Backdating Employee Stock Options: Accounting and Legal Implications

Summary

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Until recently, financial research has been puzzled by an unusual pattern of stock returns during the period surrounding stock option grant dates for CEOs and other top executives. Financial accounting and reporting standards clearly define the appropriate accounting treatment when employees receive stock-based compensation. Examples of stock-based employee compensation plans include stock purchase plans, stock options, restricted stock, and stock appreciation rights. In most instances, determining the measurement date is not difficult because corporate governance provisions, stock option plans, and applicable laws specify the required granting actions that would confirm the stock option grant and establish the measurement date. Some backdating companies used incorrect stock-option measurement dates because all required granting actions were not complete. Backdating occurs when an employee stock-option grant reflects a grant measurement date earlier than the true grant measurement date. From an accounting perspective, backdating practices that involve the concealed award of in-the-money stock options result in misleading financial statements because employee-compensation expenses are hidden.

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Backdating Employee Stock Options: Accounting and Legal Implications

Until recently, financial research has been puzzled by an unusual pattern of stock returns during the period surrounding stock option grant dates for CEOs and other top executives. David Yermack ("Good Timing: CEO Stock Option Awards and Company News Announcements," Journal of Finance, vol. 52, no. 2, June 1997) and Keith W. Chauvin and Catherine Shenoy ("Stock Price Decreases Prior To Executive Stock Option Grants," Journal of Corporate Finance, vol. 7, no. 1, March 2001) first documented that stock prices tend to fall in the period before, and rise in the period following, employee stock option grant dates. Such circumstantial evidence suggested that companies withhold good news or publish bad news prior to long-term employee stock option awards to reduce stock prices. Erik lie ("On the Timing of CEO Stock Option Awards," Management Science, vol. 51, no. 5, May 2005) dug deeper into this phenomenon, documenting an unusual pattern of negative returns prior to option-award grant dates that reversed in the post-grant date period. lie concluded: "Unless executives have an inf...

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