Pervasive 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 (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.
SIGNIFICANCE OF EMPLOYEE STOCK OPTIONS
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. 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 pre-approval 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-the-money," 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 "at-the-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. …