Back dating of stock option

In 1972, a new revision (APB 25) in accounting rules resulted in the ability of any company to avoid having to report executive incomes as an expense to their shareholders if the income resulted from an issuance of “at the money” stock options.In essence, the revision enabled companies to increase executive compensation without informing their shareholders if the compensation was in the form of stock options contracts that would only become valuable if the underlying stock price were to increase at a later time.

(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.

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.

Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options.

An example illustrates the potential benefit of backdating to the recipient.

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