Stock Option Backdating - Essay Example

Over the past few months, triggered by a study by Erik Lie and Randall Heron in late 2005, many companies have been scurrying to conduct independent internal investigations on stock option backdating or came under the scrutiny of the Securities and Exchange Commission (SEC). According to a report by Wall Street Journal Online (2006), as of 11 July 2006, 63 companies have been involved in stock option backdating. Apple and Apollo are among the latest additions to the list (Forelle and Maremont, 2006; Grant and Nuttall, 2006). Backdating can take on several meanings. The most culpable form of backdating involves "intentionally changing the date used to set an option's exercise price to one on which the stock's price was at a low" (Ellsworth et al., 2006). This form of backdating was abetted by the relatively lax legislation before the Sarbanes-Oxley Act was enacted in 2002. The Sarbanese-Oxley Act mandated that stock options be filed within 2 days after they are granted (FindLaw, 2002), mitigating the backdating problem. Before the Sarbanese-Oxley Act came into effect, option grants were reported using Form 5 which primary use is for the disclosure of "the transactions and holdings of directors, officers, and beneficial owners of registered companies" (Securities and Exchange Commission, n.d.). Furthermore, the form is required to be filed only "on or before the 45th day after the end of the issuer's fiscal year" (Securities and Exchange Commission, n.d.). This essentially means that if the stock options were granted early in the fiscal year, investors would not come to know of them until almost 1 year later, giving more leeway for insiders to manipulate the date on which the exercise price was established. Most of the 63 companies involved in stock option backdating "relate to a roughly six-year period prior to the Sarbanes-Oxley legislation" (Grant and Nuttall, 2006). For example, irregularities are observed in the exercise price of the stock options granted by Apple Computer Inc between the period of 1997 and 2001 (Grant and Nuttall, 2006). The second form of backdating refers to "company actions and policies that had the effect of causing an option to be granted with an exercise price that was lower than it should have been under applicable rules" (Ellsworth et al., 2006). Such company actions and policies include sloppy documentation, delays in the grant approval process, and the wrong interpretation of APB Opinion No. 25 Accounting for Stock Issued to Employees (Ellsworth et al., 2006). Summary of Statement No. 123 Accounting for Stock Issued to Employees prescribes that the intrinsic value or fair value based method of accounting be used for the valuation of stock options (Financial Accounting Standards Board, 1995). Most companies continue with the intrinsic value based method of accounting (Ellsworth et al., 2006). Under the intrinsic value based method, "compensation cost is the excess, if any, of the quoted market price of the stock at grant date or other measurement date over the amount an employee must pay to acquire the stock" (Financial Accounting Standards Board, 1995). If company actions are efficient, the measurement date would be the same as the grant date, and no compensation cost is recorded. More often than not, due to procedures such as the signing of the resolution by the directors, the measurement date would be at a later date than the grant date. If the price of the underlying stock has risen over the period between the measurement date and the grant date, the stock option is in the money and the difference should be recognized as compensation expense. Backdating occurs when companies, whether intentionally or unintentionally, choose to use the price of the underlying stock on the grant date as the basis for measuring the compensation cost. An example of the above form of backdating of stock options is Michaels Stores Inc., which understated compensation expenses by as much as $60 million between 1990 and 2001 (Bulkeley, 2006; Maremont, 2006). Michaels Stores Inc. chose the exercise price of the options based on an "earlier effective date of the options" (Bulkeley, 2006; Maremont, 2006). The last form of backdating of stock options manifests in "the practice of timing option grants to take advantage of stock price moves expected as a result of not-yet-public company development" (Ellsworth et al., 2006). This is a gray area under the laws (Forelle and Maremont, 2006). An example of this form of backdating of stock options could be seen in the case of Apollo Group (Forelle and Maremont, 2006). The acting executive chairman - John Sperling of Apollo received 5 grants of stock options between 1995 and 2001, all of which fell on dates that happened to the low of the underlying stock. According to Forelle and Maremont (2006), "One, in January 2000, carried an exercise price equal to the year's lowest closing price." "Another, in December 2000, was at the fourth quarter's low. Another carried the lowest closing price of 2001's second half." Forelle and Maremont (2006) continued. The grant issued in December 2000 was dated 2 days before Apollo released better than expected quarterly earning results (Forelle and Maremont, 2006). Backdating stock options in itself does not violate the laws. However, it leads to tax and accounting implications. The current rule governing the accounting of stock options as a form of employee compensation is Statement of Financial Accounting Standards No. 123 (revised) Share-Based Payment effective 2005 that supercedes Statement of Financial Accounting Standards No. 123 Accounting for Stock-Based Compensation effective December 1995 (Financial Accounting Standards Board, 1995; Financial Accounting Standards Board, 2004). Statement of Financial Accounting Standards No. 123 Accounting for Stock-Based Compensation indicates a preference for a fair value based method of accounting for stock options granted to employees as compensation (Financial Accounting Standards Board, 1995). Though at the same time, it also allows the intrinsic value based method to be used in accordance with APB Opinion No. 25 Accounting for Stock Issued to Employees (Financial Accounting Standards Board, 1995). Under the fair value based method, compensation expense is measured as the fair value of the stock options on the date they are granted and expensed over the vesting period (Financial Accounting Standards Board, 1995). The fair value of the stock options is calculated using option-pricing models (Financial Accounting Standards Board, 1995). Under the intrinsic value based method, compensation is the excess, if any, of the market price of the underlying stock of the stock options over the exercise price of the stock options (Financial Accounting Standards Board, 1995). Where the intrinsic value based method is used, Statement of Financial Accounting Standards No. 123 Accounting for Stock-Based Compensation stipulates that a pro forma statement of net income and earnings per share must be prepared on the basis of the fair value based method (Financial Accounting Standards Board, 1995). If the measurement date is the same as the grant date, the intrinsic value of the stock option would be zero and no compensation expense would be recorded. Invariably, due to its favorable effect on the profit and loss statement, the intrinsic value method is the pervasive method of accounting for stock options as a form of employee compensation (Ellsworth et al., 2006). If stock options are backdated such that they are granted to the employees at a discount, then the difference between the strike price and the price of the underlying stock as at the date of the measurement date should be recorded as compensation expenses. However, many companies have not recorded such compensation expenses arising from the backdating of stock options. Moreover, by hiding the compensation expense in the notes to the accounts, Statement of Financial Accounting Standards No. 123 Accounting for Stock-Based Compensation only serves to abet the practice of stock option backdating. To address the concerns of investors of the accurate reflection of compensation costs on the financial statements and improve the comparability of financial statements, Statement of Financial Accounting Standards No. 123 (revised) Share-Based Payment was promulgated in 2004 (Financial Accounting Standards Board, 2004). This standard eliminates the use of the intrinsic value based method (Financial Accounting Standards Board, 2004). This standard has improved the visibility of employee compensation on the financial statements. However, it has not eliminated the problem of stock option backdating by employees to increase their earnings as described earlier. To fix the stock option backdating problem, the Securities and Exchange Commission might reduce the window of reporting of stock option grants from the current two days to same day reporting. Also, in order to prevent company executives from choosing dates on which the stock bottoms out, the Financial Accounting Standard Boards could further specify that the grant date be fixed on certain days to eliminate any foul play. But doing so would not eliminate the timing of news by employees either. As such, a better method of valuing stock options would be dollar averaging. This method would be fair to both the employees and the stockholders. Furthermore, other than the expensing of employee stock options compensation, it could further require the disclosure of who owns the bulk of the stock options. This should reveal the amount of compensation that the high-powered executives are obtaining. REFERENCES Bulkeley, W.M. (2006, June 15). Michaels Understated Expenses due to Past Options Backdating. Wall Street Journal, A.11. Ellsworth, A.M., Levis, J., Allen, C., Slocum, E., & Stasz, J. (2006, June 23). Stock Option Backdating - What Investors Need to Know. Retrieved July 13, 2006, from http://64.233.167.104/searchq=cache:FD9c1bUAsT4J:www.issproxy.com/pdf/CIIAlert2006.pdf+%22stock+option+backdating%22%22financial+accounting%22&hl=en&ct=clnk&cd=1 Financial Accounting Standards Board (1995, October). Summary of Statement No. 123: Accounting for Stock-Based Compensation (Issued 10/95). Retrieved July 13, 2006, from http://www.fasb.org/st/summary/stsum123.shtml Financial Accounting Standards Board (2004). Summary of Statement No. 123 (Revised 2004): Share-Based Payment. Retrieved July 13, 2006, from http://www.fasb.org/st/summary/stsum123r.shtml FindLaw (2002, January 23). One Hundred Seventh Congress of the United States of America. Retrieved July 13, 2006, from http://fl1.findlaw.com/news.findlaw.com/cnn/docs/gwbush/sarbanesoxley072302.pdf Forelle, C. & Maremount, M. (2006, June 12). Monsters Worldwide Gave Officials Options Ahead of Share Run-ups. The Wall Street Journal, A.1. Grant, J., & Nuttall, C. (2006, June 30). Apple Shares Fall on Stock Option Fears. Financial Times, 26. Maremont, M. (2006, June 9). Michaels Stores Reports Stock-Options Problems. Wall Street Journal, A.10. Securities and Exchange Commission. (n.d.). Form 5: Annual Statement of Beneficial Ownership of Securities. Retrieved July 13, 2006, from http://www.sec.gov/about/forms/form5data.pdf Wall Street Journal Online. (2006, July 11). Perfect Payday: Options Scorecard. Retrieved July 13, 2006, from http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html Read More