It seems like large companies are falling
more and more under the microscope
for various financial wrongdoings. One of those wrongdoings is stock option back-dating.
Dana R. Hermanson, Dinos Eminent
Scholar chair of private enterprise and professor of accounting in the Coles College of
Business at Kennesaw State University,
says evidence of backdating is widespread
and companies need to perform internal
audits to make sure they aren’t penalized
by an investigative agency.
Smart Business spoke with Hermanson
about what exactly stock option backdating
is, why so many companies are being scrutinized for it, and what those companies can
do to make sure they’re on the up-and-up.
What exactly is stock option backdating and
why are so many companies now being scrutinized for this?
Stock option backdating is lying about the
date that stock options were granted to executives or employees so as to make the
options more valuable. For example, assume
that ABC Company issues three-year options
for 100,000 shares to an executive on June 13,
when the company’s stock price is $22 per
share. The stock options give the executive
the right to buy the company’s stock for $22
per share three or more years from then. This
executive then has an incentive to work hard
to increase the stock price in the future — so
he or she can buy the stock for $22 and resell
it for much more.
Apparently, some companies secretly
backdated their options so that those
options were more valuable to the person
receiving them. In the example above, the
company might ‘pretend’ that the options
really were issued on April 11, when the
company’s stock price was only $14 per
share. This backdating of the options
means that the executive is getting options
on June 13 with an exercise price of $14
when the market price has already risen to
$22. The options are already ‘in the money’
by $8 per share rather than being ‘at the
money’ — where the exercise price equals
the market price on the grant date. In this
manner, the incentive compensation scheme has been rigged, as the executive
already has paper profits of $8 per share
when the grant is made. Shareholders are
the big losers in this deal.
Building upon previous work by professor David Yermack at NYU, professor Erik
Lie at the University of Iowa provided evidence suggesting widespread backdating.
He found that stock prices typically
dropped just before option grants and rose
after the grants. Either the executives
receiving options had been incredibly
lucky, or someone was secretly fudging the
grant dates. Following Lie’s research, regulators started to investigate.
Why have technology companies fallen victim to the most severe scrutiny?
Tech companies have traditionally been
very heavy users of stock options, so it’s
not surprising that many of the backdating
allegations have been in this sector. Tech
companies often have limited cash flow
during their early years, so it’s difficult for
them to afford high salaries. These companies have attracted talent by using options
to provide potentially large payoffs. Also,
many tech companies have vigorously fought against the expensing of stock
options, so some tech companies might
not have held the accounting rules for
stock options in very high regard.
What steps can they take to solve the problem?
Solving the problem will require serious
and sincere effort on the part of the board of
directors. Executives involved in backdating may need to be fired, and the company
will need to notify regulators of the problem
and fix its internal control weaknesses. It
also is critical to communicate with shareholders about the impact on the company.
Ultimately, the board will need to focus on
repairing the company’s reputation and on
setting a clear tone that such behavior will
not be tolerated.
What sort of actions or penalties can a company face if wrongdoing is found?
Companies that secretly backdated their
options avoided recording compensation
expense and, therefore, overstated their
profits. We are seeing numerous restatements of previous financials due to understated compensation expense. In addition
to restatements of previous financial
results, companies engaged in this practice
can expect Securities and Exchange
Commission (SEC) investigations and possibly civil sanctions. Even more serious,
some executives involved in backdating
face criminal investigations or charges,
and several executives have been fired.
Is backdating now a thing of the past?
The Sarbanes-Oxley Act now has made it
more difficult to secretly backdate options.
However, Lie and professor Randall Heron
of Indiana University recently found evidence that backdating still is occurring, but
to a lesser extent.
DANA R. HERMANSON is Dinos Eminent Scholar chair of private enterprise and professor of accounting in the Coles College
of Business at Kennesaw State University. Reach him at (770)
423-6077 or [email protected].