustainable value
creation. Backdating ESO grants may benefit executives by securing a low stock price by essentially using
“stockholder money to buy high and sell even lower
than their filings had previously disclosed.”5
6. Have weaknesses in their internal controls, or
7. Have ineffective corporate
governance.2
Several factors could have contributed to the wave of
option backdating scandals. First, during the dot-com
bubble of the 1990s, many high-tech companies started
using the monthly share-price low to provide maximum
option value for their executives and key personnel in
order to attract the most talented individuals.
Second, the requirement that changes in directors’
and officers’ stock ownership and ESOs grants must be
reported on Form 5 within 45 days after the end of the
fiscal year provided management with some latitude to
manage the timing of option grants dates. Pursuant to
the passage of the Sarbanes-Oxley Act (SOX) and SEC
implementation of related rules, public companies
should file changes in their ESOs grants on Form 4 to
the SEC within two business days of the options being
given.
Third, accounting standards prior to the issuance of
Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No.
123(R), “Share-Based Payment,” did not require companies to recognize any compensation expenses for the
fair value of ESO grants. SFAS No. 123(R) requires that
public companies determine the fair value of options
when granted, estimate the number of options that will
ultimately vest, and recognize the compensation
expense for the fair value of options that will ultimately
vest in each reporting period over the vesting period.
Finally, more than 262 companies mentioned in relation
to backdating have suffered substantial stock price
decreases and have been under severe scrutiny from
regulators, investor activists, and shareholders (see
Table 1).
Overall, backdating raises concerns regarding a company’s corporate governance, tax practices, financial
reporting, and audit activities.
C O R P O R AT E G O V E R N A N C E
Vigilant and responsible corporate governance should
provide an effective monitoring mechanism against the
incentives and opportunities for executives to engage in
backdating practices. Three former executives of Comverse Technology, Inc., were charged with fraud associated with alleged backdating subsequent to their
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INTERNAL CONTROL ISSUES
SOX Section 403 requires public companies to report to
the SEC within two days option awards granted to their
executives. Yet many companies in the post-SOX era
routinely miss the deadline without immediate and
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Table 1:
Option Backdating Probes and Attributes of
264 Implicated Companies*
PANEL A: TALLY OF EVENTS
Companies that have disclosed
Internal investigations
259
SEC investigations
132
DoJ investigations
59
Shareholder suits
133
Criminal cases
6
Executive departures
48
Restatements
139
Late filings
165
Material weaknesses
60
Accelerated vestings
63
PANEL B: CURRENT AUDITOR
Audit firms
Ernst & Young
67
PricewaterhouseCoopers
69
Deloitte & Touche
53
KPMG
39
BDO Seidman
13
Grant Thornton
7
Other
16
Total
264
PANEL C: COMPANY SIZE
Market values
Less than $75 million in market capitalization
21
$75 million to $749 million in market capitalization
87
$750 million to $7.49 billion in market capitalization
117
$7.5 billion or more in market capitalization
39
Total
264
*As of April 12, 2007.
Source: Glass Lewis & Co., “Yellow Card Trend Alert: Stock Option Backdating Scandal,” April 12, 2007.
gage Corp., Websense, Inc., Silicon Image, Inc., Keryx
Biopharmaceuticals, Inc., and Medis Technologies,
Ltd.6 These late filings suggest the possible breakdown
or ineffectiveness in internal controls at implicated
companies.
effective enforcement by the SEC, which suggests that
backdating may still be occurring. Companies that were
late in filing Form 4 include Hansen Natural Corp.,
O’Reilly Automotive, Inc., Digital River, Inc., Children’s Place Retail Stores, Inc., American Home Mort-
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stock-based compensation, which allowed use of the
intrinsic value for compensation expense recognition
with disclosure of fair value amounts in the notes. In
June 2005, the FASB issued SFAS No. 123(R), which
requires companies to determine the fair value of stock
options when granted by using pricing models, estimate
the number of stock options that will ultimately vest,
and recognize compensation expense for the fair value
of vested options.
SFAS No. 123(R) requires stock options to be recognized as expenses and subtracted from earnings, the
same as other salary and benefits costs. The effect of
recognizing stock option expenses on reported earnings
of public companies could be significant. For example,
earnings for companies in the S&P 500 index would
have decreased 6% and 8% in 2004 and 2003, respectively, had all stock options been expensed.7 One study
estimates that the fair value of the 28 billion outstanding employee stock options of S&P 500 companies is
about $391 billion, which has been reported as an offbalance-sheet liability.8 The recognition of the fair value of employee stock options in the income statement
for many companies can be very costly and painful.
Nevertheless, it will bring more transparency to financial reporting and force companies to consider options
as a component of their cost structure. It is expected
that shareholders will benefit in the long term from the
expensing of stock options.
SOX Section 404, SEC implementation rules, and
the Public Company Accounting Oversight Board
(PCAOB) Auditing Standard No. 2 (AS2) require management and auditor reports on internal control over
financial reporting and public disclosure of related
material weaknesses. Backdating practices of option
grants in the post-SOX period, whether caused by ineffective corporate governance, inadequate internal controls, falsification of documents, delay in filing Form 4,
or any other reasons, can constitute a material weakness. About 23% of the implicated companies reported
material weaknesses in their internal control over financial reporting in compliance with SOX Section 404.
FINANCIAL REPORTING
Option backdating happens when the actual grant dates
are days, weeks, or months before or after their stated
date. Whether a company intentionally manages the
timing of grants retroactively by setting the exercise
price of options to correspond with the lower market
price of the stock or unintentionally records the option
grant dates incorrectly, the end result is an understatement of stock option expenses in the company’s financial statements. If the effect of misstatement is material,
the financial statements should be restated. This
restatement process can delay timely filings of annual or
quarterly financial statements. Tax consequences of
backdating practices of option grants are also determined by whether the company is able to deduct compensation expenses for tax purposes.
Both accounting and financial reporting of optionbased compensation have evolved during the past several decades from compensation expense recognition
only for options with intrinsic value (in-the-money) to
compensation expense recognition for the value of
options when granted. From 1972 to 1995, accounting
for stock options was governed by Accounting Principles Board (APB) Opinion No. 25, “Accounting for
Stock Issued to Employees.” The intrinsic value of
stock options was measured when the number of shares
to be issued was known and the exercise price was
fixed, and such intrinsic value was recognized as a compensation expense. After several years of debate and
discussion, the FASB issued SFAS No. 123 in 1995. It
favored the fair value approach to the intrinsic value for
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
TA X P R A C T I C E S
Tax consequences of backdating are determined by
whether the company is able to deduct compensation
expenses for tax purposes. Section 162(m) of the Internal Revenue Code (IRC) permits companies to deduct
performance-based compensation in excess of $1 million. For tax purposes, “at-the-money options” (as
opposed to “in-the-money options”) are considered to
be performance-based compensation and, thus, tax
deductible. In-the-money options are those whose stock
price is lower than the current market price. Any reclassification of option categories may result in the loss of
the tax deduction as well as related additional interest
and penalties.
There are several tax issues regarding backdating.9
The first issue is public violations of IRC Section 409A,
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options in 2006.10 The program is intended to provide
relief for employees affected by their companies’
issuance of backdated and other mispriced stock
options. Employees normally pay income tax on the difference between the value at the dates of grant and
exercise for their stock options. When employees exercise backdated options, they may owe an additional
20% tax plus an interest tax.
adopted as part of the American Jobs Creation Act of
2004. Section 409A substantially changed the tax treatment of deferred compensation, including discount
stock options, by requiring that these options have a
fixed exercise date or otherwise are subject to a 20%
penalty tax. The second issue relates to the possible
failure of ESOs to qualify under the rules governing
ISOs. The ISOs are required to be granted at an exercise price at least equal to the fair value of stock on the
date of grant. Any backdating option that has been
granted at a discount may not qualify as an ISO. Qualified options under ISOs are not subject to income tax
and FICA withholding upon exercise. Some of these
backdating practices are associated with ISOs that are
in-the-money option grants worth a strike price below
market value. Any backdating disqualifies these options
from ISO treatment and makes them subject to the
deduction limits for tax purposes. Backdated ESOs
granted at a discount and not previously taxed could
become subject to income tax and FICA liability for
knowingly failing to withhold or pay income tax or
FICA.
Finally, backdating ESOs may be subject to exceeding the compensation deduction limits of IRC Section
162(m), which limits the tax deduction for certain executive compensation to $1 million. Only performancebased compensation in excess of $1 million, including
at-the-money options, may be deductible. These
options lose some or all of their tax deductions if they
are deemed to become in-the-money options as a result
of backdating. In this case, the company could become
responsible for past due taxes, penalties, and interest.
In summary, the tax rules relevant to stock options
affect both the companies that grant options and the
employees who receive them. Employees must include
the realized option profits as either ordinary or capital
gain income, and companies can typically take a tax
deduction for the amount their employees recognized
as ordinary income. Any backdated options can have
implications for both companies and their employees
because in-the-money options do not result in a tax
deduction. The pervasiveness of option backdating
practices encouraged the IRS to announce a compliance
resolution program that allows employees to pay the
additional taxes for exercising certain discounted stock
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
AU D I T AC T I V I T I E S
In expressing an opinion on financial statements, auditors provide reasonable assurance that financial statements are free from material misstatements, whether
caused by errors, fraud, or illegal acts. Option backdating practices are questionable at best and possibly illegal and fraudulent. Executives of many implicated
companies have been removed, which raises the question of whether auditors could rely on representations
from such executives. For the second time since the
turn of the 21st Century, a wave of financial scandals
has brought about the question: Where were the gatekeepers, including the board of directors and external
auditors, in deterring, preventing, and correcting option
grant backdating practices? The PCAOB, the watchdog
of the auditing profession, has issued an audit practice
alert that advises independent auditors that backdating
practices may have implications for audits of both financial statements and internal control over financial
reporting.11
Independent auditors should be skeptical about
backdating and spring-loading, and they should pay particular attention to the disclosures of ESO plans and
grants. They also should be skeptical that management
may intentionally withhold critical information on ESO
grants, such as their valuation, measurement, recognition, or timing. For example, nonrecognition of compensation costs of ESOs can result in misstated
financial statements because the auditors fail to discover those costs.
One important question being asked is: Is it within
the scope of the audit to examine all legal documents to
determine the legitimacy and accuracy of grant dates of
ESOs? If the answer is, yes, then why did independent
auditors not find false grant dates? For auditors, the
PCAOB’s Audit Practice Alert addresses reports and
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tion plan that aligns the interests of executives
with those of shareholders and links executive
pay with performance while providing the necessary incentives to retain well-performing
executives.
2. Ensuring that the company is in compliance with
SEC executive compensation disclosure rules
requiring accurate and complete disclosure of the
process used by the company’s board to determine executive compensation, making executive
compensation transparent to shareholders.
3. Working with the company’s compensation committee to prepare the required report that states
whether the committee has reviewed the Compensation Discussion and Analysis with management and has recommended that it be included
in filing reports with the SEC (Form 10-K).
4. Ensuring the proper recognition of compensation
expenses under SFAS No. 123(R) by using reasonable assumptions in determining the fair value
of options and key grant information and assumptions relevant to compensation expense
disclosure.
5. Reviewing court rulings (e.g., Del. Ch., Feb. 6,
2007, In re Tyson Foods) that suggest backdating
and spring-loading could be illegal and create significant liability for directors, particularly those on
compensation committees.
6. Assessing the overall tax consequences of option
backdating practices, particularly IRS rulings that
require employees who innocently cashed in
backdated options in 2006 to pay extra tax, which
may increase their tax rate from 35% of the profits to 55%.
7. Considering scheduled grants that are always filed
on the same date (e.g., at quarterly earnings
announcements or shareholders’ annual meetings)
that can hardly be prone to backdating.
8. Ensuring compliance with the SEC-required
option disclosures, including the total number of
ESO grants, cancellations, and exercises each
year as well as annual average strike prices and
terms.
9. Ensuring proper and timely filings of SEC
Forms 3, 4, and 5 concerning all transactions per-
disclosures about public companies’ practices related to
the granting of ESOs, including possible backdating.
The practices, whether legal or not, may have implications for audits of both financial statements and of
internal control over financial reporting, particularly
when companies announce restatements of their financial statements as a result.
H O W M A N A G E M E N T A C C O U N TA N T S
CAN HELP
Backdating ESO grants and related practices can have
detrimental effects on implicated companies and their
financial reports, including:
◆ An understatement of compensation costs and
lack of proper disclosures to shareholders;
◆ Distortions in reported earnings and resulting
income taxes;
◆ Restatements of financial statements;
◆ Loss of executives’ and directors’ jobs;
◆ Criminal charges against executives, legal counsel,
and directors; and
◆ Delay in filing quarterly financial statements with
the SEC.
These adversarial consequences raise serious concerns about management integrity, leading to erosion in
investor confidence and significant declines in stock
prices. It is the responsibility of all corporate gatekeepers, including the board of directors (particularly the
compensation committee), legal counsel, and independent auditor, to prevent further problems. Management
accountants should help gatekeepers effectively discharge their responsibility by complying with regulatory
requirements, accounting standards, and tax rules.
Backdating and related probes result in federal investigations and have detrimental effects on corporate governance, internal controls, and financial reporting. The
determination of these effects requires study of compensation policies and practices at each company. Management accountants can help their organizations
address a wide range of corporate governance, internal
controls, accounting, tax, and economic consequences
of backdating and examine company compensation
policies and practices. They can assist in many ways,
including:
1. Establishing an appropriate executive compensa-
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taining to the company’s stock, including option
grants and exercises for officers, directors, and
owners of more than 10% of outstanding shares.
10. Implementing proper disclosures of employee
and executive stock option policies and practices,
particularly informing shareholders of scheduled
grants that are always linked to specific corporate
events such as quarterly earnings announcements
or certain corporate governance meetings (e.g.,
board meetings or annual shareholder meetings).
Ineffective corporate governance can provide opportunities for backdating, and the persistence of such
practices impacts the effectiveness of corporate governance and internal control as well as the reliability of
financial statements and proper compliance with applicable tax rules, auditing and accounting standards, and
SEC filing requirements.
Management accountants play an important role in
the corporate governance, internal controls, risk assessment, and financial reporting of their organizations, so it
is critical for them to exercise their skills to protect both
the company and its shareholders. ■
E N D N OT E S
1 Glass Lewis & Co., “Yellow Card Trend Alert: Stock Option
Backdating Scandal,” April 12, 2007.
2 Zabihollah Rezaee, Corporate Governance Post-Sarbanes-Oxley,
John Wiley & Sons, Inc., Hoboken, N.J., 2007.
3 Stephen Taub, “First Convicted Backdater Sentenced to
Prison,” CFO.com, January 16, 2008.
4 The Corporate Library, “The Spread of Options Backdating: A
Closer Look at the Boards and Directors Involved,” October 2,
2006.
5 Gretchen Morgenson, “Options Fiesta, and Investors Paid the
Bill,” The New York Times, July 30, 2006.
6 Glass Lewis & Co., 2007.
7 Rachel Beck, “Companies Review Stock Option Accounting,”
AP Online, November 22, 2005.
8 David Zion and Bill Carcache, “The Cost of Employee Stock
Options, Part II,” Credit Suisse First Boston Equity Research,
January 21, 2006.
9 Patrick McCabe and Paul Borden, “Tax Issues Arising Out
of Stock Options Backdating Investigations,” Morrison
and Foerster, June 23, 2006. Available at:
www.mofo.com/news/updates/files/update02204.html.
10 Internal Revenue Service (IRS), “Compliance Resolution Program for Employees Other than Corporate Insiders for Additional 2006 Taxes Arising under §409N Due to the Exercise of
Stock Rights, Announcement 2007-18, February 26, 2007.
11 Public Company Accounting Oversight Board (PCAOB), “Staff
Audit Practice Alert No. 1: Matters Related to Timing and
Accounting for Option Grants,” PCAOB, July 28, 2006.
Zabihollah Rezaee, Ph.D., CMA, CPA, is a professor of
accountancy at the Fogelman College of Business and Economics at The University of Memphis. You can contact him
at (901) 678-4652 or [email protected].
Craig Langstraat, J.D., CPA, is a professor of accountancy
at the Fogelman College of Business and Economics at The
University of Memphis. Contact him at (901) 678-4577 or
[email protected].
John Malloy, Ph.D., J.D., CPA, is a professor of accountancy at the Fogelman College of Business and Economics at
The University of Memphis. You can contact John at (901)
678-4041 or [email protected].
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
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