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According to allegations in the investigation that began in late
2004 by the Securities and Exchange Commission (SEC), some
companies went a step further by backdating the grant dates
to a time when the stock price was lower than the actual date.
This meant the options were actually "in the money" at the
time of the grant and therefore should have been expensed by
the company and reported as taxable income
by the managers to the IRS. Backdating per se
is not illegal as long as certain conditions are
met, namely no documents have been forged,
it is clearly communicated to the company’s
shareholders, and it is properly reflected in
earnings and taxes. Unfortunately, according
to the researchers who initially uncovered
the backdating pattern, these conditions are
rarely met.
As of August, executives from only one
company, Brocade Communications, had been
indicted by the SEC, but there are reports
that the commission is investigating more than
60 other companies.
On the surface, backdating may seem like a
victimless crime, but Brown said that like
the Enron scandal, this is a major corporate
governance issue that rewards executives at
the expense of shareholders. "What’s going
on here is fraud. When not properly reported,
backdating does several things. First, it allows
a firm to act as if it has more income than it does. Second, it
inflates the amount of taxes a firm is required to pay. And third,
it gives shareholders the misconception that stock options are
tied to performance when they are not." Brown added, "One of
the more ironic issues here is that these firms reported higher
income than they actually had and therefore paid more taxes than
they should have, which robbed shareholders. Amazingly, some
of these companies are likely to be looking for a tax refund."
So how was backdating even possible?
According to Brown, two things were at play. First, based on the
accounting standards that were in place at the time, companies
were only required to show as an expense on their financial
statements stock option grants that were "in the money" at the
date of the grant. Since they claimed the grants were "out of the money,"
there was no need to show them as an expense.
The second issue is that new grants didn’t need to be reported
for 45 days after the end of the fiscal year in which the options
were granted. Since Enron, however, the rules have changed.
The Sarbanes-Oxley Act of 2002 (SOX) requires all companies
to report grants within two days of being issued. Additionally, the
Financial Accounting Standards Board (FASB) now
requires all stock option grants to be reported as
an expense regardless of whether or not they are
"in the money."
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