Backdated Stock Options: Crosscurrents from GAAP to the Capital Markets

Abstract

Stock options are a major component of executive pay in America today. With this popularity comes opportunities for individuals to improperly enrich themselves through manipulation of key dates related to the stock options (backdating). At this date, over 150 publicly traded companies are under investigation for the improper backdating of stock options. The first section of this paper illustrates stock option mechanics and outlines the prior and current accounting treatment of stock options. It also summarizes recent related legal activity and recent academic research. The paper then analyzes the impact of backdating on financial reports, sharehold proxies, and income tax compliance. The second section of the paper identifies commonalities associated with companies under investigation for backdated stock options. This involves an analysis of external auditors, SIC codes, corporate headquarter location and company compliance with Section 404 of the Sarbanes-Oxley Act. The final section of the paper analyzes capital market reaction to companies under investigation for backdating stock options. The analysis identifies a clear stock price underperformance of those investigating companies when compared to a peer group. It also identifies a drop in the observed price earnings ratio when compared to the same peer group as well as a decrease in the average beta coefficient for companies investigating the backdating of stock options.