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Companies would simply wait for a period in which the company's stock price fell to a low and then moved higher within a two-month period.The company would then grant the option but date it at or near its lowest point.The Wall Street Journal (see discussion of article below) pointed out a CEO option grant dated October 1998.The number of shares subject to option was 250,000 and the exercise price was (the trough in the stock price graph below.) Given a year-end price of , the intrinsic value of the options at the end of the year was (-) x 250,000 = ,750,000.Options backdating occurs when companies grant options to their executives that correspond to a day where there was a significantly lower share price.It is suspected that these situations are not a coincidence and that the board or executives were granted options based on a past date in order to make these options more profitable.ESOs are usually granted at-the-money, i.e., the exercise price of the options is set to equal the market price of the underlying stock on the grant date.Because the option value is higher if the exercise price is lower, executives prefer to be granted options when the stock price is at its lowest.
For example, suppose that it is August 16, 2006, and the closing share price of XYZ Corp. On June 1, 2006, XYZ Corp.'s stock price was at a six-month low of .
Most shareholder approved option plans prohibit in-the-money option grants (and thus, backdating to create in-the-money grants) by requiring that option exercise prices must be no less than the fair market value of the stock on the date when the grant decision is made. For example, because backdating is used to choose a grant date with a lower price than on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant.
(Under APB 25, the accounting rule that was in effect until 2005, firms did not have to expense options at all unless they were in-the-money.
Options backdating defeats the purpose of linking an executive's compensation to the company's performance, because the bearer of the options will already have experienced a gain.
In the past, granted options were only required to be disclosed to the Securities and Exchange Commission (SEC) within two months of the options being granted, which gives companies a window for backdating.
This is the granted option that would be reported to the SEC.